Third Quarter Market Discussion
Global markets got a rare break from macro shocks. Central banks were largely silent, U.S. dollar strength remained benign, and the UK’s economy had yet to show damage from the country’s vote to split from the European Union (Brexit).
The lack of surprises was welcome relief and provided widespread strength for international equities. Buying was broad with economically sensitive sectors performing well. On a regional basis Europe and many Emerging Market countries fared best.
Although the markets cheered the quiet macro environment, questions continue. The fallout from the Brexit vote remains on the horizon, commodity strength has eased in recent weeks, and markets are increasingly skeptical of the effectiveness of central bank policies to stoke growth. The unsettled picture is reflected in consumer confidence surveys in Europe. As the chart shows, skepticism remains about the direction of the economy in the coming months.
Consumer Optimism Fading
Source: Bloomberg L.P., 1/31/2015 to 9/30/2016
Security selection was positive with names in several sectors helping the portfolio outperform the Russell Global® ex-US Small Cap Index. The Fund’s holdings in Financials and Utilities led the way higher. An underweight to and selection in Information Technology (IT) detracted. Much of the weakness in the group came from a stock-specific issue tied to an Israeli technology company focused on security products.
Health Care was a source of strength with much of the excess performance coming from our Health Care Equipment & Supplies stocks.
Developing a strong record. Stock selection in Real Estate was flat on a relative basis, and performance at the security level varied greatly. Far East Consortium (35 HK), a property development and management company with projects in Hong Kong, Australia, UK, and China, was a top performer after it announced solid earnings. Shares trade at approximately 60% of our sum-of-the-parts estimates due in part to pessimism over prospects for the Chinese economy.
The company has a robust pipeline of projects nearing completion, which should translate into significant revenue improvements during the next two years. Barring a further downturn in the Chinese market, we believe Far East’s geographical diversity will help the firm continue to grow top-line revenue and the valuation gap should shrink further going forward.
Similar business, different results. Keck Seng Investments (184 HK), a hotel owner/operator, sold off after its earnings declined on a year-over-year basis. Much of the shortfall was the result of foreign exchange effects from revenues around the globe. Its properties’ fair value estimates also declined, which added to the sour sentiment of investors.
Keck Seng owns high-quality facilities in prime locations, and we believe the markdown of property values is short-lived. The company has a successful record of deploying capital opportunistically, which has driven earnings and should continue to do so in the future.
Grabbing market share? An overweight to and selection in Industrials were additive, but the group contained a key detractor. Semperit Holding (SEM AV) was down after announcing earnings would fall short of estimates for 2016.
The company operates two business lines—industrial products, including hoses, conveyor belts, and molded rubber products, and a medical division that supplies surgical and latex gloves throughout Europe. The shortfall stemmed from management’s decision to invest heavily in building out the medical side of the business to expand its capacity.
We expect the investment will convert to greater sales and margins should improve as the cost of new equipment is spread across more units produced.
With the stock trading at less than 13x estimated 2017 earnings and with a 5% dividend yield, we believe the market is focusing too heavily on a temporary shortfall and that investors could be rewarded over the long term.
As the Yen has appreciated in recent months, skepticism about the strength of the Japanese economy has increased. We believe fears are overblown and have created opportunities to own solid businesses trading at compelling valuations. Industrials is an area where we have found some attractive investments, including recent addition Okuma Corp. (6103 JP).
The company manufactures complex machine tools used in industries such as Aerospace and Automotive. Shares have fallen more than 50% over the past two years as demand for the types of products it sells has slumped. The selloff has resulted in shares trading at just 1x book value.
Orders for the last two quarters have exceeded sales, and a backlog is growing. Further, the company is completing a capital investment cycle and we expect free cash flow will improve as spending subsides. We believe these factors make for an attractive risk-reward profile for the company.
Outlook and Positioning
Global markets benefited from a break in macro events, but we expect the lull will prove temporary. Fallout from the Brexit vote remains on the horizon as do the implications of central banks’ increasingly ineffective efforts to drive economic growth.
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. Despite macro challenges, Japan continues to boast strong average earnings growth rates, and more companies are utilizing their excess cash to reward shareholders by boosting dividends and buying back shares. We are also becoming increasingly interested in names in the UK for the portfolio.
We are comfortable with our Emerging Market holdings, but are cognizant of 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.