J. STERN & CO. The Value of Long Term Investing. Monthly Commentary

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1 Monthly Commentary 2016 has been an eventful year with solid economic performance in the US and in Europe, resilient markets and significant and unexpected political changes. It has so far delivered solid but not outstanding returns in our equity portfolios and strong returns in our income-driven and emerging markets portfolios. November was dominated by the outcome of the US elections, with the market envisioning the likely positive economic implications of a Trump presidency. Though much uncertainty remains about the details of specific policies the beneficial agenda encompasses lower corporate and personal tax rates, fiscal stimulus to support infrastructure investments, a lower regulatory burden and a more protectionist trade policy. These expectations, gave rise to a sudden and significant repositioning among institutional investors as they sold consumer staples and technology to buy financials and cyclical companies that were perceived to benefit from these inflationary policies. The major part of the rotation started on November 9, Election Day, and took only 10 days to have an impact. It is a salutary reminder to us of the importance of having a consistent long-term approach. This sudden rotation has nothing to with the companies, their businesses or their valuations. Instead it is driven by benchmark outperformance issues of mutual funds and other investors. If fund managers decided to buy banks and industrials in the last two months of the year anyone who is benchmarked to the market has no choice but to do so as well or risk underperforming. Unsurprisingly, those sectors that are more economically sensitive and have higher tax structures given their domestic US exposure performed best. Financials led the market higher, with the sector closing November up 14%, given not only its economic and interest rate sensitivity but also the expectation that parts of the Dodd-Frank Reform Act and Consumer Protection Act will be repelled, reducing the regulatory burden especially for smaller regional banks and providing them with higher flexibility on their use of available capital. Following were Industrials, closing the month up 10%, on the expectation of a fiscal stimulus reigniting capital spending after years of muted revenue J. Stern & Co LLP Tel: Knighstbridge Fax: London SW1X 7LY info@jsternco.com United Kingdom

2 growth. Finally, Energy and Materials, were up 8% and 7% respectively, given not only their economic cyclicality but the already stabilising oil and commodities markets, following years of capex cuts starting to have an impact in supply, reinforced by the OPEC agreement to cut 1.2m barrels of production and the non-opec countries to cut another 500,000 barrels of production. On the contrary some of the sectors that had benefited in recent years from the scarcity of revenue growth in the broader economy, like Consumer Staples and Information Technology, sold off as they were used as sources of cash to fund the rotation into Cyclicals. As such Consumer Staples and Utilities closed the month both down 4%, whilst Information Technology was flat at 0.5%. The critical question is of course looking forward what this implies for markets and our holdings. In many respects the scarcity of revenue growth we had seen in previous years as sectors like Industrials and Materials were absorbing excess capacity build in the 2000s is starting to dissipate, helped by more accommodative fiscal policies and years of lower investment affecting supply. With the valuation gap between steady growth compounders and value cyclicals at historically elevated levels going into November, the magnitude of the rotation is not a surprise. As we look forward, we believe a more broad based level of economic growth is a healthy backdrop for equity markets, which itself will provide strong support for equities as an asset class. A normalising inflationary environment will lead to higher but still moderate interest rates and will provide higher pricing power for our companies. At the same time, the expectation of a looser fiscal and regulatory environment will have to translate into actual policy and earnings which will be a longer and more volatile pathway. That is why we believe our investment focus on quality compounders while being selective within cyclical areas, focusing on long term secular winners like Rockwell Automation and others, provides a robust balanced pool of investments that will continue to perform well through the cycle. The chart above shows a striking fact. Over the past 15 years (so through the financial crisis), the three types of stocks that delivered by far the highest annualized performance were dividend stocks, low volatility stocks and quality stocks. They even outperformed the S&P500 by as much as 3% per year over the past fifteen years. By contrast, the types of stocks that have just rallied, value stocks in the sense of cyclical businesses at low valuations and high beta stocks, performed in line with the market or underperformed Page 2

3 it. This is despite high beta stocks being the best performing stocks in five out of the past eight years, including in 2016 through the end of November. The chart exposes the risks and ultimate futility of tactical asset allocation and other technical or short-term approaches to outperforming the market. As we discuss in this month s insight Themes and Opportunities in 2017, which we hope you will enjoy, what we do not know at this stage lies within macroeconomics. What we do know is that the companies in our portfolios have strong prospects for growth and returns, they have solid balance sheets, and they are generating cash that they can reinvest in their businesses or return to shareholders as dividends. They also have pricing power to offset inflation-driven rate rises and input cost increases. Looking at the stocks in our core World Stars portfolio, which is representative of the quality and value stocks we invest in, we have calculated the likely growth in sales and earnings for the next three years. Next year we expect the companies to deliver 8.9% sales growth 18.5% operating income growth and 18.5% net income growth as well. Over the next three years we expect them to deliver 27.7% sales growth, 52.7% operating income growth and 67.8% net income growth. Over those three years that represents compound annual growth of 8.5% per year in sales, 15.2% per year in operating income and 18.8% per year in net income. These significant sales and earnings increases offered by the companies in our portfolios make us confident in the ongoing value our portfolios. We have put together our thoughts on the important drivers for our equity, income-driven and emerging market debt portfolios for next year in this month s insight, which we hope you will find of use will be a challenging year from a political and economic perspective. By taking a long-term perspective, investing in quality and value, and not least by taking advantage of opportunities to buy stocks at marked down prices like the rotation we have just experienced, we believe our portfolios can continue to deliver even in uncertain times. Equity portfolios Performance for the month was led by our holdings in industrials, including Rockwell Automation which was up 12% for the month. The company benefited from the improved outlook for the broader US economy with 55% of its sales coming from the country. Importantly the company had also reported solid results earlier in the month, driven by strength in its Automotive and Consumer end markets. Long term Rockwell remains a leader in the automation market and a pioneer in smart manufacturing through its Connected Enterprise initiative. Also among the strong performers for the month were Schlumberger and Weir, both benefiting from the rebound in the oil price. Schlumberger has throughout the recent energy market downturn displayed consistent execution reflected in the resilience of its margins and critically used the depressed environment to take advantage of strategic opportunities, most notably through the acquisition of Cameron International creating the only integrated pore-to-pipeline provider to the industry. With revenue opportunities arising from that combination already starting to be reflected in orders, the company has Page 3

4 solidified its leadership position in the industry. At the same time, given the cost efficiency measures achieved through the downturn, we believe the company is well placed to realise incremental margins of over 65% as revenues recover, meaning effectively that it can easily surpass past peak earnings, with even a more moderate revenue recovery. Similarly Weir is starting to see the benefit of capex starting to return within its Minerals division after years of a stressed environment for global miners. With cash flows starting to improve through wide reaching efficiency measures and more recently higher commodity prices, shorter life asset suppliers like Weir, are first in line to benefit from recovering miner spending levels. At the same time, with the oil price starting to inflect following massive capex cuts over the last two years and OPEC taking a more aggressive stance on supply, Weir s Oil & Gas business, is set to benefit from increased volumes and ultimately improved pricing. Among the weaker performers, American Tower declined in the aftermath of the US Presidential election, closing the month down 13%. The steady recurring revenue and dividends generated by American Tower means that it is viewed more like a bond than a cyclical growth stock. At the same time, there was some media speculation that Presidentelect Trump would be more open towards a merger between Sprint and T-Mobile USA, two of American Tower s customers, with a combined company potentially reducing its tower portfolio footprint. We would highlight, however, that these two are actually shared tenants in only 4% of American Tower s footprint, and any affect would not be immediate given that leasing agreements include five year non-cancellable terms. The company remains a secular beneficiary of higher mobile data usage and international expansion in under developed markets, and as such the recent sell off presents a strong buying opportunity. Income-driven portfolios Despite the continued volatility in the fixed income markets, the income-driven portfolios had a relatively uneventful month in November. The 0.9% decline in our core portfolio was more a reflexion of the portfolio positioning and its bias towards high quality assets that declined as part of the rotation out of the better performing and secure names, which took place in equities as well as corporate bonds. Overall our fixed income strategy was not significantly affected by the sharp rise in the US treasury yields or the widening of credit spread resulting from the short term increase in market volatility, although it was noticeable that longer duration securities were more affected like our positions in Turkcell and Petroleos Mexicanos. On a positive note, the portfolios benefited from its exposure to the energy sector and higher oil prices as a result of the OPEC decision to limit production. Emerging market debt portfolios The core emerging market debt portfolio ended the month of November with a negative - 1.2% return, vs -2.4% for the benchmark, proving the resilience of our portfolio in volatile times. The approximate 55bps parallel shift in the US curve post the elections was the main factor influencing the portfolio. With the exception of Argentina and Turkey, spreads in balance did not widen as investors remained invested in good quality and yieldgenerating instruments. Not surprisingly, there were substantial outflows out of Argentina, as investors were prone to book profits on one of the best performing Page 4

5 countries this year. We are watching current levels for selective entry levels or rolling down the credit curve. Turkey has its own idiosyncratic issues, related to politics and domestic security. The current account deficit is worsening with the depreciating currency, falling tourism revenues and rising oil prices. FDI are slowing down fuelling a negative spiral. We are monitoring closely the risks of recession on the companies we are invested in and remain comfortable with mark to market valuations. December 2016 J. Stern & Co. LLP provides this document for informational purposes only. It is intended exclusively for those to whom we have provided it directly. It is not for further distribution and does not constitute investment advice nor an offer or a recommendation to purchase or sell any security or other financial instrument. The information contained herein has been obtained from sources believed to be reliable at the date of publication but no warranty of accuracy is given. The value of any investment can fall as well as rise. Any opinion expressed constitutes a judgement as of the date of publication and is subject to change without notice. J. Stern & Co. LLP is a limited liability partnership, registered in England and Wales with registered number OC378306, and is authorised and regulated by the Financial Conduct Authority, as firm number CR 2016 Page 5