Man GLG Continental European Growth Fund – latest update

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  • 30 mins 01 secs
Rory Powe, Portfolio Manager, Man GLG, discusses the Man GLG Continental European Fund and the performance of the fund in 2018 to date, and answers the questions you want to know.

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WARREN SHIELS: Hello, and a warm welcome to Man GLG Continental European conference call with Rory Powe, Portfolio Manager, and myself, Warren Shields, Director within UK retail sales. We’ll follow our usual format for these quarterly calls. In a moment I’ll ask Rory to provide an update on the strategy, with the slides you can access and follow online. On this conference call, Rory will provide an update on the performance of the fund, covering Q3 and year to date. He will discuss the strategy and cover the portfolio positioning which we hope you will find useful. I will now hand over to Rory.

RORY POWE: Good morning everybody and thank you for making the time to listen in to this call. I’m going to turn to page 4, where I’m going to address performance in this year 2018 to date. And after I’ve talked about performance I’ll talk about the strategy of the portfolio, where there has been little change. And I will then look at how the portfolio is positioned today. And again there’s been no dramatic changes compared to how we were positioned for example at the beginning of this year.

But if we just look at page 4, you can see that the fund enjoyed a very strong period of performance in the first eight months of the year, both in absolute and relative terms, when stock selection much more than the sector profile of the fund contributed to the strong performance of the fund. But we then had a very poor September, where you can see that the unit price was down by 3.7% and, conversely, the index was barely down only ½%. So that was a poor month. And in a way September was a trend that continued into October. But before I talk about October, because of September the fund finished Q3, and that’s really I think formally the quarter that this call is meant to focus upon.

But I don’t think there’s much point because October renders Q3 less important, but we finished Q3 down marginally in absolute terms, but quite materially from a relative perspective. In October the fund fell by 9%, and that was disappointing, both from an absolute and more importantly a relative point of view. And I’ll talk in a minute about why our performance in both September and October has been so weak, both from an absolute and relative point of view; having said that, inclusive of this poor recent period of performance, the fund is still ahead of its benchmark calendar 2018 to the end of October by 2.6 percentage points – if there’s a silver lining that is the silver lining.

But let’s talk about the cloud on page 5, which is recent performance. And I think, you know, we are, I am as a portfolio manager disappointed by the recent performance, and volatility in the last 48 months or so during which time we’ve run this fund, and we being myself and my team, obviously it’s been a Man GLG fund for some time, the fund has been pretty resilient during difficult periods of market performance. But this wasn’t the case in September and October. And I think the portfolio was in the eye of the storm. And I would describe what’s happened recently as a perfect storm, more on that in a minute. But one symptom of the risk aversion that reared its ugly head in September, and more so in October, was a very brutal rotation out of growth stocks.

Which given the growth bias of the portfolio we were vulnerable to that. But that was exacerbated by the fact that I would describe our growth bias as conspicuous growth. You can quantify that for example by the fact that on our estimates the portfolio overall should deliver a 13% CAGR in EPS for the five-year period, our forecasting period 2018 to 2022. We always have a five-year rolling forecast period for our stocks. That is good growth. But I think the knives were out in October for stocks that had performed very well year to date, that were enjoying strong growth. And also I would say that the knives were also out for mid and small caps, and the portfolio has a much higher exposure to mid and small caps than the benchmark.

So that is really what happened. And also the portfolio’s lack of exposure to what I would describe as traditional defensives, for example consumer staples, for example utilities and telecoms, did it no favours. And we’ve always made it clear to our investors that our sweet spot exists really between the two poles of our universe. Those poles being on the one hand the banks and the very value oriented end of the spectrum in our universe, and I’d include resource stocks and the industrial cyclicals there. But equally at the other extreme end of the spectrum we tend to avoid traditional defensive stocks; largely because they don’t have adequate growth for what we are looking for. And we would argue we don’t think they’re as defensive as it says on the tin.

For example we think quite a few of the consumer staples are vulnerable to disruption today, and other negative influences. But it didn’t help because the money gravitated to the most defensive realms of the market. Now, we would argue, and I’ll come on to this in a minute, that our portfolio actually has many defensive attributes in the form of the resilience of the economics behind the companies, and I’ll talk about that in more detail. But they’re not I would say stereotypically defensive, unlike the sectors I just mentioned where we have a shortage of representation.

Finally, if I’m talking about September and October, we have to include the fact that Ryanair on the 1st of October downgraded its profit expectations for the year ending March 2019 by approximately 15% if we take the lower end of the new guidance of €1,100m. The reason being, I won’t go in to too much detail now but I’ll happily answer questions on it later if you want. But the main reason for this downgrade was the fact that fares are now more likely to be down approximately 3% in the current year, rather than what they and we expected to be flat fares. And the reason for that was largely strikes, when you have strikes you have to cancel flights, you have to accommodate those passengers on other flights where you’d normally earmark those last minute seats for higher fare tickets; whereas instead they had to devote them to the cancelled passengers. Plus also it’s clear, more clear now with the benefit of hindsight that capacity growth in European short haul over the autumn is running at about 8%, and that’s also contributed to fare weakness. Ryanair remains a core position notwithstanding the difficulties its currently experiencing.

We insist that the investment thesis for it is fully in place. Namely its competitive advantages, most obviously in the form of its low cost per passenger, but also the fact that it’s addressing a structurally growing market which we expect to consolidate in Ryanair’s favour, which long term or even medium term will result in higher fares and better profits per passenger. But Ryanair’s warning on the 1st of October was another factor behind the fund’s very poor performance. It’s a top three position in the portfolio. As a caveat to what I’m saying in the middle of October the nine-month reporting season got going, and we’ve been very pleased with the results from our holdings. And I’d also note that the nadir of both our absolute and relative performance was in the middle of October, which coincided with the beginning of the reporting season, which I don’t think is a coincidence. The fundamentals really need to come back to the fore.

And that brings me on to the strategy, which if I can just set the scene on the next slide, slide 6, and talk about why we think that earnings growth in Europe is going to become more difficult for more companies, and how probably 2017 will prove to be the higher watermark for earnings growth. Not earnings but earnings growth, in that we’re likely to see quite a sharp deceleration in earnings growth here on. And I think we’re talking single digit earnings growth, mid-single digit maybe. If you strip out energy and some of the profits bounces that are taking place with the banks, you’re more really talking about mid-single digit earnings growth across Europe. And that may be challenged in 2019.

And why is it becoming more difficult? Excuse me for just dwelling on this for a moment, but it really does set the scene for how we’re strategically positioned, and why we are in no mood to compromise on the quality of companies that we’re investing in. And our stock selection throughout the last few years, and particularly at the moment, is informed by an insistence upon only investing in what we consider to be Europe’s strongest companies. This is no time to compromise. Why? Because competition is always intense, but I think it’s become more intense in the last few years as the rehabilitation of the banks, plus recovery of the capital markets has made access to capital easier for companies who want to steal the economics of companies enjoying high returns on invested capital. Secondly those competitors, but also new competitors, are taking advantage of quite a few disruptive forces at the moment, which is questioning a lot of business models out there. And that makes us wary of a lot of companies’ so called defensiveness.

Even though the European economy is on track to grow at between 1½% and 2%, I would describe demand as relatively fragile. And I would also note that spending habits are shifting, and consumer behaviour is changing. And so a lot of areas of consumer strength in the past are now seeing that growth shift elsewhere. Plus I think consumers today are better equipped than they have been for many years to find value for money, to search for the lowest price. And I think the hesitant consumer anyway armed with technology to locate the best value for money keeps downward pressure on pricing. This actually makes us quite sanguine about the inflation outlook for Europe, but it doesn’t make us sanguine about margins. We think anyway when you’ve got cost pressures in the form of higher oil prices, but also oil related, other oil related commodities, and also the beginnings of wage inflation in Europe.

Obviously there’s a shortage of labour in Germany, but even in France where you have still quite high unemployment, the construction industry for example at the moment is complaining about a shortage of workers. And we’re likely to see wages rise. And this is going to put pressure on companies that rely heavily upon labour, and maybe have relied too much upon labour and haven’t invested enough in productivity and technology. And so I think that a lot of companies will struggle to pass on these higher costs in the form of higher prices, because of the lack of pricing power. And so you’re going to see a pinch point in margins, rather than inflation at a time when the supply chain is becoming more characterised by tensions caused by economic nationalism, Brexit, and also the ongoing dispute between the US and China.

So I don’t want to depress the audience too much, because thankfully there are still many companies that will grow. But I think if we rely upon the average, if we rely upon investing in average European companies we’re not going to get enough bang for our buck in the form of earnings growth. And as investors in Europe we insist upon getting bang for our buck in the form of not just earnings growth but sustainable earnings growth. And we’ve always made it clear to our investors that it’s the sustainability of the earnings growth that’s more important to us than the quantum of the growth, and the prevalence of competitive advantages that are likely to have staying power – which brings me on to the second piece I want to talk about on strategy on page 7, where I just want to recap on the attributes we’re looking for.

These attributes lead us to companies with strong earnings growth. It’s because of these attributes that the portfolio today on our estimates has a CAGR compounded annual growth rate in our EPS estimates of approximately 13% in the next five years. And we’re looking for companies that firstly have a very strong market position, where they are ongoingly strengthening their competitive advantages. Secondly we want them to enjoy that leadership position in a market where the drivers are structural not cyclical. So our portfolio does not rely upon the vicissitudes of the macroeconomy; instead it relies upon companies getting stronger in markets where the drivers are secular. And it really helps if that high market share corresponds with a fragmented set of customers. Therein we typically find pricing power a rare quality these days, and something that we try to capture in the portfolio, and celebrate in the concentrated nature of that portfolio.

Resilience is also crucial at a time when the risk to global growth is more skewed to the downside than the upside, and when there are lots of uncertainties prevailing. Today we want to invest in companies that have resilient business models. What I mean by that is not just pricing power and the fact that they’re serving markets that aren’t economically sensitive, but also there’s a high or important percentage of their revenues that are recurring in the form of selling consumables, selling once use only tests for the diagnostics market, companies selling services or spare parts, companies that rely heavily upon replacement, rather than original equipment.

So SEP for example in the first nine months demonstrated that now 68% of its revenues is coming from on the one cloud subscriptions, or rentals, and on the other hand from software support, but of which I would describe as predictable revenues. And today I think it’s more important than ever that we invest in companies where the downside risk is limited, thanks to the resilience of the model. But also there’s good growth to come, and sustainable growth to come, thanks to the levers that company is pulling in the form of asserting its competitive strengths on its backyard. And we want to invest in companies with high returns on investor capital. We want the net operating profits after tax to grow more quickly than the invest capital. Not every year, but we want there to be an improvement in the return on investor capital in the next five years. And again we don’t compromise on financial strength. Operational leverage yes; financial leverage no. The net debt to EBITDA of the portfolio is 0.7 times.

So hopefully the message here is that we are uncompromising about quality. And as a result on page 8 the third part of the strategy I want to discuss is how we’re positioned today, and firstly the pie chart on the left shows that we have 87% of the fund in what we call established leaders, so a clear bias. You may remember that we have a minimum of 50% and a maximum of 100% for established leaders, but we’re very much at the high end of where we typically sit in terms of our exposure to established leaders. And yes, we do have exposure to emerging winners. And it’s probably not a surprise that emerging winners, for example Delivery Hero recently have been a source of our poor performance during a time of heightened risk aversion. The second point I want to make is on the same slide, slide 8, is how there’s a clear bias in favour of global companies, rather than those that I would describe as European-centric. And that’s not a material departure from where we’ve been in the past, but I’d say the global bias has still risen in the last 12 months.

And then on slide nine you can see that the portfolio has a clear bias in favour of companies that sell to other businesses, business to business type models. And it’s here that we tend to find much more pricing power than we do in the more cut throat business to consumer world, where I think there’s much more disruption. And then if we have 18% in business to consumer with an asterisk, companies like Ferrari, companies like Carnival, that are selling actually through dealership or through travel agents, principally through travel agents, they’re not actually on the very frontline. I would describe them as wholesale businesses, but we sort of acknowledge that they’re consumer companies. And then finally the 21% that’s genuinely business to consumer, and is on the front line is very much biased in favour of luxury goods companies, but also Ryanair is part of that 21%. And I would say that in the case of luxury goods companies there’s no downward pressure on pricing. Companies like Montcler and Brunello Cucinelli enjoy considerable pricing power. And finally is that we have a very resilient portfolio in terms of 61% being invested in companies where an important percentage of their revenues come from recurring revenues.

This strategic positioning of the portfolio has resulted in some activity on page 10 since the beginning of the year. The number of positions has actually come down to 31 holdings today within the range of 30 to 40. I’m normally happier when we’re nearer 30 than 40 in terms of numbers of stocks. We’ve added some new positions which we’re very pleased with. I think we’ve freshened up the portfolio with some excellent new names. And on the right-hand side we’ve made a number of disposals, which outnumber the additions. And one symptom of that activity is that I’d say we’ve got a shorter tail than we had before. But also if you look at companies like Pandora or XXL that have left the portfolio, that has contributed to us having less exposure to the end consumer than we used to have. So I would describe these changes to the portfolio as being very constructive. We’re very confident in the portfolio, but also this activity has not elevated the portfolio turnover that significantly. A lot of the positions that have been sold were quite small positions. And so our run rate for the last 12 months portfolio turnover is 47%, you can see at the bottom.

And all of this, just to conclude really on page 11, results in a portfolio with strong earnings growth, the multiple has come down because of the decline in the performance recently, and we make no apology for the premium multiple of the portfolio versus the benchmark. And we don’t foresee a world in Europe where bond yields are going to rise precipitously, because we think inflation will remain in abeyance. We think that the premium one pays for defendable and genuine earnings growth if anything should have gone up recently. And so we’re very comfortable with the way the portfolio is positioned and its characteristics today. Because the share prices have come back recently our TSR, total shareholder return, or I’d rather call IRR, for the next three years is now above 15% versus our target of 10%.

You can see the top 10 positions on slide 12. And I think on the right-hand side of page 12 you can see the performance numbers. And I’d highlight the fact that to the end of October, despite our recent poor performance, and I accept the fact that it has been poor and I apologise for that, but we stick to our guns. We have a lot of confidence in the portfolio. And I’d also highlight the fact that on a three-year annualised basis we remain above our target of absolute returns of above 10% and relative performance of above 3%. And so yes we apologise for recent poor performance, but we’re not too apologetic because we think this is the right portfolio for the next three years, and the next five years. And hopefully we can build upon the strong longer-term performance numbers that I showed you also on page 13. That’s the end of the presentation. I’ve slightly overshot on time, and I’m happy to hand back to Warren.

WARREN SHIELS: Rory, the first question we have is how have you been reacting to current or recent volatility?

RORY POWE: Yes, thank you for that question. So I think when you get market volatility of this nature, you’ve got to cross examine your portfolio and double check everything. But to summarise my answer to that question is the activity I showed earlier has not been concentrated in the last few weeks or months. Indeed in the last few weeks or months we’ve done very little, we’ve made very little changes to the portfolio, and I think it’s times like this that it’s wrong to do anything too defensive. And equally I think it’s wrong to do anything that’s too offensive. And I think it’s important to be consistent by sticking with the portfolio. The way we read the selloff is that higher wages and inflationary pressures and higher bond yields have really set this off, a lot of factors, and the papers are full of them every day, so I’m not going to repeat them now, but there’s a concern about earnings growth, I think. And I think those concerns are justified, but what doesn’t concern me as much is the threat of inflation. And so if that’s the world that we see, where growth is slow and earnings growth is scarce, then our strategy should be to focus upon companies where we think they’re largely insulated from those negative influences.

WARREN SHIELS: Thanks Rory. Another question we’ve got is given the global nature of your portfolio, what are your views on China?

RORY POWE: Yes, so the Chinese economy slowed down in the third quarter, but it’s still enjoying strong growth. Let’s retain some perspective on that, and continues to outgrow the rest of the world at an annualised rate of above 6%. There have been instances of quite marked weakness, for example in the automotive sector. In China the car market’s been very weak this year, and particularly weak in September, largely because of the annualisation of tax cuts for buying cars in China, and so the impact of that has now worn off. I think also a lot of the concerns about China recently have related to luxury goods, and concern that Chinese demand for luxury goods might be diminishing both at home and when the Chinese are travelling abroad.

If we take Montcler as an example, it showed tremendous growth in China in its third quarter and no evidence of any slowdown. And also we would highlight the strength of its sales to Chinese travelling all over the world. Again there’s no evidence of slowdown there. And there was some concerns about a crackdown by the Chinese authorities on the Chinese exceeding their limits of approximately €6,000 of what they can buy abroad and bring home, because the authorities were concerned that’s being sold at a mark-up. But that crackdown should not affect most of the companies, particularly those that have already been very strict about what they allow customers to buy in their store. And again the evidence doesn’t support the fact there’s been any slowdown there.

Another area of concern is the semiconductor industry, where China’s deliberately building up its own home grown semiconductor industry, and that might contribute to overcapacity. But again if there’s a slowdown now in the memory sector of the semiconductor industry, we actually would view that as quite healthy, and symptomatic of the fact that a lot of the players in that industry are deliberately pulling back on capex for the time being. And I think the semiconductor industry arguably is a microcosm of what’s going on in the global economy, which is that companies are being a lot more measured about their capital expenditure throughout this cycle. Indeed you could argue there’s not been enough capital expenditure, and too many companies have concentrated upon share buybacks.

And so I don’t think many industries are going to be guilty of having excess capacity. And when there’s signs of some surplus capacity in the short term, the players, and you can see this in the airline industry in Europe, are reacting very quickly to that, and curtailing their capacity plans. And that augers for I think a longer cycle. I mean my mantra is lower for longer. I think that the global economy, and a lot of industries behind that global economy, are going to grind ahead in a solid way, but nothing spectacular. But when people talk about cliff edge or end of cycle or late cycle, I think those fears are exaggerated. And I think bond yields going up is the market’s way of policing the cycle, arguably more effectively than central banks. And therefore we want to hold our nerve at the moment with our companies.

And we see, we always talk about the five-year roadmap. And the one reason we sold Pandora is we’re concerned about the roadmap ahead: we’re not able to forecast accurately where we think their numbers will be in five years’ time. We have no confidence in our predictions; there are too many moving parts. We want to concentrate upon companies where we see good visibility in earnings for the next five years, which doesn’t rely upon the macro economy.

WARREN SHIELS: That’s great, Rory, and that concludes the Q&A session for the update. Finally, on behalf of myself, Rory and the MAN GLG Continental European team, we’d like to thank you for your continued support.

RORY POWE: And I’d just like to reiterate Warren’s point about thanking you for your support. We can’t function without you, so thank you.

WARREN SHIELS: Thank you for listening to this quarterly update.