The first quarter of 2018 has been a quarter of two halves with the MSCI World Index starting the year strongly reaching all-time highs at the end of January, before retreating back to mid-November levels. Although US tax reform and broad economic strength aided company earnings, investors sold stocks following tit-for-tat tariff moves between the US, and China and technology sector weakness stemming from Facebook’s questionable control over its user’s data (note that Facebook has never been owned in our Global Sustainable Equity strategy).
We remain optimistic on the outlook for our technology investments however, and believe we are at the early stages of both cloud computing adoption and increasingly broad semiconductor usage. Both are areas where we have significant holdings. Enterprises are being forced to digitalise to remain competitive and digitalisation is increasingly considered a top priority for senior management. Companies held in the fund such as Microsoft, Adobe, Salesforce.com, Autodesk and SAP offer cloud-based software solutions which can be quickly deployed and offer a way for customers to improve efficiency, customer service and reduce their carbon footprints (due to cloud computing typically being run on carbon neutral datacentres). Additionally, we view semiconductors as a fundamental building block in the digitalisation of all sectors. Semiconductors are being increasingly adopted in a broad array of applications as we transition to a smart and connected world.
One such example is the auto industry, where the shift to electric and autonomous vehicles is resulting in a significant increase in the amount of semiconductor content required. The quarter saw further evidence of the magnitude of this transition with VW (one of the world’s largest auto manufacturers) announcing a €20 billion battery technology investment. We also witnessed further support at the government level with China adjusting EV subsidies to only include vehicles with over 150km range (from 100km previously). Various German cities also joined Paris, Madrid, Rome, Mexico City and Athens in planning to ban diesel vehicles by 2025. We expect rapid technological improvements combined with government support for a low carbon transition to result in further disruption to incumbents who are slow to change.
While our long term negative view on the oil price is in part due to electric vehicle (EV) growth displacing demand for gasoline, we have also seen further progress in renewable energy development. Late in the first quarter we saw Softbank’s Vision Fund announce a plan to support a $200 billion 200GW solar power development in Saudi Arabia. When completed this site will be 100 times larger than the next largest proposed solar development and produce double the energy the whole global photovoltaic industry supplied in 2017.
Interestingly, the Saudi government is one of the largest backers of the Softbank Vision fund and this move, combined with the looming Aramco initial public offering (IPO) adds further support to the country’s ambition to diversify away from oil. Aside from the environmental benefits of solar energy, growth of the solar industry is expected to save the Kingdom $40 billion annually by obviating the need to burn domestically produced oil to generate power. This 200GW solar investment will generate the power equivalent to more than 200 nuclear power stations. Having the world’s largest oil economy so visibly diversifying away from oil provides further support to our low carbon investment approach.
Following the success of the BBC’s Blue Planet 2 series, there has been a spotlight on society’s obsession with plastic and the subsequent impact it is having on our oceans. Scientists estimate that if current production and management trends continue, there will be roughly 12 billion tonnes of plastic waste in landfills or the natural environment by 2050 (more than double today’s levels). With the global population forecast to grow to almost 10 billion people by 2050 and the ocean being a key food resource, action must be taken today. Encouragingly, governments seem to be taking modest steps evidenced by the banning of microbeads and taxes on plastic bag and bottle usage. As oil is a primary raw material in plastic, a global shift away from plastics and towards recycling will be an incremental negative for the long-term oil price. We plan to engage with company management teams to better understand what they are doing to reduce plastic usage and waste in their businesses.
Fund performance and activity
Over the period the fund declined by 2.8% in sterling terms, outperforming the MSCI World Index by 1.9% and proving to be resilient in the volatile market backdrop. Stock selection within technology, financials and healthcare sectors positively contributed while stocks within consumer discretionary and telecommunications detracted.
Contributors to performance included Adobe (Knowledge and Technology), the developer of software for creative professionals and digital media. The transition to a recurring cloud-based subscription model is progressing smoothly and the company's long-term earnings potential continues to increase. Adobe inventions are helping to drive the creation of ideas and exchange of information - presenting new ways of solving social and environmental problems. Education is one of Adobe’s largest end markets. In addition, the shift to digital media enables customers to reduce waste and save natural resources.
Encompass Health (Health), a leading provider of post-acute care in the US, also performed well. The company's share price rose as it reported positive results which demonstrated robust organic growth in its Home Health and Hospice segments. The company also announced an acquisition which will further expand its presence into the US hospice segment. Following strong performance we reduced our position to a size which takes into account the potential risk of a change to government rebates. Encompass is well positioned to benefit from an aging demographic pressuring US healthcare costs because its inpatient rehabilitation centres and home care services offer a cost advantage over senior nursing facilities.
Shimadzu (Safety), a Japanese manufacturer of analytical and measuring instruments, continued to perform well as a result of solid global demand for its scientific instruments and a positive update on its China business (which accounts for over 20% of instrument sales). Shimadzu specialises in liquid chromatographs and mass spectrometers, where improved instrument performance is resulting in a growing number of applications related to food and environment safety testing, healthcare services, and drug discovery.
Detractors from fund performance included Gildan (Quality of Life), the North American t-shirts and basic apparel manufacturer renowned for its high social and environmental standards. Its shares underperformed as its competitors reported weak results. While less exposed than its competitors to challenging retail conditions, Gildan is still experiencing some disruption from the ongoing shift to ecommerce. We are confident Gildan will be one of the winners in the evolving apparel landscape. Its vertical integration enables it to produce high quality garments at very competitive price points and it has a dominant franchise in the print wear industry where it is supplying blank t-shirts and sports garments to screen printers. We believe the recent acquisition of American Apparel will lead to higher rates of growth and improved returns.
Vodafone (Knowledge & Technology), one of the largest operators of mobile and internet services in the world, continues to be a frustrating holding. The company reported results that were broadly in line with expectations but its top line growth is still weak. Adding to the pressure on shares were reports of increased competitive intensity in Italy and an announcement that its management had recommenced deal negotiations with Liberty Global (with the expectation that a rights issue will be necessary to part fund any potential deal). The position is under review but we believe Vodafone is nearing the end of its long restructuring to becoming an integrated mobile and fixed/cable operator and its earnings and cash flow should start to grow again. Mobile and fixed communication networks are an essential backbone to the functioning of modern society, to knowledge exchange and a connected more efficient world.
Shares in RELX (Knowledge & Technology), a world leading provider of information and analytics for professional and business customers, declined as a result of the strong euro weighing on profitability and concerns about increasing price competition in academic journals. RELX’s services facilitate the exchange of information that drives forward science and better heath, reduces risk and fraud for industry, governments and civil society, and promotes the rule of law and justice. Principally through the information it produces, RELX has a positive impact on both the environment and society by informing debate, aiding decision-makers and encouraging research & development.
In terms of activity and fund positioning, turnover (a measure of trading activity) in the fund was 12.5% over the quarter and 37.1% over the past 12 months. This higher turnover is partly reflective of our collaboration with the Denver office following the completion of the Janus Henderson merger last year. The merger has had a positive impact on the investment resource available to the Global Sustainable Equity fund team and many of the new positions in the fund over the last nine months have come about as a result of working with the fund managers and research analysts based in Denver. Aaron Scully, our new team member, has been of great help to us in building good working relationships with our Denver-based colleagues. We typically target portfolio turnover of below 30% on a 12 month basis and expect turnover to be lower over the coming quarters.
The fund remains skewed towards our Knowledge & Technology and Efficiency themes resulting in a continued overweight position towards the information technology and industrial sectors versus the index. The fund remains underweight to the energy, consumer staples and financial sectors and regional weighting remains much in line with the MSCI World benchmark. The fund is managed to keep regional weightings in line with the MSCI World benchmark while sector weightings are an outcome of where we are able to find the most compelling individual stock ideas while maintaining a balanced risk profile.
During the quarter, new positions were initiated in Capital Senior Living, Equinix, ING Groep, Lam Research, Salesforce.com, Sanepar, Walker Dunlop and Waters. Positions in Acuity Brands, AIN Holdings, Amer Sports, Arcadis, CVS Health, Delphi Technologies, F5 Networks, Invitation Homes, Tomra Systems, Trimble and Unicredit were divested.
We view the market volatility in the first quarter of 2018 as somewhat overdue following the record low volatility and market strength experienced through much of 2017. As long-term investors in companies that are transforming the world for the better, we are able to use this market volatility to our advantage. We have been able to add to high conviction positions at what we consider to be attractive share prices. We have been working hard to create a resilient portfolio of companies which we believe can deliver growth and strong cash flows regardless of the market environment.
When we look at the broader market, it is ever more apparent that the fastest growth subsectors are increasingly aligned with sustainability. We are finding exciting investment opportunities in areas such as cloud computing and artificial intelligence, electrification of transport, energy efficiency, smart cities, industry 4.0, sustainable infrastructure, financial services, education and research and healthcare. We view these as long-term investment trends that will transcend both economic and political cycles, giving us confidence in the duration of future growth. Thanks to the UN Sustainable Development Goals, we see sustainability growing in importance at the company management and board levels. Companies and investors are realising sustainability simply makes good business sense. And if it makes good business sense, then it makes good investment sense. Sustainability is our investment strategy.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility.
Combined ratio: a measure of an insurance company's profitability which compares costs against revenues.