GMO Intl Active Q3 letter
The International Active EAFE Strategy underperformed the MSCI EAFE index by 2.0 percentage points in the third quarter; the strategy fell 7.9% net of fees and the benchmark lost 5.9%. Country and stock selection were both negative. The strategy lagged its benchmark by 4.7 percentage points for the first three quarters of 2014, returning -6.1%.
A Letter to Clients
First, I want to thank you for your patience and support. Despite the challenging performance in the International Active EAFE Strategy this year, we believe the companies we own offer compelling opportunities for excess return in the long run. I wanted to take this opportunity to describe some of the key ideas in the portfolio and why we believe they offer such compelling upside.
The key detractors from performance this year have been Japanese banks, Russian holdings, and our European recovery stocks. We continue to have strong conviction in all of these positions and, with a couple of exceptions in Russia, we continue to hold them. Somewhat offsetting these positions have been our holdings in tobacco and our overweight position in small cap companies, both of which have added to relative performance.
While detracting from performance this year, we believe Japanese banks offer a compelling long-termrisk/reward profile. Our thesis is that the market is being lazy and myopic by fixating on the recent profitability of the banks and consequently missing a very important concept: bank margins are unsustainably low due to interest rates being artificially compressed by central bank manipulation.
The market is ignoring that Japanese banks have been able to achieve ROEs around 10%, loans are growing, and prices on new loans have stabilized. We believe that margins will increase without the distortionary effects of the Bank of Japan’s quantitative easing policy. Given the short-term maturity of the majority of bank loans, in our opinion, the increase could be significant. In addition, if the inflation currently evident in the economy is sustainable then interest rates are negative and the yield curve has much further to rise, yielding even more upside for the banks.
Another detractor from performance has been the portfolio’s exposure to Russia. The portfolio was invested in the secular growth of the Russian credit market via two holdings, Sberbank and TCS Group. Given the uncertain long-term effects of sanctions, the credit trends in Russia are delayed and, as a result, we exited both positions. However, we continue to own indirect Russian exposure, either in the form of companies with assets in the country or companies for
We continue to have conviction in Europe where solid and improving companies are selling for cheap valuations. While the recovery in Europe is spotty, its banking system has a stronger balance sheet, labor competitiveness is improving, and the weakening euro should boost exports. The European Central Bank has been shrinking its balance sheet since 2012, but this could reverse, pulling equity markets up in the same manner as it appears to have done in the U.S. and Japan.
The market also has yet to take into account the corporate restructuring and M&A activity occurring in Europe that is resulting in lower costs, better balances sheets, and sustainable free cash flow generation. In our view, the improvement in efficiency and profitability quietly being achieved in Europe must eventually be rewarded by global equity investors. We are well positioned to benefit when the markets realize how much stronger corporate Europe has become.
This is not the first time the markets have tested our resolve. We have been alone on our investment island before. In the cases where our holdings’ performance has been lower than expected, we are confident our investment theses remain intact. History shows that investors with the willingness and patience to take the long view are well rewarded.
As always, we would be happy to talk with you about these positions or answer any other questions you may have. Please contact your Client Relationship Manager if you would like to set up a phone call or a meeting. Thank you.
– Drew Spangler
Full GMO letter here IA_3Q14