Ardevora Quarterly Review - First quarter 2019

Fedshift

Let’s remind ourselves how 2018 ended. Trump’s unexpectedly aggressive attitude to America’s trading partners, especially China, had rattled investors. Building wage pressures and a hot running economy pumped by Trump tax cuts had prompted the Fed to tighten monetary policy. Chinese growth was decelerating at an alarming rate. 2018 ended with a terrible December, one of the worst on record. Recent experience often exerts a disproportionately strong influence on opinions. Most investors, judging by the raft of end-of-year strategy pieces from analysts, expected a poor start to 2019.

It is not easy to be contrarian. We are, at heart, pack animals, who prefer the safety of a crowd. There was a strong urge to sell stocks and wait for a better second half of the year. Hope lay in the narrative of a difficult first half of the year rescued by a more benign second half. If bound in to stock markets, the temptation was to seek safety in defensive, economically insensitive stocks, and to avoid areas of the world which felt the most uncomfortable: Emerging Markets and North America. The correct thing to do, was to think differently, embrace others’ anxiety and stay in stocks, especially the more stressful ones.

We use the MSCI ACWI (net) Index as a proxy for the performance of the world’s stock markets. In GBP terms it returned 9.6% in Q1 2019; a pretty stellar quarterly return. The best kinds of stocks were either the most unloved from the last quarter of 2018, or with high growth and on scarily high valuations; both anxiety inducing in their own way. The best hunting grounds for a stock picker were North America and Emerging Markets (where an equally weighted index outperformed a market cap weighted one). Just about every market produced good returns, even bonds. Yet, this was against a background of pitifully little “good news”: most of the quarter’s performance occurred while corporate results were generally below expectations and marginal economic data was disappointing. So what has changed to allow such a dramatic release of investor anxiety?

In 2018, investors did not like the combination of slowing growth and a cautious, tightening Fed. One has changed, and it only needed one change to release anxiety. The Fed unexpectedly reversed course early this year, signalling a clear intent to put further interest rate raises on hold for the rest of the year. This Fed shift, a perception the Fed would be just as responsive to signs of economic weakness as strength, had a profound impact. It has seemingly shifted investors’ focus from poor near-term news to a belief that the worst has passed. The effects are seemingly contagious. Whereas the Chinese policy response to slowing growth was generally viewed suspiciously last year, it has been embraced as likely to be effective this year. The third pillar of 2018 anxiety has also begun to fade: rhetoric from Trump has softened on trade with China, as he pushes for a favourable resolution. A China-America fixated view has seemingly blinkered investors. Events in Europe and recent corporate earnings trends from Japan have been largely ignored.

Economic news out of Europe has been fairly dire. Italy, France and Germany are all teetering on the edge of recession. Brexit is unfolding into a kind of slow motion trade war. Political discord seems to be mounting. Japan has its own problems. It is more sensitive to global growth. Profit expectations had rebounded during February, like the rest of the world, but have been deteriorating through March, signalling that trouble may be brewing.

It seems to us that investors are looking for risk in the wrong place. We believe investor views are overly focused on a China-America axis. Trump wants a trade deal and so does China. The easy win is for China to favour American imports, especially in commodity areas, to help reduce the trade imbalance (something Trump has explicitly targeted). The easiest way for China to achieve this is to crowd out trade with other non-US trading partners. Europe and the more resource based emerging markets look most vulnerable. China and America may experience a gradual release of trade tension and a benign environment for growth for the rest of the year, but the rest of the world may not be so lucky. Risks are mounting for the second half of the year.

 

Portfolio Review

Most of the things we think are important were helpful for stock picking this quarter. To recap, our investment cases revolve around our assessment of three things: management behaviour, analyst behaviour and investor behaviour. We always start with management, or CEO, behaviour.

Our cautious approach to CEOs was helpful. We like stocks where we can put together an argument for sensible CEO behaviour given current circumstances. Such arguments usually pull in some evidence around capital allocation for a business. We generally prefer businesses with good returns on capital and prudent balance sheets. These kinds of stocks generally performed well.

Some of our stocks have consistently super-duper looking capital management. These are rarely obviously disliked by investors. To make money out of these stocks we need to build a case for why analysts and investors may be “missing something”. Our cases usually revolve around two things: either something unusual about the business, or something unusual about the conditions the business currently faces. Framing it this way allows us to gather a fairly eclectic group of stocks together into a single portfolio. On the one hand, we can be happy to own stocks like Chipotle Mexican Grill, Eagle Materials and Cree which have recently experienced some trauma that has shaken investors’ confidence, and where we are looking to play what we see as misplaced investor anxiety. On the other hand, we can be happy to own stocks like Xilinx, Cadence Design Systems or Sartorius, which have unusual business models in unusual times when growth appears, to us, to be unusually easy. Both types of stocks were helpful this quarter.

Generally investors looked willing to let go of some of their anxiety as long as news wasn’t truly terrible. Owning disliked stocks was difficult last year, especially in December, but forgiveness was a common currency this year. A majority of our top contributors so far this year were stocks that were not much fun to own in the 4th quarter of last year. Anxiety is unwinding, as referenced in the stock examples above.

Uncomfortable growth stocks were also rewarding. Our best performing stock this quarter was MercadoLibre and our best performing theme was the evolving semiconductor industry. We have liked the semi industry for some time, but stocks in this area gave us a wild ride in 2018 too. We stuck with the ones we felt were “special”, like Xilinx, Cadence Design Systems and Synopsis, and they rewarded us this quarter. We also saw anxiety unwind for our less structurally loved stocks like MKS Instruments and LAM Research.

We have a lot of our portfolio in less exciting growth stocks, which can plod along at a rate a bit faster than average. These rarely feature in the outstanding performers in any given quarter, but they generally performed well too.

Our performance drags came generally from two main sources. First, we equally weight our positions, so when a particularly large stock does well, even if we own it, our relative underweight to the index can harm us; around a third of our worst detractors were these kinds of stocks. Amazon, Microsoft, Visa and Alphabet are all stocks we like, but we just don’t have as much in our portfolios as a market cap weighted index like the MSCI ACWI (net) Index. The rest of our detractors were mainly in laggard, defensive sectors like Health Care and Staples.

So what of the future? Average management behaviour, aside from the usual skew to over-confidence and delusional self-belief, looks pretty normal to us, so no red flags there. We see building evidence of disruptive forces in technology and media threatening established firms, but not at an alarming pace, yet. Investor behaviour looks susceptible to recency and confirmation bias, but in the opposite way to the end of 2018. The longer this stock market rally continues, the more investor anxiety shifts from “why stocks could go down” to “what if I miss the rally”. Despite an environment that is still difficult for growth and where downside risks abound, we suspect investors will shift their focus from downside avoidance to upside opportunity cost. Analysts were generally too gloomy in our view, especially in February and March, and too sceptical on the sustainability of current growth themes. To us, they seem to prefer narratives around buying laggards in the rally rather than chasing secular growth. All this makes for an interesting quarter.

 


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This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authority’s (“FCA”) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora Asset Management LLP (authorised and regulated by the FCA). Registered office: 6 New Bridge Street, London EC4V 6AB. Registered in England No. OC351772. Past performance is not a guide to future performance. Care has been taken to ensure the accuracy of this document’s content, but no responsibility is accepted for any errors or omissions herein. The views expressed are our own and do not constitute investment or any other advice and are subject to change. In particular, we are not recommending or expressing an opinion on the merits of buying or selling any securities mentioned herein. Ardevora Asset Management LLP is authorised and regulated in the United Kingdom by the FCA, and operates in the United States as an “exempt reporting adviser” in reliance on the exemption in Section 203(m) of the US Investment Advisers Act of 1940.

 

Previous Commentaries

Annual Commentary Period ending December 2018
Quarterly Commentary Period ending September 2018
Quarterly Commentary Period ending June 2018
Quarterly Commentary Period ending March 2018

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