Brandes Investment Partners, L.P. Emerging Markets Equity Strategy Notes Second Quarter 2018 (April 1 – June 30, 2018)
The Timothy Plan Mutual Fund Emerging Markets portfolio declined 9.8% (gross of fees) in the second quarter, underperforming its benchmark, the MSCI Emerging Markets Index, which fell 8.0%.
Currency impact, geopolitical turmoil and fears of economic slowdown due to trade wars and rising U.S. interest rates were the main factors pressuring many of our holdings.
Our positions in countries with external financing vulnerabilities or current account deficits, namely Turkey, Brazil and Argentina, were the hardest hit. Currency declines in these three countries, where we were overweight relative to the MSCI Emerging Markets Index, accounted for the largest driver of the quarter’s underperformance. We believe the challenges associated with the currency fluctuations are short term in nature and we remain optimistic about the prospects of our holdings.
Notable detractors included Turkish banks Vakif Bank and Garanti Bank, as well as real estate investment trust Emlak Konut.
Among our Brazilian holdings, education companies Kroton Educacional and Estacio Participacoes, as well as integrated oil company Petrobras and its subsidiary Petrobras Distribuidora weighed heavily on returns.
Kroton and Estacio reported lower-than-expected near-term results and weak 2018 earnings guidance. The companies have also been facing regulatory policy uncertainties and a muted economic environment coupled with high unemployment in Brazil. We believe this negativity has been more than accounted for in Kroton’s and Estacio’s share prices. Our longer-term investment theses for the companies remain positive as they traded at 9.0x (Kroton) and 9.5x (Estacio) on a forward price-to-earnings basis as of June 30.
Over the past two months, Petrobras has been struggling with a diesel fuel pricing fiasco and investor concerns that its 2011-2014 pricing restriction issues may reappear. In late May, Brazilian truck drivers went on strike after Petrobras raised diesel fuel prices by 10%. The strike triggered a number of events, including the resignation of Petrobras’ chief executive officer after the government intervened to require concessions in diesel prices. Non-intervention of government in management was a key demand when he accepted the role.
Despite government commitment to reimburse Petrobras for any losses from the lower diesel prices, its shares declined, as many investors were worried that the company would lose independence in setting domestic fuel prices or that the government would not fully reimburse the losses. We believe the market has overreacted and we took advantage of the sell-off to add to our position in Petrobras.
Meanwhile, sizeable foreign exchange depreciation and the spillover effects from higher inflation and lower gross domestic product growth estimates hurt Argentinian shares, including those of oil & gas firm YPF. In early May, the Argentinian government announced a fuel-price freeze agreement with YPF and two other major oil companies operating in the country as part of its efforts to control consumer prices.
Positive contributors included Hong Kong and Chinese retailers, most notably Lifestyle International and Lifestyle China, as well as Bosideng, which all continued to enjoy improvements in the Chinese retail market. For Bosideng, a strong increase in its profitability, which was up almost 60% year-over-year, drove up the share price. Additionally, the down clothing company has been in talks with a major e-commerce player, Alibaba Group, about a strategic partnership.
Indian technology company Infosys and Brazil-based food producer Marfrig Global Foods also helped performance.
In early April, Marfrig announced the acquisition of a majority stake in U.S. meatpacker National Beef from Leucadia National. The deal made Marfrig the second-largest beef producer in the world and strengthened its footing in the U.S. meat industry. Marfrig has also been in discussions with several companies to sell its subsidiary, Keystone, a major supplier of meat to McDonalds. The company plans to use some of the sale proceeds to continue to improve its levered balance sheet.
Select Activity in the Second Quarter
The Emerging Markets Investment Committee exited the strategy’s position in Lifestyle China as the shares strongly appreciated this year and reached our estimate of intrinsic value.
Moreover, the increased market volatility in the quarter provided the opportunity to initiate positions in a number of companies that we believe are undervalued based on our long-term purview.
New purchases included Mexican consumer finance company Gentera and U.K.-domiciled Vivo Energy, a leading fuel retailer in Africa. The investment committee also added Brazil-based credit and debit card operator Cielo and health care insurer Hapvida Participacoes.
Cielo is Brazil’s largest merchant acquirer/processor with 51% market share of credit and debit transaction volumes. Banco do Brasil and Banco Bradesco collectively own a 58.7% controlling stake in Cielo.
A merchant acquirer enables card payments by renting or selling a merchant a point-of-sale (POS) terminal, which captures pertinent information for a transaction and routes it for processing and settlement. Although its market share and fees per transaction have declined over the past seven years due to intensifying competition, Cielo has managed to double its earnings over the same period. It has offset pricing pressure with volume growth and increased revenues from renting its POS machines, as well as by entering the business of receivables discounting (i.e., providing faster payment to merchants as there is a 30-day settlement period for credit card purchases).
In our view, Cielo’s resilience in navigating the increasingly competitive market reflects the strength of the franchise. We believe Cielo’s revenues are cyclically geared to an uptick in consumer spending as the Brazilian economy recovers from recession, and the company should benefit as more and more people choose card payment over cash.
A key investment consideration is that Cielo’s current level of profitability does not appear sustainable. While transaction volumes should continue to grow over time, profits per transaction are likely to decline further from continued fee compression or cost increases due to more intense market rivalry. Additionally, future regulatory changes could have an adverse impact to profitability of the industry.
Given Cielo’s good balance sheet and competitive positioning, we consider it well placed to deal with these uncertainties and that the company’s share price seems to adequately imply the risks.
As discussed earlier, we took advantage of the recent market challenges (e.g., increased volatility, currency pressure, geopolitical tension) to allocate to what we consider undervalued businesses with solid fundamentals. While many have fled the asset class, we continue to believe it is an exciting time to invest in emerging markets companies, in particular for value investors.
As of June 30, emerging markets value stocks were among the very few asset class subsets that traded at a valuation level in line with its 10-year historical average. In comparison, emerging markets growth stocks traded at two standard deviations above historical average. There was only one other time in the last 20 years where emerging markets growth stocks were more expensive on a forward P/E basis.*
Furthermore, while growth companies tend to be perceived as higher “quality” as they have generally enjoyed stronger margins and returns on equity, as well as better sales and earnings growth than their value counterparts, the gap in these fundamentals (for value vs. growth companies) has actually narrowed over the last several years. Earnings growth discrepancy is at a 20-year low, while margin differentials have compressed.
In our view, the wide valuation gap, combined with narrowing differences in fundamentals between value and growth stocks, makes a compelling case for value investing in emerging markets.
In terms of strategy exposures, Brazil, Russia and Mexico remained key overweight positions as of June 30. Our weightings to Brazil and Mexico increased in the quarter as we added Hapvida Participacoes, Cielo and Gentera, and selectively averaged down on a number of our existing holdings given the market weakness.
On a sector basis, we maintained higher allocations to consumer discretionary and telecommunication services than the benchmark.
Our largest underweight positions remained in China and Taiwan, which coincided with our significant underweight to the information technology sector.
We believe the current positioning of the Brandes Emerging Markets Equity Strategy bodes well for the long term. Thank you for your continued trust.
*Based on forward price-to-earnings. EM value stocks represented by the MSCI Emerging Markets Value Index; EM growth stocks represented by the MSCI Emerging Markets Growth Index.
Forward Price/Earnings: Price per share divided by expected earnings per share.
Intrinsic Value: The actual value of a company or an asset based on an underlying perception of its true value.
Return on Equity: Net income divided by shareholder’s equity.
Standard Deviation: The dispersion of a data set relative to its mean.
The MSCI Emerging Markets Index with net dividends captures large and mid cap representation of emerging market countries. Data prior to 2001 is gross dividend and linked to the net dividend returns.
The MSCI Emerging Markets Growth Index with gross dividends captures large and mid cap securities exhibiting growth style characteristics, defined using long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.
The MSCI Emerging Markets Value Index with gross dividends captures large and mid cap securities exhibiting value style characteristics, defined using book value to price, 12-month forward earnings to price, and dividend yield.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
The foregoing Quarterly Commentary reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. The information provided in the commentary should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that the securities sold have not been repurchased. The actual characteristics with respect to any particular account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Unlike bonds issued or guaranteed by the U.S. government or its agencies, stocks and other bonds are not backed by the full faith and credit of the United States. Stock and bond prices will experience market fluctuations. Please note that the value of government securities and bonds in general have an inverse relationship to interest rates. Bonds carry the risk of default, or the risk that an issuer will be unable to make income or principal payment. There is no assurance that private guarantors or insurers will meet their obligations. The credit quality of the investments in the portfolio is not a guarantee of the safety or stability of the portfolio. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Securities of small companies generally experience more volatility than mid and large sized companies. Although the statements of fact and data in this report have been obtained from, and are based upon, sources that are believed to be reliable, we cannot guarantee their accuracy, and any such information may be incomplete or condensed. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Please note that all indices are unmanaged and are not available for direct investment. Past performance is not a guarantee of future results. No investment strategy can assure a profit or protect against loss. Market conditions may impact performance. The performance results presented were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regulatory environment may have a negative impact on future performance. The margin of safety for any security is defined as the discount of its market price to what the firm believes is the intrinsic value of that security. The declaration and payment of shareholder dividends are solely at the discretion of the issuer and are subject to change at any time.
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