2018 September Newsletter

Portfolio Q&A

This month, let’s review a few client questions that have come up in recent meetings. We’ll look at FIM’s exposure to the Turkey mess, some reasoning behind our relatively conservative portfolio positioning, and a few examples of innovation at our portfolio companies.

Do we have exposure to the Turkey mess in my portfolio and, if so, what are you doing about it?

August has been a turkey of a month for Turkey and for that country’s currency (the lira), as well as its stock and bond markets. Trends and events there, including high and rising inflation, a central bank (controlled by President Erdogan’s son-in-law) unwilling to raise interest rates, and an escalating conflict with President Trump (who’s not afraid to use trade as a weapon of negotiation) over the imprisonment of an American pastor, came together and triggered fear among holders of Turkey assets. In the first two weeks of August, the lira plunged 25% (see figure), Turkey’s 10-year government bond yields (US$-denominated) spiked two percentage points, and the stock market dropped 8%. 

FIM-managed portfolios have no material direct exposure to the Turkish lira, economy, or stock and bond markets. In fact, my colleagues and I scoured through our holdings for potential exposure, and we came back with just a few, insignificant bits. These include a Canadian gold streaming company with a long-term project in the country, a Belgian diaper company with less than 5% of Turkish revenues, and a UK listed investment company with a small stake in a Malaysian healthcare group that owns hospitals in Turkey. 

Where we’ve been feeling more of a near-term impact from the Turkey turmoil is the secondary effect to the US dollar. The dollar has moved higher against currencies we have exposure to, like the euro, as traders seek its per­ceived safety and bid up its price. We’ve also seen select international stock markets move lower, as traders speculate that the European banking sector has exposure to Turkey borrowers and that other emerging markets will also feel the negative consequences of the stronger US dollar. We believe these secondary effects, while worthy of close monitoring, will not affect the long-term return outlooks for our international positions. Should the spillover continue and further impact pricing on any of our favored international holdings, you can bet we will be looking closely at adding to these positions, given the long-term potential we see with them. 

Why is the FIM team seemingly conservative with its asset allocation these days (mix of stocks, bonds, cash) and cautious even within asset classes?

First off, we are still finding good things to invest in, on both the stock and the bond side. But yes, our allocations to so-called “risk assets” (like stocks and high-yield bonds) across our four core strategies are running at the lower end of our historical ranges. We’ve also been holding an above-normal average exposure to more defensive stocks and shorter-term US Treasury securities. Why the reluctance to hold more risk? In a nutshell: We’re not super-thrilled with prices for these riskier assets, and we still believe in cycles. For example, we know that historically, when the Fed raises rates, stock market valuations (the price level compared to measures of funda­mentals like earnings or revenues) usually decline. A recent table from KKR (see below) shows this phenomenon quite clearly. While valuation compression need not translate into an immediate problem for US stock markets if earnings growth stays robust, it does create more vulnerability should the outlook for earnings decline. And lately, between trade tensions and signs of increasing inflation, we do wonder if the consensus view on earnings is too sanguine. 

Another example comes in the high-yield bond market where yield spreads (the interest offered above and beyond a risk-free Treasury bond) are quite low (i.e., prices for lower quality bonds are quite high). These tight spreads come even though ratios of corporate debt to earnings have been on the rise (see chart in next column). We’re also hearing from bond market professionals we regularly speak with that the quality of newly issued loans and bonds is deteriorating (for example, the covenants required of the issuers are quite “light”). Again, this does not mean imminent trouble for corporate bonds, but it does make it harder to find much value that we can get comfortable with here, especially in longer-term paper.

Innovation is the lifeblood for any company. Can you provide some examples of how our portfolio companies are innovating? 

You’re right. Standing still is not an option for companies that hope to thrive long into the future, and developing new products and services is an important part of the resilience equation. Here are a few examples of newer offerings from our portfolio holdings.

The Canadian solar and infrastructure lighting company Carmanah Technologies recently reported strong sales of the SmartOne Solar product it makes for partner/customer Globalstar (a major satellite company). Globalstar knew that Carmanah had expertise in building solar-powered devices that could withstand the harshest of environments (e.g., Carmanah’s industry-leading marine lanterns). It charged Carmanah with designing and building an internet-of-things (IoT) device that was virtually indestructible and could provide years of battery life for asset tracking and other data transmission tasks that  its clients demanded. Carmanah’s SmartOne Solar device is just that: an intrinsically safe, solar-powered asset tracker and monitor solution with a 10-year battery life.

Ichigo Inc. is a Japanese real estate company with a solid track record of finding underutilized buildings and rehabbing and/or repurposing them into higher value properties. The Knot is its new, boutique hotel brand that fills a void in the Japanese hotel sector. While there are countless budget hotels and scores of luxury ones, there are few, quality properties in the middle. Ichigo’s second hotel under The Knot brand launched this summer in Tokyo’s bustling Shinjuku district after the company did a full, modern rehab of a 39-year-old, underperforming hotel. Seismic reinforcements, energy efficiency upgrades, and remodeling of all guest rooms and public spaces were undertaken to rejuvenate the hotel and extend its life. As Ichigo’s first few company-owned hotels prove their concept in the market, management is confident it will have licensing opportunities in the future that could see The Knot expand throughout Japan. 

Huhtamaki is a Finnish packaging company that must innovate to stay ahead of peers and continue winning the business of the food product companies it serves. Earlier this year, one of these innovations, its GreeNest egg containers, launched in select parts of the US. These containers use 50% grass fibers that make it both home and commercially compostable. In addition to cutting the product’s carbon footprint 10% and reducing its use of recovered paper, the grass used in the containers is sourced from nature reserves that otherwise would have to pay to remove this grass in their livestock management programs. We expect that products like these will keep Huhtamaki relevant as its customers increasingly embrace sustainable solutions throughout their supply chains. 

Swiss healthcare giant Roche Holding AG is one of the world’s leaders in the fight against lung cancer. With four approved medicines and more than 10 under development, the company continues to allocate its development resources toward uncovering new approaches, medicines, and tests. This month, Roche’s Alecensa, a highly selective oral medicine used to treat certain types of non-small cell lung cancer (NSCLC), was granted rapid approval for use in China. Clinical data has shown that Alecensa significantly reduces disease progression by more than half com­pared to the existing standard of care and, with Chinese approval now obtained, the medicine is available in some 57 countries.

FIM Group Staff
By: FIM Group Staff

Investment Team Spotlight: Wärtsilä

Summary Snapshot
Ticker: WRT1V FH / WRTBF
Share Price | Market Capitalization (08/20/2018): €18.215 | €10.78B

Company Description: Helsinki, Finland-based Wärtsilä was established in 1834 and is a global leader in on-demand power generation (large engines), marine equipment, and services. In 2017 its sales amounted to 4.92 billion euros and the company employed 18,065 people globally (58% of them in Europe). Wärtsilä spends roughly 3% of its annual sales on research and development.

Investment Thesis: With a global population of some 7.6 billion persons, we anticipate that the trends underlying globalization will continue forward, regardless of the populist movement du jour. Increased living standards and an ever-smaller planet require much more efficient means to an end.

Wärtsilä is directly exposed to two industries – industrial transportation and on-demand (flexible) power generation – that are buttressed by these forces, driving demands for cleaner, more efficient, and more effective use of both. 

Wärtsilä is split into three divisions: Services (~50%), Marine Solutions (~25%), and Energy Solutions (~25%). Success within its Energy Solutions and Marine Solutions verticals creates a “virtuous cycle,” whereby business becomes “stickier” and more lucrative as the company can sell services, in turn staying front of mind with customers and driving further sales, and so on.

The base case here is global growth, plus a couple of percentage points; however, recent regulations and technological innovations should bolster this opportunity.

Marine Solutions deals in power (supply, conversion, propulsion, exhaust treatment), processing (waste and water, flow, gas), and voyage (automation and navigation, entertainment systems, simulation and training, fleet opera­tions, ship traffic control, and specialty products).

The International Maritime Organization (IMO), an agency within the United Nations, has set its sights on reducing the pollution generated by marine shipping and transportation. Three areas were identified a half-decade ago and are set to come into force over the next five years: ballast water management, sulphur and sulphur oxide (SOx) emissions reduction, and CO2 emissions reduction.

Ballast water management is straightforward and will require vessels to have onboard treatment systems either installed on new ships or as retrofits. Large vessels typically burn bunker fuel, which is high in sulphur (leading to SOx emissions), requiring ship owners to switch fuels to a low-sulphur variant, install scrubbers, or change propulsion systems (e.g., LNG propulsion). Switching to low-sulphur fuels will be hampered by refiner capacity, while changing propulsion systems will be extremely cost prohibitive. Scrubbers will likely be the most efficient means to meet these new standards in the near term to midterm.

Phase two of these regulations sees targets for CO2 emissions reductions on the order of 30%, which will require technology improvements, operations changes (such as planning/routing as seen with aircraft), and alternative fuels.

We’ve read research suggesting that the total opportunity in this market segment is on the order of a quarter-trillion dollars over the next half-decade. About 80% of this opportunity is seen as dependent on new ship orders and new demand; roughly $35 billion of that amount will be related to ballast management systems and scrubbers.

While environmental legislation is a positive, driving demand for Wärtsilä’s Marine Solutions segment (and, by extension, its Services segment), there is nevertheless a large opportunity for ship managers (recouping an estimated 20 billion euros wasted annually in fuel, time, and the like).

Ultimately, Wärtsilä and its marine competitor Alfa Laval look well-positioned to catch this regulatory wave. While we’ve been cautious in choosing cyclical companies for your portfolio, we believe that Wärtsilä will be able to weather all reasonably expected market conditions in the coming years, due to a strong core demand and the extra boost by the aforementioned themes.

Energy Solutions is far from an afterthought. Wärtsilä’s marine background provides the expertise to run this business segment. As power plants on board large vessels are ideally suited (that is, efficient and effective) solutions for projects on terra firma, ships, like modern trains, often have what amounts to an energy utility on board that generates electricity, which in turn drives their electric motors.

As with its Marine Solutions segment, Wärtsilä is an industry leader in flexible energy generation. In a world racing toward renewables, the transition period and ultimate makeup of an energy solution is likely to be mixed. Wind, solar, and even hydroelectric (facing drought, aging facilities, and so on) power generation can fluctuate wildly. Wärtsilä’s small power plants and energy infrastructure offerings can help to bring balance to a system.

So what do unpredictable (and thus inherently intermittent) power generation facilities require? They need sufficient power storage and flexible backup generation, in addition to a grid that can handle what amounts to a true paradigm shift for a rather staid industry.

Storage is expensive, and even as scale and adoption ramp up, we anticipate the cost to be prohibitive for many companies. That said, a small, flexible, backup generation capability paired with existent and future storage solutions should increase both efficiency and effectiveness, thus reducing the storage need.

That is where Wärtsilä comes in. Its flexible generation solutions can start up quickly, meaning that while its peak generation may not be as efficient as that of a large gas turbine, when one considers the entire power generation cycle, Wärtsilä is highly competitive.

Wärtsilä, in fact, has long been on our radar. We’ve met with management, and you yourself have actually had exposure through your position in Investor AB (the Swedish holding company control­led by the Wallenberg family). Recently, market volatility allowed us to be opportunistic and add a direct stake to your portfolios.

Ultimately, we believe Wärtsilä is set to be firing on all cylinders (so to speak) over the coming years. We also like what we see through our environment, social, and good-governance lenses. In Wärtsilä we expect moderate growth with increasing profitability, and thus a rising dividend over time. All these moving parts together, plus the company’s ability to innovate and do accretive (small) acquisitions, should drive shareholder value over time.

While Hawaii is pretty far from Finland, please note it isn’t too far for Wärtsilä

Sources: Company Meetings, Bloomberg, Wärtsilä


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