Gliding over the speed bumps
Two strategies for international equities
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.