Active Management: Risk-Focused Process
January 31, 2020
Prudential Insurance Company of America, The
Moderator: Feaveta, Mario
October 24, 2018
02:00 PM ET
This is Conference # 3063998
Hello, it's Mark.
Hi Mark, it's Mario. I think we have successfully made contact here.
So let me just start. I'll be very brief because we are a little bit behind. To everyone who's dialed in we are grateful for your patience. And I'll just briefly introduce Mark Baribeau, Portfolio Manager Head of Global Equity Investing at Jennison Associates. Welcome everyone to PGIM Investments Quarterly Outlook talking about global equity funds. I'm going to turn it over to you Mark.
Thank you everyone. I thought it would quickly go through third quarter results, what's driving the returns, some of the themes that are in the portfolio, of course talk about the current market because it's been extraordinarily volatile in October, and then go to Q&A. And I'll try to be very brief with comments because Q&A will be more interesting.
So for the quarter you can see in the market a decent four point three percent return for the market, the fund was up three point four percent, slightly underperformed because of emerging markets, I'll talk about that in a minute. In terms of where the strength was, it was really concentrated in health care and technology. Technology was our best sector during the quarter, we outperformed by about two hundred and ninety basis points, and I'm going to focus a little bit on that.
Healthcare was also strong for us, we're even with the market for the quarter but very strong double-digit return, so that was great to see. Really good to see the market broaden out there with different participation in healthcare.
The weak spot for the portfolio in the quarter was consumer discretionary. We underperformed there largely due to, again, emerging markets in a couple of stock-specific companies that we continue to own and like, but it was a little bit of a choppy quarter in that particular group for us.
The rest of the market we don't have a lot of exposure to except the new communication services sector which includes most of the internet companies which have been reclassified. And those were down for the quarter pretty much across the board, North America, US, Asia, so it was a little bit of a sloppy quarter in that part of the market which had been so strong in the first half.
So if we isolate some of the key trends, I guess, the key one regionally is emerging markets. Our exposure had dropped to thirteen percent by the end of the quarter, down from twenty in June and twenty five at year-end. So we've been pretty systematically reducing exposure there due to worsening economic conditions, really, partially as a result of the Fed raising rates/reducing global liquidity, but also partially just self-inflicted growth problems in those parts of the world. It still hurt us in the third quarter, though, accounting for more than all of our underperformance. Our best region was Europe where we outperformed nicely in Q3, and in North America where we also outperformed.
The other major factor within the portfolio was technology itself. I mentioned that we outperformed quite a bit in the quarter, but the source of the outperformance was very different than prior years. Four of our top ten stocks in the quarter, including the top three, were all in the payments arena. So I'm going to spend a couple of minutes there because I think it's an interesting theme that's developed over the last year and a half to two years. And it's been a really important driver of performance for us this year, and we expect it to be a very interesting part of the market going forward.
So if we skip to page four you can see here just credit card penetration around the world remains low particularly in emerging markets. In developed markets like the US, Japan, UK, etcetera, you still have this trend of people still migrating from cash to plastic, either credit or debit, and that's beneficial to mature companies like Mastercard or Visa. We own Mastercard in the portfolio, it was one of our top contributors in Q3.
But the real interesting developments are all occurring in e-commerce and in digital payments where companies around the world in this particular space are developing unique applications to solve for local consumer problems. And particularly in underpenetrated parts of the world where you can't wait for credit card penetration to rise so why not just leap frog developed markets and go to an internet-based technology which enables payments to occur online. And so we've seen that with Alibaba and Tencent in China where the biggest use cases is in force.
And you can see that on page five mobile payment volume in China is approaching over fifteen trillion dollars, the US dollars up from very small levels just five years ago or six years ago. And this explosion in activity has created one of the biggest payments ecosystems in the world, bigger than MasterCard and Visa's global business, so it's really incredible what's happened here. And Tencent and Alibaba have driven the innovation to allow this to occur, and China's on its way to being the first cashless economy in the world.
We're also seeing companies such as Wirecard in Germany, [ID on] in the Netherlands, Square in the US, MercadoLibre in Latin America, also create unique technology platforms that enable e-commerce to occur cross-border, very seamlessly to improve fraud and authentication rates very, very quickly, to improve conversion for even traditional retailers, not just e-commerce players. So all of these trends are converging at the same time and leading to a very exciting industry. So it's one of the features of the portfolio I thought I would focus on a little bit at this time because it's very thematic to what's driving market returns for us.
As a reminder on page six, why do we focus on these types of ideas? High-growth companies, high-growth disruptors, companies that come along that have unique business models that are able to generate well above average earnings growth, cash flow growth, revenue growth for long periods of time tend to dominate the market in terms of return profile.
And if here we just break the market down into quintiles looking at top quintile of growth versus the lowest quintile, the bottom twenty percent. And over a rolling five-year period going back to nineteen ninety-seven you can see very strong double-digit returns for that top quintile and even the second quintile, also very strong double-digit rates of return. So we think it's a really fruitful part of the market to spend our time on, to do your research on because we find over time these turn out to be the biggest long-term investments driving performance.
When you also look at the markets as a whole there's a lot of sluggish activity there, there's a lot of companies that have sales growth below five percent, even about twenty percent of the market almost below one percent. So even in the best type of economic environment we've operated in several years still a large part of the market is very slow-growing, and so it creates a lot of opportunity in the growth space.
When we look at the markets today we're dealing with a very interesting kind of two-factor risk. So as we exited the third quarter, as I mentioned, emerging markets were already on a slide. The last one to go is China and it's a result of, of course, the tariffs imposed by the United States has really destabilized markets there, and certainly perception or confidence in growth.
At the same time, of course, the Fed's raising rates in the US to slow the economy down because we're at full employment. And it's just a natural mid-cycle adjustment, the kind of thing that we're used to dealing with over time. We just haven't had to really deal with it for a long period of time, but as you know, it's been a very slow-moving cycle.
So you have these two cross-currents, both of which are negative for future growth, and both of which are weighing on equity market sentiment in October. So it's been, obviously, a choppy period from that perspective, but as we go through earnings season what we're finding is the very strong secular growers in the portfolio. So far earnings results have been quite positive, the market may not be rallying strongly on those numbers because we're still in a little bit of a, I think, a confidence issue in the stock market right now. But at least we know as time progresses here as we move into two thousand nineteen some of these stocks will have a chance to base out, grow into the valuation a little bit, and hopefully reassert themselves.
So with that I'll throw it open to questions. Hopefully that was good, quick overview of how we're positioned today.
That's great. Thank you, Mark. And yes, as Mark said, we are open for Q.&A. To anyone who's dialed into the webinar we invite you to use the Q&A window to type in a question. We've gotten some questions already so we can just start going through the questions we've already received.
So Mark, the first question is about the FAANG stocks. It's a subset of the US market that really was all over the news in twenty eighteen. The question is are the FAANG stocks now at risk of a pullback?
Well FAANG has been, this year, very diffuse in terms of performance. In other words, it's only been driven by Netflix and Amazon, those have been the outstanding stocks year-to-date among that cluster. And so the question is can Amazon and Netflix pull back in a market correction?
Well yes, they can; Netflix has, Amazon not so much. But Netflix just reported a phenomenal third quarter with well above average subscribers and revenues and very strong guidance for Q4, so I think there is good visibility there. So we don't invest in FAANG, we invest in the individual stocks and we take them one at a time. And they're all going to have different cadences to their growth, to the business drivers; they're all unique businesses and that's the way we treat them, but on a valuation basis we're not really that concerned.
Next question is about the emerging markets in China in particular.
Another theme that we've been hearing about more lately China growth seems to be slowing down, is that a concern?
Yes, it's a concern. It's the most important development in the world economy, everything else really doesn't matter. The United States is the most important element in the global economy but it's kind of at a steady state right now, although it's going to get trickier because we're in a rising rate environment.
And so China becomes the linchpin, and so much of the success of every company were invested in that's European or American is coming from pretty good sales in China; not universally across our portfolio, but a great number of them. And so it's important that China's economy not dramatically underperform expectations. The estimates we've seen from some pretty good economic work suggests that in January when the full tariffs go into effect, if they do go into effect, you're looking at stripping out a percentage point to growth from China's economy. And it doesn't include any negative impact that you'll see on US consumption from higher prices, this is just the direct China impact.
And so we don't think they're just going to sit still and have that impact be that negative, they will try to--as they already have--start using monetary policy to be more stimulative. The tariffs, fortunately, have hit at an inopportune time for China because they were in a tightening program to slow things down, and it occurred at just the wrong time; so they're going to have to reverse course on that, they've already started to in October.
So we think they'll take some limited policy moves to try to soften the blow, but it's going to be a blow none the less. And it just means that many companies around the world are going to miss numbers as we go into next year, and so it's one of the reasons why the equity markets are not doing well this quarter is that realization is dawning on investors and it's not a good one.
So we're trying to maneuver around it, how we doing that? First, directly, our only direct exposure in China is through internet companies which are one hundred percent Chinese-based, they're dealing with Chinese consumers so they're not a part of the global trade system.
Secondly, the indirect exposure, it's impossible to get away from it completely but we have been avoiding companies who will be directly impacted by tariffs and that will really have no way around that.
And as I said, it's almost impossible to neutralize your portfolio from the impact because so much of the world is tightly linked, they'll be negative feedback everywhere. But we're doing our best to insulate where we can and just understand those linkages better.
I'll take a moment just to remind our webinar participants if you have a question please feel free to type it in. We've gotten a number of questions in, we'll try to answer as many as we can.
Mark, it looks like we got a question following up on your comments about Chinese internet stocks asking if you could elaborate a little bit on Alibaba and Tencents. They're now at fifty-two-week lows and they're large holdings of the portfolio, what's the outlook for those two stocks in particular?
Yeah. Both are very interesting at these valuation levels. You're just not going to be able to buy companies with structural growth of thirty percent and higher at twenty-one times, twenty times earnings, they're very, very inexpensive at this point. So some of the sentiment in the stock is just the China effect, some of the sentiment in the stocks is company specific and it has to do with timing of either investment spending or product releases.
In the case of Tencent, some of their games that are very popular on their platform, mobile games, have been delayed in terms of approval for monetization; so the games are being played, they're very popular, but they can't monetize them. We expect or hope that that delay will end in Q4 early two thousand nineteen, in which case Tencent will be one of the few largest companies in the world that will have accelerating top and bottom line growth next year, and the rest of their business looks pretty healthy to us.
And then secondly on Alibaba, top line growth is very strong but their earnings growth is going to be weak for a couple of quarters because the pace of investment spending has been stepped up as they take advantage of new market opportunities in China. And the timing of that began in Q2, more heavily in Q3, and then it will probably reach a peak in Q4. So that means, again, next year you're going to see improvement in earnings growth, again this is holding other things constant.
So we like the outlook for two thousand nineteen for both companies at this point and we're assuming, yes, there is some slowdown in China, but consumer spending in the third quarter in China with seventy eight percent of GDP growth, that's the record, it's the first time that's happened. So consumers are already dominating incremental growth in China, which is what we want to see, so it's not, perhaps, not as bearish as the market thanks right now and maybe that's a great opportunity, time will tell. But we continued on both stocks because of the strong secular growth prospects, and we think the timing in two thousand nineteen could actually look okay.
Mark, let's change gears a little bit away from China for second. I know your team does a lot of research and invests in cutting-edge technology, we got a question about artificial intelligence or AI. What are your thoughts about AI?
Well it's in use everywhere in the technology ecosystem. So the biggest AI user in the world is Google, that's why they're well-positioned to dominate in autonomous driving; it doesn't mean they will, but it's one reason why they could. So as new applications come along in AI you can expect that application to be adopted by many different companies. So it's not necessarily a technology you could sell, it's just an application you need to continue to further analyze data, more accurately direct the correct products to consumers, more accurately predict demand for your products and services at your company.
So it's a very valuable tool, it's very data-intensive, very computing-intensive. So it has natural demand drivers for companies like Google, like Nvidia whose graphical processing chips are used at the heart of that compute problem. So it does have some direct investment implications, but indirectly I think it's just going to be part of any successful company's future.
Mark, we got a question about risk management and steps you take for risk management in the portfolio. So the way it's worded, assuming a recession were to occur within the next couple of years, are there any particular steps you would think of taking at that time?
Well hopefully we take them beforehand. So if you look at our portfolio this year you get a good idea of kind of how we migrate, so emerging markets exposure declines dramatically. Secondly what's well understood is within the portfolio the direct cyclical earning streams of companies has been--or companies who's earning stream are more cyclical-sensitive have been eliminated. You can't eliminate all cyclicality because every company in the world will have earnings that will be impacted by a recession, but some more than others. So over the course of this year because the Fed has been tightening we have been reducing cyclical exposure, so we've already positioned the portfolio that way.
The second thing you do is it's not always obvious what companies will outperform in a downturn. Sometimes companies that have a very strong product that's selling well even though the economy is in trouble you want to own that stock even if it doesn't perform particularly well because it will be the first to lead out of a recovery. And so we like to play offense to some degree in times of trouble, in other words, seek out the strongest fundamental ideas. Don't get overly defensive because even very defensive companies will start missing numbers and then there's no rebound because they have very little growth.
So it comes in three parts: eliminate the obvious risk, reduce cyclicality, and play offense in a smart way with your strongest positions.
Mark, our webinar participants have a lot of questions about China today, so another question came in. That's all over the news, the way you said, it's a big concern; if you could elaborate you touched on the tariffs between the US and China, if you could elaborate on that, your outlook, and how it's going to progress, and if you think there's a risk that the US might even increase or impose more tariffs on China in the near future?
Well there's been tariffs put in place already, then there's been announced tariffs to be put in place in January which we're conveniently done to do it after Christmas so that consumers in the US don't see sticker shock when they're Christmas shopping, so it's a little cynical too. But the big coverage of tariffs will occur in January so we're not out of the woods, it's going to get worse before it gets better.
And so there are certain product categories or clusters of companies like US retailers are going to be in big trouble because they're not going to be able to pass those price increases on. There's going to be a whole host of US companies whose input costs are going to go up, Caterpillar already complained about that when they reported this week and the stock reacted very negatively to that. So it's going to be a problem, if the US ups the ante beyond what has been talked about for January you could be looking at deep economic problems.
We have one follow-up question to your comments on Alibaba and Tencent. It's really about the risk, you talked about the upside, is there something that could be a catalyst that would change your outlook, maybe make it a little bit more risky, maybe something you're less excited about for Tencent and Alibaba?
There are two risks, one risk for each company. For Tencent the risk would be that the government is becoming more intrusive--not into social media--but into where they also dominate, but into mobile gaming. That they are concerned that consumers spend too much time gaming in China. Gaming is very popular in Asia in general, but particularly China.
And just to give you an idea how dominant Tencent is, the average Chinese person today spends two hundred and ninety minutes a day on their smartphone, so that's almost five hours. Of that the majority of time is spent on WeChat, Tencent's super app. In addition to that consumers spend another hour on mobile games, so then you look at that and Tencent has about seventy percent market share today of mobile games.
So when you look at time spent or engagement by consumers, imagine if there were a US company where Americans were spending almost four hours per day on that company's website, that's a huge pool of profits to exploit. So if in that kind of gaming part of the government's delays in monetization are actually more nefarious, they're not just bureaucratic delays but they're actually trying to hurt the industry, we would be very concerned. That could be a risk factor that we would take very negatively.
Now on the Alibaba, totally different. It's primarily an e-commerce engine, yet it's very profitable because it's a marketplace model. They don't build inventory like Amazon, and so profitability cash flow growth there is phenomenal and they dominate the market. So they have huge penetration left in rural China, that's where a lot of their growth is going to come in the next few years. In addition, they're doing things on their platform to increase their take rate, the amount of money that they can collect from the ecosystem of people looking, shopping, and buying things, and including ad revenue like Amazon is doing today.
And so the outlook there from a structural basis looks pretty good. So the number one risk factor for them isn't very different, it's just the economy. If China were to go into recession and it were consumer-based, obviously Amazon's growth would slow down versus expectation. And I think that's part of what the market's fear is today, that's why it's so inexpensive. So either the market's wrong and it's a great opportunity or the market is right and China's headed for trouble next year; like deep trouble, not just a moderate slowdown.
Looks like we have time for one last question and this is a general question about your portfolio and the activity you've had in the third quarter.
Any recent acquisitions of companies in the portfolio that you're particularly excited about?
Going into the third quarter one of the interesting areas that we really liked was healthcare. So as you know most of our exposure in the last year has been in med tech, which has been very good. And the pharma opportunities started to show up again because you we're starting to price in some patent expirations coming in the next few years, pricing in pipeline issues there were big concerns over the last two years about pricing in general in the industry.
So valuations became very low and so one of the stocks we ended up buying in the third quarter was Merck, which has a very attractive growth profile. It's not a high growth profile, it's a stable growth profile because of the really big successes they're having in cancer. Their product Keytruda is becoming the de facto standard in cancer treatment in the market.
On the flip side, if we go to Europe one of the stocks that we bought in Q3 was Safran, it's an aerospace company in Europe. Tt's going to benefit from the next few years from a huge not upgrade cycle, but engine overhaul for a huge fleet of jets that are due for maintenance. So it's a very steady growth rate over the next few years, they're in a great market position, they're going to dominate it, and the demand is there because these engines need refurbishment.
So it's a timing issue, they have a great market position, and so we really like the growth profile. And it's insulated really from global issues with China, it's insulated from cyclicality, not entirely but mostly because the recurring revenue model here is very positive.
And then lastly in Europe, Givaudan we bought. Very interesting company, they do flavors and fragrances, so they're additives for all sorts of consumer products, either food or cosmetics. Very stable growth rate, the stock was very opportunistic; this summer we took advantage of that opportunity, and we expect them to continue to do well over the next couple of years.
One of the big changes that's occurred in their end market demand profile is very large consumer staples companies like Unilever, Nestle, etcetera have had a tough time growing, Procter and Gamble, millennials don't really like their processed food. And what's happening is the majority of their sales are going to small and regional players that are specialty food manufacturers that actually have a product that consumers really want. And so their growth rate, to us, looks pretty good with this new set of consumers and the structural shift in the industry.
So those are some of the ideas that are kind of interesting out there in the third quarter, different parts of the world, different industry mixes, some healthcare or some consumer, are very consistent with what we would normally do.
Mark, we're out of time for today's webinar, but thank you very much for your thoughtful presentation.
Okay, thank you everyone for listening.
We've been hearing comments from Mark Baribeau, Managing Director Head of Global Equity at Jennison Associates. Mark heads up a team that currently manages over seven billion dollars in assets across global, international, and emerging markets strategies. Jennison in is a sub-advisor on a fund run by PGIM Investments, the PGIM Jennison Global Opportunities Fund, which has outperformed it's benchmark, the MSCI All Country World by over five hundred basis points per year over the trailing one-, three-, and five-year periods, top three percentile in Morningstar category. So really happy to have Mark, as always we appreciate it.
And now I have a few comments, just some important disclosure. Keep in mind that today's webcast was for financial professional use only and must not be made available to clients. Refer to the prospectus for detailed information on the funds, including investment objectives, risks, charges, and expenses. Portfolio holdings are subject to change, past performance does not guarantee future results, current performance may be lower or higher than the past performance data quoted. Investment return and principal value will fluctuate so that investor shares when redeemed may be worth more or less than original cost. For current month-end performance information including SEC standardized return visit pgiminvestments.com. Consider a fund's investment objectives, risks, charges, and expenses carefully before investing; the prospectus and summary prospectus contain this and other important information about the fund. Contact the PGIM Investments sales desk at 800-257-3893 to obtain a copy of the prospectus or summary prospectus, read them carefully before investing.
That concludes today's webinar, Ron I'll hand it back to you.
We are all concluded. Thank you.