2nd Quarter 2014
The second quarter of 2014 proved to be a relatively calm period in international equity markets, with the performance of the major regions tracking broadly sideways with little volatility. Overall, the Fund’s MSCI EAFE Index benchmark rose by 4.1%.
Although there was some divergence in regional performances during April—with Japan the laggard after the Bank of Japan passed on the opportunity to increase the already huge stimulus applied to the Japanese economy—these had reverted by quarter-end to leave a relatively tight spread of returns around the index, with Japan leading the pack. In Europe, the positive news of the European Central Bank (ECB) announcing its willingness to use a broad array of measures to head off the prospect of deflation in the Eurozone, was largely offset by investor concerns about the on-going conflict in Ukraine and the spread of Syria’s civil war into Iraq.
Japan’s recovery after April was the product of economic data releases that showed first quarter Gross Domestic Product (GDP) growing at its fastest pace in nearly three years and rising inflation numbers (both likely the result of buying ahead of April’s 3% sales tax increase). While second quarter and May-onwards data should gradually build a real picture of the impact of the tax hike, investors viewed the numbers positively against the backdrop of otherwise relatively weak Japanese equity performance thus far this year.
The spread of returns was also relatively tight on the sector level. Energy was the only real exception, as the sector responded well to rising oil prices during the period. This was particularly the case in June with developments in Ukraine and then Iraq. Otherwise, the index was marginally led by traditionally defensive sectors—Consumer Staples, Healthcare and Utilities—while more cyclical sectors lagged.
Struggling Pharma Picks
The Fund underperformed the benchmark since its April 14 inception through the end of the quarter. The principal driver was poor stock selection in Europe and within the Healthcare and Consumer Discretionary sectors, notably Thrombogenics, H Lundbeck, and Zon Optimus.
Pharmaceutical companies Thrombogenics and H Lundbeck, based in Belgium and Denmark respectively, were two of the biggest detractors during the period. Despite difficulties the past 18 months, we favored Thrombogenics on the belief in the efficacy of its principal drug Jetrea as a unique, non-surgical treatment for VMA (vitreo macular adhesion). After the stock spiked up in April on takeover rumors, it sank on revelations of potential safety concerns with Jetrea in the U.S., its largest target market. With our investment case broken, we decided to sell the position from the portfolio, but not before further news from management of a failed takeover process and search for a U.S. co-promotion partner hit the stock again.
H Lundbeck fell despite generally positive news about its drug pipeline and clinical study results. The two negative news elements behind the weakness were that the January launch of key drug Brintellix (anti-depressant) was solid rather than stellar in terms of early sales, and that Desmoteplase (stroke drug) failed a phase III clinical trial and any further development is likely to be dropped. The failure of Desmoteplase, while not a positive, was not a great negative in terms of our valuation and not a core part of our investment case. On the positive side, Lundbeck completed the acquisition of Chelsea Therapeutics during the quarter, which brings into the fold an established drug for launch in new markets. Critically, this drug should help the firm bridge an earnings and cash flow gap until Brintellix reaches peak sales beyond 2017. We maintained the position in the Fund.
Portuguese broadcast media firm Zon Optimus declined on rumors that rival Vodafone is to be more aggressive on the pricing of triple-play media bundles in the Portuguese market. The development remains a rumor, and the company’s first quarter earnings announcement confirmed that growth in its own bundled service offerings has been strong and remains on a trajectory that is solidly supportive of our investment thesis.
Four of the top-five contributors to relative performance were Japanese companies, including Inpex and Nippon Telegraph & Telephone (NTT). Oil/gas exploration and production company Inpex rose strongly in response to the stronger oil price but also on the announcement that a key project, Ichthys, had reached 50% completion and is both on track and on budget.
NTT posted strong gains due mainly to regulatory changes that will indirectly allow it to bundle the fibre services of NTT with the cellular services of its DoCoMo subsidiary. To promote competition, NTT has historically been banned from bundling services, allowing competitors KDDI and Softbank to grow via more rounded product offerings. The changes allow NTT to wholesale its fibre network capacity to third parties, DoCoMo included. This first step towards an official sanction of bundling is also a first step towards NTT being able to stem the steady decline in market share that it has experienced since the government broke its telecom monopoly in the mid-2000s.
Outside of Japan, Hong Kong real estate conglomerate PCCW made a notable contribution as it rose on the announcement that its telecoms subsidiary (Hong Kong Trust) was acquiring cellular competitor CSL. The move creates the potential for cost savings and operational synergies, and we think should bring better order to a market that has seen multiple episodes of disruptive price competition.
Buys and Sells
Portfolio activity during the quarter was focused on selling stocks that reached our assessment of fair value, particularly in Europe, and replacing them with new ideas that we believed had a more attractive risk/reward profile (largely companies in Japan and the Pacific ex-Japan region). The result was an increase the underweight in Europe relative to benchmark (now more than 10%) and a corresponding increase in the overweight in Japan and Pacific ex-Japan.
New additions included Softbank, Fujitec, and Spotless. Japanese conglomerate Softbank has grown to be the third largest telecoms company in the world through a series of acquisitions and strategic investments. This strong record augurs well for the future, but our investment case is based on what we believe to be the undervaluation of existing assets like Softbank Mobile and Yahoo Japan. It also reflects two key events: the IPO of Chinese e-commerce giant Alibaba (in which Softbank has a 34% stake) and the success or not of the planned merger of Sprint (owned by Softbank) and T-Mobile in the U.S. Assuming that the historic order returns to cellular pricing in Softbank’s domestic market (there has been a price war with DoCoMo), we believe the stock is very cheap, and that much of the risk from current levels is skewed to the upside.
Fujitec is Japan’s only dedicated manufacturer, distributor, and operator of elevators and escalators but is only eighth globally with approximately a 2% share of the market. The market has grown consistently due to increased urbanization in Emerging Markets, particularly China, which currently represents around 60% of new installations. Like its peers, Fujitec’s business model is classic “razors and razor blades”—new installations are carried out at small margins with the main contribution to profits coming from long-term service and refurbishment contracts. The Japanese government has also recently mandated that the entire stock of elevators in Japan needs to meet more stringent safety standards. We think Fujitec trades at a significant discount to its global peers (Kone and Schindler are the quoted pure plays). Add in an attractive mix of exposure to Asian markets (including India), and we believe that the valuation discount to its global peers will narrow.
Commercial cleaning and waste management firm Spotless is the leading provider of outsourced facility services in Australia and New Zealand and listed via an initial public offering (IPO) in May. Outsourcing in Australia is expected to grow rapidly over the coming years, led by central and state governments and through government-mandated policies in the health, education and commercial/leisure sectors. The firm’s business model provides good stability and long-term visible revenues once contracts are secured. The IPO offer came to market at a price only just above that implied by our “bear case” valuation (assuming no growth in the company’s operations from this point onwards), and considerably below that implied by a still conservative central case valuation. With the risk skewed significantly to the upside for an attractive business in an expanding market, we participated in the IPO.
In addition to the sale of Thrombogenics noted above, we sold two stocks that performed well and reached or traded close to our estimate of intrinsic value during the quarter, namely cellular network provider Ericsson and Japanese condominium builder Daito Trust Construction. In addition, two stocks were sold because they failed to meet our expectations.
Oil services firm Transocean was cut from the portfolio on signs that a favorable day-rate environment (one of the initial “pillars” of the investment case) has turned negative in the face of new capacity coming on stream. We knew the capacity was in development, but had believed that the other elements of the thesis would play out by the time it did. This has not been the case and lower day-rate environment creates a headwind that undermines our valuation assumptions.
We sold African oil exploration and production firm Tullow Oil (based in the UK) in June after a strong performance during the quarter on the back of rising oil prices, but a disappointing longer term story. The decision to sell was in part specific to Tullow, and partly related to the higher levels of conviction developing in the other stocks held in the Energy sector. The firm’s previously industry leading record of exploration success has turned negative recently, pushing out the timescale over which value might be realised. Other positions across the sector have either shorter duration return profiles, or longer term profiles in which we have higher conviction. We therefore took advantage of recent strength to sell out of the stock.
Equity markets have continued to rise in recent months, with the riskiest assets making the strongest gains. Economic data has been encouraging, especially in the European periphery, and this has also helped to propel the re-rating of equities, but central banks continue to pump record levels of money into distorted currency and capital markets, though we are now seeing the first signs of a decoupling of monetary policies. Although we continue to find attractive opportunities at the individual stock level, equity markets more broadly are currently trading at or above average valuations with the improvement in fundamentals already discounted, in our view. With a policy of near-zero short-term rates and signs of euphoria in equity markets (more IPOs, more junk bond issues, etc.), equity investors could be facing a “lose/lose” situation. Any signs of economic strength will be negative for interest rates (and equities), while should real activity fail to pick up, current equity valuations will begin to look rather rich. We therefore continue to expect the next few months to be more challenging than was the latter part of 2013. We expect greater volatility, characterised in particular by a tug-of-war between improved economic momentum and anxiety about a potential change in Federal Reserve and other central bank policies.
The rise in equity markets and lessened upside potential has prompted us to shift the portfolio towards a more defensive stance that is not necessarily reflected in the current sector exposure but it is clearly exhibited from the operating characteristic of stocks recently purchased. In our opinion, these new positions offer higher visibility of cash flow growth and, importantly, potential downside protection. Indeed, over recent months we have, at the margin, added to Healthcare and Consumer Staple names, and reduced exposure to Financials. From a regional point of view, this has led to a significant underweight in Europe to the benefit of Asia.
In doing this we have maintained our process focus on identifying opportunities to hold attractive franchises at compelling prices. We will not simply buy companies that look cheap, but seek companies with recurring and visible cash flow streams that we believe are unduly penalized by investors. We hope to further exploit valuation anomalies created in what is likely to remain a volatile environment.
Pictet Asset Management
As of June 30, 2014, Thrombogenics comprised 0.00% of the portfolio’s assets, H Lundbeck – 1.48%, Zon Optimus – 1.34%, Inpex – 2.22%, Nippon Telephone & Telegraph – 1.26%, Softbank – 1.80%, PCCW – 1.75%, Fujitec – 0.75%, and Spotless – 0.77%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.