Key highlights
• Macro policy enablers over the past two years have spurred a rally in global equity markets, although the turning point is already upon us
• Our Fund has generated attractive returns despite avoiding the hubris associated with some big technology, consumer and industrial names
• There are many ways to benefit from broad market rallies while maintaining discipline on valuations
• Industrial robotics is an area of interest and rapid evolution which is capturing our curiosity.

A perspective on performance

Since inception of the Pendal Concentrated Global Share Fund in 2016, global equity markets have been heavily influenced by the pro-growth agendas of governments around the world. The Trump Administration has dominated headlines but it is worth noting the US hasn’t been alone in implementing fiscal stimulus. Europe, China and Japan have contributed their fair share of fiscal expansion and amid an environment of ultra-low interest rates, equity markets have received material valuation support and many cycle-oriented companies have flourished. Most notably, US-headquartered major corporations have been at the forefront of this rally, assisted by new tax reforms and buoyant economic conditions.

While the Fund has been positioned well to benefit from this environment through overweights in financials, consumer products and technology companies, we have been very selective and particularly cautious on valuation. Within financials, our clients’ money has been put to work in regional banks and stock exchanges while steering clear of the investment banks. We’ve also aligned with consumers of beverages and entertainment, while in technology we have favoured the producers of technology components like chip makers.

Our Industrials weighting has been sub-optimal relative to the rally in some parts of this sector. That said, the Industrials sector is deep and varied, giving us ample opportunity to source attractive returns. US rail is one such industry that was attractive to us and is the epitome of the investment characteristics we seek:

• Monopoly or duopoly companies generating strong free cash flow,
• Run by capable management with owner-operator mentalities,
• Trading on attractive mid-cycle buyout ratios of more than 8%, and
• Paying healthy, sustainable dividends.

Since the Fund’s inception we have taken successful positions within industrials through CSX Corporation (+80% total US dollar gross return), Norfolk Southern (+88%) and Union Pacific (+57%), measured to the end of October.

We also generated great returns through investments in Boeing (+121%, the sector’s best performer) and incurred a disappointment from investing in GE (-36%). Like many things in life, sticking to your discipline can sometimes be hard when trend followers are going in the opposite direction. But as contrarian investors with a definite bias towards quality and value, we remained both compliant and comfortable with our process which has delivered results for investors through many cycles of the past.

While we were disappointed with not having a few more in the Industrials sector, spectating the rally from the sidelines did reveal a number of gems to consider when sentiment turns and valuations come back to more sensible levels. Sentiment has definitely started to turn this year, with fears of an end to the monetary system-fuelled growth phase of the economic cycle driving significant de-valuations. These share price corrections have been piquing our interest in certain segments which are being carried lower with the general tide of de-rating. One such area we have been looking at with deepening interest is robotics/factory automation companies, many of which have experienced de-ratings in excess of 50% in 2018.

So why the interest in Robotics/Factory Automation amidst a sea of red?

The robotics/factory automation space is highly investable, with the annual demand for industrial robots forecast to grow by 14% p.a., according to the International Federation of Robotics. This growth is being driven by the rising cost of labour, which has improved the payback period on investments in robotics from five to less than two years. Growth is also being promoted by new industrial applications as well as significant subsidies from various levels of China’s Government. Growth aside, the industry also features a number of companies that hold dominant market share (>50%) and a track-record of sustaining extraordinary margins. These companies are well placed with scale and earnings leverage to invest further in automation.

Forecast annual worldwide supply of industrial robots
 

Source: International Federation of Robotics

These attractive characteristics coupled with the sector’s valuation de-rating since the start of the year led us to undertake significant research into the sector, which included visiting companies operating in the space located in Japan, China and the US.

Robotics / factory automation related company meetings – 2018

Our meetings revealed very little to dispel our positive impression of the sector and confirmed much of the de-rating has been due to transient concerns over the automotive and semi-conductor capital investment cycle, together with slowing activity due to uncertainties over cross-border trade policies. That said, there was some concern over supply/competition dynamics as new companies emerge in China which can be expected to aggressively roll-out capacity and offer rapidly improving technology, priced around 30% cheaper than the incumbents along with ‘pay when satisfied’ trading terms. The logical conclusion here is profitability for the incumbents is at risk. However, history tells us this isn’t necessarily the case and one such incumbent, Fanuc, a Japan-based global manufacturer of factory automation technologies, serves as a great case study to argue an alternative outcome.

Fanuc –maintaining a competitive advantage

Fanuc holds a somewhat mystical status amongst investors due to its secretive nature, its charming obsession with the colour yellow and the location of its headquarters in the idyllic forests at the base of Mt Fiji. In a more general context, these are characteristics many associate with a religious cult rather than a leading industrial company with over 60 years’ experience and renowned for the big yellow robots found in the world’s most advanced car manufacturing facilities. However, the company’s roots are actually not in robots but the somewhat less glamorous field of computer numeric control (CNC) systems (i.e. computers and motors that control machining tools), where it holds 50% market share globally (70% in Japan) and is a key driver of its 30-40% earnings (EBIT) margins.

Fanuc CNC System

 
Fanuc Industrial Robots

Like any other company with a dominant position, Fanuc has met its fair share of challenges. In the 1980s its share in Japan fell to a low of 50% compared to a peak of 80% during the 1970s. Technology played a part in Fanuc’s decline in the 1970s, with the company’s electro-hydraulic stepping motor technology superseded by the faster and operationally simpler DC Servo Motor. Fanuc pulled out all stops to not only catch up but exceed its competition through technology partnerships and aggressive technology implementation, guided by feedback from its customer service network.

The technology threat of the 1970s was followed by a competitive threat with the major machine tool makers boycotting Fanuc for its refusal to allow them to customise the numeric control module. Products from Yaskawa and Mitsubishi were introduced but were eventually marginalised due to end-user preference for Fanuc’s superior aftermarket support.
In both instances, it was Fanuc’s extensive service network that helped protect the company’s market position. This service network goes far beyond being a piece of infrastructure to keep customer equipment in working order; it also serves as a sounding board to help capture customer feedback and direct product development. The network is as valuable today as it was in the 1970s and 1980s as Fanuc face-off against a new generation of competitors and undertakes a sizeable research and development program, amounting to 7% of its sales revenue.

Keeping a close eye on the robots

The robotics/factory automation sector is home to a number of companies that harbour significant competitive advantages which facilitate a profitable ride through industrial automation tailwinds. That said, we don’t currently hold positions in the afore-mentioned names on valuation grounds. Despite the significant valuation de-rating, companies in the robotics/factory automation space remain expensive offering less than an 8% buy-out yield based on mid-cycle earnings. We maintain a watching brief and await an entry point where the risk/reward balance is more favourable. We are more positively disposed to users of industrial robotics like semi-conductor manufacturers – Analog Devices and Texas Instruments.