Widespread selling gave way to an uneven rebound with markets tied to oil, commodities, and emerging economies benefiting. Equities in developed countries linked to central bank policies struggled.
The inflection point came in late January and coincided with the Bank of Japan adopting negative interest rates. Investors viewed the move as evidence that Prime Minister Abe Shinzo’s efforts to normalize the country’s economy were stalling. An unexpected offshoot of the policy was a stronger Yen.
The stronger Japanese currency and resulting softening of the U.S. dollar gave a lift to Emerging Markets (EM). The relief came on two fronts—it eased pressure for leveraged countries that hold dollar denominated debt and it provided a boost to materials and oil.
Despite moves by China’s central bank to spur consumer borrowing and spending, investors remained concerned about the country’s transition from a manufacturing to service economy. We continue to monitor the transition and have taken weakness as an opportunity to selectively add to our holdings.
Europe struggled as a new wave of stimulative measures by the European Central Bank (ECB) were viewed as a sign that deflation remains a concern for the region. We believe that worries related to falling prices will persist as the region slowly reduces its debt load. We continue to monitor the situation and despite the tepid economic environment in Europe, the valuations adequately reflect this phenomenon and it remains a fertile hunting ground for investment ideas.
A weakening U.S. dollar and firming oil prices benefited Emerging Markets, including many of our holdings. Inflation fears fueled by a softer dollar led to strong performance by precious metals. As a result, our Materials holdings were among the top performers for the period. Security selection detracted with most of the weakness coming from stocks in Financials and Information Technology (IT). The Fund lagged its benchmark, the Russell Global® ex-US Small Cap Index.
Strong stock selection in Industrials bolstered results despite the sector being essentially flat for the Index. We’ve found several attractive opportunities among Machinery companies, and the industry contained a top contributor.
Hitting on all cylinders. DEUTZ AG (DEZ GY), a manufacturer of diesel engines primarily for the European market with more than 35% of its sales tied to construction equipment, was a top performer. The company reported earnings in line with analysts’ estimates, but expects margins to increase moderately in the year ahead. Trading at book value and 4x enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA), we believe DEUTZ is attractively valued and its low cost position will make it an early beneficiary once economic growth improves.
A Canadian boost. On a regional basis, Canada was a source of positive performance. Much of the strength was tied to rising gold and oil prices but a rising Canadian dollar also helped. While the strengthening currency is a recent development, it will be a welcomed change if it continues for businesses such as Reitmans Ltd. (RET.A), a women’s retailer. The company was a solid contributor, but its impact was tempered when it stumbled at the end of the quarter. The previously weak Canadian dollar negatively impacted its gross margin causing an earnings shortfall.
Despite the lackluster earnings results, we have been encouraged by management’s progress in closing a number of locations and an increase in same store sales. Trading at approximately 80% of book value and with a dividend yield of more than 4%, we believe the stock remains attractive. Additionally, margins should increase when the consumer loosens her purse strings.
Delayed recognition. More than half of the weakness in IT was tied to a single holding, Wasion Group Holdings, Ltd. (3393 HK), a Hong Kong-based manufacturer of electronic power meters and data collection terminals. The stock sold off in part due to general weakness in China’s economy and was further hurt by a delay in a contract award from the Chinese government. Because the contract wasn’t approved until late in 2015, payments were pushed into the new year and revenues fell short of expectations for the most recent quarter.
Given its strong appreciation, we aggressively trimmed our exposure in the back half of last year; however, we began buying after this quarter’s sell-off. The stock is compelling, having fallen nearly 60% from its 2015 high and trading at 1.1x book value and 8.5x trailing earnings.
Outlook and Positioning
Economic challenges continue to create attractive valuations globally; we are taking advantage of pricing pressure by upgrading our holdings opportunistically. We exited nine positions this quarter and added three. Our exposure to Energy is down modestly and we’ve reduced our allocation to Consumer Staples.
The turnaround for EM countries is welcomed, but we won’t be convinced it has staying power until we begin to see a pattern of positive earnings revisions. As such, we view the next three to six months as critical to the staying power of the recent rally.
While we acknowledge that an uptick in strength of the U.S. dollar may be a setback for the group, we believe valuations, as shown, have returned to the levels that previously coincided with substantial double digit returns over the next ten years.
Compelling Valuations in Emerging Markets
Cyclically-Adjusted Price/Earnings Ratio*
Source: © BCA Research 2016, 12/31/1987 to 3/31/2016
*Calculated using Emerging Market stock prices and the six-month moving average of earnings per share in U.S. dollar terms, and then deflating by U.S. consumer price inflation (source of data MSCI Inc.)
Past performance does not guarantee future results.
China appears poised for continued challenges in its quest to become a consumption-based economy. We expect this will result in slower growth in the near-term. The chance for a policy mistake also remains during this transition period. However, if weakness continues, it should provide an opportunity for investors to gain exposure to the region at discounted levels.
We continue to focus on finding sound businesses with strong management teams that have a history of prudent capital allocation decisions. We believe owning dividend paying companies with robust balance sheets provides downside protection while allowing for upside potential.
Thank you for the opportunity to manage your capital.