GMO International Active performance and commentary for the 2nd Quarter, 2015.
GMO International Active: Performance
The International Active EAFE Strategy outperformed the MSCI EAFE index by 2.8 percentage points in the second quarter; the strategy rose 3.4% net of fees and the benchmark gained 0.6%. Positive stock selection was offset somewhat by slightly negative country allocation. The strategy beat its benchmark by 3.7 percentage points for the first half of 2015, returning +9.3%.
GMO International Active: Regional Commentary
In the first six months of 2015, the Nikkei has outperformed the S&P 500 by roughly 14% in U.S. dollar terms as two macro themes are presently captivating investors’ collective attention. First, we are witnessing a material rotation of risk assets out of Japanese Government Bonds (JGBs) into equities by, among others, the Japanese Government Pension Investment Fund (GPIF). At the same time, Japanese corporate management teams are increasing their commitment to shareholder returns. The convergence of these events is not a coincidence, in our view; Japanese pension funds are forced buyers of equities, which raised the bar for expected return. A positive cycle has been set in motion, but the question remains one of sustainability.
The Bank of Japan’s domination of the bond market in 2013 and 2014 has driven the price of JGBs to unprecedented levels. The asset allocation decision to rotate out of bonds was formalized on October 31, 2014, when GPIF announced its intention to raise the equity target from 12% to 25% and reduce JGBs from 60% to 35%, with trading set to commence on January 1, 2015.
From 1986 to August 2012, the cumulative returns of JGBs outperformed the Nikkei 225 by more than 200%. The magnitude of this equity underperformance highlights the perils of asset overvaluation and the malaise of low return on equity (ROE) in Japan. One may ask, given the historic relative performance of the Japanese stock market vs. the bond market, why move to equities? According to the GPIF, it forecast 10 years of rising bond rates against the backdrop of needing 1.7% real return to meet its pension obligations.
It is turning to the equity market in search of “smart beta” stocks that offer “bond-like” characteristics of stable and above-average ROE with high liquidity. However, in September of 2014, of the roughly 3,600 listed Japanese companies, only 700 had a market cap greater than $750 million with fewer than 350 companies producing 8% ROE or higher. Compare that to the U.S., which at that time had 3 times the GDP, but more than 10 times the number of companies that met those criteria. Clearly, the Japanese market needs to make some changes to insure that Japanese management will be good custodians of the capital that is being increasingly sent their way.
GPIF’s forced buying of equities has created a governance response in Japan. Professor Kunio Ito, an influential professor of finance from Hitotsubashi University, issued a comprehensive report commissioned by the Ministry of Trade and Industry that called for a “capital efficiency revolution” in Japan. The report read like a value manager’s manifesto. For the first time, there was official endorsement of the importance of generating an ROE higher than the cost of capital. Professor Ito’s framework for putting the primacy on generating shareholder value came shortly after the announcement of the creation of the JPX 400, an index of 400 companies in Japan with ROE higher than 8%. GPIF and other auxiliary government pension funds explicitly use the new index for passive investing of the money intended to be allocated to equities.
When the JPX 400 started trading on January 6, 2015, several companies suffered the shock of not being included and took action in the form of buybacks and dividends. Shortly thereafter, the Financial Services Agency (FSA) released the Japanese Stewardship Code, largely modeled on that of the U.K., which encourages company board members to engage with institutional shareholders to make sure shareholder interests are properly protected. The largest proxy advisory firm seized upon the governance momentum to issue new proxy voting guidelines that included an automatic vote against a corporate board that produces lower than 5% ROE for five consecutive years. There are finally real consequences of poor performance for Japanese management teams.
The obvious question: Is the Japanese market outperformance due to aggressive buying from the GPIF or a genuine uptick in expectations for shareholder value return in Japan? We believe the answer is both. We estimate that there is roughly $80 billion of demand for equities from the domestic pension funds, with daily Topix turnover of $200 billion, which would be about 2% of market volume for 230 trading days.
As 45% of daily volume is high frequency trading, the domestic pension funds represent upwards of 5% of the real directional flow on a daily basis, which can have a positive impact on market action. However, the real impact of GPIF will not be clear until the end of the calendar year when pension buying is anticipated to stop. In addition, companies have responded to the call for higher returns to shareholders. According to J.P. Morgan, 12-month rolling share buybacks are now running at just under 1% of Topix market cap; almost a tripling off the post-Lehman Shock lows. Total dividends paid is about triple buybacks, implying roughly 2.4% yield. Taken together, Japan Inc. is returning over 3% by being better managers of capital.
Is this a shareholder revolution? It is still too early to tell, but the signs are positive. We remain enthusiastic about value stocks in the Japanese market, mainly banks and telecom names. For banks, we believe that the discount to the market is still too large given that their earnings should benefit from a rise in the yield curve and their capacity to deliver higher dividends and buybacks will increase as they exit the cross shareholdings. The telecom companies we hold are committed to delivering upwards of 10% compounded EPS growth. The robust nature of telecom cash flows allows these names to overcome earnings shortfalls with material buybacks to reach their respective EPS and ROE targets. After decades of malaise, there is an atmosphere of heightened commitment to delivering shareholder return. After all, the management of Japan Inc. is now working for GPIF, and in a way, its own retirement. Strong incentives indeed.
GMO International Active: Country Allocation And Market Update
Country and currency allocation was 0.1% behind the benchmark. Our weight in Europe is lower than that of the benchmark, but we have an overweight position in the eurozone. In January we hedged the account such that the exposure of the portfolio to the euro was closer to that of the benchmark, and the hedge against the euro was negative in the quarter. This was mostly offset by an underweight position in the underperforming Australian market, which added to returns.
The Pacific was the best performing region in the quarter. The only stock market in Asia that has been able to keep pace with Japan this year has been China, both up about 18%, although most of the Middle Kingdom’s move came in the second quarter whereas most of Japan’s performance came in the first. This contrasts sharply with the rest of Asia where markets are down in U.S. dollar terms over the quarter, the worst being Indonesia. The common theme across Asia ex-Japan has been a gathering economic slowdown that we attribute to an ebbing of dollar liquidity, which is slowing money supply growth – the reversal of the process that propelled the boom in the region since the early part of this century. It is curious that the same process is, we believe, working in China, but in the second quarter its stock market has shot higher at the same time its economy has predictably struggled in line with the rest of the region. We suspect that it is a combination of assumed exchange rate stability combined with panicky monetary easing that seems designed to lift asset prices, an attractive combination for speculators. Indonesia’s predicament is a template for what we fear could happen elsewhere, even China at some point. This is that capital outflows and exchange rate weakness are met with weak economic growth, tying the hands of policy makers who have been backed into a corner after a decade of accommodating an unsustainable boom. A rising cost of capital across the region would not be good for equity markets.
Europe did reasonably well in the quarter, but the strong run in European stocks came to a halt at the end of the quarter when Greece defaulted on a €1.3 billion payment to the IMF, triggering a sharp selloff in eurozone equity markets. Further volatility resulted from the Tsipras Government’s launching a referendum on the proposals outlined by the EU, ECB, and IMF for reducing the country’s debt burden.
Though the Greek population voted down the proposals by a wide margin (probably surprising the Tsiparas Government as much as anyone), at the time of writing the main political parties in Greece seem to have capitulated to an even harsher set of packages amid fears of an imminent exit from the eurozone. We remain of the view that several sectors in the eurozone – such as construction – offer reasonable valuations on depressed margins and sales and that a Grexit scenario can at worst delay recovery in some of these highly depressed sectors. It should be noted that the leading economic indicators in the eurozone have recently been extremely robust, though it remains to be seen if the Greece-induced volatility will derail this. Outside of the eurozone the U.K. economy remains on a robust recovery trajectory.
During the second quarter, the U.S. market turned lower against the backdrop of a strengthening dollar, geopolitical volatility (including the potential for a Grexit from the eurozone), as well as the volatility in the Chinese stock market. Domestically, the market continues to suffer from declining earnings estimates (mainly due to energy companies), and valuation levels, which continue to be elevated. However, an improving job market and the prospect of increased consumer spending given the decline in fuel prices have continued to give support to the market. Record cash balances and strong cash flow generation are fuelling share repurchases and M&A activity, and will likely limit some of the downside risk posed by elevated valuation levels.
GMO International Active: Stock Selection
Stock selection beat the benchmark by 2.9% in the second quarter. Holdings in Europe, Japan, and Australia outperformed. On the negative side, stock selection in emerging markets hurt returns, particularly holdings in Korea.2
Stock selection in Europe outperformed in the second quarter. Holdings Peugeot in France, house builders in the U.K., and Vodafone were all large contributors to returns. Our holding in Peugeot enjoyed a strong quarter, helped by the French car maker’s field trip to China, where the company operates a joint venture with Dongfeng and Changan. CEO Carlos Taveres revealed that volumes and pricing in Europe remained robust and that the company was ahead of schedule on its “Back in the Race” recovery plan. In tandem with some ambitious targets on Chinese sales, this triggered material earnings upgrades from some sell-side analysts. U.K. house builders and home improvement companies, particularly Taylor Wimpey, Howden Joinery, and Berkley Group, received a boost from the Conservative election victory (the party was perceived to have a far more favorable attitude toward the sector than the Labour Party, which accused the sector of hoarding land). At the same time, the building companies continued to reap the benefit of a remarkably benign land market with smaller private builders remaining starved of capital and unable to bid up prices. Market participants re-rated U.K.-based Vodafone, as M&A speculations resurfaced. Cable giant Liberty Global’s main shareholder sees an obvious fit between the two companies’ European operations. Vodafone’s telecom business in the U.K., Germany, and the Netherlands would be immediately complementary to Liberty’s cable services, allowing a joint company to offer bundled telecom and television packages in those countries. Such a move would take advantage of massive synergies and enable a clearer valuation of Vodafone assets; currently the value of businesses in India, Turkey, and Africa is not being reflected in Vodafone’s share price.
In Japan, our holdings in banks outperformed the market in the second quarter. A main driver of this trend is the increasing market expectation that banks will exit the crossholdings with their corporate customers. The practice of holding the other company’s shares traditionally cemented the relationship when a company decided from which bank to borrow in an economy that is severely “overbanked.” It has always been unclear whether the crossholdings genuinely helped banks make loans, but it is clear that the practice left bank balance sheets exposed to moves in the stock market. Exiting these crossholdings is positive as it allows investors to focus on a bank’s credit risk and no longer worry about the embedded equity market risk. Insulating the bank’s balance sheet from equity market moves also increases its capacity for higher levels of dividend payouts and share buybacks. Holdings in NTT DoCoMo (NTT), Japan’s largest integrated fixed line/mobile operator, outperformed in the quarter due to two factors. First, the company released a mid-term plan that included financial targets that were focused on delivering higher ROE and EPS growth. The EPS forecast included a commitment to achieving ¥350 of earnings per share in 2018, or roughly 13% compounded annual return. The company made it clear that should organic earnings trend below this forecast, management will buy back shares. The second positive factor is NTT has started a new wholesale service for fiber optic cable to the home (FTTH). The new scheme encourages the three cellular service providers to bundle NTT’s fiber with their wireless service. The benefit to NTT is that they aim to dramatically reduce marketing expenditure to get incremental subscribers. Cost savings are material, which gives further credibility to the goal of achieving the EPS target.
Asciano, the Australian port and rail company that we have written about many times in the past, received a buyout offer from Brookfield Infrastructure Partners of Canada. The stock traded up sharply as a result.
Korean car company Hyundai Motors has been a value trap for over a year. The latest blow to the stock was poor sales numbers due to their aging model line-up. We believe the stock is now discounting a halving of margins and remains very inexpensive. Any positive moves on the corporate governance front, or a weaker won, should be positive for the share price.
GMO International Active: Currency And Hedging
For the most part currencies rallied against the U.S. dollar in the quarter. The euro climbed 3.6% despite rumblings about Greece, and the U.K. pound gained 5.9%. The Japanese yen was one of the few currencies that fell, declining 2.1% while the Australian dollar gained 0.6%.
As mentioned above, in January we hedged the account such that, despite more exposure to eurozone markets than the benchmark, the exposure of the portfolio to the euro was roughly in line with that of the benchmark. As of June 30, 4.1% of the account was hedged. The hedge against the euro was negative in the quarter.
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