Charles Brandes 2013 Letter: Contrarian Investments In Europe, Japan Pay OffVW Staff
Charles Brandes 2013 Letter Year in Review: The Benefit of Perspective
Amid Market Cycles, a Singular Focus on Value
Reflecting on 2013’s strong market performance, it’s easy to forget that just five years ago the investing environment was very different from today. Back then, the financial crisis and ensuing global market decline cast dark clouds of uncertainty, perhaps testing the mettle of even the most patient, long-term investors. Th rough this experience, and bearing witness to strong equity gains in 2012 and 2013, there are two important takeaways for investors everywhere: one is that markets, regions, industries and companies go through cycles; and two, the price one pays can matter greatly to investment returns.
After the Rain, Some Clearing
Like other value investors, we were not spared from the adverse effects of falling markets and negative investor sentiment in 2008 and the years that followed. Within the trough of economic and market challenges, a number of our strategies declined as investor focus on company fundamentals took a back seat to concerns over broader economic issues. A flight to safety was widespread, and investor preference turned to fixed-income and passive equity strategies, as shown in Exhibit 1.
What a difference five years can make. Many investors showed renewed interest toward actively managed equities in 2013, as Exhibit 1 illustrates, as a number of key market indices recorded solid gains in 2013 and for the five years ended December 31, 2013. See Exhibit 2 on page 2.
The Hunt for Potential Bargains and the Rewards that Followed
Although 2013 was certainly rewarding for many investors, the performance for Brandes strategies was a result of decisions we made years ago. Taking advantage of opportunities brought on by price declines in various markets, which suffered due to factors specific to individual countries and regions within the last five years, we invested in businesses at a time when prices were low and—as our analysis showed—were mispriced compared to their estimated true worth. Th is mispricing was most dramatic during the depths of the 2008-2009 financial crisis, when we found compelling value opportunities.
During that time, investor concerns were valid and discounts to some company valuations were certainly warranted. However, we believe that while most people considered 2008 to 2009 the “riskiest” period to invest due to heightened stock-price volatility, for a price/valuation-focused, long-term investor this actually appeared to be a good time to commit funds to equities. 1
While most investors were preoccupied solely with “risk,” we were intensely focused on assessing the wealth- generating potential and the value of underlying assets of individual companies. Although the macroeconomic climate has certainly been volatile over the past five years, we continue to believe that attempting to forecast macro events is essentially pointless and futile. Yet understanding the sensitivity of a company’s earnings and cash flows to larger events enables us to assess bull-, base- and bear-case scenarios in determining our estimates of the company’s worth.
As we diligently followed our process and philosophy, we found opportunities, in 2013 and in previous years, in areas where we felt the markets were overly punitive for the various headwinds faced.
Overall, we are pleased with the firm’s investment performance in 2013 and over the long term.
Investing Beyond the Benchmark: Then and Now
As is oft en the challenge for disciplined value investors, the positions we took years ago in our strategies overall, such as in the then-troubled regions of Japan and Europe, were controversial among some clients. Our holdings differed significantly in names and weightings from the benchmarks.
As unsettling as it was on the surface, some of our strategies were in the top decile or top quartile of manager allocations to Europe, Europe ex-U.K. and Japan at various points during the last five years relative to peers in the Intersec universe.2 But our conviction as value investors led us to ignore the noise then. Fast forward to today, and we take the same approach. As an example, in the Global Equity Strategy our allocation to the United States at 28% was roughly half the MSCI World Index’s U.S. allocation of 54%, and much less than the MSCI All Country World Index’s U.S. weight at 48% (as of December 31, 2013). Th is was our lowest U.S. allocation in Global Equity since 1997. Another example is that our emerging-market allocations increased throughout 2013, because political and other macro concerns mounted, making some valuations more attractive to us.
We believe the last fi ve years, and 2013 in particular, have shown once again the potential benefits of focusing on company-specific fundamentals in conjunction with the price one pays. Graham-and-Dodd value investing has produced meaningful outperformance, if one had the patience and fortitude to stay the course.
Stock Selection Highlighted by Review of Regions, Sectors and Industries
While some markets recovered substantially in 2012 and 2013, we are still finding pockets of value opportunities globally. In this commentary, we highlight what we believe are a few of the important and relevant industries and regions (United States, Europe, Japan and emerging markets) impacting the portfolios.
United States: Focus on Selection
With the U.S. market up 32% in 2013, as measured by the S&P 500 Index and up nearly 200% (including dividends) since the low on March 9, 2009, many company fundamentals and valuations have changed dramatically. Th e question that seems to be in many headlines now is whether the U.S. market as a whole is overvalued or whether we are still in the early stages of a prolonged market recovery. While there are compelling arguments on both sides, we are finding fewer opportunities in the United States and our allocations have accordingly been reduced, which in part is due to finding what we view as better opportunities elsewhere, such as in Europe and the emerging markets. As indicated in Exhibit 4, on page 4, as of December 31, 2013, the Shiller P/E3 was 25.6x for U.S. stocks vs. their 30-year median of 21.8x, and 14.1x for Europe stocks vs. their 30-year median of 17.5x. And although this would generally indicate, on a portfolio positioning standpoint, reduced exposure to the United States and an increasing weight to Europe as a whole, stock selection remains key. Whether macroeconomic indicators are positive or negative, or whether market valuations as a whole appear inexpensive or pricey, focusing on the fundamentals of individual companies and comparing them to market prices is critical to value investing. And despite the substantial recovery in the U.S. market, based on our company-level analysis we still find opportunities in a number of companies in the information technology (IT) and financial services sectors.
“Mature” IT Firms
Th e characteristics of companies that comprise the IT sector have changed dramatically over the last five to 15 years. Many of the former high growth, high P/E multiple “darlings” have matured while newer cloud-based and social media companies—with their allure of high-growth and loft y P/E multiples—have captured the most attention. We have found attractive opportunities in the former: more mature and former high growth IT stocks. Today, we find that many of the mature tech companies, despite a tempering of their once rapid pace of growth, have higher returns on capital and growth rates still equal to or better than the market, strong balance sheets with good free cash fl ow, a track record of returning cash to shareholders, and most importantly, have recently been trading at attractive valuations.
As shown in Exhibit 3, IT holdings in the Brandes U.S. Value Equity Strategy generally had stronger capital structures, meaningfully lower valuations that we believe more than compensate for secular risks from potential technology shift s, and yet still reasonable growth profiles as compared to fundamentals of IT companies in the S&P 500 Index. Additionally, while many of the Brandes IT sector holdings may not have the growth excitement that some of their tech brethren have, they could, nevertheless, benefit if enterprise-technology spending picks up.
Well-Capitalized U.S. Banks
In our view, U.S. banks have shown improving profitability and capital positions despite the relatively modest macroeconomic recovery. At the height of the financial crisis, many investors shunned U.S. banks amid fears of all things financial. Since then, U.S. banks’ underlying fundamentals have improved and are considered to be at healthy levels:
• Higher capital levels as measured by equity 4 /assets of over 11% versus 9% to 10% pre-2008. 5
• Higher tangible equity to tangible assets: 8.3% (up from a low of 4.8% in 2007; higher number means banks can absorb more losses before needing new equity).
• More conservative ratio of loans to deposits: 75% versus 95% in 2007 (lower ratio indicates a bank being more conservatively run).
• Lower ratio of non-performing loans to gross loans: trending down from 4.8% in 2009 to 3.2% (lower percentage means there are fewer “problem loans”).
Despite these fundamental improvements, U.S. bank valuations remain depressed and well below their long- term averages. In our view, today’s price-to-book (P/B) at 1.1x (as of 12/31/2013) compared to the 20-year average of 1.8x, for U.S. banks (Source: Bloomberg) seems like an excessive discount, especially in light of the added confidence surrounding their liquidity and capital positions. In our valuations, we acknowledge and conservatively assume that future profitability of U.S. banks will be less than in the past due to decreased leverage, greater regulations and restrictions, and ongoing lawsuits, as well as other competitive challenges.
However, it is interesting to note that while we have been finding attractive opportunities in many of the major U.S. banks, we have not been as attracted to many of their European counterparts despite the apparently attractive valuation of the European banks. Compared with European banks, we believe U.S. banks enjoy an advantage due to the following:
• Better capitalization and less dependency on wholesale funding, which ebbs and flows with sentiment, and is recovering from weak asset markets.
• Lower regulatory uncertainties—many European banks need more equity capital and are heavily reliant on wholesale funding, a big part of which they currently get from the European Central Bank.
• Greater regulatory concerns among European banks—including the planned asset-stress testing in 2014 and the transition to a euro-wide bank regulator.
Europe: Finding Value Opportunities in Depressed Local Markets
While Europe appears to have emerged from the recession, and although a number of key metrics have stabilized or even improved, the macroeconomic situation in many countries remains fluid and uncertain. However, as shown in Exhibit 4, at the depths of the financial crisis, the Shiller P/E for Europe dropped dramatically from about 24x in May 2007 to about 10x in March 2009, indicating potentially attractive opportunities for long- term investors.
Although the macro issues were very real and serious—including the potential for a partial or full European Union breakup, high unemployment, elevated debt-to-GDP ratios, recession and fiscal austerity—we focused first on individual company fundamentals and then stress-tested their sensitivities to various macro outcomes. As many of the region’s economies have begun to recover since the crisis, the range of potential outcomes has been reduced. Undervalued Food and Staples Retailing in Europe Although we have been attracted to each holding for different fundamental reasons (e.g., turnaround prospects, industry-leading sales growth and profit margins, strong asset backing and high lease-adjusted returns on invested capital), one theme was consistent: attractive valuations. Companies in the European food and staples retailing industry as a whole were trading at a meaningful discount from historical averages relative to the market, as shown in Exhibit 5. Some of the European retailers have been among the lowest- priced consumer stocks anywhere.
As an example of a holding in the industry, we found a compelling value opportunity in a leading France- based food and staples retailer. 6 Many investors seemed to have little confidence in the company aft er years of weak performance in many key markets, numerous CEO changes, unsuccessful corporate restructuring efforts and repeated profit warnings. As is common in the industry, investors appeared to be mostly taking a wait-and-see approach to the company’s turnaround and attributed little credit to the potential for a successful recovery. Nonetheless, the company has benefited from a number of positive developments: New management has sold a number of assets at attractive prices; significantly improved the balance sheet; continued execution on a number of other restructuring initiatives; and an improvement in the French retail market. These factors led us to believe the company’s share price was misaligned with its fundamentals, and it has since recovered substantially on the back of these positive developments.
European Oil Majors Priced Well Below Average
We also continue to see opportunities among mispriced companies in the European oil and gas industry.
We believe the industry is currently priced at a discount to the overall market and its peers in other parts of the world due to headwinds which are short term and cyclical in nature. For instance, in the upstream segments, capital spending has been high over the last five years without commensurate production growth. On the refining side, margins have been low as a result of overcapacity and sluggish demand brought about by the challenging economic environment in the local economies. We believe that production across the industry should increase as a strong pipeline of projects moves from development to production, and overcapacity in the refining industry should ease as European refineries close and retail demand for oil products begins to recover.
As shown in Exhibit 6, on page 6, European oils were trading at a 30% discount to the market—near the wider end of what has been observed in the past.
As an example of an opportunity we see in the industry, we continue to invest in an Italy-based energy firm, 6 which is among the world’s 10 largest integrated oil companies and has significant presence in the Italian
energy sector and in other countries. Our analysis showed that the recent market valuation for the company may not reflect its underlying fundamentals, with the market’s valuation merely equivalent to the sum of the company’s oil and gas reserves and the value of its publicly listed subsidiaries. Th is implies that at current prices, the market is giving no value to the company’s substantial assets in power production, refining and marketing, and seemed to have largely ignored the company’s multi-billion euro investment to grow its reserve base.
Exhibit 6: European Oil Has Traded at a Discount
Additional Resource: Europe
—Our Quarterly Commentary for 4Q 2011: “Fundamentals Overshadowed” offers more perspective on European macroeconomic concerns that we saw as we focused on individual company fundamentals. Please note, access to certain materials may be limited. To learn more about our views and product offerings, please visit brandes.com.
Japan: Keeping the Faith in Companies Japan was up 54.6% in 2013 in yen terms, and 27.2% in U.S. dollar terms, as measured by the MSCI Japan Index, as sentiment has changed significantly with Abenomics’ three-arrows strategy as well as a weakening yen and a stabilizing euro. We have had a meaningful allocation to Japan in a number of our strategies over the last few years. As Japan has appreciated, we trimmed our allocation slightly in 2013. However, we continue to hold a number of attractively valued companies even though as a whole Japan now is not as attractive to us as it was a few years back.
With the recent good news on Japanese equity returns, it’s easy to forget how dire the situation seemed a year or two ago, when headlines indicating Japan’s situation was hopeless saturated the media. Th en the Tohoku earthquake hit with the resulting tsunami and Fukushima nuclear disaster. As events unfolded, we received many questions from our clients regarding our Japanese allocation and specific Japanese holdings. At that time, we were the global manager with the highest allocation to Japan in the Intersec Global peer universe. 7 Again, although the macro issues were (and still are) very real and serious, we focused first on individual company fundamentals and then stress-tested their sensitivities to various potential macro outcomes. Many of our Japanese holdings are multinational companies with earnings, cash flows, and assets not solely dependent on the local economy. As glimmers of hope started to creep into public sentiment, and very depressed valuations began to turn, our overweight in Japan positively contributed to returns in 2013. We are still meaningfully allocated to Japan in many of our equity strategies.
Additional Resource: Japan
—Our Quarterly Commentary for 1Q 2012: “Japan: What a Modicum of Good News Could Produce” offers more perspective on macroeconomic concerns that we saw as we focused on individual company fundamentals. Please note, access to certain materials may be limited. To learn more about our views and product offerings, please visit brandes.com.
Emerging Markets: Shifting Investor Sentiment
In contrast to the strong recovery in most major developed equity markets, sentiment toward emerging markets changed rather dramatically in 2013 with the MSCI Emerging Market Index down 2.6% as macroeconomic
actors, negative headlines, and fear of a repeat of the late 1990s’ Asian crisis negatively impacted prices. As these fears have pushed prices down, our allocations to emerging markets in many of our equity strategies have increased. We continue to scour many emerging markets closely for opportunities, just as we did in Japan and Europe a few years back when the headwinds and negative sentiment overly punished prices relative to fundamentals. We would not be surprised to see our exposure to emerging markets gradually increase.
Additional Resource: Emerging Markets —We wrote extensively about our thoughts on emerging markets in our Quarterly Commentary for 3Q 2013: “Emerging Markets Concerns Rising—So Are Select Opportunities,” including the pitfalls of treating emerging markets as one homogenous market and the importance of active stock selection.
Looking Ahead: Our Continued Commitment to You
Similar to the way they behaved following the 2008 financial crisis, many market participants continue to focus on short-term macroeconomic issues today. Heading into 2014, topping the list are the timing and extent of the U.S. Federal Reserve’s decision to start winding down its quantitative easing program, if and when interest rates may start to rise, and the corresponding impact on asset flows, particularly within emerging markets. While we view this as interesting, we focus on individual company fundamentals and their sensitivities to various scenarios to guide us in selecting companies worthy of inclusion in our client portfolios.
Not every year has been or will be like 2013, and we realize there were times when the positions we took may have been uncomfortable for some as market sentiment and investor preferences shift ed and the value investment style was out of favor. Nonetheless, with our value philosophy consistently guiding our investment decisions, we believe Brandes portfolios are well-positioned for the long term.
Importantly for us, as stewards of your investments, we remain committed to the qualities you’ve come to know and expect from Brandes: Independence, stability, repeatable investment process, Graham-and-Dodd value style, patience and conviction. These traits set us up to help you pursue your long-term financial goals, as markets continue to cycle.
Thank you for your trust, patience and confidence.
1 In February 2009, the Shiller P/E for the S&P 500 and MSCI Europe was 12.7x and 9.7x versus their 30-year medians of 21.8x an d 17.5x, respectively. These showed a significant discount to historical valuation levels. Exhibit 2: Market Returns Five Years Post-Financial Crisis Annualized Returns ending 12/31/2013 Description 1 Year 5 Years S&P 500 – Total Return 32.39% 17.94% MSCI World Index – Net Return 26.68% 15.02% MSCI EAFE – Net Return 22.78% 12.44% MSCI Europe – Net Return 25.23% 13.36% MSCI Emerging Markets – Net Return -2.60% 14.79% MSCI Japan – Net Return 27.16% 7.65% Source: S&P, MSCI via FactSet. Past performance is not a guarantee of future results. One cannot invest directly in an index.
2 Source: Intersec Research; Our Global Equity Strategy’s allocation to Europe has been in the top decile since 3Q12 and in 1Q1 3 was in the top one percentile. Our Global Equity Strategy’s allocation to Japan has been for the most part in the top one percentile since 3Q09. Our International Equity Strategy’s allocation to Europe Ex-UK has been mostly in the top quartile since 1Q12. Our International Equity Strategy’s allocation to Japan was in the top one percentile from 1Q08 through 4Q12. Statistics per the Intersec Global and International peer universe, respectively. Intersec based its rankings on data collected from portfolio managers and from custodial banks monthly in the form of market values and contributions for total fund and aggregate purchases , sales and income data for each equity market.
3 Source: Morgan Stanley, MSCI, S&P, various national sources; Shiller P/E defined as inflation adjusted price to 10Y average earnings per share from continuing operations.
4 Equity defined per Bank for International Settlements, Basel III “Criteria for Common Equity Tier 1,” Paragraphs 52-53, December 2011, http://www.bis.org/publ/bcbs211.htm
5 Source for all four bullets: SNL Financial, as of 9/30/2013 (latest available company reports)
6 Brandes is not naming this company because the SEC limits discussions of specific companies in certain situations.
7 Source: Intersec Research; Our Global Equity Strategy’s allocation to Japan has been for the most part in the top one percent ile since 3Q09. Our International Equity Strategy’s allocation to Japan was in the top one percentile from 1Q08 through 4Q12. Statistics per the Intersec Global and International peer universe, respectively. Intersec based its rankings on data collected from portfolio managers and from custodial banks monthly in the form of market values and contributions for total fund and aggregate purchases, sales and income data for each equity market.