International Equity Strategy

December 2018

THE MARKET ENVIRONMENT
An overabundance of geopolitical headlines, ranging from trade concerns to the continuing Brexit saga, shook global markets in the fourth quarter. Threats of escalation to ongoing trade tensions between the U.S. and China by President Donald Trump’s administration spooked investors early in the quarter. The U.S. expressed a preparedness to extend tariffs on remaining Chinese imports should upcoming discussions prove fruitless. Taking the trade wars into consideration, the International Monetary Fund trimmed its outlook for 2019 economic growth by 0.2% for the U.S., China and the global economy to 2.5%, 6.2% and 3.7%, respectively. However, trade tensions were eased somewhat after a meeting between U.S. President Trump and Chinese leader Xi Jinping resulted in a postponement of planned tariff increases scheduled for January 1.  Later, the U.S. implemented a partial shutdown of its government owing to an impasse over border security and immigration policy, which added further strain to U.S. markets. 

Elsewhere, Brexit negotiations faltered, which prompted the resignation of U.K. Brexit Secretary Dominic Raab and the decline of the pound sterling. Despite the discord, U.K. Prime Minister Theresa May survived a vote of no-confidence held by her own Conservative Party in December. In Japan, third-quarter gross domestic product growth was revised downward from -1.2% to -2.5% at an annualized rate, which was down from 2.8% growth in the second quarter. Likewise, the pace of economic growth in China decelerated to 6.5% in the third quarter from 6.7% in the second quarter, with fears that fourth-quarter growth could sink to an even lower rate. 

Erratic energy prices also served as a source of concern during the reporting period. Supply/demand imbalances and other market factors caused key energy benchmarks to fall 40% by year-end from nearly four-year high levels reached in October. In response, the Organization of the Petroleum Exporting Countries and other countries agreed to a reduction in production of 1.2 million barrels a day effective for six months beginning in January. 

Geopolitical events have been and will always be part of the investing climate. Elections, trade disputes, wars and other forms of conflict tend to have large impacts on short-term stock prices. However, we believe that underlying value is largely unaffected by macro events. Instead, a company’s true worth is based on its ability to generate cash and create value for its owners over the long term, in our view.  As value investors, this is what we study, analyze and price. We will remain focused on fundamental factors and utilize discipline to take advantage of the market’s volatility and investors’ impatience. We have faced numerous situations like this in the past and have been able to create long-term value for our investors. We remain confident that we will continue to deliver strong long-term results, especially given where valuations are today.

THE PORTFOLIO
Top Performers:
Despite a difficult macroeconomic environment driven by inflationary fears, Bank Mandiri reported strong loan growth in the third quarter, tracking ahead of full-year estimates. The company’s stock price also increased due to a rally in the Indonesian stock market along with an improved outlook on the Indonesian banking sector as a whole. We believe Mandiri continues to be well positioned to benefit from consumer-led, structural macroeconomic growth while maintaining a cost of funding advantage over its smaller competitors. Our investment thesis for the company is intact as we believe its capital position is solid and its management team is working to enhance shareholder value.

Willis Towers Watson delivered strong third-quarter earnings results, in our view, as organic growth reached 5% after totaling 3% in the second quarter. Management now believes full-year organic growth will be closer to 4% after originally projecting a range of 3-4%. In addition, the company lowered its fiscal-year tax rate guidance from 22-23% to 20-21%, which was lower than our estimates and drove increases to earnings per share estimates for the full-year period as well. We believe that Willis possesses several inherent strengths. The company is one of the largest brokers in the world and operates in the attractive insurance brokerage industry. In our view, the industry does not bear underwriting risk, requires little capital, is highly free cash flow generative and traditionally earns high operating profit margins. We continue to believe that Willis is significantly undervalued relative to its normalized earnings power.

Axis Bank’s fiscal first-half earnings results exhibited a continued underlying improvement in asset quality, which is the key driver of the company’s profit normalization, in our view. Despite slower loan growth, management believes activity should pick up in the second half, particularly on the corporate side, which accounts for over one-third of total loans. Axis has also more than doubled its market share in credit card spend over the past five years to about 11%. As a whole, our investment thesis is driven by the normalization of credit costs where trends remain positive, in our estimation. We believe India’s strong economic growth, coupled with low financial penetration, should result in attractive long-term growth rates for the Indian banking sector. We have confidence that the company is a solid investment that should reward shareholders into the future.

Bottom Performers:
BNP Paribas issued third-quarter revenue, operating income and profit before tax that missed market forecasts, while net income exceeded projections. The company experienced negative leverage in all three of its operating divisions on an underlying basis, which management attributed to the persistent low interest rate environment, increased investment in the international financial services division, and in particular, sluggish trading conditions in the corporate and institutional banking division. However, the substandard operating results were not especially surprising to us given the difficult end-market conditions coupled with costs invested to restructure parts of the business. In October, we met with CEO Jean-Laurent Bonnafé who expressed confidence that BNP will reach its 2020 return on equity target of more than 10% and expects this ratio will approach 11% within the next five years if market conditions remain constant. The firm has been pressured this year by fears about European politics, although these headlines have not reduced our assessment of the long-term intrinsic value of the company. BNP possesses a dominant retail banking franchise along with a diversified business base, which allows for cost of funding, liquidity and scale advantages versus its smaller peers. The firm also improved its risk profile by exiting riskier business lines and increasing its capital level. This approach has worked to further strengthen its balance sheet. BNP has been focused on a cost transformation project that is front-end loaded, so we believe it should start generating greater net savings in 2019 and 2020.

Credit Suisse Group’s share price suffered from general market pressures along with third-quarter earnings results that were relatively weak, in our view. Key metrics tracked below our full-year estimates, which was not especially surprising given the recent downturn in equity indexes along with disappointing results in capital markets that both had a negative impact on revenue generation. However, we were pleased that management partially mitigated revenue challenges by way of better cost reduction (e.g., adjusted operating expenses declined 6.3%). Importantly, the company continues to follow through on its commitment to reduce overall costs, evidenced by the adjusted cost base that fell from CHF 21.2 billion in 2015 to roughly CHF 17 billion in 2018 (constant currency). Management also believes there remains scope for further cost reductions going forward. CEO Tidjane Thiam stated that he anticipates profit improvement in 2019 from factors under the company’s control, such as lower funding and restructuring charges. Lastly, Credit Suisse’s board of directors approved a share repurchase program to buy back up to CHF 1.5 billion and anticipates repurchasing at least CHF 1 billion in 2019, while noting expectations for a similar sized buyback for 2020. Overall, we remain satisfied with the strides taken by the management team to strengthen the company’s underlying fundamentals.

CNH Industrial released fiscal nine-month results that were solid, in our assessment, and aligned with our estimates. Total revenue rose 11.5% from a year earlier and the company realized revenue increases in all segments. Total earnings grew an impressive 45% as the company continued to achieve margin expansion across the business, particularly in the key agricultural and construction equipment segments. While management noticed that buyer sentiment for agricultural equipment has weakened somewhat, demand is still strong. The company expects demand will stay constant for the near term. Importantly, price realization remained positive across all geographies and increased 3% year-over-year in the third quarter. Likewise, construction equipment revenue grew nearly 25% and margins expanded by 390 basis points, while pricing across this segment was also positive (roughly +3%). Despite these strong results, CNH’s share price dropped, as third-quarter revenue missed market projections and management reaffirmed full-year net sales and earnings per share that both fell short of market expectations.  

During the quarter, we initiated positions in Ctrip.com International and NAVER. There were no final sales.

Past performance is no guarantee of future results.

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Past performance is no guarantee of future results.

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