Fourth Quarter Market Discussion
The relative calm of the third quarter gave way to a new wave of volatility in global markets. Currency movements, ongoing concerns about Brexit fallout, and a surprise result in the U.S presidential election injected uncertainty, and international equities were under pressure.
Investors largely viewed Donald Trump’s victory as bullish for the U.S. economy and adopted a risk-on stance in response. As a result, the Yen weakened and Japanese exporters in Industrials benefited. A stronger U.S. dollar put pressure on Emerging Markets, but some of the weakness was offset by firmer energy prices. The overhang from the expected economic split by the United Kingdom (UK) from the European Union created headwinds and UK stocks lagged.
Security selection was positive on a relative basis with names in the majority of sectors helping the portfolio outperform the Russell Global® ex-US Small Cap Index. The Fund’s holdings in Real Estate and Consumer Staples led the way higher. A stock-specific issue in Health Care was the primary detractor to relative and absolute performance.
On a regional basis, holdings in Australia were top contributors, followed by names in the United Kingdom and Brazil.
A boom in free cash flow? Holdings in Materials were down modestly on an absolute basis but outpaced the benchmark, and the group contained a top contributor. Incitec Pivot Limited (IPL AU), an Australia-based leader in explosives and a well–established producer of fertilizer, was a top performer after the company began operations in its newly completed ammonia plant located in Louisiana.
This new facility was completed under budget and allows the company to take advantage of inexpensive North American natural gas in the ammonia production process.
The plant should mark the end of an eight-year capital expenditure cycle. As the company’s investment needs ebb, we expect free cash flow will surge. The additional funds could be used to repurchase shares or will help the business weather soft demand in the future.
Additionally, management’s cost-cutting initiatives have been effective, and we expect margins will lead to upside earnings surprises as product prices recover from tepid demand in farming and mining.
Going on defense. Industrial holding Chemring Group PLC (CHG LN) boosted results. The supplier of flares, sensors, and electronics in the Defense industry was up due to a combination of currency and geopolitical developments.
Weakness in the British pound spurred by Brexit concerns benefited the UK-based company as its products should be more competitively priced compared to those from countries with stronger currencies. Results from the U.S. elections were also viewed by investors as constructive for defense spending as a whole, with Chemring being rewarded along with other players in the space.
A stock offering in the beginning of 2016 helped bolster the company’s balance sheet, and we have been pleased by its consistency in meeting earnings expectations for the past several quarters. Trading at 1.1x book value, Chemring is priced at a discount to its long-term historical average and at the lower end of its five-year range.
Misdiagnosed. Trinity Biotech PLC (TRIB), a developer and manufacturer of diagnostic products, fits our strategy of holding businesses with competitive advantages that should allow them to grow faster than peers. The stock was down sharply after pulling its bid for Federal Drug Administration (FDA) approval of a rapid test used for detection of heart attacks in emergency room settings. The test showed promising results, but the company rescinded its application based on an FDA recommendation.
The decision was a major disappointment, but the market’s reaction, in our view, is overblown. Trinity remains a premier diagnostics company in diabetes testing. Trinity is also a key player in the HIV rapid test diagnostic market in Africa and controls a third of the segment in the U.S. The company’s infectious disease line generates $43 million in annual sales—equal to about one-quarter of the Dublin-based business’ market cap.
Japanese Industrials reaped the rewards of a depreciating Yen in recent months. We’ve trimmed on the strength and our overweight to the country has essentially been erased. The move reflects our approach of harvesting gains to mitigate risk and not a sign of negative sentiment in the area.
Conversely, weakness in the UK has resulted in several names hitting our watch list and we have added companies opportunistically.
Outlook and Positioning
The volatility that dominated global markets for much of 2016 should persist into the first half of the year. Fallout from the Brexit vote remains on the horizon as does the impact of a new administration in the U.S. Questions about the strength of European banks is an additional wildcard that could have a material effect on the economy as well as equities.
We cannot control macro factors but, as bottom-up investors, we can capitalize on the opportunities that emerge in response to external events. As the chart shows, the performance gap between international and domestic stocks is wider than it’s been in the past 20 years. Additionally, valuations for international stocks remain significantly more attractive than U.S. stocks. We view the discrepancy as an opportunity to own a portfolio of businesses trading at compelling valuations that is diverse by region, sector, and industry.
Time for a Reversal?
Source: Bloomberg L.P., Russell®, and Heartland Advisors, Inc., 7/31/1996 to 12/30/2016
Economic predictions are based on estimates and subject to change.
Past performance does not guarantee future results.
Japan remains attractive from a long-term perspective, but strength in economically sensitive areas has made bargain hunting more challenging. While Developed Europe remains fertile ground for investment ideas we are also seeing opportunities in Emerging Markets such as Brazil.
We are comfortable with our Emerging Market holdings, but believe political headwinds and inflationary pressures require heightened attention when evaluating companies in the group.
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.