Brandes Emerging Markets Value Fund commentary for the third quarter ended September 30, 2015.
The last three months proved to be a continuation of challenging conditions for emerging markets, with the asset class generating the worst quarterly returns since the third quarter of 2011. News on China’s slowing economic growth intensified worries on its ramifications to the global economy. The renminbi devaluation, although relatively minor, generated fears of potential spillovers to other emerging countries. In late August, the Shanghai Composite and the Shenzhen Composite indices lost a combined $1.2 trillion in market capitalization over the course of four days, putting a stop to their upward trajectory that started in late 2014. The selloff prompted the People’s Bank of China to cut its interest rate and lower reserve requirement for banks—in the hope of easing market concerns about the slowdown.
Meanwhile, investor sentiment took a turn for the worse in Brazil as the country continued to face political and economic challenges, including falling commodity prices and rising inflation. The Brazilian real lost over 20% (vs. the U.S. dollar), making it one of the worst-performing currencies in the quarter. The MSCI Brazil Index fell over 30% in the last three months and more than 40% year to date (in U.S. dollar terms). Despite the general market decline, Brazil remains home to select companies with what we view as attractive valuations and appealing long-term prospects.
Another headwind during the quarter was oil prices, which continued to drop due to a weak outlook for the global economy and continued high supply from major oil producers. Uncertainties surrounding the world economy also compelled the Federal Reserve to keep U.S. interest rates unchanged in its September meeting, causing questions about the potential rate-hike timing to remain.
Brandes Emerging Markets Value Fund – Performance
For the quarter, the Brandes Emerging Markets Value Fund Class I USD (the “Fund”) fell -18.94% underperforming the MSCI Emerging Markets Index, which dropped -17.78%. The Fund’s Brazilian holdings all declined in the last three months and negatively impacted performance. Integrated oil company Petrobras weighed heavily on returns as it struggled to recover from the corruption scandal involving the company, and investors appeared increasingly concerned about the firm’s debt burden. See the Fund’s commentaries from the first and second quarter of 2015 for more details on our view of Petrobras. Other significant detractors included commercial banks Banco do Brasil, Banco Bradesco and Banco Santander Brasil, as well as Companhia Brasileira de Distribuicao, a Brazilian food retailer with a significant stake in Via Varejo (the country’s largest consumer electronics retailer).
Brandes Emerging Markets Value Fund – Portfolio holdings
Steel manufacturer POSCO and airline Copa Holdings also hurt performance. South Korea-based POSCO saw its share price fall due to investor fears of slowing economic growth in China, one of the company’s revenue sources. We have factored China’s slowdown into our valuation for POSCO and believe the company offers competitive advantages that may not be fully reflected in its share price. For Panamanian Copa Holdings, the share-price decline could be attributed primarily to weak demand and currency depreciation in a number of its end markets, especially Brazil, Venezuela and Colombia. Additionally, overcapacity, which we consider a near-term challenge, has negatively affected the airline industry in Latin America in general.
Another major performance detractor during the quarter was Indonesian telecommunication services provider XL Axiata. In March 2015, the company announced a new business strategy which included a shift in focus from customer volume to service quality. Effectively, the company raised the price of starterSIM packs while aiming to upgrade its data services—a move which may stifle volume in the near term but could potentially boost longer-term profitability. Since the announcement, the market has reactednegatively to the fact that XL Axiata’s 2015 revenue and EBITDA will likely remain stagnant compared to last year as the company seeks to clean up its subscriber base and attempts to reprice. We view the company’s action as a bold but sensible strategy to generate greater long-term value.
During the period, O2 Czech Republic contributed positively to performance. The telecommunication services company finalized the spin-off of its infrastructure assets into a new entity in early June and its share price moved higher in the third quarter as its majority owner, PPF, continued its buyout of the company. In August, PPF disclosed that it owned nearly 85% of O2 Czech Republic and confirmed that it would not attempt to raise its stake above 90%.
Other contributors included South Korean autos, specifically Kia Motors. On a relative basis, the Fund’s significant under-allocation to China-based companies aided performance. Additionally, the Fund benefited from its position in Hong Kong-based Yue Yuen, whose share price increased after it announced strong results for the first half of 2015. Yue Yuen is the world’s largest manufacturer of athletic and casual footwear, operating as an original equipment manufacturer (OEM) and original design manufacturer (ODM) for major brands such as Nike, Adidas, Reebok, Asics, New Balance and Puma.
Brandes Emerging Markets Value Fund – Initiated Position
In the third quarter, the emerging markets investment committee initiated a position in Sociedad Quimica y Minera de Chile (SQM). Founded in 1968 and headquartered in Santiago, Chile, SQM produces and distributes specialty plant nutrition solutions, potassium fertilisers, industrial chemicals, iodine and its derivatives, as well as lithium and its derivatives. For much of 2014 and 2015, SQM’s reputation has been marred by governance concerns. In March 2015, Canada-based PotashCorp withdrew its board members after clashing with controller Julio Ponce over the handling of a tax probe and allegations of payments to politicians by SQM.
In May 2014, Production Development Corporation CORFO, a Chilean government agency, initiated arbitration against SQM. CORFO alleged that the company was underpaying a lease at its Atacama site, where some of SQM’s best mining assets are located, and was not in compliance with certain technical requirements. In June 2015, CORFO asked for early termination of the lease agreement and the lease payments that would have been paid plus punitive damages. Arbitration proceedings are in process.
We believe the negative pressure provided a good entry point for an investment in SQM. Year to date through 30 September, the company’s share price fell over 30%. While the governance concerns present a near-term challenge, we believe the risk/reward proposition in the shares is favorable. Main features that made SQM an appealing investment candidate to us include:
- Attractive market share: SQM has a leading global market share in the production of iodine, nitrates and lithium (inputs used in a variety of chemicals and fertilizers).
- Cost advantage: SQM’s minerals are of good quality and have been inexpensive to extract because most are located very close to the surface.
- Geographic diversification: The company sells its products in 110 countries, with no individual client accounting for more than 10% of revenues. Sales are well diversified among Latin America, Asia, Europe and North America.
- Valuation: As of September 30, 2015, SQM’s shares traded at 1.6x price-to-book value and less than 8x cash flow. Both valuations were near their five-year lows.
Other major Fund activity included the full sale of Gedeon