Charles Brandes 2013 Letter Year in Review: The Benefit of Perspective
Amid Market Cycles, a Singular Focus on Value
Reflecting on 2013’s strong market performance, it’s easy to forget that just five years ago the investing environment was very different from today. Back then, the financial crisis and ensuing global market decline cast dark clouds of uncertainty, perhaps testing the mettle of even the most patient, long-term investors. Th rough this experience, and bearing witness to strong equity gains in 2012 and 2013, there are two important takeaways for investors everywhere: one is that markets, regions, industries and companies go through cycles; and two, the price one pays can matter greatly to investment returns.
After the Rain, Some Clearing
Like other value investors, we were not spared from the adverse effects of falling markets and negative investor sentiment in 2008 and the years that followed. Within the trough of economic and market challenges, a number of our strategies declined as investor focus on company fundamentals took a back seat to concerns over broader economic issues. A flight to safety was widespread, and investor preference turned to fixed-income and passive equity strategies, as shown in Exhibit 1.
What a difference five years can make. Many investors showed renewed interest toward actively managed equities in 2013, as Exhibit 1 illustrates, as a number of key market indices recorded solid gains in 2013 and for the five years ended December 31, 2013. See Exhibit 2 on page 2.
The Hunt for Potential Bargains and the Rewards that Followed
Although 2013 was certainly rewarding for many investors, the performance for Brandes strategies was a result of decisions we made years ago. Taking advantage of opportunities brought on by price declines in various markets, which suffered due to factors specific to individual countries and regions within the last five years, we invested in businesses at a time when prices were low and—as our analysis showed—were mispriced compared to their estimated true worth. Th is mispricing was most dramatic during the depths of the 2008-2009 financial crisis, when we found compelling value opportunities.
During that time, investor concerns were valid and discounts to some company valuations were certainly warranted. However, we believe that while most people considered 2008 to 2009 the “riskiest” period to invest due to heightened stock-price volatility, for a price/valuation-focused, long-term investor this actually appeared to be a good time to commit funds to equities. 1
While most investors were preoccupied solely with “risk,” we were intensely focused on assessing the wealth- generating potential and the value of underlying assets of individual companies. Although the macroeconomic climate has certainly been volatile over the past five years, we continue to believe that attempting to forecast macro events is essentially pointless and futile. Yet understanding the sensitivity of a company’s earnings and cash flows to larger events enables us to assess bull-, base- and bear-case scenarios in determining our estimates of the company’s worth.
As we diligently followed our process and philosophy, we found opportunities, in 2013 and in previous years, in areas where we felt the markets were overly punitive for the various headwinds faced.
Overall, we are pleased with the firm’s investment performance in 2013 and over the long term.
Investing Beyond the Benchmark: Then and Now
As is oft en the challenge for disciplined value investors, the positions we took years ago in our strategies overall, such as in the then-troubled regions of Japan and Europe, were controversial among some clients. Our holdings differed significantly in names and weightings from the benchmarks.
As unsettling as it was on the surface, some of our strategies were in the top decile or top quartile of manager allocations to Europe, Europe ex-U.K. and Japan at various points during the last five years relative to peers in the Intersec universe.2 But our conviction as value investors led us to ignore the noise then. Fast forward to today, and we take the same approach. As an example, in the Global Equity Strategy our allocation to the United States at 28% was roughly half the MSCI World Index’s U.S. allocation of 54%, and much less than the MSCI All Country World Index’s U.S. weight at 48% (as of December 31, 2013). Th is was our lowest U.S. allocation in Global Equity since 1997. Another example is that our emerging-market allocations increased throughout 2013, because political and other macro concerns mounted, making some valuations more attractive to us.
We believe the last fi ve years, and 2013 in particular, have shown once again the potential benefits of focusing on company-specific fundamentals in conjunction with the price one pays. Graham-and-Dodd value investing has produced meaningful outperformance, if one had the patience and fortitude to stay the course.
Stock Selection Highlighted by Review of Regions, Sectors and Industries
While some markets recovered substantially in 2012 and 2013, we are still finding pockets of value opportunities globally. In this commentary, we highlight what we believe are a few of the important and relevant industries and regions (United States, Europe, Japan and emerging markets) impacting the portfolios.
United States: Focus on Selection
With the U.S. market up 32% in 2013, as measured by the S&P 500 Index and up nearly 200% (including dividends) since the low on March 9, 2009, many company fundamentals and valuations have changed dramatically. Th e question that seems to be in many headlines now is whether the U.S. market as a whole is overvalued or whether we are still in the early stages of a prolonged market recovery. While there are compelling arguments on both sides, we are finding fewer opportunities in the United States and our allocations have accordingly been reduced, which in part is due to finding what we view as better opportunities elsewhere, such as in Europe and the emerging markets. As indicated in Exhibit 4, on page 4, as of December 31, 2013, the Shiller P/E3 was 25.6x for U.S. stocks vs. their 30-year median of 21.8x, and 14.1x for Europe stocks vs. their 30-year median of 17.5x. And although this would generally indicate, on a portfolio positioning standpoint, reduced exposure to the United States and an increasing weight to Europe as a whole, stock selection remains key. Whether macroeconomic indicators are positive or negative, or whether market valuations as a whole appear inexpensive or pricey, focusing on the fundamentals of individual companies and comparing them to market prices is critical to value investing. And despite the substantial recovery in the U.S. market, based on our company-level analysis we still find opportunities in a number of companies in the information technology (IT) and financial services sectors.
“Mature” IT Firms
Th e characteristics of companies that comprise the IT sector have changed dramatically over the last five to 15 years. Many of the former high growth, high P/E multiple “darlings” have matured while newer cloud-based and social media companies—with their allure of high-growth and loft y P/E multiples—have captured the most attention. We have found attractive opportunities in the former: more mature and former high growth IT stocks. Today, we find that many of the mature tech companies, despite a tempering of their once rapid pace of growth, have higher returns on capital and growth rates still equal to or better