During the quarter, both the US and Canadian Equity Strategies continued to outpace their respective benchmarks in terms of dividend growth. From a return perspective, US Equity Strategy portfolio performed in line with the S&P 500 Total Return Index while our Canadian Equity Strategy outperformed the S&P/TSX Composite Total Return Index. For a more detailed discussion on performance see each Strategy’s respective section below.
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 September 30, 2022. 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 September 30, 2022. Companies without a consensus dividend forecast were excluded.
Source: Bloomberg, FactSet, Bristol Gate Capital Partners.
Commentary – Quality is Job 1
We usually end our quarterly notes thanking clients for their continued support. In turbulent times like these, that unwavering confidence in our investment process is worth noting up front and is particularly appreciated as it allows us to remain focused on the long term.
A cocktail of high inflation, aggressive global central bank policy, an ongoing war in Europe, a growing Cold War with China, the global consequences a strong US dollar, amongst other risks has resulted in a highly uncertain macro environment. As US Federal Reserve Chair Jerome Powell said in September, “The chances of a soft landing are likely to diminish (as the Fed keeps raising rates)…No one knows whether this process will lead to a recession or, if so, how significant that recession would be.”
Financial conditions are tightening, economic growth is slowing, and things are starting to break. One current high-profile example in the financial press is the UK pension scheme, where a strategy to leverage their bond portfolio to generate additional returns has spectacularly backfired, forcing them to sell assets to cover losses and margin loans. More than a decade of virtually free money funded a lot of questionable ideas that usually involve unsustainable leverage and/or poor business models. Those two characteristics can be a death blow when rates are rising rapidly as they currently are. We would not be surprised if more things start to break.
The damage stock markets have sustained thus far has largely been sentiment related. Valuation multiples have contracted significantly, accounting for all of the S&P 500’s decline to date. Its 12-month forward P/E ratio has fallen 29% since year end compared to the Index’s price decline of 25% to the end of September. We believe the next phase of this cycle, if it has further to go, will be driven by a revision of earnings expectations. Consensus earnings forecasts for the S&P 500 have largely remained stable to this point, inadequately reflecting the deteriorating macro environment in our view.
In markets like these, we are always reminded of the 1980’s Ford commercial slogan, “Quality is Job 1”. Business quality is one of the four pillars of our investment process and is something that we do not compromise on when building our portfolios, believing it inherently builds resilience. In ecology, resilience is defined as the capacity of an ecosystem to respond to disturbances by resisting damage and recovering quickly. Resilience accepts that uncertainty and change are inevitable and focuses on withstanding the unexpected. While the definition of quality may slightly vary from person to person, we think US Supreme Court Justice Potter Stewart put it best in his landmark case defining obscenity, “I know it when I see it.” At Bristol Gate we define quality based on the nine traits in Exhibit 1 below.
Exhibit 1. Quality Traits of Bristol Gate Dividend Growers
Source: Bristol Gate Capital Partners Investment Presentation.
We believe quality companies exhibit stable and persistent earnings, high returns, strong cash flows, stable and wide profit margins, and low debt levels. All our portfolio companies are investment grade rated by the major credit rating agencies. We believe these characteristics fundamentally reduce risk and often provide us the conviction to stick with our companies when stock prices are gyrating wildly, as they currently are. Leverage especially matters because too much of it significantly reduces resiliency. Often, companies with too much leverage do not make it to the other side of the challenges we are currently facing. The free money to fund excessive risk taking is no longer there.
As with everything we do, we seek objective evidence to corroborate our views and conclusions, including our assessment of our portfolio’s quality. S&P Global has provided Quality Rankings on common stocks since 1956. Their ranking is driven by the long-term growth, cyclicality and stability of a company’s earnings and dividend record. They recognize that a company’s earnings and dividend performance are the end results of the interaction of a wide variety of factors including but not limited to, market demand for a company’s products or services; product development, production, and marketing strategies; the strength of its executive leadership; its industry position and competitive advantage; its capital structure and capital investment policies. As S&P states, “Over the long run, we believe a company’s record of earnings performance and dividend distributions can tell investors a lot.”
Companies rated “A-” or higher are considered above average quality. “B+” is considered average and anything ranked “B” or lower is considered low quality. Companies without a 10-year history are not rated (“NR”).
Exhibit 2. S&P Global Quality Rankings
As at September 30, 2022.
Source: Bristol Gate Capital Partners, FactSet, S&P Global.
Approximately 60% of the constituents of our US Equity Strategy have above average quality rankings, compared to approximately 30% of the S&P 500. Over 80% of our portfolio is average or better versus 55% for the Index. We believe the three companies (14%) in our portfolio not rated will eventually be classified as average or better once they have a 10-year history. Our sole below average ranking is
Microchip Technology Inc., a company we believe will also graduate to higher rankings in due course now that it has committed to and is executing against a clearly defined capital allocation strategy.
During times like these quality matters because stability and consistency of earnings combined with dividend growth is often more appreciated by the market when there is a lack of it available. We believe we are in one of those periods now. The quality and resilience of our portfolios are critical in allowing us to look through the current turbulence with optimism and predict into the future with some degree of confidence. Our holdings have the ability and willingness to continue investing through the uncertainty, increasing their competitive advantages and coming out stronger on the other end. They have done so in the past and we expect the same going forward.
US Equity Strategy (all returns USD)
During the quarter, the US Equity Strategy performed in line with the S&P 500 Total Return Index. Central banks globally are seeking to reign in persistently high inflation with aggressive policies. Higher rates, higher costs and the growing risk of an economic slowdown further soured investor sentiment.
Exhibit 3. US Equity Strategy Risk and Return Metrics
Source: Bristol Gate Capital Partners Inc. Please refer to “Important disclosures” section below.
Both our overweight and stock selection in the Communication Services sector were the primary contributors to performance in the quarter. Starbucks Corp. was the largest absolute individual contributor to portfolio returns following strong quarterly results in August and a very positive outlook during its Investor Day in September.
Both our overweight and stock selection in the Real Estate sector were the primary detractors from returns in the quarter. On an absolute basis, American Tower Corp. was the largest detractor on growing concerns regarding its high foreign exposure in a strong US dollar environment and fixed contractual annual price increases in its core U.S. market that are below current inflation rates. On the currency issue, we believe that the long-term growth available in the international segment more than compensates us for the currency risk. We suspect that the international segment will once again be looked at as a positive when the macro environment normalizes, and the U.S. dollar potentially gives up some of its recent gains versus other currencies. In terms of the margin concerns related to high inflation, we just do not believe it is as significant a risk as the market does. American Tower has a high fixed cost base including ground rent, which is primarily fixed under long-term lease agreements with its own annual cost escalations, property taxes and depreciation and amortization. These are not significantly affected in the near term by inflation. In fact, high inflation and by extension higher interest rates, may actually lower the price of its land-related costs over time. In the case of certain variable costs such as power and fuel, some or all are directly passed through to tenants.
In addition, in the past we have discussed how businesses with high margins have inherent inflation protection, not needing to raise prices as much as low margin businesses to cover cost increases and maintain dollar profits. American Tower has extremely attractive incremental margins. A cellular tower with one tenant produces gross margin of approximately 40% and a 3% return on investment. Moving to three tenants on the same tower increases gross margin to over 80% and return on investment to approximately 25%. The characteristic is an inflation shock-absorber in our opinion.
Year to date, the US Equity Strategy has lagged the S&P 500 Total Return Index. Our zero weights in Energy, Staples and Utilities have overwhelmed the positive contribution from stock selection. It is not unusual for us to underperform the Index when those sectors are performing relatively well as they have historically offered little opportunity to find high quality, high dividend growers consistent with our investment philosophy.
We added to Applied Materials Inc. and trimmed Cintas Corp. and Dollar General Corp. as part of our regular quarterly rebalancing process that brings positions back to equal weights after they exceed targeted thresholds. The macroeconomic backdrop remains uncertain. We believe owning quality companies that are financially sound and can grow their dividends at above average rates will allow our portfolio to successfully navigate this challenging environment. We believe quality is more than just an idea and can be measured. Sixteen of our 22 portfolio companies have announced dividend increases thus far in 2022, averaging 19.3%. In addition, as shown in Exhibit 4, our holdings in aggregate have delivered higher revenue and earnings growth compared to the Index, while paying out a lower portion of their earnings to shareholders and generating significantly superior return on equity. We believe the willingness and ability to increase their dividends at such a high rate in the context of the current macro environment speaks to the strength and durability of our investments’ business models.
Exhibit 4. US Equity Strategy Portfolio Characteristics
As at September 30, 2022.
Source: Bristol Gate Capital Partners, Bloomberg.
Canadian Equity Strategy (all returns CAD)
During the quarter, the Canadian Equity Strategy outperformed the S&P/TSX Composite Total Return Index. As we outlined earlier, central banks globally are seeking to reign in persistently high inflation with aggressive policies. Higher rates, higher costs and the growing risk of an economic slowdown further soured investor sentiment.
Exhibit 5. Canadian Equity Strategy Risk and Return Metrics
Source: Bristol Gate Capital Partners Inc. Please refer to “Important disclosures” section below.
Outperformance was primarily driven by stock selection in the Financials and Materials sectors, as well as having no exposure to the Energy sector. Element Fleet Management Corp. was the largest absolute contributor to returns over the quarter as the company is in a unique position to benefit from higher interest
rates, energy prices as well as inflationary pressures. Company management also raised their full year guidance.
We added to Enghouse Systems Ltd. and InterRent Real Estate Investment Trust and trimmed Element Fleet as part of our regular quarterly rebalancing process that brings positions back to equal weights after they exceed targeted thresholds.
Fourteen of our 23 portfolio companies have announced dividend increases thus far in 2022, averaging ~12%. In addition, our holdings in aggregate have delivered revenue and earnings growth of ~14% and ~11%. Like our U.S. Strategy, we believe the willingness and ability to increase their dividends at such a high rate in the context of the current macro environment speaks to the strength and durability of our investments’ business models.
To all our clients, thank you for your continued trust and confidence. Since our inception, we have continually invested for the long-term by owning the best prospective dividend growers for the coming year. Dividends and dividend growth have played a significant role in terms of their contribution to total returns in other tumultuous periods such as the inflationary 1940s and 1970s or the stock market’s “lost decade” of the 2000s. We believe rising income leading to rising value is a fundamental investment “truth” across markets and time and do not believe the concept has lost its relevance in today’s environment.
Sincerely, The Bristol Gate Team
There is a risk of loss inherent in any investment; past performance is not indicative of future results. Prospective and existing investors in Bristol Gate’s pooled funds or ETF funds should refer to the fund’s offering documents which outline the risk factors associated with a decision to invest. Separately managed account clients should refer to disclosure documents provided which outline risks of investing. Pursuant to SEC regulations, a description of risks associated with Bristol Gate’s strategies is also contained in Bristol Gate’s Form ADV Part 2A located at www.bristolgate.com/regulatory-documents.
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.
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.
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.