The iMGP Oldfield International Value Fund gained 0.27% during the first quarter of 2024, underperforming the MSCI EAFE Index benchmark return of 5.78% and MSCI EAFE Value Index (up 4.48%). The Morningstar Foreign Large Value Fund peer group gained 4.00% in the quarter.
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Quarterly Portfolio Manager Commentary
International stocks have rarely been as attractive as they are today. On a forward price-to-earnings (P/E) basis, the S&P 500 is now trading at a premium of over 40% to MSCI EAFE markets. While it is true that the US is typically more highly-valued than the rest of the world, the historic premium has been closer to 15%. The S&P’s current P/E ratio of 21x seems to reflect an extrapolation of high earnings growth experienced in the past. This requires a heroic set of assumptions. In a recent paper, the Fed’s Michael Smolyansky pointed out that non-financial companies in the S&P 500 grew real earnings per share by 2.0% per year between 1962 and 1989. From 1989 to 2019 this has accelerated to 3.8%. Over the same periods, growth in real operating profit per share has decelerated from 2.4% per year to 2.2%. Importantly, over both periods, operating profit has grown by less than GDP. How come earnings growth accelerated over the last 30 years while operating profit per share growth did not? The answer is that the entire outperformance at the earnings level came from falling interest rates and taxes. With effective taxes of the S&P firms at 15% in 2019 and interest rates still at historically low levels, this tailwind will not get repeated. Even the belief that taxes will stay at 2019 levels seems optimistic to us given the US’ huge fiscal deficit. Any investor who believes that the market can grow real earnings by more than real GDP over the long term is probably fooling themself. We struggle to see a scenario where this bleak growth outlook is consistent with the current S&P 500 P/E ratio at 21 times. Most likely US investors are in for a disappointment. International markets also benefited from falling interest rates and taxes, but their valuation at 14.8x P/E is much more reasonable. With high growth unlikely to be repeated, valuations matter. The strategy is currently trading on a forward P/E ratio of 9.8x and we remain excited about the opportunities we see in international markets.
The Fund rose very slightly in the first quarter of 2024 while the MSCI EAFE Value Index rose 4%. While just over half the stocks in the portfolio provided positive absolute returns in US dollar terms during the quarter, only six outperformed the benchmark. The largest positive contributors to the Fund were Embraer (+44% in price currency), easyJet (+12%), and Exor (+14%). The largest negative contributors to performance were, in order of impact, Reckitt Benckiser (‑22% from the point of purchase to the point of sale), Fresenius (‑11% total return in local currency), BT Group (-11%) and CK Hutchison (-10%).
The Embraer share price performance was largely driven by its rising orderbook, including a substantive 90 jet order from American Airlines Group. The firm also had continued success with its military cargo plane, the C-390, which is now gaining traction internationally, including orders across Europe, the Americas, Africa, and Asia.
In terms of activity during the quarter, we sold Bayer to fund a new position in Reckitt Benckiser. Bayer proved to be a poor investment. Having been held since inception of the fund. We sold because of the risk of further litigation. With an already levered balance sheet Bayer has limited ability to meet new litigation payments that may come from polychlorinated biphenyls (PCBs), new liabilities related to glyphosate as well as potential litigation in the US around the impact on biodiversity of its herbicides, fungicides, and pesticides.
Reckitt Benkiser is a diversified consumer staples business with brands across health, hygiene, and nutrition. Its brands in the hygiene business include Harpic, Vanish and Cillit Bang; health includes Nurofen, Strepsils and Dettol; whilst the nutrition business is dominated by baby formula brand Enfamil.
The company has been built around acquisitions, with Reckitt Benckiser itself formed in 1999 following a merger between Reckitt & Colman and Benckiser. Prior to 2016 the company’s largest acquisition was around $3 billion. In February 2017 they purchased infant formula maker Mead Johnson for $16.7 billion. This proved to be a bad transaction with low single digit returns on the investment and excess leverage which the company spent the last 7 years reducing.
Reckitt Benkiser has best-in-class margins that helped protect it from the worst of the inflation in recent years and announced they were buying back shares. At a decade low valuation, the shares looked attractively priced for what was meant to be a relatively low risk investment.
As part of our pre-mortem analysis there were three key areas we thought could derail our investment. One such area related to poor organic sales growth; while this may not be a disaster for the investment, it would likely result in disappointing returns. A large (and poor) acquisition, in the mould of Mead Johnson, would be a major disappointment.
Finally, a large product liability issue had the potential to derail the investment.
The company had faced various fines and issues with products over the years. Given Reckitt Benkiser’s healthcare-related product exposure, we did not consider any of these out of the ordinary. However, following a court ruling in the middle of March, the company now faces a major liability relating to necrotizing enterocolitis (a life-threatening inflammatory disease of the bowel in preterm infants) with its Enfamil baby formula in the US.
Despite convincing arguments in favor of Reckitt Benkiser, the jury ruled in favor of the plaintiff, Ms. Watson. She was awarded a headline sum of $60 million. The company’s reaction to the verdict was one of ‘surprise’ and ‘disappointment’. Reckitt Benkiser will now appeal the ruling but is facing around 400 other cases across the US and this result may encourage additional claimants to come forward. It is likely that it will take a couple of years before we know the actual conclusion of the US legal cases. Determining the liability is a near impossible task, analysts assume anywhere between zero and $10 billion. What we do know is that we do not know what the outcome will be. As a result, the investment case changed from being a view on operational delivery (and the return of cash through dividends and buybacks) to a view on litigation (which would impair the cash return prospects) and we therefore sold the shares. It goes without saying that we are very disappointed by the outcome of our short holding period in Reckitt.
We used the proceeds from Reckitt to increase the existing holdings in two other consumer companies, Heineken and Henkel.
Fresenius, the diversified healthcare company, has been restructuring to a more focused core. This is through a combination of disposals of the Peruvian hospital business and fertility clinics, restructuring the project management business, Vamed, and deconsolidating the dialysis business, Fresenius Medical Care (FMC).
Today the core assets are the hospital businesses in Spain and Germany and the Kabi business. Kabi sells a range of healthcare products including intravenously administered generic drugs and fluids, biosimilars (generic versions of biological drugs) and clinical nutrition.
As well as restructuring and shrinking the business, Fresenius has also been investing in the biosimilars business. The restructuring and investment have been a drag on both profits and cash flow. However, we expect an improvement in the coming years. We expect the net debt to EBITDA ratio to improve from an unhealthy four times at the end of 2022 to under three times in the next year or so, this could be accelerated by selling shares in FMC, although we don’t think this is necessary as it would take leverage to just two times net debt to EBITDA.
The stake in FMC is worth around 25% of the current share price and adjusting for this would imply that core Fresenius trades on just eight times 2023 net income. Despite the issues faced in current years this appears to be too low a valuation for a business that is expected to grow earnings organically at mid-single digits in the coming years.
| By Sector | By Region | ||
| Finance | 15.5% | Europe | 70.0% |
| Consumer Discretionary | 12.0% | North America | 0.0% |
| Information Technology | 4.2% | Asia ex-Japan | 20.1% |
| Communication Services | 4.7% | Japan | 2.7% |
| Health Care & Pharmaceuticals | 9.5% | Latin America | 7.3% |
| Industrials | 23.1% | Africa | 0.0% |
| Consumer Staples | 22.1% | Australia/New Zealand | 0.0% |
| Real Estate | 0.0% | Middle East | 0.0% |
| Utilities | 0.0% | Other Countries | 0.0% |
| Energy | 4.9% | *Cash is excluded from calculation. | |
| Materials | 0.0% | ||
| Cash | 4.1% |
| By Region | |
| US Equities | 0.0% |
| Developed International Equities | 80.6% |
| Emerging Market Equities | 19.4% |
| By Market Cap | |
| Small Cap | 0.0% |
| Mid Cap | 25.7% |
| Large Cap | 74.3% |