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