International Value
Period ended September 30, 2019
MARKET COMMENTARY
The MSCI World ex-USA Index returned -0.9% in the third quarter of 2019 but is up more than +13% since the beginning of the year. Global central bank policy continues to be accommodative. The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and Brent crude finished the quarter down -9%. Energy was the MSCI World ex-USA Index’s second worst-performing sector (after materials), declining -5% in the quarter. It has been the index’s worst-performing sector over the past year returning -12% (Brent has declined -27% over the past year). Utilities +3% and consumer staples +2% were the best-performing sectors in the quarter. These are also the top sectors, by far, over the past year. The MSCI World ex-USA Index returned -1% over the past 12 months but these sectors are up considerably: utilities +15% and consumer staples +8%.
Concerns about slowing economic growth have become increasingly pervasive amid trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US). The timing of the next global economic slowdown and/or recession is unclear but it is certainly possible in the near to intermediate term. Despite this, we are overweight cyclicality in our portfolio – particularly financials and industrials – as this is where we see the greatest price vs. fair value dislocation in the market. We believe we own good businesses with strong balance sheets that will enable these companies to grow their value through the economic cycle.
To illustrate our approach given the current state of affairs, consider the thesis behind our positions in banks (the portfolio’s largest absolute and relative industry weight) and utilities (the portfolio has no exposure). The MSCI World Bank Index trades at 10.1x consensus earnings, which is 13% below its long term average of 11.7x. The MSCI World Utilities Index trades at 18.1x consensus earnings, which is 14% above its long term average of 15.8x. Returns-on-equity for the two indexes are similar1. Dividend yields are also similar but because valuations are so different, utilities have to pay out about 2/3 of their earnings in dividends while banks pay out less than half of their earnings to arrive at similar yields2. Because banks retain more of their earnings, it has allowed them to amass capital and strengthen their balance sheets, and in recent years, buyback their own stock. Given the information above, for the two indexes to generate equivalent returns going forward, one of several things would need to occur. The valuation gap would need to widen even further, utilities would need to accelerate earnings growth, or banks would need to suffer a major destruction of capital. To us these seem like unlikely scenarios because the valuation gap is already near an all-time wide, organic growth prospects for utilities are limited, and banks have accumulated near record levels of excess capital on their balance sheets to protect against a downturn. Thus, we view banks as superior risk-adjusted investments irrespective of near-term economic growth.
The portfolio continues to trade at a large discount to the market. The portfolio trades at 7.3x normal earnings compared to 13.8x for the MSCI World ex-USA Index. It trades at 0.9x book value compared to 1.6x for the 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: 3Q 2019
The Hotchkis & Wiley International Value portfolio (gross and net of management fees) outperformed the MSCI World ex-USA Index in the third quarter of 2019. Positive stock selection drove all of the outperformance, and was most positive in financials, communications services, and healthcare. The underweight allocation to materials also helped. We believe the strategy’s ability to invest across the cap spectrum is a long-term advantage, but this was a headwind during the quarter as small and mid cap stocks lagged large and mega caps. The overweight and stock selection in energy was the largest detractor, along with stock selection in consumer staples and technology. The largest positive contributors to relative performance in the quarter were Vodafone, BAE Systems, Tokio Marine, Enstar Group, and Societe Generale; the largest detractors were Embraer, Frank’s International, Ericsson, Danieli, and Global Indemnity.
LARGEST NEW PURCHASES: 3Q 2019
Britvic is the largest supplier of still soft drinks in and the number two supplier of carbonated soft drinks in Great Britain. Britvic owns the #1 or #2 brand in each of its respective categories, in addition to distributing key Pepsi brands. The company will soon complete a major multi-year supply chain investment that will significantly increase profitability and free cash flow, as well as allow for meaningful new revenue opportunities. Valuation is attractive.
Haseko is a contractor for the condominium industry in Japan and is vertically integrated into the design, construction, sales, management and refurbishment of condominiums. The Company has a dominant market-share in its core geographies trades at a low multiple of earnings, has a net cash balance sheet and returns capital to shareholders.
Taiwan Semiconductor is the world’s leading semi-conductor foundry. The industry is seeing growing demand for leading edge logic/processing chips, and TSMC is well positioned to manufacture the majority of these chips. TSMC has massive market share and limited competition, as the high capital costs and R&D expertise required in this space make it is difficult to replicate. TSMC has good capital allocation, net cash on its balance sheet, and is attractively valued.
________________________
1 9.1% ROE for banks, 10.9% ROE for utilities, based on FY1 consensus estimates.
2 4.3% dividend yield for banks, 3.5% dividend yield for utilities. 44% dividend payout ratio for banks, 64% payout ratio for utilities.
