When asked what the stock market was going to do, JP Morgan once famously responded – “It will fluctuate”. It turns out Mr. Morgan was exactly right. What’s more, his response is just as applicable to the market today as it was then. Given the uncharted waters of rock bottom interest rates and associated high asset prices, any bold statements on the direction of equity markets must be taken with a grain of salt. The best one can do is to take a bottom-up approach, investing in quality assets with enduring moats. In the current market environment of buoyant optimism and elevated multiples (particularly in NZ), our focus has remained on capital preservation and we have accordingly been holding a significant cash balance (21% as at 30 June). With this continued cautious approach, the second quarter of 2015 yielded a return of 10.36%. This was helped by Kirkcaldie & Stains, Mondelez International, depreciation of the NZ Dollar (down 9.8% vs USD) and hindered by a decline in European Stocks which make up 33.71% of the portfolio.

During the quarter, Elevation Capital Management Limited (on behalf of clients - including the Value Fund) filed a Notice of Substantial Holding on the ASX disclosing a +8% position in Pental Limited. Pental is a company we wrote about in Q2 & Q3 2014. It is a leading producer of household products including well-known brands in New Zealand, such as Janola and Sunlight Liquid. The Company is currently embarking on a program of investment in order to increase efficiency/reduce costs and broaden its product portfolio through the release of additional products under the existing brands. We are pleased with the direction management have taken the Company thus far. We were also pleased to see that one of our long-held positions, Tiffany & Co. raised its dividend by 5%. This represents the 14th dividend increase in the past 13 years, reflecting the sort of distributable earnings growth we like to see from the businesses we invest in. We initiated several new positions this quarter, including SGS SA and The Swatch Group SA. SGS is the largest testing, inspection and certification (“TIC”) company in the world, domiciled in Switzerland. We believe the TIC industry to be very attractive and expect it to benefit from powerful structural and long-term growth trends. New regulations and the increasing awareness of customers to the importance of (and protection of) global brands will be significant drivers of growth for the TIC industry in the future. Additionally, growth in global trade, migration of production to less developed markets, greater supply chain complexity, outsourcing, privatisation and increasing innovation/higher technological complexity will add to the momentum behind the industry. Growing public and consumer concerns about safety, quality and performance are prompting companies to invest more heavily in this area to assure their clients about the quality of their goods and services (think of companies like Fonterra in this regard). In addition, beyond compliance with regulation, companies now believe that proactive management offers a way to create value and provide corporate stability. With widespread use of the internet and the rise of social networking, the protection of global brands has become more complex and important. Companies are therefore increasingly seeking to manage asset integrity and product quality throughout the supply and distribution chain. We see these trends continuing and becoming stronger. Additionally, the economic cost of SGS’s services is small in the overall cost of goods sold equation for many multinational companies, but it is extremely important. This means a large proportion of the business’s revenue is recurring, leading to steady and predictable cash flows. Swatch Group shares have traded down ~ 29% over the past year, having been impacted by the prospect of competition from smart watches (particularly the Apple Watch), as well as the slowing of Chinese demand for luxury goods and the unpegging of the Swiss Franc from the Euro. We view these issues to be more than factored into the price at current levels, with shares trading at well below historical and peer group average EV/EBITDA, EV/EBIT and P/E multiples. Swatch has a number of characteristics which we believe make it a sound long-term investment proposition, including its unparalleled stable of enduring brands, the vast majority of which benefit from the advantages in the watch industry offered by the ‘Swiss Made’ tag. It is also vertically integrated, leading to Swatch having industry leading gross margins and we believe there is potential to expand EBITDA and operating margins further. The largest factor in both equity and fixed income markets globally right now is the ever present prospect of an increase in base interest rates. The US Federal Reserve is poised to lift rates later this year, with a Wall Street Journal poll of economists now showing that 73% of economists now believe the Federal Reserve will increase rates in September. When the same poll was conducted in March, only 38% of economists believed September would be the month rates were raised. In developed markets, we continue to see the recovery of Europe – albeit a slow, drawn-out recovery. The easing of monetary policy by the ECB has obviously been a tail wind for European equities but we continue to find interesting value in European markets. Once again, the recurring theme of Greece’s survival – or not – as a member of the Eurozone and the Euro currency union was centre stage throughout the quarter. At the time of writing, it appears that an agreement has been reached between Greece and its creditors for the third bail-out package. In China, the stock market has seen a remarkable increase over the past year and, in the past two weeks, a substantial correction. Despite the recent correction, the one year return on the index is still > 86%. In a recent article in The Economist titled ‘The Bubble Question’, the puzzling relationship between Chinese economic growth and the growth in its stock market was considered. From 2010 to 2014, China was one of the fastest growing economies on earth, while its benchmark index, the Shanghai Composite, was consistently among the worst performers in world equity markets. Thi relationship has been flipped since mid-2014, with growth in the Chinese economy beginning to slow, while the Shanghai composite index has catapulted. There are clear signs that this is a bubble. For instance, the level of outstanding margin loans to investors in China is up 300% over the past year and, in a recent study it was found that two thirds of new investors in the Chinese stock market last year did not complete high school (with the implication being that they do not necessarily understand the products they are investing in). On the other side, the forward P/E of Shanghai Composite Index companies has increased from 7x to 15x which is the ten year average. In this context, the increase could simply be seen as mean reversion, a concept which is surprisingly underappreciated in finance. 

Bond markets have also shown signs of “overheating” during the first quarter of 2015. Not surprisingly more recently, bond prices have pulled back and yields have risen, with the German 10-year Bund’s yield climbing above 1% for the first time since September 2014. Similarly, US Treasury auctions have seen 10-year notes selling at the highest yields since September of last year. Locally, we noted the eighth consecutive decline in dairy auction prices. This is a timely reminder that it is prudent to diversify away from New Zealand and NZ dollar denominated assets. In our view, too many people remain leveraged to the ongoing success of the NZ economy which itself remains inadequately diversified with over reliance on the dairy trade and housing (complacency is particularly high in Auckland in our view). The 25 basis point reduction of the OCR is a sign that not all is well in the New Zealand economy. As has often been the case over the past two years, the Reserve Bank of New Zealand finds itself between a rock and a hard place, with inflated property prices in Auckland posing a risk on one side, offset by a less optimistic picture for the rest of the economy on the other, particularly given recent and continuing declines in business sentiment. 


In Closing

We continue to shift the portfolio to truly global businesses which own brands with pricing power or companies that provide services which are a necessity to global businesses or governments. Our portfolio demonstrates a clear shift away from commodity and manufacturing businesses that are in a battle for market share or to find markets for their products. Virtually every economy in the world today is trying to export some product and simple economics tells us a seller (exporter) must find a buyer (importer) and that occurs via the equilibrium price. This race to export has led to widespread deflationary pressures - our own dairy industry has fallen victim to this rather dramatically, driven by changes in global supply. Global dairy prices have fallen >40% since February. A recent Bloomberg article titled ‘The US is Producing a Record Amount of Milk and Dumping the Rest’ illustrates how easily this can happen (with specific reference to the NZ dairy industry), as US milk producers have achieved record production levels and the surplus supply flows on to international markets. Businesses which sell undifferentiated, commoditised goods or services are therefore at the mercy of global markets as they are price takers, rather than price makers. We do not see deflationary trends changing in the foreseeable future. Remember, deflation has been at work in Japan since 1990 and the global economy since 2009/2010. This is why we seek to invest in brands that have pricing power or services that are integral to global business irrespective of deflationary forces which maybe impacting their client. In this deflationary context, we also need to be mindful of macroeconomic trends including, importantly, savings rates. Wealthier households account for 15% of consumers on a global basis and they save approximately 20% of their income on average. The other 85% of households actually have a dissaving rate. So, when focusing on households we have to be in the luxury or aspiring luxury categories or we have to be in the everyday necessities categories across a multitude of brands. At some stage this dissaving amongst such a large segment of the population will change and that is going to create some real difficulties for a number of economies, hence we continue to maintain a conservative positioning within the Fund as global uncertainties remain high and increasingly difficult to predict when you also factor in technological impacts.

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