30 January 2019
A year of two halves saw Pictet Water fund's 'barbell' strategy tested by political wrangling, its managers tell Michael Hurley
"2018 was an unusual year for us; it was a year of two halves," says Cédric Lecamp, portfolio manager of Pictet's institutional water fund (EUR).
Despite posting negative returns of 7.9%, according to Morningstar figures the fund was the best performer in the water category in a stormy year for global equity markets. This compares with -4.11% for its reference benchmark index, the MSCI World E.
Since its inception in January 2000, the fund has delivered a return of 6.64%, versus its benchmark's performance of 3.04% over the same period.
The fund has traditionally done well against its reference index, due to a so-called 'barbell' strategy – which incorporates a 'defensive core' of utilities coupled with more growth-orientated industrials.
"The barbell strategy of the portfolio has performed well over the past 21 years, and allowed us to navigate pretty much all market conditions. But that strategy didn't work so well against the MSCI World in the first half of 2018.
"Water utilities in particular faced structural challenges in the first quarter, as they underperformed despite their usual defensive characteristics, and then resumed normal service in the second half, as the barbell strategy again functioned well against a more volatile market environment," Lecamp explains.
The fund, which has assets of €3.95 billion ($4.5 billion), was invested in 54 stocks at the end of 2018. The majority of holdings (56.3%) were in the US, with 10.8% in Great Britain, 6.4% in France, 5.7% in China, 4.8% in Switzerland and 2.5% in Brazil.
Louis Veilleux: Water utilities were hit in the first quarter by a lot of idiosyncratic events across the world, at the same time
It divides its investments into three segments: water technology (about 53% of its assets), water supply, which includes utilities (about 36%), and environmental services, which includes waste management (11%).
Louis Veilleux, co-lead manager of the fund, says water utilities were hit in the first quarter by "a lot of idiosyncratic events across the world, at the same time, which compounded broad-based market fears".
"One such fear was of rising interest rates, [driven by] fears that the US Federal Reserve would raise US rates. This resulted in the whole market coming down in early February, with the utilities, often seen as bond proxies, coming down more than the market," Veilleux says.
Meanwhile, UK utilities were negatively impacted not only by Brexit negotiations, he says, but also by Labour, the country's largest political opposition party, formally announcing its intention to nationalise water utilities if it gains power.
Emerging market utilities were also impacted, with those in Brazil hit by difficult economic conditions stoked in the run-up to its May general election.
"An example of idiosyncratic issues is that some of our companies in China are involved in public-private-partnership (PPP) projects. They have a lot of growth ahead but it's a little [difficult] to finance that growth.
"One company had a rights issue, with the capital raise at a 40% discount – that heavily impacted the stock price, to say the least," Veilleux adds.
The fund was also disrupted by personnel changes, with several managers departing mid-way through the year. Lecamp and Veilleux assumed its management on 31 August. "With a new team comes some new ideas... but there's no big changes in how we manage this product," says Lecamp.
He says the fund's underperformance relative to its benchmark was "recovered, but not quite entirely reversed" in the second half of the year, and it "strongly outperformed" the global equity market in the fourth quarter. This is despite finishing about 400 basis points below the MSCI World.
"In a volatile corrective environment the utilities outperformed. The waste management companies continued on steady trends of route consolidation. [However], in the second half of the year, technology firms were much weaker," he adds.
"We're still reassured of our portfolio's performance over that period because [as] the volatility increased, the fund proved a bit more defensive than global markets, and again in the early part of January [it is] still demonstrating its ability to stay in line with global markets in a very sharp rebounding environment," Lecamp says. So far in 2019, it has delivered returns of 7.53%, against the MSCI World's 6.65%, as of 25 January.
Stocks that performed strongly in 2018 include industrial, healthcare and consumer products conglomerate Danaher and biotechnology product developer Thermo Fisher Scientific, which ended the year as its second and fourth-largest holdings, respectively.
US public utility American Water Works, its largest holding, "had a very strong year [and] performed extremely well" in autumn, says Veilleux. "Its earnings are not dependent on GDP [growth], since they have regulated assets, but will be dependent on the investments they make in the future of their infrastructure," he adds. "It, and the US in general, has a huge water pipeline replacement cycle that it will go through over the next decades. We're looking at the company's earnings growing [between] 7% to 10% per share."
Meanwhile, it exited building product manufacturer Forterra, due to high operating leverage and weak capitalisation, according to a Pictet note.
Despite the fund's underperformance against its reference benchmark in 2018, the fund's managers remain "very positive in the long-term fundamentals of this space", says Lecamp.
"On a global basis we're expecting very significant growth to happen that should be supportive for our water names.
"We think that there is a very long runway for growth in US water utilities, as there remains hundreds of billions of dollars of infrastructure needs that stand to be captured by these companies, which today have very small penetration for clean water or waste water services.
"Then in the water technology side, the demand from these global utilities and PPPs creates an even bigger backdrop for secular growth in terms of the services and technologies to improve productivity and the returns from water," Lecamp explains.
"Finally, waste management, which doesn't get mentioned as often, is set to benefit as waste volumes will likely double by 2025, driven by demographics, urbanisation, and economic development, and will require a professionalised solution."
|Top 10 holdings, as of 31 December 2018|
|American Water Works||US||5.07%|
|Thermo Fisher Scientific||US||3.81%|