In late February and early March, Patrik Sjöblom met several company management teams in Washington, New York, London and Stockholm. He also attended Daiwa’s Japan Conference in Tokyo, J.P. Morgan’s Aviation, Transport and Industrials Conference in New York and CITI’s Business Services Conference in London.
What was the purpose?
The purpose of the trip was a combination of ‘discovery research’ in order to find new ideas for the portfolio and ‘update meetings’ with a number of to us well-known companies, some of which we currently hold.
What stood out most about the companies you visited?
During the course of three weeks on the road, I met with 52 companies of which 5 new names that we have identified as priorities to undertake deeper research work on. Characteristic for Bell AM’s agnostic sector/region approach to investments, these 5 are domiciled in Australia, Japan and the US, and are exposed to attractive growth drivers in end-markets like commercial aerospace (Financial Products Group of Japan), mergers and acquisitions in SME (Nihon M&A of Japan), water infrastructure (Xylem of the US), mortgages guarantees (Zenkoku of Japan), and consumer staples packaging (Amcor of Australia). In addition, meetings with to us well-known companies (20 in total) confirmed, and in a couple of instances strengthened, our conviction in why we own or not own them. Assa Abloy, BAE Systems and Bunzl were 3 companies that we own and for which our conviction level was strengthened.
How is this market/sector performing at present?
For Japanese equities, structural issues such as decreasing population and workforce, rigid labour and immigration policies, overall subpar cost structures etc (in short, lack of profitable growth), continue to hamper performance (e.g. MSCI Japan has underperformed MSCI World by 3.8% in the last six months and by 10-30% over the last 4-5 years). However, in this limping market, there are brilliant, often SMID Cap, investment opportunities; Financial Products Group, Nihon M&A and Zenkoku could be three of them.
Looking at global industrials, performance (+1.3% vs. MSCI World in the last six months) has been driven by the US (+3.7%) following promises by the new Administration to increase spending, preferentially treat US production and cut taxes. European industrials have performed in line with the global average and laggards have been emerging market industrials; the latter obviously at a clear disadvantage should the preferential treatment of US production become reality. Not surprisingly, the early cyclicals have been the strongest performers within industrials (e.g. Global Machinery +5.1% vs. MSCI World) and in particular US Machinery (+7.6% vs. MSCI World). At this point, we prefer the more stable growing niches of the industrial space (e.g. aerospace, defence and business services) as not only valuation is less demanding but also offer better multi-year earnings visibility.
What can local investors learn from this market/sector?
With regards to Japan, there are no obvious trends that would have a significant read across on Australian sectors. However, seen as a market to invest in, the somewhat dire structural backdrop yields one key conclusion: investing in Japan should be active quality based stock picking.
Turning to global industrials, I note the overall tone in commentary regarding energy and commodities is more confident now compared with a year ago. This could possibly be a slight positive for the resources dependent Australian investor.
Do you have any holdings in this market/sector?
Currently, we hold no stocks in Japan. Historically, we have had some exposure but typically been underweight. In industrials, we are marginally overweight but with main exposures found in aerospace and defence (>1/3 of the industrial weight) and stable industrials and business services (~1/2 of the industrial weight).
Are you considering changing your allocations to this market/sector?
Country and sector allocations for us are pure outcomes of the investment process and stock picking and not intentional decisions. Following further research and due diligence on the new names mentioned earlier, we may invest in one or more of the companies and thereby increase our allocation to both Japan and industrials.
What is driving the growth in this market/sector?
While Japan is hardly a growth market, with exception of some construction work ahead of the 2020 Tokyo Olympics, some companies manage to monetise and grow thanks to the lacklustre and somewhat inefficient overall macro backdrop. E.g. Nihon M&A thrives thanks to hundreds of thousands of Japanese SMEs lacking succession plans and the population is getting increasingly older, and Financial Products Group global franchise benefits from cheap domestic funding due to the low growth low inflation environment.
Industrials in general are typically leveraged plays on ups and downs in GDP growth. However, our selection of stocks in the sector are characterised by either very large and often growing backlogs with multiple years of production secured (aerospace and defence) or high shares of recurring revenue streams often supported by secular growth drivers that tend to be relatively uncorrelated with the direction of GDP growth.
What are the risks to this market/sector?
Merely looking at the Japanese stocks that match our quality based investment approach, valuation is a key risk factor to consider. The scarcity of profitable growth investments makes the few stocks that actually deliver this ‘over-owned’ with significantly elevated valuation multiples as a result. To some extent this could be said to apply globally, but in the case of Japan it appears even more pronounced.
Overall high valuation levels have been supported by cheap money (QE programs in the US, EU et al) and deflationary trends holding down the short end of the yield curve. With most QEs having ended and, starting in the US, inflation beginning to pick up, we remain very watchful on valuation overall and in particular for stocks that have become “bond-proxies” and where the negative correlation between valuation and interest rates is very high.
Another area of concern is global trade. Policy making going forward shows tendencies for increasing protectionism (Trump, Brexit). In this context, it is worth noting global trade as percentage of GDP has been weakening every year since 2012 (60.8% in 2012 to an estimated 58.0% in 2016). Falling energy and commodity prices explain part of this but not all; adding trade barriers now will undoubtedly amplify the negative trend and put shackles on growth.
What implications do these findings have for your portfolios?
Provided further in-depth research renders QARP (Quality At Reasonable Price) outcomes, we may decide to invest in one or more of the new names from this research trip.
Next planned trip?
My next planned research trip is Europe in September when I am planning a number of visits to company HQs/plants as well as attending conferences in Germany, Switzerland and the UK.