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.
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.
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.
These setbacks are part of what we face in the short term and while it’s always disappointing to underperform, our reaction to these setbacks is significantly more relevant. Ryanair, Cairn Homes, Neinor and Richemont are all top ten positions in the fund today, having been in the bottom ten performers over the previous 12 months. This is reflective of the value we see in the long term and our belief in the strength of these business models over the medium term.
The simple answer is we’ve got no idea and, frankly, how the index performs is less relevant for the fund. Activity has been minimal, we are comfortable with the shape of the portfolio and will selectively be adding to some of the weaker names mentioned above over the coming months. As ever, only time will tell, but we see significant value in the fund over the medium term.