International Value

Period ended June 30, 2019
 

MARKET COMMENTARY

The MSCI World ex-USA Index returned +3.8% in the second quarter and is now up +14.6% since the beginning of the year, recouping its losses from the fourth quarter of 2018.  An increasingly dovish tone from central banks contributed to positive equity markets.  In addition, geopolitical tensions subsided with the resumption of trade talks between the US and China.  All MSCI World ex-USA sectors were positive except real estate, which declined -2%.  Growth again outpaced value, further widening the valuation gap.  Over the past five years, the MSCI World ex-USA Growth Index has returned +22% cumulatively, while the MSCI World ex-USA Value Index has returned 0%. 

A top-down view would suggest that the international equity markets are fairly valued.  However, this is far from a normal market; significant valuation differences exist within and between sectors, geographies and even asset classes.  On the one hand, the market’s valuation suggests that investors have a reasonably healthy risk appetite.  On the other hand, certain attributes imply that investors are exceptionally risk averse.  A glaring example is the negative yield on some country’s government debt, like German bunds, where investors are guaranteed to lose money if held to maturity.  A preference for a small, yet certain loss over a wider range of outcomes exemplifies extreme risk aversion.  This risk aversion is borne out in international equity markets through a comparison of different sectors.  Sectors with low economic sensitivity and stable earnings streams have outperformed sectors believed to be more cyclical.  Regulated utilities, for example, are largely insulated from economic slowdowns and exhibit more stable earnings than most other businesses.  Investors looking to position themselves defensively have been drawn to the sector, driving share price performance and P/E multiple expansion. The P/E ratio for most utilities now stand at close to 20x.  This is arguably a rich price to pay for a sector with modest prospects for growth, and as a result we do not view this as being a safe investment.  The long-term upside potential is likely minimal.  Most REITs, consumer staples, and healthcare companies exhibit a similarly unappealing long-term risk-reward tradeoff. 

In many cases, international banks and other financials trade at half the valuation of the non-cyclical markets segments.  Select companies within industrials, technology, and energy also trade at substantial discounts to their intrinsic values.  These sectors may have a higher correlation with economic cycles than non-cyclicals, but valuations render the long-term return prospects more appealing irrespective of near-term economic growth. Businesses with strong balance sheets that are well-positioned competitively should be able to sustain and grow their value through the full economic cycle. Some may even enhance their value at the expense of weaker peers during times of economic volatility. In our view, these types of businesses represent compelling investment opportunities.

The wide dichotomy between undervalued and overvalued pockets of the market has facilitated a portfolio that trades at a large valuation discount to the market, in our view, without assuming undue risk.  The portfolio trades at 7.2x normal earnings compared to 13.5x for MSCI World ex-USA Index.  It trades at 0.9x book value compared to 1.6x for the MSCI World ex-USA Index.  This valuation discount combined with healthy balance sheets and good underlying businesses has us confident about the portfolio’s prospects as we look forward.    

ATTRIBUTION: 2Q 2019

The Hotchkis & Wiley International Value portfolio (gross and net of management fees) underperformed the MSCI World ex-USA Index in the quarter.  International value stocks underperformed international growth stocks by about 4 percentage points for the second consecutive quarter, which was a significant performance headwind relative to the broad benchmark.  Stock selection in financials, energy, and communication services also detracted from performance.  Positive stock selection in healthcare and industrials helped relative performance, along with the underweight allocation to real estate and overweight allocation to industrials.  The largest detractors to relative performance in the quarter were Royal Mail, Credito Valtellinese, Danieli, Frank’s International, and Ezaki Glico; the largest positive contributors were WestJet Airlines, Hitachi, TE Connectivity, Bayer, and Zurich Insurance Group.    

LARGEST NEW PURCHASES: 2Q 2019

Royal Bank of Scotland was rescued by the UK government during the financial crisis. After shedding numerous non-core businesses and shrinking its balance sheet considerably, RBS has re-focused on its core strengths in consumer and commercial banking in the UK. The business is well positioned competitively and generates high returns on capital. RBS is significantly over-capitalized versus its own targets and peers and is expected to increase its returns of capital to shareholders. RBS’ share price has been negatively impacted by Brexit-related fears and the overhang from the UK government’s remaining holdings. The shares trade at a discount to tangible book value and a low multiple of normalized earnings.

Unicredit is the largest bank headquartered in Italy.  In addition to being the #2 Italian bank by market share, Unicredit also has significant banking operations in Germany, Austria and a number of Central and Eastern European countries. Shares in the bank have underperformed due to market concerns about the ongoing pressure on bank profitability from low rates and slow economic growth in Europe.  As one of the largest banks in Italy, investment sentiment for Unicredit has also been negatively impacted by ongoing political instability and the resultant impact on Italian sovereign rates. Following a period of restructuring, the balance sheet is well capitalized, asset quality is improved, and profitability is recovering.