Our firm’s name comes from the famous gate in Bristol, England where many explorers set out to establish new trade routes. The gyrations of the market over the past several quarters have given us some sense of what it must have felt like crossing the North Atlantic during the Age of Exploration in the 15th century. Much like the weather “bombs” that create gigantic waves in the region (a record 95 footer in 2000), the Coronavirus had us on a wild ride in the first half of the year. After rising approximately 32% in 2019, the S&P 500 fell 20% in the first quarter of 2020, only to rebound 21% during the second quarter.
In our last quarterly note we highlighted a Harvard Business Review study that showed several prior epidemics experienced V-shaped rebounds in GDP. While the economy is showing early signs of recovery from the recession caused by the Coronavirus pandemic, stock markets have had a surprisingly strong bounce in no small part due to the substantial fiscal and monetary stimulus unleashed by central banks and governments around the world. The US Federal Reserve currently has no plans to raise rates until at least 2022, with other major central banks even further out.
Lower rates for longer globally, ongoing uncertainty leading to significant dividend cuts across sectors that typically offer decent dividend yields, and investor expectations for future dividend payments from S&P 500 companies to remain flat from 2019 levels to the end of the decade will make generating income from traditional approaches more difficult. In such an environment, companies that can sustainably grow their dividends at attractive rates should be well positioned to see growing investor interest, in our view.
Exhibit 1. Dividend Cuts & Futures Market Dividend Projections
Source: S&P Dow Jones Indices & CME Group.
We believe our investment process, focused on identifying high quality businesses at reasonable valuations with strong balance sheets and growing cash flows to support high dividend growth will continue to help us achieve our long term goal of strong returns in a range of economic outcomes. And like the ballast tank in a ship, the financial flexibility offered by such businesses will provide fundamental stability and capital preservation when waters get rough again.
Bristol Gate US Equity Strategy (all returns USD)
The US Equity Strategy gained 21.8% in the second quarter compared to the 20.5% rise for S&P500 Total Return Index®. Cintas, Broadcom and Broadridge were the three largest relative contributors, while Ross Stores, Tyson and Allegion were the largest relative detractors.
Although trailing the S&P 500 year-to-date by approximately 330bps, we are reasonably pleased with our performance on a relative basis in light of our limited exposure to the large cap tech stocks that have been driving a substantial portion of the market’s return. Many of these stocks do not pay a dividend, which effectively excludes them from our investable universe.
Exhibit 2. S&P 500 vs Nasdaq 100
Source: Wall St. Journal.
In times such as these, where the market leadership group is narrow and includes stocks which our process does not allow us to own, we look to perhaps more comparable benchmarks such as the S&P 500 Equal Weight Index, or the S&P 500 Dividend Aristocrats Index to gauge our results. Relative to these measures, our performance continues to differentiate itself both in the near and long term, highlighting the diversification benefits adding our strategy to a portfolio mix can have.
Exhibit 3. Bristol Gate US Equity Strategy vs. S&P 500 Dividend Aristocrats and Equal Weight Indexes
Source: S&P Dow Jones Indices.
The quarter saw an unusual amount of trading activity, driven by the effects of Covid-19. In early April, we added Activision Blizzard and Microsoft, utilizing our two units of cash from the sales of Boeing and Southwest Airlines in March (discussed in our Q1/20 letter). Moody’s was also acquired, replacing Bank of America. In June, we added the CME Group and Dollar General. The purchases were funded from the sales of Estee Lauder and Ross Stores.
All our sales were driven by reduced dividend growth prospects brought about by the effect of Covid-19. Estee Lauder and Ross suspended dividends following a significant reduction in retail traffic. Although we believe both are great businesses, they could not meet our criteria for high dividend growth in the near term with the challenges they were experiencing and had low visibility as to when business would return to more normal operations. In Bank of America’s case, our reduced dividend expectations were due to Fed actions to lower the benchmark interest rate to zero while launching a new round of quantitative easing to offset the economic impact of the virus. We also believed the probability of a credit cycle and rising loan loss provisions increased given the significant contraction in economic activity and rise in unemployment.
Activision Blizzard experienced an increase in video game play as people spent more time at home, but the leader in the attractive video game market is also well positioned to capitalize on the upcoming video game console cycle for years to come. Sony and Microsoft are expected to launch new consoles ahead of the holiday season and the video game stocks have historically done well in the early parts of a console cycle as players build their game libraries.
Microsoft reported seeing “two years’ worth of digital transformation in two months” as businesses adapted to working from home. We believe the transition to the cloud is still in the early phases and the world’s largest software company will be a key beneficiary with its broad offering.
Moody’s is one of a limited number of regulatory designated rating agencies whose products are deeply embedded into customer workflows/processes. Its robust business model with high barriers to entry will benefit as we expect strong refinancing activity brought about by the reduction in rates and the challenges of Covid.
The CME Group is the world’s largest derivative exchange, offering the widest range of futures and options products for risk management. In the near term, trade volumes experienced a significant benefit due the volatility created by the virus, but we believe secular tailwind such as over-the-counter products migrating to exchanges and greater global participation in derivatives markets will sustain dividend growth over the medium to long term.
Dollar General operates at the intersection of value and convenience. Its largely rural store base has been an essential service for customers during the pandemic, but its significant new store opportunity and strong unit economics are what attracted us to the stock. We believe the company has a long runway for growth that should support a rising dividend for several years.
We believe the names we added have attractive dividend growth prospects with a high probability of sustainability even if an additional wave of Covid re-emerges. Virtually all new additions saw an uptick in business activity during the first wave of the virus, providing an element of downside protection if a second wave comes. Yet, each has the opportunity to participate in any recovery given the secular drivers in their respective businesses. We believe the additions are consistent with our goal of using the volatility in the markets to high grade our portfolio and find attractive, sustainable dividend growth in an environment where the overall market’s dividend growth expectations are negative for the coming year.
Exhibit 4. US Equity Strategy Returns and Risk
All securities positions were re-balanced to equal weights on June 25th.
Bristol Gate Canadian Equity Strategy (all returns CAD)
The Canadian Equity Strategy gained 11.1% in the second quarter compared to the 17.0% rise for S&P/TSX Composite Index®. Enghouse, Alimentation Couche-Tard and CAE were the three largest relative contributors, while Canadian Natural Resources, TC Energy and Bank of Nova Scotia were the largest relative detractors.
The strategy is trailing the S&P/TSX year-to-date by approximately 230bps. Not owning non-dividend paying stock Shopify, now the largest weight in the index, cost the strategy more than 300bps of relative performance.
Exhibit 5. Canadian Equity Strategy Returns and Risk
In the quarter we added Telus, Waste Connections, TMX Group, while exiting NFI Group, ONEX Corporation, Magna International, Canadian Natural Resources and Bank of Nova Scotia. We also took the opportunity to reduce the number of names held in the portfolio from 25 to 23 to further concentrate our holdings in our best ideas following a deterioration in expected dividend growth across the market. In June, we added FirstService, funded from the sale of CAE.
All our sales were driven by reduced dividend growth prospects brought about by the effect of Covid-19. CAE suspended its dividend following a significant reduction in air travel, resulting in lower need for pilot training.
Telus is one of the big three national telecommunication carriers in Canada. Through a network sharing agreement with Bell, it serves wireless customers across Canada and is well positioned to benefit from increased mobile data consumption and the transition to 5G.
Waste Connections is one of the largest integrated waste haulers in North America in a large, yet still very fragmented solid waste services industry. The company’s business model is predicated on predictable revenue that tends to perform throughout the economic cycle, that is complemented with strategic acquisitions which improve route density and network advantages, generating attractive returns.
TMX group is the leading exchange in Canada that also offers data-driven solutions. The recurring revenue from these services has increased substantially in recent years, improving revenue visibility. At the same time TMX continues to be trading at attractive valuation, when compared to global peers of similar calibre and size.
First Service is a North American leader in the real estate services business. In another large but very fragmented industry, management has successfully grown the business through a combination of organic growth and strategic acquisitions, while maintaining significant insider ownership. Its two business segments and diverse client base provide revenue sources that are both cyclical and unrelated to the economy, contributing to the name’s dividend growth sustainability.
All securities positions were re-balanced to equal weights on June 24th.
We continue to work from home and are planning a staged return to the office over the coming months. Business continues as usual despite the physical distancing.
With the strong rebound in the market and a resumption of client flows following a pause during the most volatile periods of quarter, our AUM/AUA has grown to approximately $1.7 billion as of June 30, 2020.
We thank our clients for their continued support.
The Bristol Gate Team