International Value

Period ended December 31, 2018
 

MARKET COMMENTARY

In US dollar terms, the MSCI World ex-USA Index was down a modest -1.5% through the first nine months of the year before falling -12.8% in Q4.  The end result was a -14.1% return for calendar year 2018, in US dollar terms.  In local currency terms, the MSCI World ex-USA finished the year -10.9%.  The dollar strengthened about 4% vs. the Euro and about 6% vs. the Sterling, and weakened about 3% vs. the Yen.  Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, global trade tensions came to the forefront.  Markets began pricing in slowing economic growth in several major economies. At the same time, the European Central Bank implemented and spoke of future restrictive monetary policy which appears to have added to equity investor apprehension.  The forward P/E ratio for the MSCI World ex US declined from 16.0x at the beginning of the year to 12.6x at the end of the year.  The index’s median P/E since 2005 is 14.1x, so it went from well above average to comfortably below average over the course of the year. 

Fears that slowing economic growth would weaken demand – along with higher than expected production - weighed heavily on oil prices.  Brent crude closed the year at $54/barrel, down 20% from the beginning of the year ($67) and nearly 40% from its early October high ($86).  Commodity securities were among the worst-performers of the year, with the energy and materials sectors lagging the broad benchmark significantly.  Financials and industrials, also cyclical sectors, declined disproportionately.  The non-cyclical healthcare and utilities sectors performed best.  The performance dispersion and resulting valuation spread between “cyclicals” and “defensives” suggests the market views a global recession as likely.  At present, while acknowledging the uncertain economic outlook, we view the value opportunity in cyclical stocks as vastly superior to non-cyclicals.  The low price we pay for such businesses provides a margin of safety in the long run almost irrespective of near term economic growth.

Given the wide value spreads between sectors, our portfolio today looks very different from the benchmark. The portfolio also trades at a substantial valuation discount to the index, which makes us optimistic about its prospects irrespective of market direction or temperament.  The portfolio trades at 6.6x normal earnings compared to 12.4x for the MSCI World ex-USA Index, and 0.9x book value compared to 1.5x for the index.    

ATTRIBUTION: 2018

The Hotchkis & Wiley International Value portfolio (gross and net of management fees) underperformed the MSCI World ex-USA Index in 2018.  The strategy’s focus on valuation and its ability to invest across the market cap spectrum are two important advantages, in our view.  Both of these characteristics detracted from relative performance in 2018; however, as international value lagged international growth and small caps lagged large caps.  More than 20% of the portfolio was invested in stocks trading at a discount to book value compared to less than 12% for the index.  This group of stocks lagged the overall market by a wide margin during the year.  Conversely, the portfolio was underexposed to stocks with a price-to-book ratio above 4x, which held up much better than the overall market.  Nearly half the portfolio was invested in small and mid caps compared to about 30% for the index—this overweight also detracted from performance.  Partially offsetting these headwinds was positive stock selection in technology, REITs, healthcare, and consumer staples.  The underweight position in materials was a modest help as well.  The largest individual detractors to relative performance were WestJet Airlines, Societe Generale, Adient, Royal Mail, and Credit Suisse; the largest positive contributors were Ericsson, ARRIS International, Tokio Marine, Zurich Insurance Group, and Koninklijke Philips.    

LARGEST NEW PURCHASES: 2018

Credito Valtellinese is the 10th largest bank in Italy with ~$25B in assets. The majority of Italian banks are struggling with extremely high levels of non-performing loans, often with 20% - 30% of the gross loan book classified as non-performing. Credito Valtellinese initiated a rights offering with plans to accelerate the disposal of its non-performing loans. Despite the improvement in the loan book quality, Credito Valtellinese continues to trade at a very low multiple of book and normalized earnings and in-line with peers with much unhealthier loan books.

Tokio Marine is a property-casualty insurer domiciled in Japan. The company is the 3rd largest P&C insurer in its home market, as measured by net written premiums. It also has a sizeable presence in North America resulting from several acquisitions completed over the past decade. We are attracted to the sustainable earnings power of Tokio Marine’s diverse insurance operations, the excess capital on the balance sheet, and the improving governance and financial performance. Stable margins and a focus on capital efficiency should drive an expansion in return on equity and deliver better-than-expected growth in earnings and book value per share. Despite these attractive attributes, Tokio Marine shares trade at an attractive valuation relative to its book value and normal earnings power.

Unilever is one of the world’s leading suppliers of consumer goods in the food, home care, and personal care product categories. Unilever owns some of the strongest brands in the world with thirteen brands having sales of greater than €1 billion.  Leveraging its brand strength, Unilever has attained an exceptional global market position with #1 or #2 market share across 85% of its business. Dividend growth has averaged 8% over the past 36 years and we expect continued dividend growth and share repurchases. We believe Unilever’s stable business model coupled with its emerging market exposure make it an attractive candidate within consumer staples and also provides diversification.