M&G Global Dividend Fund The year in review

Transcription

1 January 2017 M&G Global Dividend Fund The year in review Fund Manager Stuart Rhodes In our previous review, we wrote that we were active managers prepared to back conviction when we see opportunities in the market. We were rewarded for this handsomely in However, we believe we are in the early innings of the fund s recovery as valuations across the portfolio remain highly attractive, with clear signs that value as a style is starting to play a much larger role in overall share price performance value outperformed growth on a global basis for the first time since the financial crisis. All three of our investment categories (assets, quality and rapid growth) positively contributed to performance in It has been pleasing to show performance being generated across different industries and geographies. In the face of extreme swings in market sentiment, we demonstrated discipline and emotional resolve to hold the course when things were not going our way. The operational results and subsequent share price performance of some of our key holdings have more than justified their position in the fund, and highlighted just how attractive their share prices were in the early part of the year. Companies such as Methanex, Las Vegas Sands, Gibson Energy and Pembina Pipeline were all highlighted in the last review and have performed exceptionally in 2016, but still trade a long way off from what we see as an appropriate valuation is shaping up to be an exciting year. Outperformance in our energy-related investments was not just linked to commodity prices, but a combination of strong operational and strategic performance. This resulted in excellent cashflow growth, or contract wins that will be major contributors to cashflow growth potential. Dividend growth was robust across the portfolio in 2016, with the majority of holdings delivering increases in the region of 5-15%. We also have 12 current holdings that increased their dividend by over 15%. The fund is well placed to continue to increase the distribution in line with its objectives, with a larger percentage increase projected for this financial year than in recent years. We believe the favourable combination of growing income and attractive valuation offers the potential for meaningful capital appreciation over the long term. Market background It was a year of change. Global equities delivered positive returns in 2016, but the markets were driven by a new regime. Energy and materials led the markets higher as commodity prices recovered from their lows in January and February, while financials rebounded from a weak first half to end the year comfortably ahead. Defensive sectors, meanwhile, experienced an abrupt reversal of fortune, as sentiment turned on safety at any price. Although utilities, telecoms and consumer staples outperformed in the first six months of the year (healthcare underperformed for sector-specific reasons associated with US drug pricing), the market s preference for safety began to wane in the second half, with this rotation away from defensives accelerating in November following Donald Trump s victory in the US presidential elections. The surprise outcome led to a reappraisal of economic prospects, which sent bond yields higher and US equities to all-time highs, while expectations of growth and reflation triggered a rally in cyclical stocks. From a regional perspective, the US outperformed once again, but that was the only similarity with Emerging markets outperformed, despite giving back some of their gains towards the end of the year, while Japan, 2015 s standout performer, was a laggard in Europe underperformed amid lingering concerns about the region s financial sector, while returns from the UK were dictated by a weaker currency after the nation chose to leave the European Union. It was a year of change, but the changes started from extremes in the market environment. We would argue that company fundamentals and valuation, which are key determinants of equity returns over the long term, leave plenty of upside for disciplined stockpickers. Fund developments Each investment category positively contributed to performance in 2016, as Figure 1 (overleaf) illustrates. This is especially pleasing given the large shifts in style performance throughout the course of the year. It is important that we continue to have representation across all three categories to achieve appropriate diversification, but with an appreciation that clusters of opportunities will tend to be concentrated from time to

2 Millions of tons time in one category. Given the market s recent obsession with safety and security, which was still prevalent at the beginning of the year, the assets category provided that cluster of opportunities so we shall start there: Figure 1. Diversified sources of performance 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% Cumulative attribution by source of dividends in 2016 Quality Assets Rapid growth Source: M&G, Factset, 31 December Holding period returns (gross of fees and transaction costs) relative to MSCI AC World Index, calculated in sterling. Assets It has been quite a year for the assets category. In our last review, we noted the emergence of some truly exceptional opportunities for long-term investors, which proceeded to reach their most attractive valuations in January/February 2016; this was at the peak of Chinese growth concerns reverberating around the market. Strong discipline and emotional resolve was required at this juncture to ignore the noise and irrationality of market participants. We held the course, continued to do the analysis on our investments, tested the fundamentals rigorously, and carried on swimming against the tide, buying the weakness where we found no fault in the dividend thesis of the investment. We strongly believe the decisions we made during this difficult period will benefit this section of the fund for many years ahead. These decisions contributed strongly to overall fund performance in 2016, but as we highlight in three examples below, we feel that we have only just started on the path back to proper valuations in many of our investments in this category. Methanex is our largest holding in the assets category and a high-conviction position we have been a shareholder of the company since the fund s inception back in Methanol pricing improved considerably as we moved through the second half of 2016, and now stands at very healthy levels. This is combined with excellent operational performance, in which some major capacity additions have been commissioned successfully. Current contract pricing would enable the company to cover its dividend multiple times over, and so we expect to see a return to dividend growth in 2017, alongside an aggressive programme of share buybacks. Methanex s valuation is trading considerably beneath the replacement value of its own plants, and so buying its own shares back at these levels makes perfect sense. We previously noted that a methanol price of US$400 per tonne was required to incentivise the construction of new plants in the industry. Many commented at the time that this was a far-fetched assumption, but as the year progressed, overall methanol demand was exceptionally strong. We think it is becoming increasingly obvious that the world will require more methanol capacity over the next few years. Demand has been tracking around 5-10% per annum (see Figure 2), making methanol one of the fastest-growing commodities in the world. This is being driven by traditional chemical derivative demand, diesel/gasoline blending, further penetration of the Chinese olefins pool and entirely new demand sources such as substitution for marine fuel. As a result, prices are already starting to march up towards that US$400 range. The company would make around US$800 million of free cashflow at that level, which represents around 20% of the current market capitalisation at the time of writing. We think these shares are still incredibly cheap, and we are highly optimistic about their prospects for 2017 and beyond Figure 2. Annualised global methanol demand Source: Alembic, 27 December CAGR 8% Gibson Energy was a strong performer in 2016, rising 37% in Canadian dollars (69% in sterling, 45% in euros and 41% in US dollars) alongside paying some sizeable dividends. Its infrastructure business performed exceptionally well throughout the course of

3 the year and continues to be the foundation of value in the shares. No fewer than eight major projects were completed during the year, many ahead of schedule and under budget. Gibson has also continued to win new contracts, underpinning future growth. Cashflow from this business steadily rose over the course of the year, and long-term take-or-pay contracts help ensure that this growth will continue into 2017/2018 and beyond. We are fully confident that the infrastructure segment will be capable of supporting the dividend policy of the firm into the medium term. This will be further accelerated if the company is successful in reinvesting the proceeds from divesting its industrial propane division into future growth projects in infrastructure. The potential sale of this division will also increase infrastructure as a percentage of the overall company, and is another catalyst to a re-rating of the shares closer to its peer group. The additions we made to our holding when the shares were trading at a 10%+ yield early in the year have proven to be very valuable. At the time of writing, the stock is still trading at a 7% dividend yield and a marked discount to the rest of the sector we believe the shares still offer compelling value, despite the share price moves in Pembina was another business we talked about in our review of We are pleased to report that its cashflows grew strongly, despite the underlying commodity environment, coupled with continued execution success on its sizeable pipeline of new infrastructure investments. The majority of these continue to be remunerated by fee-for-service contracts, providing visibility as well as confidence in the ability of the company to continue to grow its dividend distributions to shareholders off an attractive current base of 4.5%. We see further potential for outperformance going forward, as the company expects cashflows to nearly double from 2015 levels and its operational performance in 2016 gives us no reason at all to doubt these forecasts. In addition, the quality of the cashflows will improve as they grow, as many of Pembina s contracted projects come into service over this period. Figure 3 shows the portion of fee-based revenues increasing each year, with a notable increase in the highest quality take-or-pay section. Its outstanding project pipeline currently stands at US$5 billion, and there is a steady stream of projects coming online and contributing cashflow over the next several quarters. Our confidence in the company s growth opportunities, and its ability to execute, was further enhanced by a visit we made to several assets in the middle of the year. % Figure 3. Pembina Pipeline: summary of operating margin by type (US$ million) % % Source: Pembina Pipeline, December and 2015 figures based on actual results (including internal allocations), while forward years are based on Pembina s current long-term forecast and actual results may vary depending on asset utilisation, commodity pricing and other factors. See Forward-looking statements and information and Non-GAAP and other measures. Quality = 66% = 77% = 81% 1% = 82% 1% A 2015A 2016A 2017E 2018E Frac spread Product margin Fee-for-service Take-or-pay / cost-of-service = 84% Valuations have not been appealing in this area of the market for quite some time. As a result, the percentage of the portfolio attributed to quality drifted downwards throughout the course of the year, and now sits below 50%. Consumer staples represent a high proportion of our investable universe within quality, and we continue to struggle with valuations. We believe the market is still demanding too high a premium for safety and security, especially given that growth rates have been deteriorating for some time now. Tobacco remains our dominant exposure in this sector, as we believe their earnings growth potential remains intact and valuations are far more compelling than other areas within staples. Tobacco has been a little disappointing in 2016, with Imperial Brands in particular standing out as one of our biggest detractors. However, we remain very comfortable with the long-term capability for our tobacco investments to generate excellent dividend growth, and hence the collective weighting of our three holdings remains around 10%. Healthcare is the other major contributing sector towards the quality portion of the fund. The sector performed poorly last year, and is probably the only area within quality that is starting to look genuinely interesting again. There have always been many candidates in this sector that satisfy our stringent dividend criteria. The focus on healthcare, in both the build-up to and aftermath of the US election, has

4 created some much more attractive entry points across the board than we have seen in the past couple of years. We are currently spending quite a bit of our research time focused on this sector. Outside the two main sectors mentioned above, notable positive contributors have been Microsoft, Arthur J Gallagher (an insurance brokerage firm) and our three US banking investments: JPMorgan, Wells Fargo and US Bancorp. Despite the higher premiums demanded in this segment of the market, our focus on valuation and growth prospects has led us to outperform in this category these companies are very good examples of this in action. These all remain core holdings for the fund and we believe offer compelling long-term value, despite strong share price performance in Rapid growth There were specific bouts of market volatility throughout the course of last year that presented sizeable opportunities in this area of our investable universe. We purchased more new names in this category in 2016 than in any other calendar year in the fund s history. In fact, over half of our new positions were rapid growth investments. These opportunities include: 1. Chinese growth concerns hit the market hard early in the year, with growth companies in particular focus. We were able to initiate two new investments in MasterCard and AIA, both of which we had been tracking for some considerable time and were glad to finally get the entry price opportunities. They have both performed well since purchase, and we remain very comfortable with their long-term prospects. 2. The EU referendum in June also created considerable market volatility in the immediate aftermath of the leave result, and this allowed us to invest in St. James s Place at truly distressed prices. This has proven to be a superb entry point for a business with powerful fundamentals, and it continues to be a core holding. 3. Finally, the US election proved to be a major market event resulting in sizeable underperformance in certain areas of the market. The traditionally defensive portions of the market performed poorly, but there was also some collateral damage to great growth companies that have been labelled with the same brush over the past couple of years. Nike and Visa, two longstanding consumer sector candidates for the fund, fall into this category. They now trade at very reasonable valuations given the nature of their long-term growth potential, in which we still have every confidence. Both were added to the fund towards the end of the calendar year. Beyond these new holdings, we also had considerable success last year from some of our longstanding rapid growth investments. Broadcom and Pandora, for instance, have continued to deliver exceptional operational performance. This has driven their share prices much higher than since their initial purchase, coupled with some sizeable dividend increases along the way. They both remain core holdings. Last year also marked a return to form for Las Vegas Sands, following a challenging Our investment here has always been predicated on the idea of supply-led growth in the base mass-gaming market driving higher visitations and cashflows for the company. After the key opening of its Parisian property in Macau in September, the share price began to rise on the back of increased visibility of this thesis coming through in the second half of the year. Monthly gross gaming revenue has increased healthily for five consecutive months at the time of writing, bucking a two-year trend of negative revisions. Figure 4 highlights the clear turnaround in the market, and we think the structural story here is in its early innings. Despite a 12-month return of nearly 29% in US dollars (54% in sterling and 33% in euros), we continue to see upside to valuation, underpinned by a solid 5% dividend yield and growing cashflows from the ramp up of the Parisian over the next year. Further international expansion opportunities, as well as the potential sale of stakes in its real estate assets, also remain under-appreciated by the market, in our opinion. 20% 15% 10% -5% -10% -15% -20% -25% Figure 4. Macau monthly gross gaming revenue in % 0% -21.2% -1.0% -21.4% -9.5% -9.6% -8.5% -16.3% Source: Bernstein 3 January % 1.1% 7.4% 8.8% 14.4% y/y growth rate 8.0%

5 Transactions After two years of slightly elevated turnover in reaction to market conditions, fund turnover returned to historical levels with 11 new purchases and 12 complete sales. The number of holdings is currently 44. This is expected to very gradually increase over time to the more traditional range of holdings. Our cap remains at 50, as we feel this is the limit we can realistically look after in sufficient detail, and we also want every single position contributing to performance. The results of our complete sales continue to be pleasing, realising over 370 million in profits during Considerable outperformance was achieved over the investment period in Prudential, Yum Brands, Schroders, Roche and Svenska Handelsbanken these were all sold on valuation grounds. Xilinx, Banco Bradesco, and HollyFrontier also generated sound profits over their investment period. Eaton and Cummins were sold at minimal losses and were simply reinvested into more attractive ideas across the portfolio. The two major disappointments were Rio Tinto and Nordea, both of which failed to live up to our expectations. These were sold at a loss, as we had lost conviction in the investment thesis and their ability to generate growing dividends over time. As mentioned earlier, the bulk of new investments were under the rapid growth category. As a result, this category has increased to 18.9% of the fund, the highest percentage in some time. This has primarily been at the expense of the quality category, which now represents 47.8% of the fund, below our historic range of 50-60%. Valuations have been a struggle for a while in this category, especially in the consumer staples sector. The lack of replacement options saw the weight fall in the fund, as companies like Roche and Svenska Handelsbanken exited last year. Assets now represents 26.2% of the fund, and performed well across the board last year. We scaled back some of the holdings slightly as share prices rose to prevent the weight of the category, and some of the individual holdings, becoming too large in the portfolio. These reductions were only a reflection of the portfolio weight and not the valuation levels we believe the most attractive valuation opportunities continue to rest within the assets category. The geographic exposure of the fund did not change materially throughout the course of the year. North America represents approximately two thirds of the fund with c.55% in the US and the remainder in Canada. Europe ex UK is still an underweight, but we have noticed recently an increase in opportunities to invest in well-regarded international businesses, at more attractive entry points than their global counterparts headquartered in the US. We continue to hold c15% in the UK in multinational businesses that we believe are not materially affected by the referendum result, and will still generate excellent dividend growth over the long term. Exposure to emerging markets, either directly or indirectly, is now beneath the 10% level. This gradually reduced throughout the year as share prices dramatically corrected from the lows of the first quarter. Banco Bradesco was sold in its entirety as the stock more than doubled in US dollars during the period, achieving a full valuation in a short space of time. Outlook Valuation appears to matter again we think this bodes extremely well for large sections of the fund. We remain steadfast in our belief that the anticonsensus decisions we made in 2015 will continue to benefit performance over the next few years. Discrepancies still exist between underlying fundamentals and share prices and we believe that this gap will close further in We will continue to avoid paying over-the-odds for safety and security alone, and will remain vigilant in making sure we firmly believe that each individual investment has the capacity to grow above market levels going forward. Rapid growth was an exciting category last year, in terms of putting new money to work, and we remain hopeful that we will be able to continue this trend in A number of companies have been added to our watch list, and we patiently await appropriate entry points. Dividend trends across the fund are positive ultimately a sign of management confidence and we think these growth rates reflect well on the companies growth potential and financial stability. In 2016, 12 of our holdings increased their dividend by over 15%, which is highly encouraging. We are pleased with the rebound in performance in 2016, but also believe we have only just started down that path. Happy New Year everyone. M&G January 2017 The fund invests mainly in company shares and is therefore likely to experience larger price fluctuations than funds that invest in bonds and/or cash.

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