“Value investing is at its core the marriage of a contrarian streak and a calculator.” –Seth Klarman (Trades, Portfolio)
When stocks become cheap, the prognosis typically improves for an equity market recovery. Despite what our emotions tell us, most bear markets decrease—rather than elevate—risk of future losses. As with stocks, commodities follow a similar rule of thumb. With sharp (70% plus) declines in many commodity prices from recent peaks, the risk/reward balance swings in favor of reward. Furthermore, not all substantial and sustained equity market declines lead to recessions. In 1988 and 2002, the US equity market swooned over many months, yet recession did not ensue. What will calm investors and spur renewed buying interest? With the US dollar giving up ground this year, depreciating versus the euro and yen, the downward pressure on commodity prices should abate. We expect that stabilization of commodity prices should alleviate concerns of demand destruction, evident in the deterioration in both credit markets and bank balance sheets. Furthermore, emerging markets equites, undervalued relative to history and mature markets, should eventually attract more buying interest. Despite concerns about the developing world, these countries generally have younger populations, the prospect of renewed productivity, and superior economic growth rates relative to Europe, Japan, and even the mighty United States. However, with a steady economy, positive bond yields, and a legal haven for fleeing capital, the United States has enjoyed a strong currency for over two years. The US Federal Reserve is likely evaluating the deflationary effects globally of US dollar appreciation. This could mark the end of the rising dollar and weak commodity price trend since mid-2014. From Cause-way’s perspective, value stocks may be poised to outperform global markets in the near future. Value moves in cycles. Over the past 25 years, the current weakness in value rivals even the late 1990’s technology, media and telecommunications bubble in depth. We do not need “reflation,” as some critics argue. Simple mean reversion bodes well for a recovery in value stocks. Given the historically wide deviation in value versus growth within industries (value is historically cheap), a stabi-lization in inflation expectations should encourage investors to take risk, rather than crowd into stocks with perceived quality and upward earnings momentum. Unimpeded, stock markets should eventually price correctly the fundamentals of a business; this is the cornerstone of value investing.
On several valuation metrics, certain equity style characteris-tics such as defensiveness and price momentum look expensive versus other segments of markets, with multiples well above their long-term averages.
The conundrum for beleaguered value managers (and their clients) is that value and high beta stocks (stocks with high benchmark index sensitivity) dominate the list of the greatest bargains across equity markets, especially emerging markets.
In order to understand better the opportunity in value stocks, we spoke to Causeway fundamental portfolio managers Conor Muldoon (financials and materials sectors), and Jamie Doyle (technology and telecommunications sectors), and quantitative portfolio manager, Arjun Jayaraman, for their perspectives.
Arjun, how much longer do you expect value to continue its drawdown?
AJ: Based on history, we are due for a value rebound, although it is of course impossible to predict exactly when that rebound will occur. Investors would probably have a lot more con-fidence in cyclical and financials stocks if they expect stable (rather than deteriorating) Chinese and US real gross domestic product growth. With credit cheap in most regions, plus room for more fiscal spending, many developing economies will likely muddle through this period, avoiding a crisis. It would help if these governments, especially Beijing, would acceler-ate state-owned enterprise reform to re-invigorate invest-ment and spark competition. Globally, especially in emerging markets, governments need to dismantle barriers to trade and foreign investment in goods and services. With adversity often comes the political will for change. Long before we see these improvements, equity markets typically rally with the prospect of rising productivity.
Conor, what do you see in the financials sector that should get investors’ attention?
CM: Many of the banks that interest us are trading substantially below their tangible book values (book value less goodwill). As a group, bank stocks have performed very poorly in 2016. We believe the market has overreacted. We have not seen such low bank valuations since the 2011-12 euro crisis. Some banks are even trading well below their absolute lows reached in the 2008-09 financial crisis, when investors feared spiraling credit losses, recession and severe dilution of equity capital. We can understand the current anxiety evident in markets. The specter of flattening yield curves portends a likely hit to bank earnings. But it is hard to envision what would cause most banks to need capital replenishment. Capital ratios have more than doubled since the mortgage crisis and leverage has declined precipitously.
Lending standards have tightened. Liquidity at banks has improved significantly. Bank oversight—with annual stress tests—is highly stringent, and banks have shed volatile businesses, especially those that consume capital. Stagnating economies will likely push up loan loss provisions, but we still expect several prominent banks (well managed or restructuring), to be able to return capital to shareholders. We like some of the cheapest US money center banks as well as several European and UK banks. On behalf of our clients, we will gladly accept higher dividend payouts while waiting for a “re-rating” upward to valuations more consistent with disciplined capital allocation and an improving return on equity trajectory.
JD: Keep in mind that bank stocks’ “leverage” works both ways. In a market rebound, banks will likely outperform overall indices by a wide margin. 2009 was a most spectacular example of this.
Jamie, last but not least, what’s happening in technology, another cyclical area of stock markets?
JD: Year-to-date to mid-February, the technology hardware & equipment industry group is still struggling, down over 13% within the MSCI World Index. The cyclical semiconductors stocks are faring the worst, then hardware, and software, and all areas of technology have declined by double digit percentages since the beginning of the year. Within software, the large cap “legacy” vendors have held up relatively well, while the high-flying, high-growth companies have been crushed. We typically use stock market gloom to upgrade our client portfolios to the highest quality, best-positioned competi-tors in every sector. One of our current holdings is a world leader in memory semiconductors (and other technology commodi-ties), as well as mobile phones. In semiconductors, this giant hasa sustainable cost advantage over peers. Best of all, the company has committed itself to sizable share buybacks. This makes a lot of sense given the stock’s low valuation, trading currently below 10x next year’s earnings and at a discount to book value. Although not yet wildly generous, the dividend yield, combined with superior financial strength, adds to our level of patience.
Important Disclosures
The Firm, Causeway Capital Management LLC (“Causeway”), is organized as a Delaware limited liability company and began operations in June 2001. It is registered as an investment adviser with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. Causeway manages international, global, and emerging markets equity assets for corporations, pension plans, public retirement plans, sovereign wealth funds, superannuation funds, Taft- Hartley pension plans, endowments and foundations, mutual funds and other collective investment vehicles, charities, private trusts and funds, wrap fee programs, and other institutions. The firm includes all discretionary and non-discretionary accounts managed by Causeway.
Causeway claims compliance with the Global Investment Performance Standards (GIPS®).
The International Value Equity Composite (“International Composite”) includes all U.S. dollar denominated, discretionary accounts in the international value equity strategy, which do not apply a minimum market capitalization requirement of $ 2.5 billion or higher ($5 billion or higher prior to November 2008), permit investments in South Korean companies after October 2003, do not regularly experience daily external cash flows, and are not constrained by socially responsible investment restrictions. The international value equity strategy seeks long-term growth of capital and income through investment primarily in equity securities of companies in developed countries located outside the U.S. From June 2001 through November 2001, the International Composite included a non-fee -paying account with total assets of approximately $2 million. This was the sole account in the International Composite from June through September 2001. The account was included in the International Composite at account inception because it was fully invested at inception. The benchmark is the MSCI EAFE Index.
The Global Value Equity Composite (“Global Composite”) includes all U.S. dollar denominated, discretionary accounts in the global value equity strategy which are not constrained by socially responsible investment restrictions. Through March 30, 2007, Causeway managed the Global Composite using research and recommendations regarding U.S. value stocks from an unaffiliated investment advisory firm under a research services agreement for an asset-based fee. The global value equity strategy seeks long- term growth of capital and income through investment primarily in equity securities of companies in developed countries located outside the U.S. and of companies located in the U.S. The benchmark is the MSCI World Index.
The International Value Select Composite includes all U.S. dollar denominated, discretionary accounts in the international value equity strategy which apply a minimum market capitalization requirement of $2.5 billion or higher at the time of initial investment ($5 billion or higher prior to November 2008). The international value equity strategy seeks long-term growth of capital and income through investment primarily in equity securities of companies in developed countries located outside the U.S. The benchmark is the MSCI EAFE Index.
The Emerging Markets Equity Composite includes all U.S. dollar denominated, discretionary accounts in the emerging markets equity strategy. The emerging markets equity strategy seeks long- term growth of capital through investment primarily in equity securities of companies in emerging markets using a quantitative investment approach. The benchmark is the MSCI Emerging Markets Index.
The International Opportunities Composite includes all U.S. dollar denominated, discretionary accounts in the international opportunities strategy that are not constrained by socially responsible investment restrictions. The international opportunities strategy seeks long -term growth of capital through investment primarily in equity securities of companies in developed and emerging markets outside the U.S. using Causeway’s asset allocation methodology to determine developed and emerging weightings, and using Causeway’s international value equity strategy or Causeway International Value (Trades, Portfolio) Fund for the developed portion of the portfolio and Causeway’s emerging markets strategy or Causeway Emerging Markets Fund for the emerging markets portion of the portfolio. The benchmark is the MSCI All Country World Index ex U.S.
The Global Absolute Return Composite includes all discretionary accounts in the global absolute return (“GAR”) strategy. The GAR strategy seeks long-term growth of capital with low or no correlation to the MSCI World Index through investment in long and short exposures to common and preferred stocks of companies in developed countries located outside the U.S. and of companies located in the U.S. The benchmark is the BofA Merrill Lynch 3-Month U.S. Treasury Bill Index. The GAR strategy takes long and short positions in securities directly and/or using swap agreements. The strategy will use leverage up to four times total assets. The use of leverage is speculative and will magnify any losses. Short positions will lose money if the price of the underlying security increases, and losses on shorts are therefore potentially unlimited. The strategy involves significant expenses including financing charges and transaction costs which will reduce investment returns and increase investment losses. To the extent swap agreements are used, the strategy risks loss of the amount due under a swap agreement if the counterparty defaults or becomes insolvent. To the extent assets are held by a prime broker, recovery will be limited in the event of the prime broker’s insolvency. The strategy involves liquidity risks since a portfolio may not be able to exit security exposures immediately, particularly during periods of market turmoil.
The International Small Cap Equity Composite includes all U.S. dollar denominated, discretionary accounts in the international small cap equity strategy. The international small cap equity strategy seeks long-term growth of capital through investment primarily in common stocks of companies with small market capitalizations located in developed and emerging markets outside the U.S. The benchmark is the MSCI ACWI ex USA Small Cap Index.
New accounts are included in the Composites after the first full month under management, except as noted for the International Composite above. Terminated accounts are included in the Composites through the last full month under management. Account returns are calculated daily. Monthly account returns are calculated by geometrically linking the daily returns. The returns of the Composites are calculated monthly by weighting monthly account returns by the beginning market values. Valuations and returns are computed and stated in U.S. dollars. Returns include the reinvestment of interest, dividends, and any capital gains. Returns are calculated gross of withholding taxes on dividends, interest income, and capital gains, except returns of Causeway- sponsored mutual funds are net of such withholding taxes and reflect accrued tax treaty reclaims. The firm’s policies for valuing portfolios, calculating performance, and comparing compliant presentations are available upon request. Gross-of-fees returns are presented before management, performance-based and custody fees, but after trading expenses. Net-of -fees returns are presented after the deduction of actual management fees, performance- based fees and all trading expenses, but before custody fees. Causeway’s basic management fee schedules are described in its firm brochure pursuant to Part 2 of Form ADV.
Past performance is no guarantee of future performance. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Investments in smaller companies involve additional risks and typically exhibit higher volatility.
The MSCI EAFE Index is a free float-adjusted market capitalization weighted index, designed to measure developed market equity performance excluding the U.S. and Canada, consisting of 21 stock markets in Europe, Australasia, and the Far East. The MSCI World Index is a free float- adjusted market capitalization weighted index, designed to measure developed market equity performance, consisting of 23 developed country indices, including the U.S. The MSCI Emerging Markets Index is a free float- adjusted market capitalization index, designed to measure equity market performance of emerging markets, consisting of 23 emerging country indices. The MSCI All Country World Index ex U.S. is a free float-adjusted market capitalization weighted index, designed to measure the equity market performance of developed and emerging markets excluding the U.S. consisting of 45 country indices. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. Each month the index is rebalanced and the issue selected is the outstanding Treasury Bill that matures closest to, but not beyond 3 months from, the rebalancing date. The Treasury Bills comprising the Index are guaranteed by the U.S. government as to the timely payment of interest and principal. Accounts in the GAR strategy will primarily be exposed to securities that will not be similarly guaranteed by the U.S. government. The MSCI ACWI ex USA Small Cap Index is a free float-adjusted market capitalization weighted index, designed to measure the equity market performance of smaller capitalization stocks in developed and emerging markets excluding the U.S. market, consisting of 45 country indices. The MSCI ACWI ex USA Small Cap Index covers approximately 14% of the free float-adjusted market capitalization in each country. The Indices are gross of withholding taxes, assume reinvestment of dividends and capital gains, and assume no management, custody, transaction or other expenses. It is not possible to invest directly in these indices. Accounts in the Composites may invest in countries not included in their benchmark indices.
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.
Contact Sarah Van Ness at 310-231-6127 or [email protected] to request a complete list and description of firm composites and/or a presentation that adheres to the GIPS® standards.
Market Commentary
The newsletter expresses the authors’ views as of 2/24/2016 and should not be relied on as research or investment advice regarding any stock. These views and portfolio holdings and characteristics are subject to change. There is no guarantee that any forecasts made will come to pass.
