Note: LTM Dividend Growth is the median of the actual trailing 12-month dividend growth as reported on Bloomberg at September 30, 2021 of the individual stocks held by Strategies or Index constituents. 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 individual constituents of the Indices as of October 14, 2021.
Source: Bloomberg, Bristol Gate.
As we enter the fourth quarter, concern over COVID-19’s effect on the global economy has given way to inflation worries. A confluence of production/supply chain disruptions, rising commodity prices, significant government stimulus, tight labour markets, and a broad return in demand once economies reopened has caused inflation to run at levels not seen since the early 2000s.
Exhibit 1. Global Fund Manager Survey Biggest Tail Risk
Source: BofA Merrill Lynch.
The Federal Reserve maintains that many of the pressures will prove temporary and anticipates inflation will fall back close to 2% in 2022. However, that outlook is uncertain with Chair Powell admitting, “It’s very difficult to say how big the effects will be in the meantime, or how long they will last.”
US 5 Year 5 Year Forward Breakevens indicate longer term inflation expectations remain muted, but appear to be trending higher. The “inflation angst” caused the market’s fear gauge, the VIX Index, to jump as investors rotated sectors and repositioned portfolios to chase the apparent trend.
The only trend we follow is high dividend growth, so to understand how inflation would affect our strategy, we analyzed data back to 1970, comparing the performance of high dividend growers to the broader market under various rates of inflation. The results in the chart below speak for themselves. The higher inflation went, the better High Dividend Growth did relative to the S&P 500.
Exhibit 2. High Dividend Growers and S&P 500 Returns vs. Inflation (x-axis)
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: Bloomberg, FactSet, St. Louis Federal Reserve, Bristol Gate Capital Partners.
We also analyzed returns of other assets at various levels of inflation (x-axis). The High Dividend Growth cohort performed admirably in all cases and particularly well in higher inflationary periods. Real returns per unit of risk, defined as return volatility in this case, were best on a relative basis when inflation was highest (in the top two quintiles).
Exhibit 3. Asset Returns in Various Inflation Environments
Notes: Annual data between 1970-2020. Inflationary environments broken down into quintiles, using year over year growth in the US Consumer Price Index. High Dividend Growers defined as the top quintile of dividend growth in the S&P 500, equally weighted and reset annually. BBG Comm is the Bloomberg Commodity Index. Return data is averaged. Returns for the S&P 500 and High Dividend Growers are price returns only. We do not believe including dividends would materially change conclusions. Real returns per unit of risk equals nominal return less inflation divided by standard deviation of returns.
Source: Bloomberg, St. Louis Federal Reserve, Damodaran Online, FactSet, Bristol Gate Capital Partners.
Although commodities, a popular inflation hedge, also performed well in these instances, we prefer the durable through cycle characteristics of dividend growers. As Morningstar says:
Companies that are focused on growing dividends tend to be higher-quality, cash-rich businesses that hold up well in down markets, participate in up markets, and are capable of excess returns over a full market cycle.
In addition to being core, defensive holdings, companies that are growing their dividends provide some protection from inflation: A rising dividend is fundamental to investors’ ability to preserve purchasing power through their equity portfolio.
It’s also likely that dividend-growth stocks will be less sensitive to losses during periods of rising interest rates. For example, high-yielding stocks intuitively become a less attractive income source when yields rise on bonds, a less risky asset class. But because dividend growers tend to sport more modest yields, they were never the first choice for yield hounds in the first place.
We believe the solid fundamentals of the high quality, high dividend growers we invest in can protect against high inflation if it materializes and position them to perform regardless of whether it does or does not. Here are a few examples:
- Visa and Mastercard charge a percentage on every transaction over their networks making revenues inherently indexed to inflation. With largely fixed cost networks, most of that inflation falls directly to the bottom line. Cross border volumes remain depressed because of lower international travel due to COVID and a significant percentage of global transactions are still done with cash. Both provide highly probable growth opportunities going forward.
- Currently, most of the semiconductor industry is supply constrained. Many of Texas Instruments’ customers are unable to meet demand because of inventory shortages. The company smartly built inventories before the constraints hit the industry and has been less aggressive than some peers in taking pricing since, preferring instead to cement customer relationships for the long term through reliable and fair supply. If the company does need to exercise the pricing lever to protect profit margins, we believe the opportunity is there.
- Sherwin Williams has experience unprecedented input cost inflation because of industry wide shortages for key resins, additives, and solvents. Supply chain challenges that first arose in February with the winter storms in Texas were exacerbated by hurricane Ida which had a more severe and longer lasting impact on the petrochemical supply chain than initially expected. The company has already taken three price increases this year and intends to take more if necessary. There has been little impact on demand to this point. The price of paint typically accounts for 10-20% of the total cost of a paint job with labour comprising by far the biggest component. A 10% increase by Sherwin Williams translates to paltry 1-2% for the end consumer. That is too small to matter in most cases.
- Moody’s is one of nine Nationally Recognized Statistical Rating Organizations (NRSROs) approved by the SEC. It competes in a regulated oligopoly that is vital to the functioning of financial markets. Moody’s and Standard & Poor’s (S&P), the two largest rating agencies, are estimated to have approximately 80% market share. The companies typically charge 5-6 basis points for a rating initiation and 2-3 basis points for ongoing monitoring. However, a rating can reduce annual interest costs by 30-60 basis points. That cost/benefit spread inherently provides the agencies plenty of pricing power. Many investors are concerned about how higher rates will impact near term issuance but historically, Moody’s revenues have not been strongly correlated to interest rates. Longer term, bank disintermediation remains a significant global opportunity for the rating agencies as markets move from bank centric financing models to capital markets-based ones.
We do not know whether inflation will prove to be temporary or not. We learned long ago not to pontificate on macro events and more importantly, not to construct a portfolio for any specific view. The future is largely unknown and being prepared for variety of outcomes is the best course of action. We believe our high dividend growth strategy does that, providing the potential to perform well regardless of what the environment throws at it.
Bristol Gate US Equity Strategy (all returns USD)
The trailing 12month median dividend growth of our US Equity Strategy was 12.9% at quarter end compared to the S&P 500’s median 5.5%. Over the next 12 months, our model is predicting median dividend growth of 16.7% for our portfolio companies. This compares to the median of the S&P 500 constituents of 5.6% as forecast by consensus.
The US Equity Strategy declined 0.6% in the third quarter compared to the 0.6% rise for S&P500 Total Return Index®. Sector allocation had a greater negative effect on relative performance than security selection, with the largest sectoral impacts coming from our overweight in Industrials and underweight in Financials.
Thermo Fisher Scientific, Intuit and Zoetis were the largest individual absolute contributors to the Strategy’s return. On a relative basis compared to the benchmark, Thermo, Intuit and Sherwin Williams were the largest contributors.
Activision, Applied Materials and Roper Technologies were the largest absolute detractors to the Strategy’s return. On a relative basis compared to the benchmark, Activision, Applied Materials and Moody’s were the largest detractors. Activision alone accounted for most of the underperformance following a lawsuit for harassment and inequality at its Blizzard division and reports of the Chinese government restricting video game play for minors to just one hour per day, three days a week. Both instances weighed on sentiment, causing the company’s forward earnings multiple to derate to 18x from 23x. We believe the stock reaction was excessive.
Since the lawsuit was announced in July Activision has made significant progress in restructuring the Blizzard leadership team which we anticipate will lead to cultural improvements. They also confirmed an agreement with the U.S. Equal Employment Opportunity Commission (EEOC) to settle claims and to further strengthen policies and programs to prevent harassment and discrimination in the company’s workplace. Under the agreement, Activision committed to create an $18 million fund to compensate and make amends to eligible claimants. Any amounts not used for claimants will be divided between charities that advance women in the video game industry or promote awareness around harassment and gender equality issues as well as company diversity, equity, and inclusion initiatives, as approved by the EEOC. There is more work to be done but we are encouraged by the initial steps to rectify the issue.
We have seen little impact from the lawsuits on Activision’s customer engagement, game play or development thus far. Diablo II: Resurrected, the first major release from Blizzard since the lawsuit was filed came out across all major platforms and earned solid reviews. We will pay particular attention to commentary in the upcoming Q3 earnings call on the next Call of Duty and Diablo IV, two major releases scheduled for 2022.
With respect to the Chinese government’s actions, the region accounts for less than 5% of Activision’s revenue and was expected to have a very limited impact on mid term growth prospects. China was not a factor in our investment thesis.
At the beginning of the third quarter CME Group was sold and replaced with Advance Auto Parts (AAP). CME had the lowest predicted dividend growth in our portfolio and our outlook for the company diminished compared to when we made our initial investment.
In AAP, we acquired a self-help story in what we believe is an attractive industry, aftermarket auto parts retailing. Saddled with the baggage of disparate, redundant and under invested in systems following an acquisition in 2014, AAP experienced many operational challenges compared to its peers. Over the last several years a significant amount of change has occurred behind the scenes that we believe has finally set the stage for company to close the performance gap. In the past, we have found these situations where otherwise high quality companies in attractive industries go from legacy to modern systems to be very powerful, giving them better information to drive 1) reduced inventory/higher inventory turns, 2) improved sales because of better parts availability, and 3) increased margins/profitability because of fewer markdowns and greater operating leverage, all of which have a compounding effect on cash flow generation and by extension dividend growth. Although there is some execution risk with respect to AAP’s ongoing operational transformation, their progress thus far, the size of the opportunity (we believe AAP can more than double their FCF on working capital improvements alone over time) and the price at which we are acquiring the shares suggest it is an opportunity worth underwriting.
We also moved to a threshold based rebalancing process from strict equal weighting during the quarter. As all security weights were within our threshold bands, no rebalancing activity occurred in Q3. We expect the move thresholds to lower transaction costs without negatively impacting our return potential. More information on the change can be found here: Threshold Rebalancing Link.
Bristol Gate Canadian Equity Strategy (all returns CAD)
The trailing 12-month median dividend growth of the portfolio companies in the Canadian Equity Strategy was 9.7% at quarter end. This compared to the S&P TSX Composite 2.5% median dividend growth. Over the next 12 months, our model is predicting median dividend growth of 14.2% for our Canadian portfolio companies. This compares to the median of the S&P TSX Composite constituents of 2.9% as forecast by consensus.
During the quarter, the Canadian Equity Strategy returned 2.1% compared to 0.2% for the S&P TSX Composite Total Return Index. Stock selection had a greater positive effect on relative performance than sector allocation, with the largest impacts coming from our picks within the Health Care and Financials sectors.
Thomson Reuters, Canadian National Railway and FirstService were the largest individual absolute contributors to the Strategy’s return. On a relative basis compared to the benchmark, Zoetis, Thomson Reuters and Brookfield Asset Management were the largest contributors.
Canadian Pacific Railway, Quebecor and Stella-Jones were the largest absolute detractors to the Strategy’s return. On a relative basis compared to the benchmark, Quebecor, Toromont Industries and Canadian National Railway were the largest detractors. Canadian National made both the absolute contributors and relative detractors list due to its large benchmark weight.
The stark difference between the performance of Canadian National and Canadian Pacific this quarter was due to the developments around the acquisition of Kansas City Southern. Kansas City reversed its decision and agreed once more to the improved offer from Canadian Pacific, due to the negative early regulatory reaction to the potential merger with Canadian National. As the two smallest Tier-1 railways and with no network overlap the combination of Canadian Pacific and Kansas City Southern faces a much smaller regulatory hurdle, albeit still a significant one. As owners of both Canadian railways, we believe this is a positive development that will allow Canadian Pacific to emulate Canadian National’s “T” shaped network, increasing its competitiveness and pushing Canadian National to focus on improving operations. Activist investor actions and the failed attempt to acquire Kansas City National have already prompted Canadian National to announce a strategic plan to improve its financial results and shareholder returns.
As all security weights were withing threshold tolerances, there was no trading activity this quarter outside regular flows.
As we reported in our earlier quarterly letters this year, we have developed an ESG framework and have implemented a “threshold approach “to the weightings in the portfolio.
Our approach to ESG has always assessed business risks and governance best practises. As you can read in our one-pager (ESG Integration), we have adapted frameworks suggested by leading organizations but have continued to rely on our proprietary data and fundamental analysis when making our portfolio stock selections.
The Threshold Analysis paper produced by our Data Scientists and discussed earlier, will help reduce trading costs and should result in a beneficial tax impact as well.
It is an exciting time for Bristol Gate as we are welcoming more employees as new shareholders of our company this month. We believe that by aligning our interests with those of our investors, our future together will be stronger and better.
As of September 30, Assets Under Administration and Management were approximately $2.7 Billion.
Thank you for your ongoing support and trust in Bristol Gate. We will continue to invest in the people and processes of the company so that we may serve you all better in the future.
The Bristol Gate Team
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 firstname.lastname@example.org. 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.