International Value

Period ended March 31, 2018
 

MARKET COMMENTARY

In the first quarter of 2018, the Russell Developed ex-US Index declined -1.6% in US Dollar terms.  The US Dollar weakened between 2% and 3% relative to other major currencies, so in local currency terms global index declined more.  International growth stocks outperformed international value stocks during the quarter, extending their recent advantage.  The only other period that favored growth to such an extent was the internet bubble of the late 1990s.  While the broad market’s valuation today is much less extreme than it was in 1999, a number of popular stocks exhibit exorbitant valuation multiples akin to internet bubble levels.  Very few people would buy a new house, car, or even a meal without regard to price, but this frame of mind seems to breakdown at times when buying stocks.  In our view, to justify the current valuations of today’s most richly valued stocks, many things have to go perfectly right for a very long period.  In our experience, such unbridled optimism rarely materializes.

Fortunately for active investors, some segments of the international market offer attractive valuations for the risks at hand.  Financials continue to represent the largest sector weight in the portfolio.  Despite healthy stock price appreciation in recent years, banks continue to trade at valuations well below their historical averages.  Critics argue that lower valuations are justified because banks will be unable to earn the same returns on capital they have earned in the past due to more stringent capital requirements.  We agree, but competitively advantaged banks like the ones we own should be able to earn above cost-of-capital returns.  Accordingly, we view 11x normal earnings and a small premium to book value as compelling valuations, particularly considering that the excess capital on their balance sheets reduce the risk profiles dramatically. 

In recent years we have been partial to industrials.  Our focus has been on attractively valued, well-managed companies with strong balance sheets and good prospects for growth.  The sector is composed of mostly cyclical businesses but with different end markets.  Different industries experience cyclical troughs at different times and therefore exhibit compelling valuation opportunities at different times.  Thus, we have been overweight industrials for an extended period but our investment mix has changed through time. 

We have gradually increase our energy weight as the sector has underperformed the market by a wide margin in recent years.  We believe oil prices have been unsustainably low and that a rise in commodity prices will be necessary to bring global supply in line with global demand growth.  Accordingly, we have positions in predominantly upstream energy companies that are positively exposed to changes in crude prices.  We have a strong preference for companies with good balance sheets so that we are not exposed to shareholder dilution in the event the reversion in oil prices takes longer than we anticipate. 

We remain underweight consumer staples but less so than we have been in recent years because we increased our weight recently.  The new positions possess great brands that are among the market share leaders, which enable them to earn good returns on capital. 

Over long periods, international value has outperformed international growth, and we have no reason to believe we have entered a paradigm shift that would change this going forward.  Style shifts can occur quickly and powerfully, and we believe we are well positioned for such a reversion.  We continue to be encouraged by the portfolio’s valuation discount relative to the benchmark. The portfolio trades at 7.4x normal earnings and 1.2x book value, a notable discount to the Russell Developed ex-US Index (14.2x and 1.6x, respectively).  We remain committed to maintaining our unwavering dedication to the principals of long-term, fundamental value investing, and that while fads can drive short term performance fundamentals prevail in the long run.    

ATTRIBUTION: 1Q 2018

The Hotchkis & Wiley International Value portfolio (gross and net of management fees) outperformed the Russell Developed ex-US Index in the first quarter of 2018.  The portfolio’s value approach was a considerable headwind as international growth stocks outpaced international value stocks.  About 75% of the portfolio trades at less than 2x book value compared to less than half of the index; this was a challenge to performance that was overcome by positive stock selection in a variety of sectors.  Positive stock selection in financials, consumer staples, and industrials helped relative performance.  The overweight in technology and underweight in materials also helped.  Stock selection in materials, consumer discretionary, and telecommunications detracted from performance.  The largest individual positive contributors to relative performance were Royal Mail, Credito Valtellinese, Danieli, Zurich Insurance Group, and Barclays; the largest detractors were WestJet Airlines, Frank’s International, Masonite International, Global Indemnity, and Vodafone.