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Investment Commentary

Annual Letter to Investors – 2021

Dividend Growth Summary

Note: LTM Dividend Growth is the median of the actual trailing 12-month dividend growth of the individual stocks held by Strategies or Index constituents as reported by Bloomberg on December 31, 2021. FTM Dividend Growth is the median of the Bristol Gate Model’s forward 12-month prediction for the individual stocks held by the Strategies and the median of consensus estimates for the constituents of the Indices as of January 4, 2022. Companies without a consensus dividend forecast were excluded.

Source: Bloomberg, FactSet, Bristol Gate Capital Partners.

Commentary

Over the last several years, we have heard many reasons to be negative on US stocks. The market was expensive, and the S&P 500 Index’s P/E multiple was at levels not seen since the late 90’s dotcom bubble. The onset of a Federal Reserve tightening cycle was supposed to crush P/E multiples. Inflation caused by an easy money policy was supposed to pressure record level profit margins. The negative effects COVID had on supply chains and labour availability was supposed to further exacerbate earnings pressures.

In 2021, the boogeymen came. US government 10-year treasury yields increased from 0.9% at the start of the year to 1.5% at year end. Inflation exited 2021 at 6.8%, the fastest annual rate since 1982. COVID related supply chain issues were severe and have yet to be resolved. US job openings are at or near all time highs as labour is scarce. And the market’s P/E multiple fell from over 30x in 2020 to less and 25x at year end. Despite all of this, the S&P 500 generated a total return of 28.7%. Our US Equity Strategy faired even better. Contrary to popular belief, margins did not collapse. They went on to reach new highs as companies either benefited from or adapted to the changing environment. Valuations fell because earnings increased. Although volatility rose during Q4 (we expect it to remain elevated), we note the equity risk premium remains above the long-term median of 4%, implying equity valuations are not as rich as they otherwise might appear. We believe this is especially true when compared to other assets.

Exhibit Fig 1. Implied US Equity Risk Premium: 1960-2021

Source: Aswath Damodaran, http://people.stern.nyu.edu/adamodar/New_Home_Page/home.htm 

Large US stocks sailed through the storm, but fixed income markets took on water. The Bloomberg US Aggregate Bond Index fell 1.5%, the US Treasury Index was down 2.3% and the US Long Treasury Index declined 4.7%. We suspect their challenges will persist as economies continue rebounding from the negative effects of COVID, inventories get rebuilt, inflationary pressures are maintained and economic growth rolls on.

After a 40-year bull market in bonds, where US government 10-year bond yields fell from over 15% in 1981 to near zero in 2020, the fixed income component of the traditional 60/40 portfolio may not provide the ballast it has in the past. Among bonds with the same yield-to-maturity and term length, lower coupon bonds have higher convexity. This means prices are most sensitive to changes in rates the closer we are to zero percent yields. The absolute change in price for a given change in yield will be greater when yields initially start rising off the zero bound (compared to rising at a higher yield). In our view, bonds lose many of their characteristics as a risk mitigator near the zero bound and offer more return free risk than risk free return. It is no surprise to us that the 2021 Top1000funds.com / Casey Quirk CIO Sentiment Survey saw more of the world’s largest asset owners intending to increase equity allocation in 2021, largely at the expense of fixed income.

Exhibit Fig 2. Institutional Asset Allocation Intentions

Notes: Annual data between 1970-2020. High Dividend Growers defined as the top quintile of dividend growth in the S&P 500, equally weighted and reset annually. Returns for the S&P 500 and High Dividend Growers are price returns only. We do not believe including dividends would materially change conclusions.

Source: https://www.top1000funds.com/cio-sentiment-survey-2021/

As one respondent in a survey of global sovereign asset managers by Invesco notes, “The traditional diversifying exposures for a large institutional investor, vis-à-vis nominal duration, is questionable given nominal rates are parked at zero today. The situation with regard to real rates is, of course, even worse, with the outlook not offering much hope for improvement. To what extent are rates able to provide the defensive balance and diversification in our portfolio construction? It’s a concern.” Even traditional inflation hedges like gold did not help in 2021, with the metal declining 4%.

We believe our dividend growth philosophy has broad appeal in the current environment.

Our portfolio companies’ growing dividend income provides an attractive alternative to the exceptionally low yields in fixed income markets. Importantly, our income stream comes with inherent inflation protection that most bonds just do not have. That inflation “insurance” is driven by business models and balance sheets that support long term free cash flow and dividend growth well above most inflationary environments we have witnessed over the last 100+ years. We highlighted how a high dividend growth strategy has performed from a total return perspective in other inflationary environments in our Q3 note[1]. That growth is crucial in preserving and growing real purchasing power.

Relative to broader equities, such as the S&P 500, the Bristol Gate US Equity Strategy has provided better returns, often with less downside during periods of market stress, highlighted by its approximate 85% down capture since inception. We believe this is because risk mitigation is pervasive throughout our investment process.

Portfolio construction guided by expected dividend growth and application of correlation analysis, not by sector allocations. By only focusing on companies with growing dividend forecasts we avoid the high momentum, non yielding, high expectation stocks where we believe most of the risk of overpaying for growth resides. The commitment to a growing dividend instills a degree of capital allocation discipline amongst management teams. That discipline forces them to allocate investments to projects that generate returns above their cost of capital. We believe this inherently reduces our valuation risk, as these companies will grow their intrinsic value over time. Our use of a dividend growth hurdle encourages us to exit positions long before dividend growth slows to more mundane levels. By exiting companies long before they reach “maturity” (slowing revenue growth, increased competitive intensity, margin compression, multiple compression, etc.) we believe we avoid many of the problems that come when growth falls short of expectations. Lastly, our quarterly rebalancing effectively acts as a contrarian mechanism, trimming stocks that have done well and reallocating that capital to stocks that are lagging. This rebalancing helps reduce the valuation risk associated with rising stock prices and controls concentration risk.

In a world where real yields on many government and corporate bonds are negative and general market risks remain elevated (valuations, fed tightening, inflation, etc.), we believe our high dividend growth strategy is increasingly attractive to investors with income requirements, particularly those who can withstand some of the daily volatility of public stock prices and stay focused on compounding income over long periods of time, like pension funds and other large asset owners.

US Equity Strategy

The trailing 12-month median dividend growth of our US Equity Strategy was 12.0% at quarter end compared to the S&P 500 constituent median 6.2% and actual cash dividend growth of 2.7%. Over the next 12 months, our model is predicting median dividend growth of 15.0% for our portfolio companies. This compares to the median of the S&P 500 constituents of 4.4% as forecast by consensus. Portfolio changes we will be making early in the first quarter of 2022, and which will be discussed in our next quarterly letter, will further improve the projected dividend growth of our portfolio.  

The Bristol Gate US Equity Strategy finished the year off strong, returning 13.7% for the quarter and 30.2% for the year. These returns were ahead of the S&P 500 Total Return Index by approximately 270bps and 153bps, respectively.


[1] https://www.bristolgate.com/report-to-investors-3rd-quarter-2021/

Exhibit Fig 3. US Equity Strategy Risk and Return Metrics

Source: Bristol Gate Capital Partners.

During the quarter, Broadcom, UnitedHealth and Zoetis had the largest absolute and relative contributions to returns. Activision, Visa, and Texas Instruments were the largest detractors.

For the year, Applied Materials, Intuit and Home Depot were the largest absolute contributors. Activision and Tyson Foods (exited in Q1), were our only negatively returning holdings. On a relative basis to the Index, Applied Materials, Intuit and Broadcom led the way, while Activision Visa and Mastercard weighed on relative results.

The only trading that occurred during the quarter related to our systematic rebalancing process in early October. Intuit and Zoetis were trimmed to fund returning Activision to an equal weight position (4.54% or 1/22. Activision had fallen after a California Department of Fair Employment and Housing (DFEH) lawsuit alleging an environment of harassment and inequality at the company. Unfortunately, our rebalancing timing was not optimal. Intuit and Zoetis went on to post gains over 20% each from the rebalancing date to year end. Activision fell 12% over the same period with an intra period maximum drawdown of 24%. Two factors drove the negative performance. During its third quarter earnings call in early November, the company announced delays to two of its much-anticipated games, Overwatch 2 and Diablo IV. Following that, the Wall St. Journal reported that the company’s CEO was aware of the sexual harassment and cultural issues at the company and chose to ignore them.

Activision was by far our worst performing stock of the year. We remain positive on many aspects of the company. The video game industry is large and growing at attractive rates. Activision has unrivaled, wholly owned intellectual property (IP). The move to digital distribution has changed the nature of the industry. Publishers are now capturing margin that previously went to retail distributors. Digital has also created opportunities to extend the shelf life of games and to better monetize IP (mobile versions, in game investment, expansion packs, etc.) Mobile gaming has significantly expanded the market beyond core gamers. Economies of scale matter more than ever as AAA rated game development costs continue to rise and Activision is the largest Western independent publisher. Even as the largest Western independent publisher the company only has 4% market share, providing ample opportunities to grow organically and via M&A. The management team has smartly deployed capital in the past doing several transformative deals; Blizzard in 2008, the Vivendi buyback in 2013 and King in 2015. With $6bn of net cash on the balance sheet, we believe we have optionality in another potential acquisition or the company executing against its $4bn buyback authorization. We believe the stock is pricing in near zero future growth at current levels. Lastly, even with the game delays and a forecasted flat year in 2022, we believe the company can continue growing its dividend at attractive rates, above our hurdle, given its cash generation, low payout ratio (<15%) and large net cash balance.

Having said all that, we are very cognizant of the near-term risks. Sales of the recently released Call of Duty (CoD) Vanguard and Warzone Pacific can fall short of expectations. More importantly, the significant cultural issues at the company have exacerbated employee turnover in an already dynamic game developer employment market. A video game developer’s greatest asset is its people, and the employee turnover issues have the potential to impair the long-term value of the company if they are not resolved in a timely manner. As with all our names, we weigh the opportunities and risks at Activision against our four pillared investment framework (projected dividend growth, quality business, valuation and portfolio fit) and will make changes if/when better alternatives are available.

Canadian Equity Strategy

For the year, the portfolio companies delivered median dividend growth of 9.7%, well ahead of the S&P/TSX Composite constituent median increase of 3.3% and actual cash dividend increase of 5.0%. Over the next 12 months, our model is predicting median dividend growth of 11.1% for our portfolio companies. This compares to the median 4.2% for the Index constituents as forecast by consensus. We anticipate contemplated portfolio changes in early Q1/22, which will be discussed in our next quarterly letter will further improve the projected dividend growth of our portfolio. During the fourth quarter, the Bristol Gate Canadian Strategy returned 4.7% compared to 6.5% for the S&P/TSX Composite Index. Sector allocation explained most of the underperformance, with the underweight in Financials, and specifically banks, being a significant detractor. Zoetis, Brookfield Asset Management and Dollarama were the three largest absolute contributors to returns. Enghouse Systems, TMX Group and Stella-Jones were the largest detractors in the quarter both on absolute and relative basis. On a relative basis to the Index, Zoetis Dollarama and Jamieson Wellness were the largest contributors.

Exhibit Fig 4. Canadian Equity Strategy Risk and Return Metrics

Source: Bristol Gate Capital Partners.

For the year, the Canadian strategy returned 19.3% compared to the 25.1% for the S&P/TSX Composite Index. The underperformance was split between sector allocation and security selection. In sector allocation, the underweight in Financials and Energy were significant detractors, as was our stock selection within the Technology sector. Our overweights in Industrials and Health Care were negative from an allocation standpoint, as the sectors underperformed the broader market, but our stock selection within those sectors outperformed the market. Zoetis, Thomson Reuters and Brookfield Asset Management were the largest absolute contributors. Enghouse Systems, Stella-Jones and Quebecor were the largest detractors. On a relative basis to the Index, Zoetis, Thomson Reuters and CCL Industries led the way, while Enghouse Systems, TMX Group and Quebecor weighed on relative results.

The only trading that occurred during the quarter related to our systematic rebalancing process in early October. Thomson Reuters and Brookfield Asset Management were trimmed to fund returning Stella-Jones to an equal weight position. The systematic rebalancing part of our process did not help as of year end. Thomson Reuters (+4.8%) and Brookfield Asset Management (+6.5%) both outperformed Stella-Jones (-3.6%) and the Index (+2.6%) since the rebalancing. After having benefited from the high lumber prices in 2020, Stella-Jones’ Residential Lumber segment normalized in 2021. However, our investment thesis is more focused on its Utility Poles and Railway Ties segments where the company possesses competitive advantages and continues to grow at steady rates, unaffected by the swing in the lumber commodity prices. We were encouraged to see Stella-Jones pulling its M&A lever again in November, acquiring a smaller producer and distributor of utility poles. We continue to believe the company is well positioned to be a beneficiary of large infrastructure plans in the US.

Firm Update

We never thought we would be saying this in 2022 but we continue to work from home! Although we have had a couple of live get togethers in the past year, it is safe to say the hybrid work environment has been successfully adopted by all our employees and very likely to be a permanent change at Bristol Gate. Thanks to the enthusiasm and dedication of our associates we have managed the business very effectively over the past couple of years and continue to make significant improvements to the company along the way.

In the past year alone, we have made great strides in our approach to ESG investing. We have improved trading systems and introduced a change to our quarterly rebalancing approach with a new “thresholds” modification, saving on trading cost for our clients. With the given list of projects on the drawing board and our commitment to making capital investments in our business processes, we anticipate further improvements will be developed in 2022.

We are also delighted to welcome Mo Vakil as a Data Scientist and member of the investment team. Mo has a Ph.D. in Mechanical Engineering, a MSc in Finance, is a Level III CFA Candidate, is married and has one child.

To all our clients, thank you for your support and trust. We are determined to do everything we can to provide you continued income growth and strong investment returns going forward. As a final reprise to past letters, we hope to see you in person sometime soon.

Sincerely,

The Bristol Gate Team

Important disclosures

This piece is presented for illustrative and discussion purposes only. It should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities and it does not consider unique objectives, constraints, or financial needs of the individual. Under no circumstances does this piece suggest that you should time the market in any way or make investment decisions based on the content. Investors are advised that their investments are not guaranteed, their values change frequently, and past performance may not be repeated. References to specific securities are presented to illustrate the application of our investment philosophy only, do not represent all of the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable and should not be considered recommendations by Bristol Gate Capital Partners Inc. A full list of security holdings is available upon request. For more information contact Bristol Gate Capital Partners Inc. directly. The information contained in this piece is the opinion of Bristol Gate Capital Partners Inc. and/or its employees as of the date of the piece and is subject to change without notice. Every effort has been made to ensure accuracy in this piece at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and Bristol Gate Capital Partners Inc. accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. We strongly recommend you consult with a financial advisor prior to making any investment decisions. Please refer to the Legal section of Bristol Gate’s website for additional information at bristolgate.com

Gross returns in this report refer to the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite. No allowance has been made for custodial costs, taxes, operating costs, management and performance fees, which will reduce performance. Past performance is not indicative of future results. Allowance for withholding tax in the US strategy composite is partially reflected in the composite returns for periods commencing January 2017 and after. The Net returns for the Bristol Gate US Equity Strategy Composite and Canadian Equity Strategy Composite are reflective of the maximum management fee charged by Bristol Gate of 1% and 0.70%, respectively.

The Bristol Gate US Equity Strategy Composite was formerly known as the Bristol Gate US Dividend Growth Composite until April 1, 2015. The Composite inception date was May 15, 2009. The Composite consists of equities of publicly traded, dividend paying US companies and is valued in US Dollars.

The Bristol Gate Canadian Equity Strategy Composite was formerly known as the Bristol Gate Canadian Dividend Growth Composite until April 1, 2015. The Composite inception date was July 1, 2013. The Composite consists of equities of publicly traded, dividend paying Canadian and US companies and is valued in Canadian Dollars.

The S&P 500® Total Return Index measures the performance of the broad US equity market, including dividend re-investment, in US dollars. This index is provided for information only and comparisons to the index has limitations. The benchmark is an appropriate standard against which the performance of the strategy can be measured over longer time periods as it represents the primary investment universe from which Bristol Gate selects securities. However, Bristol Gate’s portfolio construction process differs materially from that of the benchmark and the securities selected for inclusion in the strategy are not influenced by the composition of the benchmark. For example, the strategy is a concentrated portfolio of approximately equally weighted dividend-paying equity securities, rebalanced quarterly whereas the benchmark is a broad stock index (including both dividend and non-dividend paying equities) that is market capitalization weighted. As such, strategy performance deviations relative to the benchmark may be significant, particularly over shorter time periods. The strategy has concentrated investments in a limited number of companies; as a result, a change in one security’s value may have a more significant effect on the strategy’s value.

SPDR S&P 500 ETF Trust (SPY US) sourced from Bloomberg has been used as a proxy for the S&P 500® for the purpose of providing non-return based portfolio statistics and sector weightings.

The S&P/TSX Total Return Index measures the performance of the broad Canadian equity market, including dividend re-investment, in Canadian dollars. This index has been provided for information only and comparisons to the index has limitations. The benchmark is an appropriate standard against which the performance of the strategy can be measured over longer time periods as it represents the primary investment universe from which Bristol Gate selects securities. However, Bristol Gate’s portfolio construction process differs materially from that of the benchmark and the securities selected for inclusion in the strategy are not influenced by the composition of the benchmark. For example, the strategy is a concentrated portfolio of approximately equally weighted dividend-paying equity securities, rebalanced quarterly whereas the benchmark is a broad stock index (including both dividend and non-dividend paying equities) that is market capitalization weighted. As such, strategy performance deviations relative to the benchmark may be significant, particularly over shorter time periods. The strategy has concentrated investments in a limited number of companies; as a result, a change in one security’s value may have a more significant effect on the strategy’s value.

iShares Core S&P/TSX Capped Composite Index ETF (XIC CN) sourced from Bloomberg has been used as a proxy for the S&P/TSX Total Return Index for the purpose of providing non-return based portfolio statistics and sector weightings.

 

There is the opportunity to use leverage up to 30% of the net asset value. Leverage is not used as an investment tool to enhance returns, but for cash management needs of certain composite portfolios.

This Report is for information purposes and should not be construed under any circumstances as a public offering of securities in any jurisdiction in which an offer or solicitation is not authorized. Prospective investors in Bristol Gate’s pooled funds or ETF funds should rely solely on the fund’s offering documents, which outline the risk factors associated with a decision to invest. No representations or warranties of any kind are intended or should be inferred with respect to the economic return or the tax implications of any investment in a Bristol Gate fund.

Bristol Gate claims compliance with the Global Investment Performance Standards [GIPS®]. To receive a list of composite descriptions and/or a presentation that complies with the GIPS® standards, please contact us at info@bristolgate.com. Bristol Gate Capital Partners Inc. has been independently verified for the periods commencing May 2009 until December 2015 by Ashland Partners International PLLC and from January 1, 2016 – December 31, 2020 by ACA Group, Performance Services Division.

A Note About Forward-Looking Statements

 

This report may contain forward-looking statements including, but not limited to, statements about the Bristol Gate strategies, risks, expected performance and condition. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events and conditions or include words such as “may”, “could”, “would”, “should”, “expect”, “anticipate”, “intend”, “plan”, “believe”, “estimate” and similar forward-looking expressions or negative versions thereof.

These forward-looking statements are subject to various risks, uncertainties and assumptions about the investment strategies, capital markets and economic factors, which could cause actual financial performance and expectations to differ materially from the anticipated performance or other expectations expressed. Economic factors include, but are not limited to, general economic, political and market factors in North America and internationally, interest and foreign exchange rates, global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events.

Readers are cautioned not to place undue reliance on forward-looking statements and consider the above-mentioned factors and other factors carefully before making any investment decisions. All opinions contained in forward-looking statements are subject to change without notice and are provided in good faith. Forward-looking statements are not guarantees of future performance, and actual results could differ materially from those expressed or implied in any forward-looking statements. Bristol Gate Capital Partners Inc. has no specific intention of updating any forward-looking statements whether as a result of new information, future events or otherwise, except as required by securities legislation.

 

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