GMO International Active EAFE Strategy commentary for the third quarter ended September 30, 2016.
The GMO International Active EAFE Strategy was 0.4 percentage points behind the MSCI EAFE benchmark in the third quarter, as the account increased by 6.05% and the benchmark increased 6.43%.
GMO International Active EAFE Strategy – Market Update
During the third quarter the prevailing trends in the global equity markets of 2016 started to run out of gas. After roughly six months of consistent market action reflecting lower rate expectations, stronger emerging market economies, and higher commodity prices, global equity investors seem to have suddenly become skeptical. Equities have treaded water for the last few months as extended low rates in the US and another round of credit stimulation for the Chinese economy have become fully discounted in valuations. In our view, the currently stalled pattern in the global equity markets is nascent evidence of the market realizing it has gotten ahead of itself.
At the heart of this are expectations for US interest rates. For the first half of the year, the market seemed convinced that the Federal Reserve would be slow to raise rates, which in turn relieved the upward pressure on the US dollar and, by extension, provided support for emerging market equities and commodities. At the same time, another round of credit expansion policy in China stabilized its economy in the short run, causing investors to become more sanguine. The interconnected themes of lower rates in the US, a weaker dollar, a recovering China, and stronger commodity prices can be characterized broadly as a global recovery narrative.
The belief in the narrative remained intact even after the British electorate’s decision to leave the European Union. Superficially this may seem incongruent, but the aftermath of the Brexit vote clearly motivated investors to favor Asia and the US over Europe and the UK. Geographically, it was consistent with the pro US, emerging markets, and commodities theme.
At the end of the summer, however, global equity markets started to question the longevity of global recovery. Since then, the US dollar has appreciated while emerging market equities and commodity prices have plateaued. This leads us to suspect that the market’s devotion to the thematic might be waning. In particular, speculation about when or if the Federal Reserve is going to raise interest rates has resurfaced. Given the year has mostly been in the midst of a recovery trade, it shouldn’t be a surprise that a relatively defensive portfolio such as ours has lagged the benchmark. In fact, we would have expected our portfolio to be doing worse. It is also not surprising that in August, when the prevailing risk themes stalled, our portfolio’s returns started to recover.
In the midst of all this, our holdings continue to churn out the cash flow and dividends we require in our investment process. These characteristics do bias the portfolio toward defensiveness, a quality we are willing to live with in the short run because we believe that our investment criteria are systematically undervalued by the market.
Stock selection has provided a counterweight to the adverse positioning in the portfolio of being underweight recovery factors and overweight defensive. So even though the portfolio has lagged the benchmark, our underperformance hasn’t been as bad as would otherwise be expected given that our factor allocations have been almost completely backward to what the market has rewarded so far this year. In short, stock selection has been fighting against the drag of poor allocation decisions.
While we continue to believe global equity valuations are not properly discounting the looming risks of the day, there is one exception. Japan is a market where expectations seem to be unusually low. When we run systematic screens on our investment criteria, Japan stands out as overrepresented. It is not uncommon to find single-digit P/E stocks with a track record of consistent free cash flow, dividends, and low debt. We’ve added positions such as NSK, a maker of precision parts for the automotive and manufacturing sectors; Asahi Kasei, an industrial conglomerate; and Mixi, an online social network and computer game designer.
Unlike in other parts of the world where stock prices reflect a rosier outlook, valuations of Japanese industrials imply much more modest expectations. It is true that cheapness in Japan has a gravitational pull toward companies confronted with a myriad of potential risks such as worsening global macroeconomic conditions, yen strength, or continued weakness in the domestic Japanese economy. But we think these risks are overly discounted in many cases and some companies are simply too cheap to pass up.
Stock selection slightly underperformed the benchmark for the quarter. The mixed performance of holdings in Japan was offset by better performance in Europe.
Market expectations regarding the direction of the currency can have a material impact on portfolio positioning in Japan. The yen’s significant move during the first six months of the year caused a sell-off in exporters that we believe was overdone. With the yen largely stable in the third quarter, our holdings in exporters such as Takeuchi Manufacturing, Brother Industries, and Nippon Electric Glass rebounded. In each of our holdings, the companies delivered a positive earnings surprise, forcing the market to reconsider whether the sell-off had gone too far.
Takeuchi, a manufacturer of mini-excavators, was buoyed by news of better than expected sales in the US owing to strength in the US housing market. Brother enjoyed better than expected sales of printers in the US and factory automation tools in China. Nippon Electric Glass, a supplier of glass substrates for LCD TVs, announced a joint venture in China to supply technology to one of China’s largest producers of TVs.
On the negative side, holdings in Telecom conglomerate NTT and home electronics retailer K’s Holdings underperformed. In the case of these two names, nothing related to earnings expectations was released, implying that market participants punished these names not for their operations but for a view that the next move for the yen is to weaken.
In Europe, the portfolio has benefited from owning Arkema, a diversified chemical company. Worries about the impact of Brexit have eased and the Chinese economy continues to stabilize, helping the global chemicals industry. Also helpful was the increase in oil prices, which motivates customers to restock those chemical inputs whose prices are linked to energy. We continue to like Arkema, as it is one of the cheapest chemicals companies in Europe. With its declining commodity chemicals business and cyclically low margins in multiple segments, we think Arkema will continue to rerate.
Melrose Industries produced a strong return in the quarter as the market greeted with enthusiasm the company’s plan to acquire the NASDAQ-listed US industrial group Nortek for GBP 2.2 billion. Melrose has a simple strategy of buying underperforming businesses, improving them (margin uplift, working capital controls, etc.), and then selling them for a profit over a three- to five-year time frame. Management has an outstanding track record – they aim to more than double shareholders’ equity on each investment made (the company issues stock to fund each acquisition) and have historically generated a return 2.9x the initial investment.
The tobacco companies Imperial Brands and British American Tobacco were detractors to performance in the third quarter. This was simply a reflection of the market rotating into cyclical names during the third quarter and defensive companies lagging. There was no negative news flow to justify the poor performance and, unless a strong global economic recovery together with a sustained uplift in inflation is imminent, we expect the companies to produce decent relative returns in subsequent quarters. As we are skeptical this will happen, we recently added to the position in Imperial, which looks particularly undervalued.
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