A solid quarter for many of the world’s markets came to an abrupt halt after the surprise decision by UK voters to split with the European Union.
Prior to the referendum, a softening dollar and firming energy prices boosted prospects for commodity-rich emerging economies as well as developed markets reliant on exports. Following the final tally, investors clamored for safety and drove the dollar higher. Yields on U.S. treasuries fell. Fears that the move would push a weak global economy into recession led to heavy selling in cyclical areas. British Financials were among the hardest hit and Energy gave up strength gained during the recent months.
On a regional basis, Japan suffered in sympathy with Europe as the Yen strengthened and dealt a blow to the country’s goals of fanning inflation and making its goods more affordable abroad.
The period ended with more questions than answers. As European leaders struggled to address details of if, when, and how the political and economic divorce would take place, volatility spiked and selling pressure was broad.
Security selection was positive with holdings in a majority of sectors contributing to the Fund outperforming the Russell Global® ex-US Small Cap Index. Global uncertainty led to a flight to safety and strong performance among precious metals. As a result, our Materials holdings were among the Fund’s top performers on a relative and absolute basis. Our Industrial stocks detracted due primarily to weakness coming from machinery names.
Health Care was a source of strength with the majority of excess performance coming from Japanese pharmaceutical company Fuji Pharma (4554 JP).
Strong medicine. Fuji Pharma, a manufacturer of generic injectable drugs and contract maker of compounds for other pharmaceutical companies, was a top contributor. During the past few years, the company has added licensed branded drugs to its lineup. The new approach is beginning to produce results. Fuji reported high single digit revenue growth and a 26% increase in operating profit improvement during the most recent quarter.
We believe its improved earnings are a sign of things to come. Trading at 1.2x book value versus a peer global average of 3.65, the company remains attractive versus its international peers; however, it is trading at a smaller discount relative to other pharma companies in Japan. As such, we will continue to monitor the stock and may trim if valuations climb significantly in the near term.
Seal of approval. In addition to strong performance by the Fund’s precious metals holdings, a chemicals company was a top contributor in the Materials space. Green Seal (1262 TT) is the dominant maker of plastic film used in food and household goods packaging. Its shares rose as it continued to make progress on expansion in China. Utilization rates for its new manufacturing lines have reached 80% and should improve margins. We anticipate the additional manufacturing capacity, along with advancements stemming from research and development efforts, will create inroads in developing higher margin customized products.
Despite being one of the most efficient manufacturers in the space, Green Seal trades at just 9.6x estimated 2017 earnings versus a peer average of 14.3x.
Getting ahead of itself. More than a quarter of weakness in Industrials was tied to a single holding, Sung Kwang Bend Co. Ltd. (014620 KS), a South Korea-based manufacturer of large industrial fittings used by petrochemical factories, ship builders, and nuclear power plants. The stock was up sharply during the first quarter, but fell back recently on profit taking. We had trimmed our exposure during the run up as we believed valuations had gotten ahead of fundamentals. Recent weakness provided an opportunity to rebuild our position at what we believe are favorable prices.
The company is one of a handful of players certified as meeting the standards to create products for fittings and valves in the highly specialized industry. The rigorous standards required to become an approved manufacturer make it difficult for new entrants to the space. Trading at just 54% of book value versus a peer average of 110%, we believe the market has gone too far in selling the name and is not fully appreciating the potential for topline improvements when the global economy strengthens.
Outlook and Positioning
Political and economic events are injecting heightened volatility in global markets, and we expect more of the same in the months ahead. Fallout from the Brexit vote highlights the dynamic. While the British Pound and European banks were among the hardest hit, effects from the vote were felt as far away as Japan and the U.S.
As bottom up investors, we cannot control macro factors, but we can capitalize on the opportunities that emerge in response to external events. This approach has led to Japan remaining a top source of compelling opportunities for the portfolio.
The country’s monetary policy has yet to produce sustained easing of the Yen and deflation remains a stubborn concern. Corporate governance has improved and there has been an uptick in share buybacks from cash-rich businesses, but progress is lagging early expectations.
Despite these macro challenges, the region boasts some of the highest average earnings growth rates, and, as shown, valuations appear much cheaper relative to other parts of the world.
Japan: Attractive Discount Based on P/E
Source: Bloomberg L.P. and Standard & Poor’s, 4/5/2013 to 6/30/2016
The United States, Eurozone, and Japan are represented by the S&P 500 Index, S&P Euro Index, and TOPIX Index, respectively.
Past performance does not guarantee future results.
We continue to monitor Emerging Markets, but are sensitive to the lack of economic clarity in many countries as well as the disproportionate effect U.S. dollar strength can have on these markets.
Our focus remains 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.