GMO International Active EAFE Strategy 4Q15 Letter: China appears to have backed itself into a cornerVW Staff
GMO International Active EAFE Strategy commentary for the fourth quarter ended December 31, 2015.
The International Active EAFE Strategy underperformed the MSCI EAFE index by 0.5 percentage points in the fourth quarter; the strategy gained 4.2% net of fees and the benchmark rose 4.7%. The strategy beat its benchmark by 6.9 percentage points for the year 2015, returning +6.1%.
GMO - 2015 Review and 2016 Outlook
Good equity investment analysis requires a healthy mix of skepticism and optimism. Th is is especially true for the value investor who searches for businesses with the potential to outperform low expectations by the market. Optimism helps remind the stock picker that things are oft en not as dire as they seem, while skepticism protects him from a bad business that is getting worse. When to modulate between these two competing and contradictory impulses is learned through the experience of many markets and cycles. The year 2015 was certainly one in which the members of the International Active team had to be both pessimists and optimists. In the first half of the year, the portfolio benefited from owning equities that were geared to an improving European economy. We believed that a cheaper euro and weaker commodity prices would accelerate the pace of the European recovery while market valuations implied more modest expectations. Holdings such as Peugeot, Mediaset, and Taylor Wimpey are all good examples of undervalued exposure to the European recovery.
In the second half of 2015, it was our skepticism of Chinese economic growth that served us well. We have long held the view that China was in the midst of an epic credit cycle, fueled with the money creation enabled by its currency peg. Credit booms usually don’t end well, and this one isn’t likely to either. The first signs of stress occurred in the Chinese equity market, which suffered significant losses in June. Then in August, the Chinese authorities weakened the currency, causing further anxiety. All of this was consistent with our view that the Middle Kingdom is in the bust phase of this cycle. The portfolio outperformed during these periods of China-related concern. We have tried our best to insulate the portfolio from further deflation of the Chinese credit bubble and the resulting economic weakness.
As we look toward 2016, we continue to be optimistic about the investments we are finding in Europe and Japan, and skeptical of many emerging market valuations despite their apparent cheapness. The positioning of value around the world implies that in 2016, like 2015, our opportunity for alpha will be in careful stock picking. With this as the backdrop, we want to take this opportunity to remind investors of the core principles ingrained in our stock selection process.
GMO - Cash-in/cash-out Investing
The investment philosophy of International Active is anchored by four criteria. We require that companies generate positive free cash fl ow, distribute some cash back to shareholders, have strong balance sheets, and sell at a discounted valuation to the market provided an appropriate adjustment for the quality of the business.
Why the obsession with cash flows and distribution? We define free cash fl ow as the cash profi t produced in excess of the cash investment required to maintain and grow the business. Our view is that consistent positive free cash fl ow is strong evidence of a healthy, well-run business. It is usually the result of one or more of the attributes we look for in our investments, such as a strong competitive position, high barriers to entry, stable industry dynamics, and management talent.
However, it is not enough to just produce free cash fl ow. We also require that management teams be willing to share some of the surplus cash with shareholders. We define cash distribution as dividend yield plus share buybacks net of share and debt issuance. A company that is issuing debt to pay its dividend would not be returning cash to shareholders in our view.
History shows that cheap companies that pay a dividend outperform those that don’t, even in price performance terms. Aft er torturing the data, the conclusion we draw is that most companies are bad capital allocators. Investors like to believe that companies are re-investing in positive NPV projects, but the reality is that most investment is poorly conceived. We worry about mal-investment, especially in Europe and Asia, where corporate managements are oft en compensated via status rather than financial rewards. In that world, they are incentivized to make their companies bigger and making the extra acquisition or launching a new production facility is usually where the glory is, regardless of the soundness of the decision to do so. Returning cash is simply evidence of a management team that is more disciplined, and a business, we believe, that will more readily improve its ROI over time.
So, our sweet spot is cash generative and cash distributive businesses that sell at reasonable valuations. Oft en these companies are cheap because market expectations are simply too low. Sometimes their cheapness is the result of the business being a little dull. Either way, such stocks should quietly compound value over time and provide returns in excess of the market averages.
Now that we’ve explained performance for the last year and provided a reminder of our investment philosophy, let’s turn toward our expectations for the future.
GMO - Thoughts on Europe
We begin with Europe, which continues to grind out an economic recovery. Despite political uncertainty and the ongoing debate over austerity, the underlying forces of labor reform, capacity rationalization, and deleveraging are still in progress. With the inception of negative rates and aggressive QE from the ECB, monetary policy has become meaningfully accommodative. The euro has weakened signifi cantly and commodity prices are in decline, both of which must be positive for economic activity in Europe. The Greek crisis seems to have stabilized for now and the recovery process in the periphery, especially Spain, has surprised to the upside. While not completely out of the woods, the existential risks and dire economic predictions of just a few years ago are increasingly remote.
Th at said, we have taken profi ts on some of our holdings in the European domestic recovery story. The portfolio particularly benefited from holdings in automobiles, U.K. house builders, and media. For the cases in which our investment thesis was fulfi lled, we redeployed the capital into undervalued opportunities primarily in telecommunications, insurance, and pharmaceuticals.
In the telecommunications sector, the portfolio owns Deutsche Telekom, Telecom Italia, Vodafone, and Telefonica Deutschland. Our investment thesis for this sector is that profitability in markets such as Germany and Italy will improve as regulators allow more consolidation and competition becomes less intense. Th is market repair story is still in its early days, and we believe these companies should continue to surprise with strong growth in cash fl ow.
European insurance companies continue to produce good cash fl ow, despite the low interest rate environment. For example, Allianz, our core European insurance holding, has struggled to make money on its investment portfolios and so has become more focused and disciplined in its core business of pricing risk. The market has ignored the growth in cash fl ow and dividends and preferred to focus on uncertainty regarding new regulation on capital adequacy.
For pharmaceuticals, we continue to own AstraZeneca and Roche, companies with improving drug pipeline potential. The market typically doesn’t pay much for research pipelines because of the risks of drug efficacy and commerciality, but we believe both companies have strong long-term prospects that are being ignored because of looming patent cliff s and short-term growth concerns. Predictably, this has cast a shadow on their valuations and given patient investors the opportunity to buy long-term cash fl ows on the cheap.
GMO - Thoughts on Japan
The portfolio continues to own and benefit from corporate governance improvement in Japan. The two sectors that constitute our most significant exposure, telecommunications and banks, are both examples of this trend. The telecommunication stocks in the portfolio, NTT and KDDI, have promised and delivered significant share buyback programs, returning some of the ample cash they generate to shareholders and streamlining their balance sheets in the process. Th is is a departure from both the history of these two companies as well as the practice for the rest of the Japanese equity market.
We continue to see significant upside in our Japanese bank holdings. To be sure, the big upside is if Japanese interest rates rise, but we believe the names should do well even in the current environment, propelled forward by steadily improving corporate governance and well-covered dividends. In our largest holding, Mitsubishi UFJ Group, corporate governance improvement took the form of a share buyback program and growing anticipation of the company selling its cross-holdings in other Japanese companies, both of which have helped raise the stock price. Japanese banks allocating capital more efficiently both internally and externally could prove an important catalyst for lifting Japan out of its multi-decade malaise.
Managements’ reluctance to return cash piling up on balance sheets has long frustrated shareholders of Japanese corporates. The companies in our Japanese portfolio all have dividends supported by cash fl ow and many have committed to further return of cash to shareholders in the form of stock buybacks.
GMO - Thoughts on China
Our view on China remains that the country is on the back end of an extreme credit cycle. For most of the last 20 years, its pegged currency and trade surplus combined to propel money creation and credit expansion. Much of this money found its way into fi xed asset investment, infrastructure, and property development. While we agree that some of this investment went toward a useful purpose, the sheer scale of credit creation has almost certainly led to bad capital allocation decisions. Th is is most evident in the three-year oversupply of recently constructed housing currently rotting in interior cities.
China appears to have backed itself into a corner. It needs to ease monetary policy to revitalize its economy and ease the bad loan burden on its financial system. However, if China lowers rates, it risks losing control of its currency as money flows into higher yielding jurisdictions. We fear that any attempt to rescue the financial system could result in currency volatility being much higher than expected. A potential silver lining is that such an event could mark the bottom for emerging markets, allowing us to invest at very cheap valuations in great long-term businesses, much like the Asian investment opportunities with which we were presented from 1998-2003.
One long-held prediction that has come to the market’s attention but we don’t believe is yet fully discounted is a further devaluation of the renminbi. Th is would result from pressure applied by lower policy rates and the resulting capital flight out of the country. Our portfolio is defensively positioned for such an outcome. In general, the portfolio would benefit from continued weakness in the Chinese economy, downward pressure on commodity prices, and a potential further weakening of the renminbi.
GMO - The Value Investing Landscape
We have long argued that value investing requires two conditions for success. First, the valuation spread between low multiple and high multiple stocks must be wide. The larger the difference in multiple between the perceived good companies and bad, the more likely it is that the market is mispricing risk and being irrational in its assessment of the relative prospects for the two groups. The second condition is that underlying macro-economic conditions need to be reasonably constructive. The process of improving a poorly performing business is quicker and easier with the tailwind of a growing economy.
Both of these necessary conditions are, however, currently challenges to value investing. Spreads are decent, but not compelling enough to convince us that valuation multiples alone can inform a winning portfolio. We see the need to be judicious and flexible when hunting for value.
And, while improving, macroeconomic conditions are still facing structural headwinds in the form of debt, demographics, and deflation. Th e scarcity of organic growth has forced markets to apply ever-higher valuations to those companies that can organically increase earnings. As it always does, however, the market is valuing this growth too highly and share prices of companies with lower expectations should outperform in the long run. We hope to profit from the market’s fixation on the short run and strive to invest in franchises selling too cheaply because of this desperate search for growth.
We are pleased that we delivered good relative performance in 2015, and we continue to search for the best possible opportunities to outperform the market this year.
GMO - Country Allocation
Country and currency allocation was 1.1 percentage points behind the benchmark. Our positioning in Europe subtracted from performance, as did underweight positions in the outperforming Japanese and Australian markets.1
GMO - Stock Selection
Stock selection beat the benchmark by 0.6 percentage points in the fourth quarter. Holdings in Europe outperformed. Th is was somewhat off set by a position in Australia.1
In Europe, performance was led by Anheuser-Busch InBev (AB InBev), Galp Energia, and Allianz. For Belgian AB brewer InBev the stock displayed some weakness in the beginning of the quarter aft er the company unveiled plans to acquire rival SAB Miller, and we took this opportunity to add to the position. Though headline multiples on AB InBev appear high, we believe high returns on invested capital will prove more enduring than the market discounts for brewing sector, where the last decade has seen a wave of consolidation (the SAB Miller deal is yet another step). Th is consolidation has conferred enormous pricing power on the major players who have managed in many western markets to increase prices despite stagnant volumes. For AB InBev specifically, we believe the company is likely to exceed cost saving guidance on the SAB Miller deal while cash flows also remain robust. Meanwhile, Galp is an atypical energy company with increasing production that should ensure strong production growth in the foreseeable future, and its transformative production growth in Brazil keeps attracting investors. It also has best in class well fl ow rates (Brazilian pre-salt) and unit economics much better than the industry average as well as highly cash-generative downstream assets. Despite that, Galp trades at a steep discount to its peers. German insurance company Allianz showed confidence in its ability to deliver top- and bottom-line growth in the coming years aft er proving its resilience in a complex interest rate environment and a sluggish macroeconomic context. The company’s cash generation is compelling and the sustainability of the return to the shareholder fi ts our investment philosophy.
Australian shares of miner Rio Tinto were added into the portfolio in the third quarter on both valuation support and hopes of a year-end restocking of iron ore by Chinese steel mills. Th is did not happen and we have since exited the position at a loss.
GMO - Currency and Hedging
The U.S. dollar appreciated against most of the benchmark currencies in the quarter. The euro fell 3.0%, and the U.K. pound declined 2.7%. The Australian dollar was one of the few currencies that rose, gaining 3.7%, while the Japanese yen was relatively fl at, losing 0.5%.
In October we closed the hedge against the euro. Our overweight position in the Eurozone has come down significantly as we have harvested gains and found value elsewhere. We see the euro as reasonably valued against the dollar and the account is currently unhedged.