Charles Brandes Q3 letter to investors.
Uncertainties Create Potentially Attractive Valuations for Stock Pickers
• Weakness in emerging-market equities has created attractive investment opportunities at the company level.
• Investor preference for index funds and exchange traded funds in emerging markets has resulted in some pronounced valuation distortions—providing a lush landscape for active managers.
• The current negative environment in emerging markets underscores the importance of a going-against-the-herd mentality.
• As recent valuations in emerging markets have become more attractive, we have been slowly adding select positions to our Brandes International Equity Strategy and Brandes Global Equity Strategy.
As true value investors, Brandes oft en moves against the crowd amid markets’ constantly changing performance cycles. Take the recent equity market weakness in a number of emerging market (EM) countries for example. Over the last year, while macroeconomic and geopolitical concerns cast a cloud of uncertainty over the asset class in general, we started to see some interesting investment opportunities at the company level as a result of such market weakness.
We believe the recent material outfl ow from EM funds, and the resulting adverse impact on the performance of the MSCI Emerging Markets Index, highlights the importance of active stock selection.1 It also reveals the pitfalls in treating EM—or any market, country, sector, industry or risk factors (such as low-volatility strategies which seek to be less volatile than the underlying index they attempt to replicate) for that matter—as one homogenous group via indexing or exchange traded funds (ETFs). In our view, amid constantly fl uctuating markets, focusing on individual company fundamentals and the price paid to acquire these investments remains the greatest drivers of long-term investment outperformance.
Short-Term Macroeconomic Concerns Contributed to YTD Declines in Emerging Markets
Year to date through September 30, 2013, the MSCI Emerging Markets Index followed a bumpy path and ended down 4.1%, with many of the larger-weighted countries of Brazil, Russia, India, Indonesia and China experiencing weakening currencies and/or equity markets. A number of factors contributed to market concerns:
• Fears of the Federal Reserve tapering its quantitative easing program
• Economic slowdown in China
• Existing and growing structural issues that vary materially from country to country—including large trade imbalances and rising debt levels (especially short- term borrowings)
• Worries over a replay of the Asian fi nancial crisis of the 1990s
After years of strong performance, emerging markets have recently underperformed developed markets (DM), as shown in Exhibit 1.
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Recent Emerging-Markets Concerns, Fund Flows and Concentration of Indexes
Th e cautious view of investors is evident in the $11.7 billion (USD) massive outfl ow of invested funds from EM year to date through August 30, 2013.2
Over the last 10-plus years, a signifi cant amount of the assets that fl owed into EM was increasingly allocated to index funds and ETFs. In 2002, passive investment strategies accounted for only 11% of EM investments. By year-end 2012, that percentage had grown to 51%.3 In our view, a key drawback to applying a passive strategy in emerging-market investing is the risk of overconcentration, as illustrated in Exhibit 2. Here we show the level of concentration of the fi ve largest companies in Brazil, Russia, India and China2 (BRIC countries) is high compared to the level of concentration in the United States. This overconcentration may limit investors’ opportunity set.
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Additionally, particularly in the BRIC countries, the largest fi ve companies tend to belong to two sectors: financials and energy. As of September 30, 2013, roughly 75% of the total capitalization of the five largest companies in each of the BRIC countries was in these two sectors.4
As a specific example, an EM index fund (or ETF) would have allocated 9.4% to the consumer staples sector during the second quarter even though the top 10 largest EM stocks in this sector were trading at a loft y average price-to-earnings (P/E) ratio of 28x.5 The Brandes Emerging Markets Equity Strategy as well as the Global Equity Strategy and International Equity Strategy had zero allocation to these top 10 names as of September 30, 2013.
Pronounced Valuation Distortions Underscore Importance of Stock Selection
As index funds and ETFs experience large inflows, investors in these passive strategies may be essentially purchasing concentrated holdings without considering price or the possible lack of diversification. Th is lack of regard for price may produce some pronounced distortions in valuations, which could become very evident when large sums fl ow indiscriminately in and out of these same vehicles.
In this environment, being very selective in the stocks added to a portfolio and focusing on the price paid for the value received for the investment are basic tenets for a Graham-and-Dodd value investor such as Brandes. For an illustration of how this discipline adds value to Brandes portfolios, consider in Exhibit 3 our active dedicated Emerging Markets Equity Strategy. The Strategy has outperformed its benchmark, the MSCI Emerging Markets Index, as of September 30, 2013—especially during recent periods of substantial $11.7 billion EM outflows from the asset class, as referenced earlier.
Widening Valuation Spreads Provide a Conducive Environment for Stock Picking
In Brandes’ view, the recent macroeconomic turbulence in EM and the corresponding outfl ows from EM funds have aided the attractiveness of EM valuations compared to those of developed markets (DM). As shown in Exhibit 4, on a price to book (P/B) ratio basis, EM now trades at a 25% discount to DM compared to a 15% premium in August 2010. Also shown is the allocation to EM in both our International Equity and Global Equity strategies, which has been increasing as EM valuations become more attractive (more on this later).
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Even though EM stocks overall seem inexpensive compared to DM stocks, there are certain EM sectors and countries at both the high and low end of normal multiples. For example, the P/B ratio of consumer staples is trading at nearly one standard deviation above normal relative to the market while utilities is trading more than one standard deviation below normal.6 As shown in Exhibit 5, wide variations in P/E and P/B both current and 10-year average, exist between countries and markets as well.
We are also encouraged by the wide dispersion of returns between the best and worst returners (90th percentile vs. 10th percentile to remove outliers). Th e spread of returns was greater in EM than in DM and widened as the investment horizon lengthened, as shown in Exhibit 6. For example, over a 12-month period, the difference between the 90th percentile performers minus the 10th percentile performers in EM was 100% vs. 45% for DM.
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As we study the widening variation in multiple areas in emerging markets such as country, sector, valuation metrics and dispersion of returns as illustrated in the preceding paragraphs, we are encouraged that a lusher landscape for stock pickers may be developing.
Increasing Opportunities and Thoughtful Allocations to Emerging Markets
We believe in the long-term favorable demographic trends in emerging markets, including young populations, a growing middle class and increasing disposable income. However, even with this positive backdrop, it is important to be selective amid a wide range of expectations reflected in individual stock prices.
As recent valuations in EM have become more attractive, we have been slowly adding select positions to our Brandes International Equity Strategy and Brandes Global Equity Strategy. As shown in Exhibit 4, in general, our EM allocations over the last 12 months have increased; from approximately 4% to 11% in Global Equity and from approximately 11% to 14% in International Equity.
If valuations within EM continue to become more attractive, particularly relative to those in developed markets, it is possible we could be adding to select positions in the future while being very cognizant of the varying degree of headwinds facing individual EM companies. Additionally, as mentioned in previous commentaries, many of our current developed-market holdings in International Equity and Global Equity are globally oriented companies that have EM exposure in varying degrees. If the prices for these DM holdings decline as a result of their EM exposure, we could decide to add to these positions, and thus provide another way to increase our indirect EM exposure.
Going Against the Herd Has its Advantage
The recent price and valuation volatility in EM—and of global markets over the long term—is a great reminder of the advantage an active Graham-and-Dodd value investor has over indexing and ETF strategies. Low U.S. interest rates have made alternatives seem more attractive in the past few years with resulting flow of funds potentially inflating some asset prices. We believe our bottom- up process and going-against-the-herd mindset could help us avoid overpriced investments and steer clear of the consequent potential underperformance.
As we search for additional EM opportunities in our global and international strategies, we will focus on the fundamentals of individual stocks and rigorously evaluate them, adjusting for each company’s unique exposure to multiple challenges, as well as recognizing its underlying strengths. As always, with increased uncertainty in the market, we will demand sufficient discounts in the price we are willing to pay for the long-term value we get. As our experience has taught us, we believe patience is key when searching for undervalued opportunities in areas with volatile prices and/or challenging macroeconomic fundamentals.
We could see our allocations to EM continue to increase and we encourage you to speak to your Brandes contact about EM stocks that have been recently added to your International Equity and Global Equity portfolio as well as the performance year to date of our active value style vs. passive alternatives.
The markets are changing constantly. What will never change is our singular focus on pursuing undervalued opportunities on your behalf—in emerging markets and anywhere in the world. We believe this is the best way we can help our clients pursue their long-term investment goals.
Thank you for your continued trust and confidence.