Welcome to the April edition of the Generate KiwiSaver Scheme Newsletter. In our first newsletter of the year we discussed that the era of low volatility could well be behind us. This has certainly been the case with share markets experiencing some large gyrations. For instance, there have been eight days when the S&P500 index in the U.S. moved by more than 2% (upwards or downwards) since the start of the year, whereas in 2017 this index did not move by more than +/-2% in a single day.

The bumpy ride provided by share markets caused the Growth and Focused Growth funds to produce negative returns in March. The more defensive Conservative Fund generated a positive return for the month. More on this later.

Returns to 31 March 2018 (after fees* and before tax).

*except the $3 per member per month fee.

Note: Past performance is not necessarily an indicator of future performance.

The significant global share market fluctuations first seen in late January continued into March. This dragged the performance of Growth and Focused Growth funds into the red.

The sustained strength in global share markets prior to February ensures that the more important longer-term performance generated from Growth and Focused Growth is still attractive; for instance, 12-month returns are 12.11% and 14.84% for the funds respectively. In contrast the more defensively positioned Conservative Fund generated positive returns in March, but lags the other funds over longer periods with a 12 month return of 5.57% (please note that all returns are after fees and before tax).

The best performing International Equity Manager (IEM) or large-cap international stock was Alibaba (BABA) which returned -1.5% (in NZD) in March. Tech stocks were generally weak in March dragged down by Facebook’s much publicised privacy data breach. Pleasingly, BABA managed to escape the brunt of this.

The IEM or large-cap international stock with the lowest return for the month was Facebook with a return of -10.5% (in NZD). The share market reacted negatively to news that Cambridge Analytica had mis-used Facebook user data in the last US election and Brexit vote. The key concern is that this could negatively impact user engagement and limit the company’s ability to target advertising to its large subscriber base. We discuss the investment thesis for Facebook in the “Stock Spotlight” section later in the newsletter.

The top-performing Australasian stock for the funds in March was local retirement village operator Summerset (SUM) with an impressive return of 9.6%. This is the second month in a row that the stock has achieved this accolade (in February the stock was up 11%) and is a result of stronger than expected results for 2017 and news the company would continue to lift its development rate.

Port of Tauranga was the worst performing Property and Infrastructure stock in March declining 4.6%. It is worth noting that half of this loss was the result of a very weak day at the end of the last quarter, and much of this was recovered on the first day of the new quarter. There was no company specific news released during the month and so putting aside the unusual price action at the end of the quarter it seems likely risks of a trade war weighed on the company’s share price.

In March, President Trump indicated that he intended to introduce new tariffs on $50 billion of Chinese imports entering the United States. This announcement followed the implementation of tariffs on steel and aluminium imports from some countries earlier in the month. These announcements weighed on the market, because it sparked fears of a trade war, which would act as a headwind to global economic growth.

In a move that commentators argued evidenced China’s understanding of the US political environment, it has hit back announcing a proposed package of tariffs on 106 US made products including cars, airplanes, and soybeans. In aggregate these proposed tariffs would cover $50 billion of US exports into China matching those previously announced by the United States. The products look like they have been targeted to maximise the impact on Trump’s supporter base.

While it is anyone’s guess how the situation will play out we suspect that a full-blown Trade War will be averted. While Trump recently indicated his intention to respond to China’s “unfair” retaliation, he has a track record of coming out with strongly worded announcements, and then moderating his stance by the time any changes are made.

A good example of this behaviour is the tariffs targeted at protecting US metals production. At the end of February, Trump announced that imported steel would attract a 25% tariff and imported aluminium will attract a 10% tariff. Less than a fortnight later, Trump then indicated that all countries affected by the proposed tariffs could negotiate exclusions. When the tariffs were implemented exemptions were made to countries in the European Union, Australia, Argentina, Brazil, Canada, Mexico and South Korea; these countries make up the majority of US steel and aluminium imports.

We also suspect that because Trump has made much of the strength in share markets since his election he will be reluctant to create a significant sell off. Additional pressure for Trump to moderate his stance comes from the looming mid-term elections (due to take place in early November), the results of which will directly impact his ability to make reforms and are widely viewed as a referendum on the current president.

It is important to note that in the short term, the negative reaction from the market reflects investor’s strong preference for certainty. There is of course the risk that the situation is not resolved and instead escalates. If this occurs it will be interesting to see how central banks react. In the meantime, it seems likely that we will see further swings in share markets as they incorporate new news.

The pickup in volatility that began in late January continued into March, but the key driver evolved from the worry that interest rates would shift higher to concern about a Trade War breaking out. The risk that Facebook’s data breach would impact tech firms’ ability to use client data to target advertising also weighed on the tech sector.

US shares ended the month down 2.5% when measured using the S&P 500 including dividends. While this is the second month of weak performance it follows a sustained period of positive returns and as a result the S&P500, including dividends, was up 14% for the year ending 31 March 2018.

Eurozone equities also registered losses in March, but these were more moderate than the United States with the Bloomberg European 500 Index dropping 1.8%. European shares were dragged down by the escalating trade conflict between China and the United States. This underlines the global nature of this risk.

In China, the Shanghai Stock Exchange Composite Index felt the brunt of share market investors increasing anxiety over the building tensions between Beijing and Washington. The index ended the month down 2.8%.

Emerging equity markets as a whole also followed the pattern set by developed markets, but the decline following Trump’s China tariff announcements were less severe than developed markets. A strong start to the year has meant the MSCI Emerging Markets (EM) Index produced a positive return in the first quarter (in local currencies).

Over the ditch, the ‘lucky country’ has the dubious honour of achieving the lowest return of the regions and countries we follow in the month of March, with the Australian Stock Exchange 200 Index declining 3.6% in local currency and over 5% in NZ dollars. The damage was done by the big banks, which make up a quarter of the index. These shares dropped between 5.3% and 7.5% over the month on the back of news from the Royal Commission Enquiry into mortgage lending. It is worth noting that these companies do not fit into our Property and Infrastructure mandate and so are not held directly by the funds.

Back home and the NZX50 Gross Index nudged 0.7% lower in March, which was another strong month relative to other markets. Interestingly, fears of a trade war did not seem to impact the local bourse, which is a little surprising given the large proportion of the economy that relies on global trade.

After 50 years at the helm of Berkshire Hathaway (which is currently one of the largest investments for both of our growth funds) Warren Buffett has become widely regarded as one of the world’s greatest investors. In his annual letters to shareholders, and in various interviews he has given, he has shared many of the lessons he has learned during his career. This month:

"One important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million’. I would decline –perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward! The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."

What is volatility

One of the most frequently used terms in the Generate KiwiSaver Scheme’s newsletters and the financial press this year has been ‘volatility’. We have used it multiple times to describe how financial markets have performed and how they are likely to track in the near term.

To understand volatility in a financial markets context it is useful to first review more common usages and then draw parallels. Three frequent usages of volatility are:

• People: a person that is volatile displays rapid and sometimes unpredictable changes of emotion.
• Chemistry: a chemical that is volatile has a higher propensity to change state.
• Statistics: volatility is a statistical measure of dispersion around the average.

These examples show that in-essence volatility typically describes changeability and unpredictability. This is also how it is often used for financial markets: volatility is typically used to describe the stability and predictability of returns from an asset class or a particular investment.

All things being equal - investments that have unstable and unpredictable returns have a higher risk than those that provide stable and predictable returns. As a result, an investment’s risk is often measured using the statistical measure of volatility.

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Facebook

Facebook is undoubtedly a name that is familiar to most readers. The firm’s origins date back to 2004 when Mark Zuckerberg developed an online student directory for Harvard, which quickly spread to other colleges before being opened up to the general public in 2006.

The company has grown its user base to a staggering 2.1 billion users on a monthly basis. An average of 66% of those using the site do so on a daily basis. In 2017, Facebook successfully monetised this significant level of traffic selling US$40 billion in advertising and generating a further $700 million of additional payments and fee revenue.

Facebook is driving strong growth in revenues by gradually shifting towards targeted advertising. Advertisers are happy to pay a significant premium to place ads in front of their targeted audience and Facebook has the data to facilitate this.

In mid-March the Observer and New York Times published articles outlining how Cambridge Analytica had collected data from 50 million Facebook users using questionable practices and then used that to target advertising for Trump in the US election and for Brexit ahead of the referendum. These stories raised question marks over how Facebook protects users’ data.

In our view, Facebook’s very large user base creates strong network effects, which makes it difficult for users to stop using the site. Surveys carried out on users post the data breach confirm that a very small number of users have deleted their accounts (around 1%). A more likely risk is that the future revenue growth from targeting advertising will be limited. A combination of new privacy regulations and users adjusting their privacy settings could well constrain Facebook’s ability to sell targeted advertising.

The growth funds continue to hold Facebook shares, because in our view it still offers an attractive combination of high earnings growth and a reasonable valuation. More specifically Facebook is trading on a lower 12 month forward earnings multiple than the NZ share market but has three times the forecast earnings growth.

Next month: Infratil