Brandes Quarterly Commentary - Volatility: Misbehaving—In Action

Volatility: Misbehaving—In Action

Last quarter, we referenced Richard Thaler’s recent book, Misbehaving: The Making of Behavioral Economics, because of its instructive background on how irrational behavior can lead people to miss opportunities—even when they recognize their error-prone ways. This past quarter we’ve seen misbehaving in action as investors headed for the hills in the face of market volatility and what they perceived to be increased risk.

As a manager focused on long-term business valuations, Brandes makes a fundamental distinction between volatility and risk: In our view, volatility is the short-term ups and downs of the market, while risk is the likelihood of permanent capital loss or falling short of long-term goals. We do not see recent volatility—even though it spiked to its highest point since October 4, 2011—as a signal to “misbehave” and run.1 Rather, by using a rational, fundamentally driven approach, we can seek attractively priced companies—sold off in the midst of volatility.

China’s economic slowdown and currency devaluation triggered a global market selloff and a rise in volatility during the quarter. This is a good example of misbehaving: many investors chose to sell when prices were falling. Exchange traded funds (ETFs) also contributed to wild price swings. According to the Wall Street Journal, nearly 80% of the 1,279 U.S. trading halts reported on August 24 were for ETFs.2 “Misbehaving” investors were penalized for selling ETFs whose share prices became unmoored from the prices of their underlying securities, which may happen during periods of heavy order flow. With the rise in the popularity and number of ETFs, we may see more of this “misbehaving” if the prices of such products disengage from the value of the securities they package.

In this edition of the Brandes Quarterly Commentary, we pick up on the economic slowdown topic from last quarter and fold in discussions about recent volatility. Specifically, we’ll add to our analysis on China and look at value potential in the United States and Brazil. First, let’s look at what Brandes, as an active manager, does when drastic price swings hit.

Active Management in Periods of Volatility

Value has gone in cycles. There’s often a misconception that value managers aren’t doing very much as they wait out a cycle. At Brandes, nothing is further from the truth. We manage actively every day and in all market conditions—particularly during volatile periods when stock prices tend to decouple from company values.

Our investment committees have many companies on their monitoring lists across all sectors and regions. When stocks start to become volatile, the Brandes investment committees go into high gear by increasing the frequency of company reviews. Analysts update company reports, and more opportunities are up for committee review. The objective is to re-allocate capital to companies we believe have the highest margins of safety, which can mean either paring or adding to existing holdings, or adding new companies to the portfolios. The primary driver of any activity is margin of safety at the security level and at the overall portfolio level. The margin of safety for any security is the discount of its market price to what the firm believes is the intrinsic value of that security.

Holding Cash Until We Find Margins of Safety

We often say that our Research Analysts are as incentivized to help us avoid overpaying for securities as they are to finding undervalued ones. This is why we held higher cash positions in a number of the portfolios prior to this most recent bout of volatility. In earlier commentaries, we discussed that value potential was showing up in pockets across the globe and selectivity was critical. Despite being newsworthy, recent market declines have not necessarily translated into an abundance of value investment opportunities that would lead us to significantly shift portfolio allocations.

Some of the companies on our monitoring lists are nearing or reaching the significant margins of safety that we demand before making an investment. In addition to declines in China and emerging markets, developed countries have also seen declines in their equity markets. Most major global indices declined by high single digits to low double digits between June and end of September. On a year-to-date and one-year basis, key global and international indices (with the exception of Japan) showed negative returns as of September 30, 2015.

China: Still Not Ready for Investment

Given recent growth forecasts and supporting data, many investors now recognize that China’s strong upward trajectory is unlikely to continue at the pace of the past 10 years. (Explore our Brandes Q3 2014 Quarterly Commentary for more detail: “China at a Crossroads: Brandes Analyst Insights.”) This realization, along with erratic government responses to market concern about the country’s slowing economic growth, contributed to the sharp decline in Chinese equities in the third quarter. As of September 30, 2015, the Shanghai Composite Index had fallen 42% (in U.S. dollar terms) from its peak on June 12, 2015.

However, the significance of this recent decline must be seen in the context of its rapid ascent since mid 2014. The Shanghai Composite Index climbed 152% from June 30, 2014 to its peak on June 12, 2015. The rise was fueled by margin lending, which was not supported by company and economic fundamentals.3 “As such, even after the market correction, we believe that Chinese company valuations do not present many value opportunities,” comments Louis Lau, CFA, a member of the Brandes Emerging Markets Investment Committee and a research analyst on the financials team. “The financial sector, including banks, comprises around 40% of the MSCI China universe and although the sector looks optically inexpensive, we have longstanding concerns about credit quality and balance-sheet transparency. Our under-allocated positions in China-based and China-exposed companies reflect our doubts on whether current stock prices adequately capture the economic challenges.”

Louis visited a number of Chinese companies across multiple industry sectors in Shanghai and Hong Kong in May 2015 and reflects upon his visit: “In the midst of equity market euphoria back in May, there were already growth and profitability concerns emanating at the company level. Going forward, evaluating how Chinese companies will navigate the backdrop of slowing growth and government policy influence will be critical in assessing intrinsic values.”

United States: Under-Allocated But Starting to Wade In

Brandes maintained high cash positions in our U.S. strategies because we were not seeing margins of safety; however, this last round of volatility shook out some value potential that we were able to act on.

Within our U.S. Value Equity Strategy, we added Emerson Electric (EMR, Financial) and Johnson & Johnson during the quarter. Emerson Electric produces electrical products and systems addressing a wide range of industrial, commercial, and consumer markets. Emerson’s positive attributes include strong market positions in the majority of its businesses, a long track record of better margins than its peers, and a healthy balance sheet.

Healthcare giant Johnson & Johnson (JNJ, Financial), which has diverse operations in pharmaceuticals, medical devices, biotechnology and consumer health, has faced potential competition in its pharmaceutical segment and lingering concerns over product recalls and manufacturing issues in its consumer segment. Nonetheless, we believe the company’s fundamentals remain attractive, including its strong competitive position and balance sheet, as well as a history of prudent capital deployment. The company generates approximately 70% of its revenues from businesses which command a #1 or #2 global market share, and 25% from products launched over the last five years. Speaking to the strength of its balance sheet, Johnson & Johnson is one of only four U.S. industrial companies with a AAA credit rating from both S&P and Moody’s.

Despite these additions, we remain cautious on the U.S. equity market, which in our opinion still appears somewhat expensive as a whole. The sustained upturn of the past six years—driven by economic recovery and the Federal Reserve’s quantitative easing campaign—has made it increasingly difficult to find compelling value opportunities in the U.S. market.

In addition, current U.S. profit margins are near all-time highs (much higher than during the tech bubble of 1999/2000). This can be explained in part by a shift toward technology and services, but also by the favorable tailwinds of lack of wage pressures, low interest rates and (until recently) a favorable currency environment. However, margins have been historically mean-reverting when a number of these factors began to reverse and as high margins encouraged new entrants/competition. As a result, we expect that long-term margins will likely decline from current levels.

Brazil: Popularity Down, Value Remains

Volatility also hit Brazil hard during the third quarter, due mainly to oil and commodity price declines and the drop in consumer confidence in the face of economic weakness and political turmoil. Despite the negative sentiment, we continue to find select value opportunities and have meaningful allocations as a result of our bottom-up analysis.

Worries over the continuing Petrobras scandal, fear of low economic growth, persistent inflation, rising interest rates and currency depreciation contributed to negative investor sentiment in the third quarter.

“Brazil is going not only through a hard period economically, but is also living through a period of disillusionment and anger on the political front,” comments Gerardo Zamorano, CFA, a member of the Brandes Emerging Markets Investment Committee and a research analyst on the telecommunications and media teams. He visited Brazil in mid-August to early September. “I see signs of this in everyday conversations, in prime time news and front page newspaper articles.”

After barely winning an election last year, President Dilma Rousseff has lost most of her support, and has an approval rating of 8%.4 “Multiple groups are calling for an impeachment, including groups inside her own party,” Gerardo points out. “Brazil’s society is fed up with corruption and is hungry for change. Political volatility has made it harder to negotiate reforms and manage the fiscal crisis, leading to lower confidence and the recent downgrade of Brazil to below investment grade by a rating agency. Facing another hard year in 2016, most companies I met with are going through cost cutting programs. Under this environment of challenges on the macro and political fronts, with near record-low consumer confidence, we are seeing near record-low valuations and we believe the market is being overly punitive with a number of companies.”

It is also important to remember that the devaluation actually helps some businesses. “In my meetings with a beef exporter, we talked about the improved competitiveness of Brazilian beef coming at a time when the U.S. market has opened up for imports from Brazil, which should trigger the opening up of other countries like Canada, Mexico, South Korea and Japan,” adds Gerardo.

Our allocation to Brazil, just like to any other country or sector, is not based on economic or political factors, but on a company-by-company analysis.

While recent volatility may have obscured what we believe is the inherent attractiveness of emerging markets, we believe the asset class remains home to some fundamentally sound businesses that stand to benefit from the long-term themes of favorable demographics and a rising middle class.

Behaving and Looking for Value

As active managers, we are on the case for value every day. Avoiding overpaying for securities and allowing cash positions to temporarily increase when value potential is scarce are part of a disciplined way to apply Graham-and-Dodd principles, even if it’s not always popular. Our strict adherence to analyzing companies individually keeps us from “misbehaving” and overreacting to exaggerated media noise.

Our ultimate goal is to seek what we believe are the best value candidates with the potential to help build wealth for our clients over the long term.

Margin of Safety: The difference between the intrinsic value of a stock and its market price.

The Chicago Board Options Exchange Volatility Index (VIX) measures market expectations of near-term volatility by tracking S&P 500 index option prices. Often referred to as the “investor fear gauge.”

The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips and P chips. With 144 constituents, the index covers about 85% of this China equity universe.

The Shanghai Stock Exchange Composite Index is a market composite made up of all the A-shares and B-shares that trade on the Shanghai Stock Exchange. Source: Investopedia.com

The securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory accounts. The viewer should not assume that an investment in the securities identified was or will be profitable.

There is no assurance that a forecast will be accurate. Because of the many variables involved, an investor should not rely on forecasts without realizing their limitations.

The recommended reading has been prepared by independent sources which are not affiliated with Brandes Investment Partners. Any securities mentioned reflect independent analysts’ opinions and are not recommendations of Brandes Investment Partners. These materials are recommended for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security.

Not all investment strategies are suitable for all investors.

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 profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time and should 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 in its discretion due to market conditions or opportunities. Market conditions may impact performance.

International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes, differences in financial reporting standards and less stringent regulation of securities markets 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. Some emerging markets countries may have fixed or managed currencies that are not free-floating against the U.S. dollar. Certain of these currencies have experienced, and may experience in the future, substantial fluctuations or a steady devaluation relative to the U.S. dollar.

Investments in small and medium capitalization companies tend to have limited liquidity and greater price volatility than large capitalization companies.

Investing in exchange-traded funds (ETFs) involves specific considerations for investors including, but not limited to, expenses, liquidity risks, and the possibility that ETF shares may trade at prices above or below their net asset value.

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1. As measured by the CBOE Volatility Index. The highest point since October 4, 2011, was recorded on August 24, 2015; Source: FactSet

2. The Wall Street Journal, Aug. 27, 2015: http://www.wsj.com/articles/stock-halts-added-to-mondays-market-chaos-1440717753

3. The Wall Street Journal, “Chinese Firms Discover Margin Lending’s Downside,” June 30, 2015 – http://www.wsj.com/articles/chinese-firms-discover-margin-lendings-downside-1435653636