We maintain a well-balanced portfolio as we are not trying to make a directional bet on the macro cycle but are staying true to the price discipline at the heart of our investing philosophy & process. However, only the most resolute bears could fail to be incrementally more optimistic about the macro outlook. That’s because the short-term trajectory for softening inflation seems well-set, the Fed recognises ‘a lot of wood has been chopped’ regarding monetary tightening, and nearly all end markets within the industrial / manufacturing economy are either outright shifting from destocking towards restocking and growth, or at least not deteriorating. In this sense, the strong rally experienced in the last two months of 2023 appears to have solid foundations.
Investment Background
Global equity markets were strong again in December (MSCI ACWI +4.8% total return in USD), following very positive returns in November. For 2023, MSCI ACWI was up +22.2% whereas MSCI ACWI Equal Weighted (where each company has the same weight, rather than being weighted by market cap) rose +8.9%. The wide gap reflected the exceptional returns delivered by the largest companies. Style-wise, MSCI Growth returned +33.2%, compared to MSCI Value +11.8% over the past 12 months.
The equity market rally was supported by bond yields continuing their move lower. US 10-year bond yields declined from 4.3% to 3.9%. At its meeting mid-December, the Fed formally recognised the progress made in bringing down inflation and suggested it would be open to cutting interest rates both before inflation hits 2% and without a recession. The Fed’s rhetoric was more market-friendly than many anticipated, opening a clearer path for investors to price in an extension to the macro cycle and a broadening of equity market returns, most notably into small- and mid-cap stocks.
Strategy Update
Performance
The fund returned +5.9% in December. In comparison, the MSCI ACWI index returned +4.1% (all in GBP). In 2023 the fund returned +11.3% (MSCI ACWI +15.3%). Since inception, the fund has returned +19.1%, compared to the global benchmark’s +15.4%.1
TopBuild (+26% in GBP) was the top positive contributor for a consecutive month. A combination of lower interest rates and higher housing starts has rapidly increased investor optimism about the outlook for the US building materials industry. Henry Schein (+13%) continued its climb from oversold levels in early November, aided by comments by both its own management team and key competitor Patterson suggesting limited market share loss from the cyberattacks it suffered. Waters (+17%) maintained its share price recovery path on industry commentary suggesting life sciences instrument sales are in the process of bottoming, which is positive for growth prospects looking into 2024. Booking Holdings (+13%) was buoyed by analyst earnings upgrades, capping a +76% share price return in 2023. There were no material detractors from relative performance.
Activity
We added four new positions, all listed in Japan and predominantly smaller companies, during December.
Tsubakimoto Chain is a ~$1bn market cap manufacturer of chains for industrial (motion control), automotive and material-handling & conveyance applications. It is a century-old business at the start of a transformation which we expect will deliver strong shareholder returns. The Industrial business is the crown jewel: the global market leader with 15%-plus operating margins and attractive growth prospects linked to automation. Group margin recovery hinges on a cyclical upturn in Japanese automobile volumes and reduced losses in the project-based Material Handling division. The margin of safety is wide, as the shares trade on 0.6x price-to-book and management appear motivated to close the discount to book. Indeed, our initial meeting with IR came via an inbound request from the company and revealed a desire to increase dividends (current yield 3%) and buy back shares using excess cash and investments. Net cash and investments currently represent over a third of the market cap.
Kansai Paint is a top 10 player in the global paint/coatings industry where high oil prices and supply chain issues temporarily depressed margins. Strong industry pricing power and input costs rolling over should drive margin recovery, with the potential for higher margins over time based on mix and structural reforms under the current management. Kansai Paint should benefit from higher growth rates than peers due to its market leadership position in India, particularly within the autos sector, where key customer Maruti expects ~20% growth. The Indian subsidiary (75% owned) is listed and trades on 33x forward earnings. The management team has already indicated a willingness to reduce net cash and sell equity investments and non-core businesses or idle land. There is plenty more of each still on the balance sheet to support shareholder returns going forward.
DTS is an IT systems integrator with a broad customer base but some industry focus – for example, Finance & Insurance are one-third of revenues. Partnerships with software providers such as ServiceNow and Atlassian are helping deliver accelerating revenue growth, which we expect can be sustained at high single-digit / low double-digit levels. Low capital intensity means returns on capital are very attractive, though these are obscured by the excessive levels of cash on the balance sheet. Based on our estimates, DTS trades on 14x earnings a couple of years out, but just 9x EV/NOPAT – far too low for a business of this quality. We expect the presence of activist investors on the register will ensure the current progress towards a more efficient balance sheet continues.
Eiken Chemical is a diagnostic testing business, with strength in a niche (fecal immunochemical testing) which we expect will see accelerating growth in developed markets as colon cancer screening penetration increases, as well the LAMP test for infectious diseases (particularly TB) in emerging markets. In both cases, the combination of low cost and high accuracy is a key competitive advantage for Eiken's tests which simultaneously provides a clear societal benefit. Margins have halved from ~20% to ~10% (TTM) within the past year due to the drop in demand for Covid-19 genetic testing reagents, reduced patent fees, and an increase in staff costs. The company has margin targets of 14.4% for 2024e (set in 2021) but a longer-term target of 20%+ (and Y75bn sales). As at DTS and Kansai Paint, the process of selling down investments and cancelling treasury shares has begun but has plenty of runway, as well as activist shareholders keeping pressure on management. Japanese peers were recently acquired for 2.3-2.5x EV/Sales, which suggests material upside to Eiken Chemical’s current ~1x multiple.
These purchases were funded by drawing down on cash balances, the full exit of SAP, and reducing several holdings which had performed well. SAP was a successful margin recovery investment case which reached our fair value estimate. Strong share performance at McKesson, TopBuild, Whitbread, and UPM-Kymmene has reduced upside relative to other ideas, so we have redeployed some capital to the new positions above and certain existing holdings with superior risk-reward.
1Inception: 7 July 2022. Fund: F share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.
