Markets have bounced around but failed to recover ground since the end of August. Worries over China’s slowdown continue unabated and commodity, energy and emerging market currencies remain under pressure. Speculation as to what the Federal Reserve might or might not do with interest rates in coming months also reached a crescendo in the run up to the Fed’s September meeting (in the event, they kept base rates unchanged).
In this month’s view I’d like to detail some of the business dynamics that are occurring underneath the surface of market noise.
A key piece of news flow this month has been AB Inbev’s approach for SABMiller, a takeover approach that has been rumoured for some time. Both companies are held in the fund (c1.5% and c1% holdings respectively). A tie up between AB Inbev and SAB may represent the last round of consolidation in an industry whose other two largest players (Heineken and Carlsberg) are controlled by long-term family ownership, and would result in the enlarged group selling approximately one in every three beers consumed globally.
SABMiller’s portfolio of brands include Peroni, Miller, Pilsner Urquell and Grolsch, as well as many dominant local champions (94% of SABMiller’s beer volumes come from brands that enjoy a number one or two position in their local market). A deal may or may not be agreed, but the approach is a reminder that portfolios of hard-to-replicate brands enjoy scarcity value. This fact should not be forgotten in a market where this year’s price-to-earnings multiple tends to be the prevailing valuation yardstick rather than long-term cash flow potential: even when current earnings and cash-flow are depressed (in SABMiller’s case earnings and cash flow are currently feeling the weight of three years of very negative currency headwinds and investment for future growth). Industry buyers sometimes look through such short-term headwinds in a way that the market rarely does.
I’d also like to mention two recent developments in the healthcare sector, one negative and one positive. First the negative: Hilary Clinton announced some policy aspirations this week regarding more regulation of drug pricing in the US. This led to a sell-off in pharmaceutical and biotech stocks. While a negative reaction from the market is understandable, it’s important to put her announcement into context. Whether or not any of her policies make it through next year’s presidential elections (and then the machinations of the US political system), her comments are a reflection of a wider ongoing trend, and my views on this remain very similar to when I addressed the topic last November:
Pricing will remain an ongoing negative for pharmaceutical companies. Healthcare systems remain very focused on keeping costs down and continue to demand value-for-money. This has been very evident this year in some areas of the US primary health care market. The cost of speciality therapies in areas such as cancer (where individual treatment programmes can be very costly) will also remain under scrutiny. We don’t think this dynamic is going away, though its intensity will ebb and flow. But we do think it will remain a manageable trend for the industry over coming years, just as it has been over the long-term history of the sector (i.e. for more than fifty years). Effective, innovative drug therapies remain a key ‘displacement factor’ for healthcare systems worldwide. Less than 10% of total healthcare costs are spent on drug therapies, but the benefits that come from this expenditure in terms of saving costs elsewhere is significant.
And this is the key - innovation in heathcare leads to a strong value proposition for customers. Even in European healthcare systems, where price regulation is greater than in the US, this fact is very much acknowledged. And on the subject of innovation comes the positive news - a recently released report from the KMR Group* that shows the effectiveness of pharmaceutical research expenditure is finally beginning to turn a corner. Data for 2010-2014 shows that success rates across all phases of development are increasing. It seems the industry’s lengthy efforts to improve research and development are beginning to have an impact, perhaps helped by recent advances in scientific understanding, particularly in the field of genetics.
Evenlode’s healthcare holdings are currently Astrazeneca, Glaxosmithkline and Johnson & Johnson. We think these holdings offer interesting long-term value, with investors currently unwilling to give drug pipelines - and the potential for new therapies to enter these pipelines over coming years - much credit at all. Over coming years, the negative impact from falling sales of older blockbuster products will ease, while growth potential in other areas looks promising.
Although it’s easy to forget, a share is not a lottery ticket, its part ownership in a real life business
I am currently reading David Kynaston’s incredibly meticulous The City Of London: A Club No More (1945-2000). It is a reminder of how little really changes in the world of stock markets and investor psychology, but also how much fluctuation there has been over the years in both the stock market and the economic and political environment: from the austerity of the 1950s, to the the terrible inflationary years of the mid-1970s, to the exuberance of the roaring 1980s and late 1990s. Investment themes come and go. In 2015 for instance, anything with exposure to energy and emerging markets is down in the dumps while investors cling dearly to the shares of companies with cyclical exposure to the UK economy. How different to 2011 when all talk was of the commodity super cycle and the UK economy was threatening a double-dip recession. Or 1973 for that matter when oil was the place to be and the UK economy certainly wasn’t!
One of the nice things about owning good quality shares operating in mature, rational industries is that they tend to be successful at incrementally adapting to changing conditions in the economy, the political environment and in their own sectors. Indeed they must to avoid being rendered obsolete. International expansion is also something we like - it helps to mitigate political and economic risk at the national level.
Unilever, for instance, would not have been able to grow its dividend by more than +10% per annum since the 1960s by just sticking to selling palm oil and margarine. It has moved on, developed new brands (it launched Dove, for instance, in 1957, a billion euro brand today) and expanded into new areas. Unilever continues to evolve, building out its presence in the fast growing categories of personal care and beauty for instance, over the last few years. The company was recently reclassified from a food manufacturer to a personal care company in various stock market groupings, reflecting this shift. Nor does Johnson & Johnson still sport the same product portfolio it did in 1962 when it began its track record of 53 consecutive dividend increases.
So even when, as an investor, you ‘do nothing’ to a portfolio, under the surface there are thousands of people (employees of the shares in one’s portfolio) getting up every morning and reacting to a changing world. This is not something that the short-term investor cares much about, but it matters for the long-term investor. I think, for instance, of Diageo’s issues with inventory over the last two years and the changes the company has now made to sales incentive structures to address the issues; the steady progress Astrazeneca has made to rebuild its pipeline over the last few years; the progress Sage, Microsoft, Informa and Relx are making in accelerating innovation for their digital products; the shift that Pearson is making away from physical textbook publishing and towards a digital and services model in the global education market; the expansion by geography and product that Compass, IG Group and Jardine Lloyd Thomson are quietly making; the new services Paypoint is rolling out with its next generation terminal, and the investment Spectris is making in innovative new test and measurement products despite the currently tough backdrop for global industrial production. In my view all these developments, and the degree to which they succeed, matter far more to the long-term investor in Evenlode than what happens to US interest rates in the next few months, or Chinese GDP growth.
We remain patiently disposed to the businesses in the Evenlode fund. This month, we have not made any significant alterations to the portfolio, but have topped up several holdings where we see good value and healthy dividends. We are also assessing several potential new opportunities for the fund. As always our focus is on strong franchises with the potential to provide attractive long-term cash flow and dividends to shareholders.
Please note, these views represent the personal opinions of Hugh Yarrow as at 24th September 2015 and do not constitute investment advice.