International Equity Strategy

September 2019

THE MARKET ENVIRONMENT
Major global markets finished mixed in the third quarter. August served as the most volatile month, bookended by relatively flat performance in July and September. Most recently, trade negotiations between the U.S. and China are providing a positive impact on global markets as the two countries agreed to restart trade negotiations in early October. Ahead of the planned trade talks, the U.S. delayed a planned tariff hike on Chinese goods from October 1 to October 15 in “a gesture of good will.” On the other hand, China exempted soybeans, cancer drugs and pesticides, among others, from tariffs on the U.S.

Despite the tempered situation between the U.S. and China, U.S. President Donald Trump made headlines for another matter late in September as a whistleblower brought to light the leader’s July telephone conversation with Ukrainian President Volodymyr Zelensky. In the call, Trump asked Zelensky to “look into” 2020 U.S. Democratic presidential hopeful Joe Biden and his son, news of which spooked investors. In response, Speaker of the U.S. House of Representatives Nancy Pelosi announced a formal impeachment inquiry on Trump to further delve into the matter. 

Elsewhere, the political crisis in the U.K. carried on as the U.K. Supreme Court ruled Prime Minister Boris Johnson’s suspension of Parliament earlier in the third quarter as unlawful. Once back in session, the body passed a law requiring Johnson to request an extension from the European Union (EU) on the U.K.’s current exit date of October 31, should the country fail to agree on a Brexit deal with the EU prior to the bloc’s summit on October 17-18. These ongoing situations stoked continued uncertainty surrounding global markets. 

Meanwhile, the European Central Bank opted to lower interest rates and ramp up quantitative easing at its September meeting, which prompted the euro to fall to a two-year low. The Federal Reserve also trimmed U.S. interest rates twice in the third quarter, while the Swiss National Bank and the Bank of Japan maintained negative interest rates in September. 

In our estimation, the lingering memory of the Great Recession is causing investors to be much more fearful than they should be at present. We see no signs of excesses in the economy that typically precede a recession. We believe the noise present today will dissipate and trade will ultimately flow more freely in the next several years. In the meantime, we weather the short-term distractions and volatility in pursuit of long-term results.

 

THE PORTFOLIO
Top Performers:
Investors responded favorably to NAVER’s second-quarter earnings release in July, which showed accelerated growth in its core search and e-commerce businesses, driven by steady growth in user traffic and improved advertising products. We continue to believe the company’s core business will grow at a healthy rate as there remains ample room to partner with advertisers and improve their return on investment. In addition to the strong results in its core business, NAVER also announced it will spin out NAVER Financial, its financial technology business. NAVER Financial is the leading digital payments company in South Korea and has significant scope for growth and monetization. Finally, after several years of investment, NAVER’s other platforms, such as Webtoons (one of the largest online comics platforms globally) and V Live (live streaming platform for music artists), have begun to monetize and should help contribute to strong growth in the future, in our view. With accelerating growth, improving profitability and strong market positions across most of their businesses, we continue to believe the company NAVER is attractively valued. 

Intesa Sanpaolo reported second-quarter total revenue of EUR 4.68 billion and net income of EUR 1.22 billion, which outpaced market forecasts by nearly 9% and 35%, respectively. For the fiscal first half, the company’s results were broadly in line with our expectations. While we were disappointed that net interest income declined 4.7%, we were pleased that loans grew 0.2%. Net income exceeded the halfway point of our full-year projections, and management expects full-year net income will be higher than in 2018, citing growth in revenues, continuous reduction in operating costs and a decrease in the cost of risk. Intesa continues to demonstrate excellent cost control, from our perspective, as lower administrative expenses (-6.2%) and personnel costs (-2.6%) led to a decline in operating expenses of 3.2%, despite investments to increase growth. Lastly, Intesa reached an agreement with Prelios to sell a portfolio of unlikely-to-pay loans and a servicing agreement for such loans. Including this sale, Intesa will achieve 80% of its 2021 deleveraging target.  

In our view, the makeup of H&M’s second-quarter sales were encouraging as the company’s online (+20%) and new business (+18%) segments both grew quite strongly in local currency. Sales in China (+8%), the U.K. (+5%) and Sweden (+5%) also delivered strong growth in excess of space growth. The sales successes are also translating to lower markdowns, which fell 100 basis points in the second-quarter year-over-year and were consistent with H&M’s guidance. Later in the third quarter, the company’s nine-month sales release showed an 8% increase in sales in local currency year-over-year, which bested consensus expectations. H&M also benefitted in the third quarter from a positive analyst note that upgraded the company. We believe H&M is progressing well, thus far, on its strategy for improvement, adding to our confidence in the investment.

Bottom Performers:
In late July, Continental issued preliminary second-quarter earnings results and a second-half profit warning. While the warning itself was somewhat expected, analysts were surprised by the magnitude of the shortfall. In early August, the company’s official second-quarter results showed weaker revenue and earnings from the year-ago period. Revenues fell across product groups with the exception of tires, where revenue was unchanged year-over-year. Even though CFO Wolfgang Schäfer stated that results were impacted by an ongoing slowdown in global automotive production, management left full-year guidance unchanged. To be better positioned for the shift to electric vehicles, the company will no longer invest in manufacturing injectors and pumps for gas- and diesel-powered engines. CEO Elmar Degenhart sees this “technological upheaval” as a significant growth opportunity for the company. Continental later unveiled a restructuring plan that includes reducing costs by EUR 500 million annually by 2023. We like that management has implemented this proposal as we believe it will benefit shareholders over the long term. 

Daimler issued two profit warnings before releasing fiscal first-half results that, as predicted, were weak. Revenue of EUR 42.65 billion was slightly better than market expectations, while an earnings loss of EUR 1.56 billion led to negative earnings per share of EUR 1.24. Total revenue growth from industrial operations fell short of our estimates, driven by poor performance in the Mercedes-Benz segment, and margins were weaker than we had projected across the firm. However, revenue growth in the trucks, vans and buses segments all exceeded our forecasts. Subsequently, we met with CFO Harald Wilhelm and discussed the company’s current challenges and planned improvements and solutions. We also met with Arno van der Merwe, president and CEO of Beijing Benz Automotive, which is one of Daimler’s most important joint venture partnerships in China. We discussed several aspects of operations in China where it sells more than 600,000 cars and about 70% of which are manufactured there, which supports margin expansion. In our view, Daimler is a high-quality company with shares that are trading below our estimate of intrinsic value. 

Although investors reacted negatively to Glencore’s fiscal first-half total revenue, adjusted earnings and earnings per share that fell short of market expectations, we saw the results as mixed. Production was broadly in line with our expectations, while lower commodity prices hampered earnings – average prices declined across all key commodities, including copper (-11%), nickel (-11%), zinc (-16%), coal (-22%) and cobalt (-58%). Even though price levels are out of the company’s control, management has been watchful for supply disruptions and can adjust output accordingly. In addition, management has been working to calibrate production at three sites: Katanga (copper/cobalt in the Democratic Republic of Congo), Mopani (copper in Zambia) and Koniambo (nickel in New Caledonia), which has pressured margins and near-term profits. We expect this pressure will ease as production improves at these locations. Despite lower earnings, we were pleased that Glencore generated a healthy amount of free cash flow, which reached $3.1 billion at the end of the reporting period and was ahead of our estimates. Lastly, the company repurchased $1.3 billion of the current $2 billion share buyback plan and has intentions to complete the program by the end of 2019.

During the quarter, we initiated positions in Henkel, Open Text and UPM-Kymmene. We also received shares of Prosus as a result of a Naspers spin-off. We eliminated Alimentation Couche-Tard and Danone from the portfolio.

Past performance is no guarantee of future results.

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Past performance is no guarantee of future results.

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