Strong year for markets, encouraging quarter for value
The fourth quarter of 2019 ended on a strong note for markets as the recession worries that dominated headlines last August have faded into the background. Additionally, a tentative deal between the US and China has relaxed much of the anxiety with respect to global trade. Notably, we believe the main driver of market returns in 2019 was unquestionably the easing of monetary policy by the US Federal Reserve (the Fed), as well as other central banks around the world. In short, after causing significant market disruption in 2018 with numerous interest rate increases, central banks reversed course in 2019 by cutting rates. We believe this, paired with signs of stabilization on the economic and trade front, has resulted in a surge in liquidity that drove global markets higher throughout 2019.
Although market gains in 2019 look impressive at first glance (S&P +31%, TSX +22%), it is important to put these figures in context. Prior to the rally that started just over a year ago (December 26th, 2018 to be exact), markets had entered bear market territory – generally defined as a decline of at least 20% from their highs. This means that a meaningful portion of the gain in 2019 was a recovery of the prior year’s weakness. This dynamic is probably best illustrated by the fact that the TSX has gained barely 3% over the last 18 months since July 2018 (see Figure 1).
We believe the move in stocks during 2019 was driven almost exclusively by multiple expansion as opposed to improving fundamentals. In fact, S&P500 earnings grew minimally during the period. An excellent example of this is seen when examining the move in Apple – currently the largest company in the world by market capitalization. Although the shares of Apple gained 89% last year, the earnings per share estimate for Apple is actually below where it was a year ago (see Figure 2). In addition, Apple’s revenues and operating earnings fell in 2019. We believe this is simply a case of investors paying a higher valuation for the same (or lower) level of earnings; in other words, multiple expansion in the absence of earnings growth.
As is often the case with a liquidity-driven as opposed to an earnings-driven stock market rally, investors in 2019 flocked to the sectors that had done well in the previous few years. In 2019, this meant technology. Within the S&P500, the tech sector was up over 50% in 2019, the best year for technology stocks since the fateful year of 1999. Following the gains of 1999, tech stocks experienced years of significant losses. Although we do not expect an exact replay of that period, we continue to view the technology sector as expensive, crowded, and therefore not a great place to find attractive investment opportunities at the current time.
Value investing gaining favour once more
From our perspective as value investors, 2019 was a tumultuous year that ended on a positive note. As we highlighted in our last quarterly letter, value investing has been out of favour for the past two to three years. This trend was most apparent last August when fears of a global recession peaked. Since then, forward indicators for global growth have stabilized and the performance of value stocks has outpaced that of the broader markets. We have seen evidence of this recovery within our holdings, many of which performed well in the fourth quarter.
Clients may recall the Warren Buffett article we sent out last August describing the difficulty faced by value investors over the last few years. Interestingly, Berkshire Hathaway stock, which had been severely underperforming the market year-to-date, bottomed four days later and then went on to appreciate by 14% into year-end. Buffett still lagged the market by a fair amount in 2019, but the hysteria surrounding the “death of value investing” looks to have subsided significantly and we now hear many market pundits talking about “how to play the rotation to value.”
Another portfolio company that fits this theme is Fairfax India. After a tough couple of years, the stock received a nice boost during the quarter after the company announced several positive transactions. In addition to surfacing value in some of its investment holdings by listing them on the Indian stock exchange, Fairfax India also announced a significant event with respect to its largest holding – a 54% ownership position in the Bangalore International Airport. Under the arrangement, the Canadian pension fund OMERS effectively purchased a 5% stake in the airport at a significant premium to Fairfax India’s previous carrying value of the airport investment. This, along with the other value-surfacing moves caused the book value of Fairfax India to increase by 26% during the quarter. We see plenty of upside to the stock as despite the move, Fairfax India closed 2019 trading at a 25% discount to its book value.
Company Spotlight: Alcon
Alcon is the largest ophthalmology medical device company in the world. The company was spun out of the Swiss multinational pharmaceutical firm, Novartis AG, earlier this year. Alcon operates in two segments:
- Surgical (57% of sales) sells equipment, consumables and implantables for ophthalmologic surgical procedures
- Vision Care (43% of sales) sells contact lenses and other eye care products
We like Alcon and chose to initiate a position since the company has strong competitive positioning in attractive markets with long-term secular growth. Alcon is focused on markets where scale and intellectual property create significant barriers to entry, and is the #1 or #2 player in all of its key product categories. Additionally, demographics in developed economies (i.e., an aging population) are driving consistent growth in volumes of eye-related issues such as cataracts, glaucoma, and macular degeneration – we expect this trend to continue well into the future.
The contact lens market is also growing at a healthy rate, with key drivers being the trade-up to daily disposables and premium hydrogel materials, higher uptake of specialty lenses, and increasing penetration in emerging markets as a result of a rising global middle class. Alcon’s core end markets are expected to continue to grow at 3-5% per year and we expect market share gains given Alcon’s recent and imminent new product launches. Alcon has a much higher reliance on out-of-pocket spending than a typical healthcare company, which should help insulate it from reimbursement pressures facing the broader healthcare industry.
We believe Alcon should deliver mid-single digit revenue growth over the next five years. With a huge runway of opportunity for margin improvement, earnings per share could grow at a rate in the mid-teens. Importantly, these growth rates should be relatively immune to economic conditions and largely within the company’s control. Unfortunately, high-quality companies like Alcon are not being given away in today’s environment. As a result, we have established a starting position and are eager to add to it should the market give us an opportunity.