GMO Third-Quarter International Active Update
The International Active EAFE Strategy underperformed the MSCI EAFE index in the third quarter; the strategy gained 5.9% and the benchmark rose 6.9%. Negative country selection was somewhat offset by positive stock selection. The strategy lagged its benchmark by 1.2 percentage points for the first three quarters of 2012, returning +8.9%.
Country Selection and Market Update
Country selection was 1.3% behind the benchmark. An overweight position in Japan subtracted from returns as exports slowed and a territorial dispute with China grew. The Australian market bounced back somewhat after underperforming for the first two quarters, so an underweight position hurt performance.*
The third quarter was a profitable one for equity investors globally, and the thanks should go to central bankers. Economic growth has generally stalled, or in Europe, declined. The European Central Bank (ECB) and the U.S. Federal Reserve intervened aggressively during the quarter. Mario Draghi, the ECB president has shown no reluctance to wade in when European policy makers have reached an impasse. In the early summer, he used strong words, which he backed up with commensurate action in September, when he announced a policy of unlimited government bond buying. On the other side of the Atlantic, Fed Chairman, Ben Bernanke, unholstered his bazooka with the so-called QE3 program of monthly targets for buying mortgage securities. With a little wobble now and again, equity markets have trended strongly upwards. In Europe, there are still many sticking points. A proposed long-term solution is to have a Europe-wide banking regulator with Europe-wide deposit insurance. As has been the case for most of the crisis, policy makers have become expert at announcing measures that the markets will welcome, then diluting the measures when it comes to implementation. The latest example is the potential uses of the European Stability Mechanism (ESM). At a leaders' meeting at the end of June, there appeared to be an agreement to use the ESM to directly recapitalize ailing banks, which was particularly welcomed by Spain. Now that the German constitutional court has ruled in favor of the establishment of the ESM and the Dutch elections are behind us, the "creditor" governments have said that the ESM cannot be used for past or legacy banking problems, but only for future issues. Not surprisingly, this quickly put an end to the Draghi rally. The U.S. economy is growing, but at a frustratingly slow pace. The European consumer has retrenched as evidenced by huge declines in auto sales in the financially stressed countries. Over in Asia, China's economy has been dragged down by loss of exports to Europe and the debt overhang at home. The increasingly nasty territorial dispute with Japan over a small group of islands has led to the boycotting of Japanese goods and stirred fears of a trade war, or even a real war, between Asia's two largest economies. This is not a positive development for the regional or global economy.
In many ways, the major events of the third quarter were a reprise of the past two years, with the relentless focus on developments in the Eurozone and obsessive parsing of the pronouncements of central bank leaders. The difference is that the global economy has become weaker. Up until recently, many investors were sanguine that major emerging markets like China and Brazil could weather any downturn in the developed markets, especially Europe. For most of this year China has been showing signs of slowing down and even government officials have acknowledged this fact. Many commodity prices have fallen in tandem with the trend in China. This, in turn, may have a negative impact on commodity producers that have done so well in the past decade. The China/Japan dispute could also have a significant effect as it is happening against a weakening economic backdrop. The good news is that equity valuations are attractive in many regions, particularly the Eurozone. We anticipate taking advantage of these low valuations in the coming months, but slowly, as the ride will likely be uneven and we believe will present multiple entry points.
Stock selection beat the benchmark by 0.3% in the third quarter. Holdings in France and the emerging markets outperformed. Stock selection in the United Kingdom was negative.*
In France, tire manufacturer Michelin outperformed as it enjoys strong pricing power and a tailwind from raw materials costs. This more than offset weak volumes, which will rebound as dealers will have to re-stock. The company's growth profile in the emerging markets, its exposure to high margin specialty tires, and most importantly its attractive valuation (the lowest in the industry) have started to attract investors. BIC was
another strong contributor to performance, as the market started to reward the resilience of the company's business model: steady growth, geographic diversification, best in class EBIT margin, no debt, strong cash generation, and return to shareholders. Just to put some of BIC's achievements into perspective, it has grown its EBIT by 70% in the past four years when the EBIT of other consumer products companies, including Procter and Gamble, Energizer, and Newell Rubbermaid, was flat.
Our holdings in emerging markets outperformed the benchmark, particularly positions in in Russia. The main contributors to this outperformance were Vimpelcom (NASDAQ:VIP) (our largest Russian holding) and TMK. Vimpelcom, one of the main Russian telecom service providers, moved sharply ahead as a resolution of the dispute between the two main shareholders, Telenor (TELN) of Norway and Altimo of Russia, appeared to be near resolution. This, in theory, would allow for the dividend to be reinstated. TMK is one of the world's largest providers of pipes, including those for oil drilling, transportation, and fracking. As Russian producers move increasingly toward the Western technologies of horizontal drilling and fracking to increase production, TMK benefits.
The U.K. market underperformed in the third quarter, driven in part by a move from defensives and quality names into value stocks. We had reduced our exposure to quality names at the start of the year due to valuations that we viewed as stretched – especially in the consumer staples arena – and increased our weighting to value stocks, such as the oil majors. These offered good yields, low valuations, and importantly (and unlike the banks) robust balance sheets. Unfortunately, this was the one area of the value universe that resolutely failed to respond to the value rally as investors instead chased financials amid signs that the ECB was making progress on stabilizing EU banking markets. Meanwhile, some of the quality names we did retain in the portfolio, most notably the tobacco stocks, were hard-hit thanks in part to some unhelpful news flow on plain packaging (we do not view this as likely in the long term to seriously impede profitability). There were a few positives. We have been steadily building a position in Weir Group, which provides pumps for mining companies and oil and gas groups. The company had underperformed due to the weakness in shale gas markets in the U.S., but forecasts now seem to have been rebased to sensible levels and we believe the long-term outlook, especially at the company's minerals arm, remains very strong. The share price enjoyed a strong quarter, in part because of bid rumors. A holding in Schroders non-voting shares also performed well. The stock price fell when index trackers dumped the stock as it was evicted from the FTSE indices, and we have been steadily buying on this weakness. Schroders offers a good dividend yield, a strong balance sheet, and a high degree of exposure to European equities, which we view as attractively valued.
Currency and Hedging
Currencies moved about quite a bit during the quarter but the biggest trend was a general weakening of the U.S. dollar. The greenback declined against most of its major rivals, particularly in September with the QE3 announcement and the commitment to keep rates low until at least 2015.
During the quarter we closed our hedge against Japan, so as of the end of the period the account was unhedged. The hedge against the yen subtracted from returns in the quarter.