FPA International Value Fund commentary and webcast slides for the fourth quarter ended December 31, 2018.
Q4 hedge fund letters, conference, scoops etc
FPA International Value Fund 4Q18 Webcast Audio
FPA International Value Fund 4Q18 Commentary
Dear Fellow Shareholders,
In the fourth quarter 2018, the FPA International Value Fund (the “Fund”) declined 6.70% (in U.S. currency), net of fees and expenses (the Fund’s net expense ratio was 1.29%). This compared to a decline of 11.46% over the same period for the MSCI All Country World Index (ex-U.S.) (Net) (the “Index”).
Long-term returns
Over the full calendar year, the Fund declined 10.81%, net of fees and expenses (the Fund’s net expense ratio was 1.29%). This compared to a decline of 14.20% for the Index over the same period.
Most importantly, since its inception on Dec. 1, 2011, the Fund has returned an average of 6.44% per year, net of fees and expenses (the Fund’s net expense ratio averaged just under 1.3% over the period). This compares to an annualized return of 4.62% for the Index.
We are encouraged by the Fund’s returns (not to mention that of our equity holdings), both absolute and when compared to the Index, any foreign value or blend category, or industry peers. However, we’d like to remind our readers, as we have often done in the past (during both positive and negative periods), that our focus is on the long term, and that we may at times experience negative short-term performance. Because of this, we encourage shareholders to evaluate the Fund’s returns over long periods of time, including a full market cycle.
We also note that cash and equivalent holdings accounted for 22% of the Fund’s total net assets at the end of the period. Since the Fund’s inception, cash exposure has averaged a little over 31%, while fluctuating from less than 12% to more than 40%, depending on the availability of suitable investment opportunities.
Notwithstanding the positive impact of cash on performance this past year, the Fund’s equity holdings outperformed the Index in 2018. Most importantly given our long-term focus, the Fund’s equity holdings’ annualized return since inception remains close to 14%, which compares favorably to 4.6% for the Index.
Looking back
In our fourth quarter 2017 commentary, we wrote that “any intelligent investor with remotely adequate incentives [would] recognize that markets around the world have reached a point of ‘total exuberance.’” We described the market environment then as one of the worst we had seen in a long time with “irrational expectations and valuations (…) across the board.” In particular, we pointed out the naivety and complacency toward technology themes and growth investments. Around the time we drafted these comments, the Index peaked. It went on to decline more than 20% from January 26 to the trough on December 21, before reversing course for a few days as is often the case at the end of the year. While the market correction was broadly felt, it was particularly severe for growth and technology investments.
In the first quarter of 2018, we also drew parallels between what we were experiencing then and what happened in the first few months of 2014, when we monetized many past investments and the Fund’s cash exposure increased to 40%. During 2018, we followed the same value discipline, and sold out of many equity holdings following a 43% increase in their value in 2017. However, this time the Fund made simultaneous investments in Brazil, which prevented the post-sale cash from rising to such high levels as we saw in 2014. We viewed Brazil as an outlier in a broad-based market rally, with the Ibovespa index having fallen 19% in the first half of the year. In our second quarter 2018 commentary, we shared some of our thoughts on the region in a paragraph called “Space Oddity.” The combined exposure of these Brazilian holdings, together with cash, at one point accounted for more than 40% of the fund’s assets in the earlier part of the year.
In the later part of the year, but especially in the fourth quarter, we benefited from this exposure, with cash holding steady (evidently) and Brazilian equity holdings outperforming the Index. Brazilian businesses accounted for five out of our six best-performing holdings and six top contributors this quarter. Despite the particularly strong quarter, we believe many of our recently added Brazilian names continue to offer significant discounts to intrinsic value.
We would also highlight that most of the Fund’s decline for the year took place in the fourth quarter, and came in large part from more recently added holdings that were already highly discounted, rather than past winners. This means we didn’t give back past unrealized gains as other market participants may have. Instead, many of our more recent additions simply became even more attractive. Three out of our six worst-performing holdings and six worst contributors this quarter were relatively recent investments. Unsurprisingly, two of them were technology-related.
Other detractors to performance in the quarter included a business related to oil and gas, along with several companies with exposure to the UK. British equities in general have experienced significant volatility as a function of the country’s ongoing negotiations to separate from the European Union (“Brexit”).
Key performers
The largest detractor to performance this quarter was Sulzer. It was also our worst-performing holding, with a share price that fell 33.9% (in U.S. currency) in the fourth quarter.3 Based in Switzerland, Sulzer is a leading provider of pump equipment and related services, with significant exposure to the oil and gas industry. Oil prices came down 35% in the period, which we believe may have caused Sulzer’s stock to experience a similar decline in price. Fundamentally though, nothing transpired in the past few months with regard to the business, its management, operating performance, or the strength of the balance sheet that would cause us to change our assessment of the company. For that reason, we remain interested in being long-term shareholders of Sulzer, and we took advantage of the price weakness to increase our investment in the group.
Our best-performing holding this quarter was BK Brasil Operacao E Assesso (“BKB”), with a share price that rose 64.1% (in U.S. currency).4 BKB also was second among our top contributors to performance this quarter. The best contributor was G8 Education (“G8”). We have commented on that company a couple of times recently, as G8 was our worst-performing disclosed holding in both the fourth quarter 2017 and the first quarter 2018.
Based in Australia, G8 is one of the country’s largest operators of childcare centers. We invested in G8 when the company was experiencing material cyclical challenges. Too much capital desperate for yields had been flowing into properties used for early education. As supply overshot demand, occupancy levels were negatively impacted. The downturn triggered material changes at G8 in terms of ownership, management, and strategic focus. The combination of these disruptive factors likely caused the prolonged, significant decline in the company’s share price, some of which took place after our initial purchase.
We have frequently noted that as value investors we often find ourselves leaning into a declining stock price at the time of initial purchase. As such, it is typical for us to see new portfolio additions rank among the worstperforming holdings and contributors in the subsequent months. As long-term investors, we are willing to weather such volatility. There are a couple of reasons for this. First, when businesses experience short-term negative developments is often when genuine bargains can be found. We also do not think one can reliably predict how a stock might respond to negative momentum, which makes it impossible to pick the optimal time to invest. If a company meets all of our quality requirements, our discipline is to invest when the discount to intrinsic value gets above 30%. If the price comes down further, and the discount widens, we add to the investment. This naturally lowers our weighted average cost per share and increases the potential upside. While simple, this approach requires both conviction and fortitude. There is no guarantee that a stock trading at an already high discount to fair value will not decline in price from there.
In the case of G8, we mentioned at the time of our initial purchase that we expected the underlying business to remain under pressure in the short term. However, we believed that recent changes could be strong positives for the company and presented opportunities for improvements after years of poorly managed growth. Furthermore, we expected long-term structural drivers to support continued demand growth for early education, and we thought G8’s business fundamentals were strong.
In the fourth quarter, the childcare center market started to show signs of improvement, in part thanks to the new government subsidies for all-day care (that had long been scheduled to come into effect in 2018). Some of the initiatives launched by G8’s new CEO (who had joined a few months before our investment) also started to have a positive impact on the business. As a result, we suspect market sentiment shifted, which drove the share price up 40% (in U.S. currency) between September 30 and December 31, 2018.5
Despite the recent increase, we remain interested in being shareholders of G8, subject to the stock continuing to trade at an appropriate discount to our estimate of its intrinsic value.
Portfolio activity
As always, through the quarter we continued to add to holdings we believe offer compelling discounts to intrinsic value, and to trim positions that are becoming less attractively priced. We also consistently rebalanced individual positions based on relative discounts to intrinsic value. While this helps ensure that our most compelling investments are more heavily weighted and can drive performance, it is important to realize that it can also inflate portfolio turnover at times, particularly if volatility increases.
More fundamentally, our equity exposure increased as we took advantage of market weakness in the fourth quarter to put more money to work. As referenced earlier, cash exposure was 22% at December 31, down from more than 26% at the end of the third quarter. This means we reinvested about 15% of our cash during the period, not including any redeployment of the proceeds from monetizing past gains during the period.
We increased our ownership of some portfolio companies whose stocks experienced material weakness, as in the aforementioned case of Sulzer. We also made new purchases, including Stroeer. Based in Germany, Stroeer is a leading provider of out-of-home advertising solutions with around 300,000 sites across the country. The group also operates a large portfolio of German-language websites, and through several acquisitions, is also a provider of direct marketing services.
In terms of sales, we exited our position in Frutarom following its acquisition by one of its larger peers, U.S.-based International Flavors and Fragrances (“IFF”). Based in Israel, Frutarom is a leading producer of key ingredients for food and beverage products. Since the merger between Essilor and Luxottica has closed, we are now holders of EssilorLuxottica stock. Based in France, Essilor is the a leading producer of eyeglass lenses. Based in Italy, Luxottica is the a leading producer of frames and sunglasses. Lastly, we sold our position in Alicorp. Based in Peru, Alicorp is the country’s leading producer of food, home and personal care products, including margarine, pastas, mayonnaise, detergent and hair care products. Alicorp’s share price had increased significantly and converged toward our estimate of intrinsic value, so it no longer offered the margin of safety we require. We continue to view Alicorp as a well-run, high-quality business that we would consider owning again at the right price.
Portfolio profile
Net of these transactions, the portfolio remained focused on our best ideas, with 31 disclosed positions at the end of the period. The top 10 positions accounted for just under 30% of the Fund’s assets, and close to 38% of the invested portion. The top five accounted for about 16% of assets and just over 20% of the invested portion. The weighted average discount to fair value of these holdings increased to 34%, which we consider an attractive level for the portfolio by historical standards.
The Fund’s median capitalization size was in excess of $7 billion, and the weighted average was about $38 billion at the end of the quarter. More than 40% of our invested assets were in companies with a market capitalization in excess of $10 billion. However, we do not consider a company’s market capitalization size to be a relevant criterion from an investment perspective. We are invested across a wide range of market capitalization sizes, from about $140 million to close to $400 billion.
Geographic exposure
We are similarly indifferent to which sector a company operates in, or where it happens to be domiciled. Nonetheless, looking at the Fund’s geographic profile at the end of the quarter, just under 40% of total assets were invested in companies domiciled in Continental Europe. For the most part, this exposure was geared toward Northern European markets like France, Holland, Ireland, Germany, and Switzerland. UK investments accounted for 13% of total assets, and emerging markets accounted for a little over 20% of total assets, which is an historical high for the Fund. As discussed earlier and in past commentaries, the vast majority of the emerging market exposure was geared to Latin America, and specifically to Brazil. Australian holdings made up 3% of total assets.
It is worth noting that while ‘emerging markets’ is often simplistically considered one region, the term encompasses a broad range of diverse economic and business realities. What’s more, many countries in this group do not meet our investment requirements. While we select stocks based on the fundamentals of the underlying businesses, we also limit ourselves to countries with established rules of law and a political system that allows for their transparent and unbiased enforcement.
Investable markets
On this front, we are wary of how political conditions are changing in China. In our view, it is increasingly clear to us that the country’s political system has morphed into a Stalinian regime and that its leaders have embraced a new agenda far less focused on economic development and business dynamics. We are concerned with how it seems to be impacting the ownership and governance of even some of the country’s most prominent companies. Given the place that China has taken in the global economy over the past 15 years, we are also concerned about the broader ramifications for many businesses around the world, particularly on the supply and manufacturing sides. This is often a topic we discuss when meeting with management teams, and many have echoed our concerns and shared plans to adjust their operational set-up accordingly.
That said, political challenges are growing everywhere, causing us to more frequently question whether certain markets should remain on our list of ‘investable’ geographies. In Mexico for instance, many executives have shared with us their concerns about the political agenda of newly elected President Andres Manuel Lopez Obrador. In Europe, changing conditions could also raise more questions. Italy is now ruled by a populist coalition of two extreme parties: The Five Star Movement and the League. In the UK, Prime Minister Theresa May is struggling with the legacy of the Brexit vote, and could end up ceding power to Labour Party leader Jeremy Corbyn, who has expressed radical views.
Lastly, we were recently reminded of the challenges that exist in Japan. Since the inception of the Fund, we’ve had limited exposure to this market. We had none at the end of the quarter. Putting aside the issue of valuations in Japan, which we generally consider to be unattractive, there are several reasons for our historical underexposure to the region, which we have explained on multiple occasions. Notwithstanding the price distorting effects and long-term implications of the Japanese government’s aggressive monetary policies (that include purchasing large amounts of equities), one of the most important challenges we face in Japan is what we believe to be the generally low quality of corporate governance. While we give some credence to the old argument that things are changing in Japan, we’ve argued that the road to travel is long, and change is happening at a slow pace.
The Nissan saga brutally reminded us of the opaque, political, and arbitrary nature of the Japanese corporate world. Having lived through the Olympus scandal a few years ago, it wasn’t a surprise to us. What transpired is stunning nonetheless. One of the world’s most respected and successful managers, and a foreign citizen, Carlos Ghosn, was suddenly arrested on bizarre allegations, then summarily fired from his post as Chairman at Nissan. The arrest was leaked ahead of time and staged for coverage by local media. While we understand Mr. Ghosn has yet to be charged with any crime, he has been detained for almost two months in spartan conditions, with constant lighting, no sense of time, limited contact with the outside world, and repeated interrogations by prosecutors without a lawyer present. As he continues to deny any wrongdoing, prosecutors have kept piling on allegations in an effort to keep denying him bail and coerce him into confessions. To make things worse, it seems the attack on the executive may have been an effort to thwart his plans to integrate Nissan with its alliance partners into a holding structure, and to remove Nissan’s CEO from his post. Such a sinister play belongs in the darkest (yet all too real) pages of Darkness at Noon, not the boardroom of a public company. We find it appalling, and hard to reconcile with our discipline of investing only in “countries with established rules of law and political systems that allow for transparent and unbiased enforcement of those laws.”
Sector exposure
From a sector standpoint, we noted in past commentaries that we often migrate toward businesses that are cash generative and not very capital intensive. Those include service-type businesses and consumer goods companies. At the end of the quarter, Consumer Discretionary and Consumer Staples together were the Fund’s largest exposure, and accounted for 29% of totalassets. The Fund still had notable exposure to Industrials, which accounted for 23% of total fund assets, and to Information Technology and Communication Services, which accounted for almost 15% of total assets. Healthcare accounted for 8% of total assets.
We also had 3% of the Fund in Financials. This represents our relatively recent investment in Irish bank AIB Group. Outside of this one holding, we have had no exposure to banks since the Fund’s inception. On multiple occasions, we stressed the risks associated with these investments, their intrinsically weak fundamentals, inherent cyclicality, the challenges of trying to anticipate the impact of higher interest rates on the business, and ultimately their poor fit with our philosophy and process. Unsurprisingly, European bank stocks have delivered poor market returns over the past few years. As a group, they’ve underperformed the Index by 20 percentage points in 2018; by an annualized 11 points in the past three years; and by an annualized 9 points in the past five years. They were down 36% last year, and 45% cumulatively since 2013 (compared to the Index, which was up 117% over that period).7
At this point, their prices are back to mid-2016 levels. In our second quarter 2016 commentary, we wrote that “if things are as bad as trading multiples imply for the banks, not being invested in them will only help us marginally,” and that they had “almost become a Pascalian wager at this stage.” We think these comments may once again be applicable to the sector. To be clear, we believe this is in part a function of expectations of future interest rates, as banks are often more a trade call than a long-term investment. More fundamentally, while emphasis is often put on their financial leverage, or the risk profile and liquidity of their assets, we are puzzled by the lack of attention paid to the underlying characteristics of these businesses (notwithstanding constant government interference), and most importantly, in our view, how they have structurally changed for the worse since the financial crisis. Because of this, even though we remain shareholders of AIB and believe the stock trades at an irrational discount, we find that many of these financial institutions simply fall short of our quality requirements.
Overall, the Fund has limited exposure to the credit cycle and financially levered companies. It also has little exposure to highly cyclical businesses, such as car manufacturers. We owned some of these companies in the past, and recognize many now trade at low multiples, even after adjusting for a likely downturn in demand and prices (this time possibly without the offsetting benefits of strong growth and high margins in China). However, while price is an important selection criterion for us, it is not the only one, and it’s never sufficient by itself to warrant an investment. First and foremost, we look for quality. We need to be able to research and analyze a business and become confident the underlying fundamentals support solid long-term returns.
In the case of car manufacturers, we continue to work toward assessing the structural effects of the many disruptive forces the industry is facing, which include (in no particular order): continued regulatory pressure; the rise of Chinese producers; the move toward electric powertrains; the rising influence of outside technology on the cabin experience; generational changes in consumer transportation preferences; the outsourcing of core competencies; and the risk of brand erosion.
While we try to provide some perspectives on the Fund’s sector profile in these commentaries, we would highlight that our portfolio is simply a residual output of our bottom-up approach. We also find that the Global Industry Classification Standard (GICS) classifications are of limited relevance. Page Group, for instance, is a provider of recruitment services, yet it is classified as Industrial. In our view, GICS’s sector definitions are too broad to give a meaningful picture of our underlying holdings.
More fundamentally, we believe the Fund is exposed to a fairly diverse group of sectors, as well as geographies, and is exposed to markets that we think have limited correlation. We also believe many of our holdings have unique secular dynamics that may make them more predictable and better suited to work through potential shortterm economic challenges.
While it is impossible to anticipate how individual stocks will perform going forward, we would argue that the Fund’s exposure to varying sectors and geographies, along with the quality of its holdings, positions it well to withstand further market dislocation. To this, of course, we need to add the cash holding, which offers us the flexibility to buy when others are selling. It may also be a driver of performance through the cycle.
High point in cycle and mounting risks
Looking at market prospects, we find ourselves increasingly of two minds about the current environment.
On the one hand, we view the recent correction as relatively modest, especially considering the strong run up in prices that preceded it. While the number of potential ideas we are currently looking at is greater than it has been in some time, we do not believe prices have reached attractive levels yet. We also continue to see significant risks in the system.
We wrote earlier about some of the political challenges. To these we would add rising social tensions in France that have the potential to derail the proposed agenda of economic reforms, and to put pressure on the European Union and its currency. This is particularly concerning in the context of the upcoming parliamentary elections, which we believe is likely to favor political extremes. The risk is further accentuated by developments in Germany, which is seeing signs of weaker economic growth and is facing a daunting transition after 18 years of Angela Merkel’s leadership.
From a macro-economic standpoint, the Chinese growth engine appears to be running out of gas. The negative impact of a trade war with the United States and a looming global backlash over privacy concerns could contribute further to the slowdown. A more dramatic crisis is also possible following years of directed, and thus often unproductive, investments, together with the aggressive use of financial leverage. Other emerging markets could face currency crises if the U.S. dollar continues to appreciate. Subject to the outcome of the Brexit process, the UK economy could experience a material downturn. Other continental European markets could also struggle to maintain improving economic momentum as a result.
Generally speaking, we are likely at a high point in the economic cycle, and at an even higher point in the credit cycle. Across the board, but particularly in the United States, leverage continues to grow to concerning levels in the areas of government debt, leveraged loans, and student borrowing (along with other forms of consumer financing). Of course, this makes both the economy and capital markets sensitive to a potential increase in interest rates. We believe one of the most impactful issues for markets could be a shift away from unprecedented accommodative monetary policies across the globe. Low interest rates have largely contributed to economic growth and the run-up in market prices in the past decade. If rates were to increase further from here, we would expect these trends to reverse.
From a capital market standpoint, the twin waves of quantitative and passive investment strategies continue to drive indiscriminate buying and combined with diminishing liquidity, to foster irrational market pricing. On that note, we would point out that John Bogle, the “father of the Index Fund,” recently warned of the dangers of his own creation in an interview with the Wall Street Journal8. He appeared to point out the fallacy of strategies set to mimic a market they have come to replace in large measure. He also talked of the socialization of returns, and the need for differentiated performance. Most importantly, he expressed concern over the consolidation of ownership and the transfer of corporate governance into the hands of corporate renters with no understanding of the business, no financial discipline, and little alignment of interest with equity holders. As a result, companies are also likely to become even more susceptible to political interference.
Opportunities in market inefficiency and increased volatility
On the other hand, many of these top-down concerns only matter in our view if they could structurally impact the fundamentals of the businesses we own (or that we are hoping to buy), and affect their ability to generate free cash flows in the long term. To the extent these risks only impact market sentiment and prices, they provide us with opportunities. The more numerous and broad the macro risks, the greater the opportunities. With large amounts of cash available in the Fund, we believe we are well-positioned to take advantage of price dislocations.
Short-term volatility also gives us an opportunity to actively rotate capital into companies we know well, consider to be high quality, and have owned in the past. Historically, this has been an important and effective contributor to alpha generation for us as investors.
More generally, from our perspective as fundamental investors, we think many inefficiencies have been building in capital markets. Following years of near-zero interest rates and with the extended use of automation and indexing as investment tools, the level of price discovery in the market may have reached historic lows. The disconnect between stock valuations and underlying fundamentals has grown in recent years to a point where it is now exemplified almost daily by wide fluctuations in prices in response to one random report on trade wars, or a comment on possible future action by the Central Bank.
This is all good news for us. It means we have less competition along with more and greater opportunities for mispriced securities. Our team is continuing to grow and mature into a unique ensemble of experienced and talented stock pickers who are all methodically applying a common investment philosophy and a consistent selection process. With this in place, we expect to be well positioned to take advantage of these inefficiencies.
While the investment environment remains challenging today, our focus is on the opportunities that could transpire in the midterm to longer term. In the meantime, we continue to abide by our strict discipline that calls for minimizing the risk of permanent losses while seeking to build capital. We keep monitoring the companies on our coverage list in case of any temporary disruption. We also continue to look in (and travel to) every corner of the equity markets for compelling investment ideas.
We thank you, as always, for your confidence, and we look forward to continuing to serve your interests as shareholders of the FPA International Value Fund.
Respectfully submitted,
Pierre O. Py
Portfolio Manager
