Year in Review: The Beneﬁt of Perspective
Amid Market Cycles, a Singular Focus on Value
Refl ecting on 2013's strong market performance, it's easy to forget that just fi ve years ago the investing environment was very diff erent from today. Back then, the fi nancial crisis and ensuing global market decline cast dark clouds of uncertainty, perhaps testing the mettle of even the most patient, long-term investors. Th rough this experience, and bearing witness to strong equity gains in 2012 and 2013, there are two important takeaways for investors everywhere: one is that markets, regions, industries and companies go through cycles; and two, the price one pays can matter greatly to investment returns.
After the Rain, Some Clearing
Like other value investors, we were not spared from the adverse eff ects of falling markets and negative investor sentiment in 2008 and the years that followed. Within the trough of economic and market challenges, a number of our strategies declined as investor focus on company fundamentals took a back seat to concerns over broader economic issues. A fl ight to safety was widespread, and investor preference turned to fi xed-income and passive equity strategies, as shown in Exhibit 1.
What a diff erence fi ve years can make. Many investors showed renewed interest toward actively managed equities in 2013, as Exhibit 1 illustrates, as a number of key market indices recorded solid gains in 2013 and for the fi ve years ended December 31, 2013. See Exhibit 2 on page 2.
The Hunt for Potential Bargains and the Rewards that Followed
Although 2013 was certainly rewarding for many investors, the performance for Brandes strategies was a result of decisions we made years ago. Taking advantage of opportunities brought on by price declines in various markets, which suffered due to factors specific to individual countries and regions within the last five years, we invested in businesses at a time when prices were low and—as our analysis showed—were mispriced compared to their estimated true worth. Th is mispricing was most dramatic during the depths of the 2008-2009 fi nancial crisis, when we found compelling value opportunities.
During that time, investor concerns were valid and discounts to some company valuations were certainly warranted. However, we believe that while most people considered 2008 to 2009 the "riskiest" period to invest due to heightened stock-price volatility, for a price/valuation-focused, long-term investor this actually appeared to be a good time to commit funds to equities. 1
While most investors were preoccupied solely with "risk," we were intensely focused on assessing the wealth- generating potential and the value of underlying ass ets of individual companies. Although the macroeconomic climate has certainly been volatile over the past fi ve years, we continue to believe that attempting to forecast macro events is essentially pointless and futile. Yet understanding the sensitivity of a company's earnings and cash fl ows to larger events enables us to assess bull-, base- and bear-case scenarios in determining our estimates of the company's worth.
As we diligently followed our process and philosophy, we found opportunities, in 2013 and in previous years, in areas where we felt the markets were overly punitive for the various headwinds faced.
Overall, we are pleased with the fi rm's investment performance in 2013 and over the long term.
Investing Beyond the Benchmark: Then and Now
As is oft en the challenge for disciplined value investors, the positions we took years ago in our strategies overall, such as in the then-troubled regions of Japan and Europe, were controversial among some clients. Our holdings diff ered signifi cantly in names and weightings from the benchmarks.
As unsettling as it was on the surface, some of our st rategies were in the top decile or top quartile of manager allocations to Europe, Europe ex-U.K. and Japan at various points during the last fi ve years relative to peers in the Intersec universe.2 But our conviction as value investors led us to ignore the noise then. Fast forward to today, and we take the same approach. As an example, in the Global Equity Strategy our allocation to the United States at 28% was roughly half the MSCI World Index's U.S. allocation of 54%, and much less than the MSCI All Country World Index's U.S. weight at 48% (as of December 31, 2013). Th is was our lowest U.S. allocation in Global Equity since 1997. Another example is that our emerging-market allocations increased throughout 2013, because political and other macro concerns mounted, making some valuations more attractive to us.
We believe the last fi ve years, and 2013 in particular, have shown once again the potential benefi ts of focusing on company-specifi c fundamentals in conjunction with the price one pays. Graham-and-Dodd value investing has produced meaningful outperformance, if one had the patience and fortitude to stay the course.
Stock Selection Highlighted by Review of Regions, Sectors and Industries
While some markets recovered substantially in 2012 and 2013, we are still fi nding pockets of value opportunities globally. In this commentary, we highlight what we believe are a few of the important and relevant industries and regions (United States, Europe, Japan and emerging markets) impacting the portfolios.
United States: Focus on Selection
With the U.S. market up 32% in 2013, as measured by the S&P 500 Index and up nearly 200% (including dividends) since the low on March 9, 2009, many company fundamentals and valuations have changed dramatically. Th e question that seems to be in many headlines now is whether the U.S. market as a whole is overvalued or whether we are still in the early stages of a prolonged market recovery. While there are compelling arguments on both sides, we are fi nding fewer opportunities in the United States and our allocations have accordingly been reduced, which in part is due to fi nding what we view as better opportunities elsewhere, such as in Europe and the emerging markets. As indicated in Exhibit 4, on page 4, as of December 31, 2013, the Shiller P/E3 was 25.6x for U.S. stocks vs. their 30-year median of 21.8x, and 14.1x for Europe stocks vs. their 30-year median of 17.5x. And although this would generally indicate, on a portfolio positioning standpoint, reduced exposure to the United States and an increasing weight to Europe as a whole, stock selection remains key. Whether macroeconomic indicators are positive or negative, or whether market valuations as a whole appear inexpensive or pricey, focusing on the fundamentals of individual companies and comparing them to market prices is critical to value investing. And despite the substantial recovery in the U.S. market, based on our company-level analysis we still fi nd opportunities in a number of companies in the information technology (IT) and fi nancial services sectors.
"Mature" IT Firms
Th e characteristics of companies that comprise the IT sector have changed dramatically over the last fi ve to 15 years. Many of the former high growth, high P/E multiple "darlings" have matured while newer cloud-based and social media companies—with their allure of high-growth and loft y P/E multiples—have captured the most attention. We have found attractive opportunities in the former: more mature and former high growth IT stocks. Today, we fi nd that many of the mature tech companies, despite a tempering of their once rapid pace of growth, have higher returns on capital and growth rates still equal to or better than the market, strong balance sheets with good free cash fl ow, a track record of returning cash to shareholders, and most importantly, have recently been trading at attractive valuations.
As shown in Exhibit 3, IT holdings in the Brandes U.S. Value Equity Strategy generally had stronger capital structures, meaningfully lower valuations that we believe more than compensate for secular risks from potential technology shift s, and yet still reasonable growth profi les as compared to fundamentals of IT companies in the S&P 500 Index. Additionally, while many of the Brandes IT sector holdings may not have the growth excitement that some of their tech brethren have, they could, nevertheless, benefi t if enterprise-technology spending picks up.
Well-Capitalized U.S. Banks
In our view, U.S. banks have shown improving profi tability and capital positions despite the relatively modest macroeconomic recovery. At the height of the fi nancial crisis, many investors shunned U.S. banks amid fears of all things fi nancial. Since then, U.S. banks' underlying fundamentals have improved and are considered to be at healthy levels:
• Higher capital levels as measured by equity 4 /assets of over 11% versus 9% to 10% pre-2008. 5
• Higher tangible equity to tangible assets: 8.3% (up from a low of 4.8% in 2007; higher number means banks can absorb more losses before needing new equity).
• More conservative ratio of loans to deposits: 75% versus 95% in 2007 (lower ratio indicates a bank being more conservatively run).
• Lower ratio of non-performing loans to gross loans: trending down from 4.8% in 2009 to 3.2% (lower percentage means there are fewer "problem loans").
Despite these fundamental improvements, U.S. bank valuations remain depressed and well below their long- term averages. In our view, today's price-to-book (P/B) at 1.1x (as of 12/31/2013) compared to the 20-year average of 1.8x, for U.S. banks (Source: Bloomberg) seems like an excessive discount, especially in light of the added confi dence surrounding their liquidity and capital positions. In our valuations, we acknowledge and conservatively assume that future profi tability of U.S. banks will be less than in the past due to decreased leverage, greater regulations and restrictions, and ongoing lawsuits, as well as other competitive challenges.
However, it is interesting to note that while we have been fi nding attractive opportunities in many of the major U.S. banks, we have not been as attracted to many of their European counterparts despite the apparently attractive valuation of the European banks. Compared with European banks, we believe U.S. banks enjoy an advantage due to the following:
• Better capitalization and less dependency on wholesale funding, which ebbs and fl ows with sentiment, and is recovering from weak asset markets.
• Lower regulatory uncertainties—many European banks need more equity capital and are heavily reliant on wholesale funding, a big part of which they currently get from the European Central Bank.
• Greater regulatory concerns among European banks—including the planned asset-stress testing in 2014 and the transition to a euro-wide bank regulator.
Europe: Finding Value Opportunities in Depressed Local Markets
While Europe appears to have emerged from the recession, and although a number of key metrics have stabilized or even improved, the macroeconomic situation in many countries remains fl uid and uncertain. However, as shown in Exhibit 4, at the depths of the fi nancial crisis, the Shiller P/E for Europe dropped dramatically from about 24x in May 2007 to about 10x in March 2009, indicating potentially attractive opportunities for long- term investors.
Although the macro issues were very real and serious—including the potential for a partial or full European Union breakup, high unemployment, elevated debt-to-GDP ratios, recession and fi scal austerity—we focused fi rst on individual company fundamentals and then stress-tested their sensitivities to various macro outcomes. As many of the region's economies have begun to recover since the crisis, the range of potential outcomes has been reduced. Undervalued Food and Staples Retailing in Europe Although we have been attracted to each holding for diff erent fundamental reasons (e.g., turnaround prospects, industry-leading sales growth and profi t margins, strong asset backing and high lease-adjusted returns on invested capital), one theme was consistent: attractive valuations. Companies in the European food and staples retailing industry as a whole were trading at a meaningful discount from historical averages relative to the market, as shown in Exhibit 5. Some of the European retailers have been among the lowest- priced consumer stocks anywhere.
As an example of a holding in the industry, we found a compelling value opportunity in a leading France- based food and staples retailer. 6 Many investors seemed to have little confi dence in the company aft er years of weak performance in many key markets, numerous CEO changes, unsuccessful corporate restructuring eff orts and repeated profi t warnings. As is common in the industry, investors appeared to be mostly taking a wait-and-see approach to the company's turnaround and attributed little credit to the potential for a successful recovery. Nonetheless, the company has benefi ted from a number of positive developments: New management has sold a number of assets at attractive prices; signifi cantly improved the balance sheet; continued execution on a number of other restructuring initiatives; and an improvement in the French retail market. Th ese factors led us to believe the company's share price was misaligned with its fundamentals, and it has since recovered substantially on the back of these positive developments.
European Oil Majors Priced Well Below Average
We also continue to see opportunities among mispriced companies in the European oil and gas industry.
We believe the industry is currently priced at a discount to the overall market and its peers in other parts of the world due to headwinds which are short term and cyclical in nature. For instance, in the upstream segments, capital spending has been high over the last fi ve years without commensurate production growth. On the refi ning side, margins have been low as a result of overcapacity and sluggish demand brought about by the challenging economic environment in the local economies. We believe that production across the industry should increase as a strong pipeline of projects moves from development to production, and overcapacity in the refi ning industry should ease as European refi neries close and retail demand for oil products begins to recover.
As shown in Exhibit 6, on page 6, European oils were trading at a 30% discount to the market—near the wider end of what has been observed in the past.
As an example of an opportunity we see in the industry, we continue to invest in an Italy-based energy fi rm, 6 which is among the world's 10 largest integrated oil companies and has signifi cant presence in the Italian
energy sector and in other countries. Our analysis showed that the recent market valuation for the company may not refl ect its underlying fundamentals, with the market's valuation merely equivalent to the sum of the company's oil and gas reserves and the value of its publicly listed subsidiaries. Th is implies that at current prices, the market is giving no value to the company's substantial assets in power production, refi ning and marketing, and seemed to have largely ignored the company's multi-billion euro investment to grow its reserve base.
Exhibit 6: European Oil Has Traded at a Discount
Additional Resource: Europe
—Our Quarterly Commentary for 4Q 2011: "Fundamentals Overshadowed" off ers more perspective on European macroeconomic concerns that we saw as we focused on individual company fundamentals. Please note, access to certain materials may be limited. To learn more about our views and product off erings, please visit brandes.com.
Japan: Keeping the Faith in Companies Japan was up 54.6% in 2013 in yen terms, and 27.2% in U.S. dollar terms, as measured by the MSCI Japan Index, as sentiment has changed signifi cantly with Abenomics' three-arrows strategy as well as a weakening yen and a stabilizing euro. We have had a meaningful allocation to Japan in a number of our strategies over the last few years. As Japan has appreciated, we trimmed our allocation slightly in 2013. However, we continue to hold a number of attractively valued companies even though as a whole Japan now is not as attractive to us as it was a few years back.
With the recent good news on Japanese equity returns, it's easy to forget how dire the situation seemed a year or two ago, when headlines indicating Japan's situation was hopeless saturated the media. Th en the Tohoku earthquake hit with the resulting tsunami and Fukushima nuclear disaster. As events unfolded, we received many questions from our clients regarding our Japanese allocation and specifi c Japanese holdings. At that time, we were the global manager with the highest allocation to Japan in the Intersec Global peer universe. 7 Again, although the macro issues were (and still are) very real and serious, we focused fi rst on individual company fundamentals and then stress-tested their sensitivities to various potential macro outcomes. Many of our Japanese holdings are multinational companies with earnings, cash fl ows, and assets not solely dependent on the local economy. As glimmers of hope started to creep into public sentiment, and very depressed valuations began to turn, our overweight in Japan positively contributed to returns in 2013. We are still meaningfully allocated to Japan in many of our equity strategies.
Additional Resource: Japan
—Our Quarterly Commentary for 1Q 2012: "Japan: What a Modicum of Good News Could Produce" off ers more perspective on macroeconomic concerns that we saw as we focused on individual company fundamentals. Please note, access to certain materials may be limited. To learn more about our views and product off erings, please visit brandes.com.
Emerging Markets: Shifting Investor Sentiment
In contrast to the strong recovery in most major developed equity markets, sentiment toward emerging markets changed rather dramatically in 2013 with the MSCI Emerging Market Index down 2.6% as macroeconomic
actors, negative headlines, and fear of a repeat of the late 1990s' Asian crisis negatively impacted prices. As these fears have pushed prices down, our allocations to emerging markets in many of our equity strategies have increased. We continue to scour many emerging markets closely for opportunities, just as we did in Japan and Europe a few years back when the headwinds and negative sentiment overly punished prices relative to fundamentals. We would not be surprised to see our exposure to emerging markets gradually increase.
Additional Resource: Emerging Markets —We wrote extensively about our thoughts on emerging markets in our Quarterly Commentary for 3Q 2013: "Emerging Markets Concerns Rising—So Are Select Opportunities," including the pitfalls of treating emerging markets as one homogenous market and the importance of active stock selection.
Looking Ahead: Our Continued Commitment to You
Similar to the way they behaved following the 2008 fi nancial crisis, many market participants continue to focus on short-term macroeconomic issues today. Heading into 2014, topping the list are the timing and extent of the U.S. Federal Reserve's decision to start winding down its quantitative easing program, if and when interest rates may start to rise, and the corresponding impact on asset fl ows, particularly within emerging markets. While we view this as interesting, we focus on individual company fundamentals and their sensitivities to various scenarios to guide us in selecting companies worthy of inclusion in our client portfolios.
Not every year has been or will be like 2013, and we realize there were times when the positions we took may have been uncomfortable for some as market sentiment and investor preferences shift ed and the value investment style was out of favor. Nonetheless, with our value philosophy consistently guiding our investment decisions, we believe Brandes portfolios are well-positioned for the long term.
Importantly for us, as stewards of your investments, we remain committed to the qualities you've come to know and expect from Brandes: Independence, stability, repeatable investment process, Graham-and-Dodd value style, patience and conviction. Th ese traits set us up to help you pursue your long-term fi nancial goals, as markets continue to cycle.
Thank you for your trust, patience and confidence.
Price-to-Earnings: Price per share divided by earnings per share. Price-to-Book: Price per share divided by book value per share Price-to-Cash Flow: Price per share divided by cash fl ow per share. The MSCI World Index with net dividends is an unmanaged, free fl oat-adjusted market capitalization weighted index that is desig ned to measure the equity market performance of developed markets. The MSCI World Index consists of 24 developed-market country indices. This index includes div idends and distributions net of withholding taxes but does not refl ect fees, brokerage commissions, or other expenses of investing. The MSCI World – Pharmaceut icals in Exhibit 1 represents the performance of the pharmaceutical sector of the MSCI World Index. The MSCI ACWI (All Country World) Index with gross dividends is an unmanaged, free fl oat-adjusted market-capitalization weighte d index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 develop ed and 21 emerging-market country indices. This index includes dividends and distributions, but does not refl ect fees, brokerage commissions, withholding taxes o r other expenses of investing. The MSCI EAFE (Europe, Australasia, Far East) Index with net dividends is an unmanaged, free fl oat-adjusted market capitalizati on index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of 22 developed mar ket country indices. This index often is used as a benchmark for international equity portfolios and includes dividends and distributions net of withholding ta xes, but does not refl ect fees, brokerage commissions, or other expenses of investing. The MSCI Europe Index with net dividends is an unmanaged, free fl oat-adjusted market capitalization weighted index that is desi gned to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of 16 developed market country indices. This ind ex includes dividends and distributions net of withholding taxes, but does not refl ect fees, brokerage commissions, or other expenses of investing. The MSCI Emerging Markets Index with gross dividends is an unmanaged, free fl oat-adjusted market capitalization index that is d esigned to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of 21 emerging market country indices. This index inc ludes dividends and distributions, but does not refl ect fees, brokerage commissions, withholding taxes, or other expenses of investing. The MSCI Japan Index with net dividends is an unmanaged, free fl oat-adjusted market capitalization weighted index that is desig ned to measure equity market performance of the developed markets in Japan. This index includes dividends and distributions net of withholding taxes, but does not refl e ct fees, brokerage commissions, or other expenses of investing. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any fi nancial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as a n indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an "as is" basis and the user of this informa tion assumes the entire risk of any use made of this information. MSCI, each of its affi liates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the "MSCI Parties") expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fi tness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profi ts) or any other damages. (www.msci.com) The S&P 500 Index with gross dividends is an unmanaged, market-capitalization weighted index that measures the equity performan ce of 500 leading companies in leading industries of the U.S. economy. The index includes 500 leading companies in leading industries of the U.S. economy, cap turing 80% coverage of U.S. equities. This index includes dividends and distributions, but does not refl ect fees, brokerage commissions, withholding taxes or other expens es of investing. The portfolio characteristics discussed relate to a single account as of date noted, deemed by Brandes to be generally represen tative of its standard account noted. Not every account will have these exact characteristics. The actual characteristics with respect to any particular account will var y based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market e xigencies at the time of investment. The information provided in this material should not be considered a recommendation to purchase or sell any particular security . It should not be assumed that any security transactions, holdings or sectors discussed were or will be profi table, or that the investment recommendations or decisions we make in the future will be profi table or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time and sho uld not be considered a recommendation to buy or sell particular securities. Strategies discussed herein are subject to change at any time by the investment manager i n its discretion due to market conditions or opportunities. Indices are unmanaged and are not available for direct investment. Market conditions may impact performance. The performance results presented were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regul atory environment may have a negative impact on future performance. International investing is subject to certain risks such as currency fl uctuation and social and p olitical changes which may result in greater share price volatility; such risks are increased when investing in emerging markets. Additional risks associated with emerging markets investing include smaller-sized markets, liquidity risks, and less established legal, political, social and business systems to support securities markets. Eme rging markets investments can experience substantial price volatility in the short term and should be considered long-term investments. Investments in small and medium capitalization companies tend to have limited liquidity and greater price volatility than large capitalization companies. There is no assurance that forecasts and forward-looking statements will be accurate. Because of the many variables involved, a n investor should not rely on them without realizing their limitations. The foregoing refl ects the thoughts and opinions of Brandes Investment Partners ® exclusively and is subject to change without notice. Brandes Investment Partners ® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada
1 In February 2009, the Shiller P/E for the S&P 500 and MSCI Europe was 12.7x and 9.7x versus their 30-year medians of 21.8x an d 17.5x, respectively. These showed a signifi cant discount to historical valuation levels. Exhibit 2: Market Returns Five Years Post-Financial Crisis Annualized Returns ending 12/31/2013 Description 1 Year 5 Years S&P 500 - Total Return 32.39% 17.94% MSCI World Index - Net Return 26.68% 15.02% MSCI EAFE - Net Return 22.78% 12.44% MSCI Europe - Net Return 25.23% 13.36% MSCI Emerging Markets - Net Return -2.60% 14.79% MSCI Japan - Net Return 27.16% 7.65% Source: S&P, MSCI via FactSet. Past performance is not a guarantee of future results. One cannot invest directly in an index.
2 Source: Intersec Research; Our Global Equity Strategy's allocation to Europe has been in the top decile since 3Q12 and in 1Q1 3 was in the top one percentile. Our Global Equity Strategy's allocation to Japan has been for the most part in the top one percentile since 3Q09. Our Internati onal Equity Strategy's allocation to Europe Ex-UK has been mostly in the top quartile since 1Q12. Our International Equity Strategy's allocation to Japan was in the top one percentile from 1Q08 through 4Q12. Statistics per the Intersec Global and International peer universe, respectively. Intersec based its rankings on data collected from portfolio managers and from custodial banks monthly in the form of market values and contributions for total fund and aggregate purchases , sales and income data for each equity market.
3 Source: Morgan Stanley, MSCI, S&P, various national sources; Shiller P/E defi ned as infl ation adjusted price to 10Y average e arnings per share from continuing operations.
4 Equity defi ned per Bank for International Settlements, Basel III "Criteria for Common Equity Tier 1," Paragraphs 52-53, Decem ber 2011, http://www.bis.org/publ/bcbs211.htm
5 Source for all four bullets: SNL Financial, as of 9/30/2013 (latest available company reports)
6 Brandes is not naming this company because the SEC limits discussions of specifi c companies in certain situations.
7 Source: Intersec Research; Our Global Equity Strategy's allocation to Japan has been for the most part in the top one percent ile since 3Q09. Our International Equity Strategy's allocation to Japan was in the top one percentile from 1Q08 through 4Q12. Statistics per the Intersec Global and Int ernational peer universe, respectively. Intersec based its rankings on data collected from portfolio managers and from custodial banks monthly in the form of market va lues and contributions for total fund and aggregate purchases, sales and income data for each equity market.