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 Richter, a Hungary-based manufacturer of both branded and generic pharmaceutical products. In recent years, the company has been transitioning its business model to become more of a “specialty pharma” with a stronger emphasis on branded drugs, an area that requires more research & development (R&D) effort but historically has been more profitable.
We began purchasing Gedeon Richter in the second quarter of 2014. At the time, geopolitical concerns in Russia, Ukraine and other member countries of the Commonwealth of Independent States (CIS), which collectively accounted for over 40% of Gedeon Richter’s revenue, appeared to be overly discounted for in the company’s share price. We took comfort in Gedeon Richter’s long history of local operations in the region, including local manufacturing in Russia, which should support its foothold there. Moreover, we believed the market underappreciated the prospects offered by Gedeon Richter’s women’s health division, its diversified exposure to regions with positive secular growth potential, as well as its R&D optionality.
Gedeon Richter performed well over our holding period. Market concerns about its Russia/Ukraine exposure appeared to be moderating, its operations and profitability remained strong, and the company started to see some positives from its branded pharmaceutical business. In the quarter, Gedeon Richter, in partnership with Allergan, received U.S. FDA (Food and Drug Administration) approval for VRAYLARTM (cariprazine), which is used for the treatment of bipolar disorder and schizophrenia. Itsoriginal branded drug for the treatment of uterine fibroids, ESMYA®, has also been gaining share in Europe, the CIS region and Canada. Given these developments and the resulting share-price appreciation to our estimate of intrinsic value, we exited the position in the quarter.
During the quarter, we also took advantage of the decline in Brazilian equities to add a couple new names to the Fund, Companhia Brasileira de Distribuicao and Kroton Educacional, as well as selectively add to a number of our positions there, including government-owned water utility Companhia de Saneamento Basico de Estado de São Paulo (Sabesp). Sabesp provides public water and sewage services to a broad range of customers in São Paulo, Brazil’s richest and most populous state. São Paulo has recently been grappling with the worst drought in 80 years. Water levels in the Cantareira system of reservoirs, which normally supplies roughly half of the 20 million residents, have fallen to just 5% of capacity. In our view, the necessary cutbacks on water deliveries will result in Sabesp earning below its regulated rate of return. This will likely continue until the drought is over or the company is able to supplement the state’s water supply. While the investment committee cannot predict the weather, we feel that Sabesp remains an attractive investment opportunity that merits a continued inclusion in the Fund.
Brandes Emerging Markets Value Fund – EMs still attractive
In the midst of significant volatility in emerging markets, our Fund weightings have not changed dramatically in the quarter. As noted, we added to a number of our positions in Brazil, and the country remained the Fund’s largest overweight as of 30 September 2015. Although the Chinese equity market—as represented by the MSCI China Index—declined over 20% in the quarter, it has still been one of the better-performing emerging markets in recent years. We remained cautious on the valuations of many China-based companies and continued to hold a significant underweight at quarter end, especially since we did not own any Chinese financials, which made up approximately 40% of the benchmark’s China allocation.
The past year has not only been difficult for the Brandes Emerging Markets Value Fund, but for value investing in emerging markets in general. For the 12 months ended 30 September 2015, the MSCI Emerging Markets Value Index underperformed the MSCI Emerging Markets Growth Index by 6.6%, representing one of the worst relative performances for value investing since the inception of both indices in 1997. In our opinion, current valuation levels for the MSCI Emerging Markets Index, such as price-to-book and price-to-cash flow ratios, indicate that emerging markets is one of the most undervalued asset classes. As of 30 September 2015, the Brandes Emerging Markets Value Fund presented attractive valuations vs. the index—with 0.7x price-to-book ratio vs. 1.4x for the MSCI Emerging Markets Index. In the current market environment, we hold the view that selectivity, discipline and a focus on margin of safety remain paramount as we invest in companies worthy of inclusion in the Brandes Emerging Markets Value Fund.
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