Glid­ing over the speed bumps

Two strate­gies for in­ter­na­tional eq­ui­ties

Investment Executive - - FOCUS ON PRODUCTS - BY MICHAEL RY VAL

in­ter­na­tional eq­ui­ties mar­kets have gen­er­ated dou­bledigit re­turns for the past 12 months, de­spite chal­lenges in the form of the Brexit ref­er­en­dum in the U.K. and the un­ex­pected elec­tion of U.S. pres­i­dent Don­ald Trump. But port­fo­lio man­agers are ei­ther cau­tious about prospects for this class of eq­ui­ties or less con­cerned about macro events and more fo­cused on stocks’ specifics.

One port­fo­lio man­ager in the cau­tious camp is Richard Jenk­ins, manag­ing di­rec­tor and chair­man of Toronto-based Black Creek In­vest­ment Man­age­ment Inc. and lead port­fo­lio man­ager of CI Black Creek In­ter­na­tional Eq­uity Fund.

“Mar­kets are up strongly due to the out­look for gross do­mes­tic prod­uct [GDP] growth in con­ti­nen­tal Europe im­prov­ing steadily through 2016 and into 2017,” says Jenk­ins, ad­ding that GDP growth in con­ti­nen­tal Europe in 2017 is ex­pected to be about 1.8%.

“Some of that [growth] is [the re­sult of] con­tin­ued con­sumer and ex­port growth in Ger­many and Scan­di­navia and from the re­cov­ery of pe­riph­eral Euro­pean coun­tries such as Ire­land and Spain,” says Jenk­ins, who shares port­fo­lio-man­age­ment du­ties with Eve­lyn Huang and Melissa Cas­son, both di­rec­tors of global eq­ui­ties with Black Creek.

“We also are see­ing a pickup in cap­i­tal in­vest­ment in Europe,” says Jenk­ins. “All of this is im­por­tant for global growth be­cause the Euro­pean Union [EU] is the sin­gle-largest global econ­omy. This is what has driven strong eq­ui­ties mar­kets.”

Yet, Jenk­ins is wor­ried the U.S. may fal­ter in tight­en­ing its fi­nan­cial con­di­tions while Europe plans to end its own loose mon­e­tary poli­cies.

“Europe may move from neg­a­tive in­ter­est rates to flat or slightly pos­i­tive rates by 2018,” Jenk­ins says. “[Euro­pean cen­tral bankers] will stop or re­duce their bond mar­ket pur­chases in late 2017 and into 2018. When you have co­or­di­nated tight­en­ing around the world, usu­ally that means bond mar­kets will re­act, which will feed into eq­ui­ties mar­kets.

“If they are tight­en­ing be­cause global economies are do­ing well, that’s off­set by good earn­ings,” he adds. “But our abil­ity to pre­dict that [tight­en­ing] will hap­pen smoothly is quite low.”

Jenk­ins notes that global economies are in un­prece­dented ter­ri­tory, with un­cer­tainty about how quan­ti­ta­tive eas­ing will be phased out in Europe and about con­tin­u­ing neg­a­tive in­ter­est rates in ju­ris­dic­tions such as Japan.

“The big worry is that there is a hic­cup,” Jenk­ins says, ad­ding that all too of­ten in the past, easy money has led to ex­cesses.

On a more be­nign note, Jenk­ins ar­gues, con­cerns about Brexit are over­done, es­pe­cially by fi­nan­cial ser­vices sec­tor firms. “Could [the mar­ket re­ac­tion to the Brexit vote] get bet­ter from here, in the sense that we have more clar­ity? Sure. But it could not get worse than it al­ready has. As an econ­omy, the U.K. is far less im­por­tant than its as­set-man­age­ment in­dus­try,” he says, not­ing that the U.K. ac­counts for only about 12% of the EU’s to­tal GDP.

Turn­ing to China, Jenk­ins ar­gues that the coun­try of­fers a mixed pic­ture as its econ­omy shifts from an ex­port ori­en­ta­tion to do­mes­tic con­sump­tion. “Some parts of the econ­omy, such as In­ter­net-based re­tail­ing, are do­ing well. But oth­ers, such as ship­build­ing, are shrink­ing or even be­ing writ­ten off.”

Jenk­ins, largely a bot­tom-up in­vestor, mea­sures ge­o­graph­i­cal ex­po­sure of the CI fund’s hold­ings by the ex­tent to which the com­pa­nies do busi­ness out­side their of­fi­cial domi­cile. On that ba­sis, about 42% of the CI fund’s as­sets un­der man­age­ment (AUM) is held in Asia, fol­lowed by 38% in Europe, and 20% in North and South Amer­ica col­lec­tively.

About 20% of AUM is held in con­sumer cycli­cal stocks, 14% is in fi­nan­cials and 14% is in tech­nol­ogy, with smaller hold­ings in sec­tors such as ba­sic ma­te­ri­als.

One top hold­ing i n the CI fund’s 30-name port­fo­lio is ICICI Bank Ltd., a lead­ing In­dia-based bank.

“In the short term, the bad l oan cy­cle within pri­vate-sec­tor banks such as ICICI seems to have peaked and is turn­ing down­ward,” says Jenk­ins. “But the l ong-term part of our the­sis is that ICICI is shift­ing its busi­ness and be­com­ing much more of a pure-play re­tail bank. It also is viewed as a leader, if not the leader, in tech­nol­ogy in fi­nan­cial ser­vices in In­dia.”

Given these at­tributes, Jenk­ins main­tains that ICICI’s valuation of about 1.2 times book value is cheap rel­a­tive to its peers. ICICI’s Amer­i­can de­pos­i­tory re­ceipts trade at about US$8.90 ($11.80) each on the New York Stock Ex­change. There is no stated tar­get.

some port­fo­lio man­agers, such as David Ra­gan, di­rec­tor and port­fo­lio man­ager with Cal­gary- based Mawer In­vest­ment Man­age­ment Ltd., who over­sees Mawer In­ter­na­tional Eq­uity Fund, shun a top-down view, pre­fer­ring to fo­cus on at­trac­tive stocks.

“There is a con­stant stream of po­ten­tial macro ‘speed bumps’ [to over­come]. If you ac­tu­ally try to run away from all the po­ten­tial risks and move your cap­i­tal away from any­thing com­ing up — such as the Brexit talks go­ing poorly [or] elec­tions in Ger­many — then you will turn over the port­fo­lio ev­ery week and you will go back­ward. Or you would be so par­a­lyzed with worry that you would sit in cash,” says Ra­gan, who shares port­fo­lio-man­age­ment du­ties with Peter Lam­pert, a port­fo­lio man­ager with Mawer.

As a con­se­quence, the team does not spend time on try­ing to pre­dict the un­pre­dictable.

“Our fo­cus is on re­silient com­pa­nies that will sur­vive chal­leng­ing en­vi­ron­ments, then profit over the long term,” says Ra­gan. “Then, we put these com­pa­nies into a di­ver­si­fied port­fo­lio and try to mul­ti­ply that re­siliency over time.”

As an ex­am­ple, Ra­gan of­fers the way in which Mawer re­sponded to the Brexit ref­er­en­dum: “We couldn’t be more ac­cu­rate than any­one else in pre­dict­ing whether the U.K. would stay or leave.” In­stead, the Mawer team looked at its U.K.-based com­pa­nies in terms of the de­gree of lever­age they carry, mis­matches be­tween pro­duc­tion and sales, and po­ten­tial vul­ner­a­bil­ity to cur­rency swings.

Jenk­ins is wor­ried that the U.S. may fal­ter in tight­en­ing its fi­nan­cial con­di­tions

“If you pro­duce a l ow-value prod­uct and the pound ster­ling moves a lit­tle bit, you can be­come un­com­pet­i­tive,” Ra­gan says. “If [firms] are fi­nan­cially lever­aged, that could be the end for some low-qual­ity com­pa­nies. So, you avoid those com­pa­nies in gen­eral.

“The com­pa­nies that we look for have re­siliency based on a solid com­pet­i­tive po­si­tion,” he adds, “and typ­i­cally of­fer a prod­uct or ser­vice that is valu­able to cus­tomers.

“One of the ways that shows up is in pric­ing power,” he con­cludes. “If, in the case of Brexit, costs go up, these com­pa­nies can pass them on to their cus­tomers. You look for these high-qual­ity com­pa­nies that will be OK no mat­ter what hap­pens.”

Ra­gan be­lieves val­u­a­tions have be­come ex­pen­sive, al­though that de­pends on the so-called “spread” be­tween a stock’s ex­pected rate of re­turn and the risk-free rate (the the­o­ret­i­cal rate of re­turn of an in­vest­ment with no risk).

Cur­rently, the 10-year risk-free rate in Europe varies be­tween 0.5% and 1%. The big ques­tion: “Where will the risk-free rate be in five years?”

“Will it be the same or lower?” Ra­gan asks, then re­sponds: “If the rate goes up by 200 or 300 ba­sis points, that’s a pretty dif­fi­cult mar­ket for eq­ui­ties and would make them over­val­ued. [The out­look] is all about where the risk­free rate is go­ing.”

The Mawer fund is fully i nvested. About 58% of its AUM is held in Europe (based on where the stocks are listed), in­clud­ing 23.7% in the U.K.; 29.2% in Asia, plus 4.8% in North Amer­ica, with smaller hold­ings in Latin Amer­ica and Africa.

On a sec­tor ba­sis, the Mawer fund is dom­i­nated by a 22.6% weight­ing in fi­nan­cial ser­vices, fol­lowed by 16.5% in con­sumer staples, 16.3% in in­dus­tri­als, 10.8% in ma­te­ri­als and 10% in in­for­ma­tion tech­nol­ogy, with smaller hold­ings in sec­tors such as health care.

One favourite hold­ing in the 61-name Mawer fund is Lon­don­based WPP PLC, a lead­ing global advertising agency.

“Dig­i­tal advertising is be­com­ing a core part of any com­pany sell­ing to the pub­lic, so you have to have a dig­i­tal strat­egy,” says Ra­gan, not­ing that dig­i­tal advertising has emerged as the fastest-grow­ing part of advertising ex­pen­di­tures. More­over, WPP has the scale and global reach to work with com­pa­nies around the world.

WPP stock is trad­ing at £16.66 ($27.40) a share, or about 15 times earn­ings. There is no stated tar­get.

Another top hold­ing is Tsu­ruha Hold­ings Inc., a dom­i­nant phar­macy chain in Japan. Much like Canada’s Shop­pers Drug Mart, Tsu­ruha ben­e­fits from a busi­ness model that com­bines dis­pens­ing pre­scrip­tion drugs with prof­itable re­tail­ing.

“In an es­tab­lished mar­ket such as Japan, you would think the drug­store mar­ket is rel­a­tively ma­ture — but it’s still frag­mented. There are lots of op­por­tu­ni­ties for Tsu­ruha ei­ther to ac­quire other en­ti­ties and bring them up to Tsu­ruha’s pro­fes­sional model or just grow and re­place old­fash­ioned drug dis­pen­saries.”

Tsu­ruha stock is trad­ing at about ¥12,440 ($143.30) a share, or roughly 25 times earn­ings.

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