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CGE Update: “Success Doesn’t Come in a Straight Line”

Seven reasons why investors in BMO Concentrated Global Equity Fund should be unfazed by momentary setbacks in performance.

May 2022

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Michael Hughes

Senior Vice President & Client Portfolio Manager - GuardCap Asset Management Limited

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Key Takeaways

  • Earnings picture remains strong despite temporary setbacks in returns
  • Portfolio holdings are highly insulated from market headwinds
  • PM team has not needed to add or delete any positions in Q1

1. It’s been a hard quarter for equity markets. How is the BMO Concentrated Global Equity Fund faring against the benchmark?1

MH We’re in an unusual position this year. Markets are down, and we’re lagging slightly behind the index1 for now—which is uncharacteristic given how we typically outperform during a downturn.2 We expect this to be temporary because, in the near term, we believe that investors are leaning towards cyclical companies that could be mistaken for Value opportunities. These types of companies are highly correlated with macro trends; they go up or down depending on where economic growth is headed. And in over 25 years, GuardCap has never invested in them. Mining, oil, chemicals, autos, airlines, casinos, cruise ships—we steer clear of these sectors precisely because they’re so economically sensitive. When the news flow or economic outlook turns negative, these sectors often suffer extreme pullbacks and experience a huge variance in their annual returns.

That’s why we aim for predictability. Our portfolio consists of solid companies that are better insulated from gross domestic product (GDP) trends, backed by secular growth drivers—such as aging demographics and digitalization—and poised to beat the benchmark over the longer term.

2. Let’s talk fundamentals. What does the earnings picture look like for the portfolio?

MH The earnings picture has been extremely good. In fact, even firms that underperformed from a price perspective have announced solid growth so far this year, which speaks to my point about the market not being focused on fundamentals. One example within the portfolio is a Japanese industrial consultancy that advises companies on automating their production lines and other tricky manufacturing processes. They reported a 61% increase in operating profit, compared to the same quarter last year—yet the stock is down by double digits. The cause for this value gap appears to be sentiment, not fundamentals. Investors are looking at macro issues like the war in Ukraine or the COVID-19 lockdowns in China, and worrying about how those unpredictable events can impact their client portfolios. But broadly speaking, we have not seen disruptions in operating profits during the last few rounds of results.

3. How long will it take for the market to rotate back from cyclicals to fundamentals?

MH To be fair, there’s more to the cyclicals story than speculative puff. They have genuinely been doing well in terms of earnings for the past few quarters. Median revenues growth for the entire S&P 500 Index was 20% in the fourth quarter of 2021, a massive rising tide that buoyed economically sensitive sectors like financials and energy. Investors responded enthusiastically because the earnings growth was very real, albeit driven by unprecedented levels of monetary and fiscal stimulus. Some of the biggest revenue growth stories were to be found in cyclical sectors – not in the traditional “growth” sectors. And that’s the problem. Because at some point, the economy rolls over, and the market starts to price in a much more negative level of GDP growth, and the easy money and loose fiscal policy that drove the cyclicals boom will be removed, just as inflation also threatens to eat into demand. Case in point: central banks have started raising interest rates by 50 bps (or more) and governments are tightening budgets to deal with inflation. Add to this, the Ukrainian conflict potentially hurts the supply of certain commodities, which could strike another blow to inflation numbers and prolong the downturn. Right now, there’s too much uncertainty to say for sure when a recovery will take place, but we expect at least some disappointments in the coming quarters.

On the upside, we remain very confident in the portfolio. It invests in 25 companies whose earnings are, to a large extent, insulated from the broader levels of economic activity. Each holding is also linked to a secular growth-driver, which means they can continue to grow nearly irrespective of what’s going on in the macro picture. If valuations dip in the meantime due to a shift in market sentiment, it doesn’t knock us off course, because we know that success doesn’t come in a straight line.

4. Speaking of central banks…rising rates tend to be negative for valuations. Are you seeing this in the portfolio?

MH We’ve seen valuations come down slightly, but that’s hardly a surprise, given that the entire market went down. Unsurprisingly, the damage has been most acute in companies that we don’t own, such as Netflix. The streaming giant benefitted enormously from first-mover advantage for several years, until recently, when a mix of competition and lower demand brought the share price crashing back to Earth. We’ve seen similar stories with Meta (formerly Facebook) and Etsy—all fast-moving tech stocks that suffered from the market’s expectations being far too high. Investors are simply not willing to pay for those high multiples in this environment. By contrast, companies that churn out steady earnings growth based on secular drivers are unlikely to drop out of nowhere, because their fundamentals are unlikely to evaporate overnight. So, the whole theory about discounted cash flows (valuations) being impacted by rising rates is not evenly true for all stocks; it applies disproportionately to high-growth, high-valuation tech companies.

5. Have you made any changes in the portfolio?

MH No, we haven’t made any radical changes in the last quarter. We’re adding to some positions where the selling was perhaps overdone, but I can’t mention any names until we’re done executing the trade. Looking further back to last year, we picked up some holdings that had high-quality recurring revenues, and that decision is standing us in reasonably good stead at the moment.

6. We know the strategy takes a bottom-up approach—but are there any sector or geographic tilts?

MH Approximately three-fifths of our holdings are domiciled in the United States, but that’s not because we think the U.S. economy is going to do well—it just so happens that the U.S. is home to some of the strongest multi-national companies in the world. The truth is we’re not terribly interested in where companies are listed. Our focus is on making sure the portfolio has a good balance of geographical sales exposure. We look at where our companies are doing business so that we don’t inadvertently build up excessive exposure to one set of markets. This also helps us limit the amount of currency risk in the portfolio.

We don’t deliberately overweight any sector, but there are some exclusions. For example, we avoid owning equities in energy and raw materials, and instead opt for areas where we can find dominant market players, such as consumer staples, health care and communication services.

7. Michael, one last question. We like to end by asking for book recommendations that have shaped the way you think. What would you suggest for our Advisor audience?

MH I recently read a book called Red Notice by Bill Browder. It covers the Magnitsky affair that took place in Russia, and it basically tells you everything you need to know about investing in that country. The author has first-hand experience with the Putin Administration and, given what’s recently happened in Ukraine, his take looks quite prescient. The sub-head alone is what got me interested: A True Story of High Finance, Murder, and One Man’s Fight for Justice.

Please contact your BMO Global Asset Management wholesaler for any support and guidance.

1 MSCI World Index (CAD).

2 BMO Concentrated Global Equity Fund – Fund of the Future: Q1 2022, slides 27 and 31. The higher Sharpe ratio relative to the index is a measure of risk-adjusted returns. Lower downside capture than the benchmark allows the fund to typically outperform in adverse conditions. The fund outperformed the market in 2018, a difficult year for markets.


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