Buffett refers to the value-destroying downside of imitation. While we can never say anything with certainty, when everyone’s convinced things can only get better, or in this case worse, we see an opportunity.
Style matters, not the market (herd)
While we’ve talked generically about the market, it’s resemblance to the portfolio is limited. We run a concentrated 26-stock portfolio where performance is driven by stock selection. After a very strong 2017 when our style and selection was in favour, outperforming by over 6%, 2018 – or the final quarter – saw this reverse, despite the work we had done around valuation risk. As it transpires, this wasn’t the main contributor to our underperformance, although our skew towards disruptors and technology did in totality drag on performance.
Style has been an important part of this. We talked throughout 2018 about valuations being ignored, especially in relation to expensive quality. We wrote several articles on the subject around our exit of Unilever, Adidas and Givaudan. In hindsight, these were the sort of names that performed well in the final quarter, reflecting their defensive qualities, not a change in earnings. Valuations for expensive quality continue to look extended; will we finally see that rotation into value through 2019?
Defensives also significantly outperformed, with around half our underperformance driven by the mega-cap names we don’t own: Novartis, Nestle, Roche, Total and Sanofi. We have said consistently that our informational advantage in the diversified pharmaceutical sector is zero and we see these businesses as average at best. Oil & gas majors have almost without fail been serial destroyers of capital. Again, we are not saying you can’t make money owning these businesses in a rising oil price environment (good luck forecasting that) but we have no desire to own businesses that make returns below the cost of capital and where they pay dividends by leveraging their balance sheets. This isn’t about mega-caps – we own SAP, ASML and Air Liquide – it’s driven by the quality of the business models. We are comfortable with this strategy but from time to time these stocks will drag on performance.
Stock selection hurt in 2018
While the above is relevant, the main reason we underperformed was stock selection, or a small cohort of names that were sizeable positions in the fund. We touch on these in more detail below but also provide you with the full breakdown of the positive and negative contributors.