Equity markets worldwide closed a volatile first quarter of 2016 with mixed performance. After posting losses through mid-February, many markets recovered, fueled by a rebound in oil prices and data pointing to the U.S. economy’s relative strength. Federal Reserve officials gave upbeat assessments of the economy while scaling back the number of rate increases expected this year, citing risks posed by global economic and financial developments.
Investors continued to grapple with a number of concerns, including China’s slowing growth and its effect on the rest of the world economy, as well as the sustainability of the recent oil price recovery.
To combat the threat of deflation and jump start growth, the European Central Bank announced more interest-rate cuts, bond purchases and a potential lender subsidy. In Japan, the government is expected to announce additional stimulus measures to help counter the effects of sluggish consumption and China’s economic slowdown. Meanwhile, emerging markets (EM) advanced, fueled by the U.S. dollar’s decline versus many EM currencies and the recovery in oil prices.
Against this backdrop, the Brandes Global Equity Fund underperformed its benchmark, the MSCI World Index, which declined 0.4% in the first quarter.
Performance Detractors
The most significant performance detractors were our financial holdings, primarily banks and capital markets, which were down double-digits during the quarter. In our opinion, the market became indiscriminately concerned about these holdings’ exposure to high-yield securities in the energy sector, as well as about expectations of prolonged low interest rates in the United States and negative interest rates internationally.
Two of the most significant detractors were Citigroup and Credit Suisse.
Citigroup (C, Financial) has energy-loan exposure of less than 4% of total loans, and is, in our view, positioned to benefit from an eventual increase in interest rates. At its current valuation (as of March 31) of just 60% of book value and 7.7x earnings on depressed net interest margins, we believe the stock offers a compelling investment opportunity.
Credit Suisse (CS, Financial) declined over 30% during the quarter as the market remained concerned about the company’s restructuring/turnaround and the possible negative effect on financial results over the next year. Nonetheless, we continue to believe Credit Suisse has an economically attractive business model and is significantly discounted at its current valuation of 0.7x tangible book value. Accordingly, we increased our allocation during the quarter.
Other detractors included Western Digital, Chesapeake Energy and Express Scripts.
Express Scripts (ESRX, Financial) declined 20% during the quarter due to a dispute with its largest client, health insurer Anthem (which accounts for 15%-20% of Express Scripts’ sales), as Anthem believes that Express Scripts needs to pass on larger drug cost savings to its customers. Under the existing contract, Anthem is entitled to a good-faith repricing of the contract terms, the deadline for which was December 15, 2015. As the deadline has passed and Express Scripts still has not provided Anthem with an offer that Anthem deems acceptable, Anthem has recently decided to take legal action against Express Scripts. Express Scripts’ CEO stated the company intends to resolve the dispute and keep Anthem as a customer.
We believe the market has over-reacted to the dispute as the current valuation prices in more than a complete loss of the Anthem contract. While there are multiple possibilities, we believe the most likely outcome is a renegotiation to extend the contract, likely at a lower margin but with increased volumes due to Anthem’s acquisition of Cigna. However there is a risk that Anthem switches to another vendor or brings the business in-house, although it lacks scale relative to peers. Given that the market seems to have priced in the worst-case outcome, we continue to believe that Express Scripts offers an attractive margin of safety.
Positive Contributors
The most significant performance contributors were our holdings in U.K. grocers, in particular Wm. Morrison and Tesco. The market seemed to appreciate their improving sales growth. Nonetheless, both companies remain attractively valued based on our analysis and offer some of the largest margins of safety in the Fund.
In addition, our positions in emerging markets, especially Russia, helped relative performance, as did our holdings of Exelon, Emerson Electric and TIM Participacoes.
Select Activity in the First Quarter
We used price declines to add to our positions in Switzerland-based Credit Suisse, as well as in U.S.-based Bank of New York, State Street and Bank of America.
We purchased France-based Total (TOT, Financial), a vertically integrated oil company operating at all levels within the oil & gas industry, including exploration & production as well as refining & marketing. We had owned Total in the past and sold it in 2014 after the company had several positive developments. However, over the past year the stock declined significantly with the fall in oil prices and has traded near book value. We believe the company has positive attributes, including:
- Solid fundamentals: While the market is concerned about the fall in oil prices, we see a strong company with industry-
leading profitability, a track record of investment discipline and strong growth potential in its liquefied natural gas portfolio.
- Improvement in free cash flow: Total’s management has announced cuts to its capital expenditure (capex), which will likely improve free cash-flow generation. We expect capex spending over the past five years to result in production growth.
- Attractive margin of safety: Using the assumption that profit per barrel and return on capital would normalize at a lower level compared to their 10-year history, and that long-term oil prices would increase as industry capex is cut, Total was trading at an attractive margin of safety relative to our estimate of long-term intrinsic value.
Positions sold during the quarter included Japanese bank Mitsubishi UFJ and Netherlands-based grocer Royal Ahold. Moreover, following thorough deliberations, the Global Large-Cap Investment Committee decided to divest our position in Brazil-based Petrobras and our equity position in U.S.-based Chesapeake Energy.
The uncertainty with Chesapeake (CHK, Financial) is (and has been) the natural gas price. We believe that supply and demand warrant a much higher price than the current sub-$2 per mmBtu level (currently even lower in Pennsylvania where Chesapeake has a significant percentage of its acreage), likely in the $4-$6 range in the medium to long term. At the current natural gas price, producers are cutting capex significantly, which could ultimately impact the supply of natural gas. The path of natural gas prices is uncertain with a lag between capex cuts and changes to production levels. At higher long-term price levels we believe that Chesapeake’s enterprise value would be substantially more than what was valued by the market.
However, as Chesapeake built out its acreage, it utilized a significant amount of debt, making it one of the more leveraged oil and natural gas companies today. As a result, while we think it likely has access to liquidity to survive the depressed natural-gas price environment for the next year or two, we cannot rule out that the management and board will choose to preemptively file for reorganization under the bankruptcy code in order to restructure the company and reduce the substantial debt burden.
Therefore, the Global Large-Cap Investment Committee decided to sell Chesapeake equity, which bears the brunt of this bankruptcy timing risk, and allocate where possible to Chesapeake debt, which we believed offers a more attractive risk/reward tradeoff as it traded at 15 cents to 35 cents on the dollar. At these levels, the yield to maturity was north of 30%, offers the potential for equity-like returns and provides some downside protection because debt holders have a higher claim on assets than do equity shareholders if the company decides to file for reorganization.
It is not typical for the Global Equity Fund to hold securities other than common equity. Exceptions have been made when the securities within a company’s capital structure offered potential investment returns that rivaled those of common equity. This happened with the preferred equity securities of U.S. banks during the financial crisis, for instance. In this particular case, Chesapeake endured an extremely difficult commodity-price environment which resulted in the market value of its common equity, preferred equity and debt falling significantly. The investment committee believes that the potential return from investing in Chesapeake debt surpasses that of many other common equity investments.
If the company files for reorganization and emerges having restructured its debt, it is highly likely that some/all of the debt will be converted to equity, allowing us to potentially participate in the upside of the company’s enterprise value. The restructured company would allow for further potential recovery in value should natural-gas prices eventually rise to economically viable levels during or after the reorganization process.
Regarding Petrobras, the investment committee decided to divest its position believing that other integrated oil majors offered a more attractive risk/reward tradeoff. As the Global Equity Fund has a wide large-cap opportunity set in which to seek attractively valued companies, the Fund could benefit substantially from a recovery in oil prices by investing in other large integrated oil companies, in our opinion. These include newly purchased Total, as well as current holdings BP Plc, Lukoil, ENI and Repsol.
We believe the Fund’s integrated oil holdings at quarter end had strong balance sheets, less dilution risk, and were well-positioned to survive the current downturn in oil prices. While an increase in oil prices would likely help Petrobras’ stock price, there are a variety of other factors that will affect the company, whereas the other oil holdings in the Fund also offer upside if/when oil prices start to rise.
Current Positioning
As of March 31, the fundamental valuation levels of the Global Equity Fund remained more attractive than those of the benchmark, as it traded at significantly lower valuations and had a higher dividend yield* than the MSCI World Index.
Over the last several years, global value benchmarks have underperformed their growth counterparts and have led to valuation differences that we believe portend a market environment that will generate attractive opportunities for value investing. It is noteworthy that value now trades at a discount not seen since the technology bubble in the late 1990s. As always, we continue to practice our disciplined fundamental valuation analysis despite value’s underperformance as we believe it is the best path to strong long-term returns.
At quarter end, the Fund’s largest overweight positions compared to the benchmark were in emerging markets and the United Kingdom, as well as in pharmaceuticals, capital markets, autos, oil & gas, and food retailers. The Fund maintained its largest underweight position in the United States. On the sector level, it had below-benchmark weightings in industrials and materials. We base our investment decisions on bottom-up security selection and are willing to go wherever we can find the most attractive value.
Looking ahead, it is important to keep in mind that notwithstanding periods of volatility and uncertainty, over the past 30 years, global equities as measured by the MSCI World Index appreciated more than investment-grade U.S. bonds and gold.* In the next 30 years and beyond, you can rely on Brandes to remain steadfast in our pursuit of above-benchmark gains based on fundamental value principles—to help you move closer to your long-term financial goals.
Thank you for your business and continued trust.
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Funds may be lower or higher than the performance quoted. Performance of A shares without load does not reflect maximum sales charge of 5.75%. Performance of C shares without load does not reflect maximum sales charge of 1.00%. If reflected in both, the loads would reduce the performance quoted. All performance is historical and includes reinvestment of dividends and capital gains. Performance data current to the most recent month end may be obtained by calling 800.395.3807.
*Class E and Class I shares commenced operations on October 6, 2008. Class A shares commenced operations on January 31, 2011, but prior to January 31, 2013, Class A shares were known as Class S shares. (Class A shares have the same operating expenses as Class S shares.) Performance shown prior to January 31, 2011 for Class A shares reflects the performance of Class I shares restated to reflect Class A sales loads and expenses. Class C shares commenced operations on January 31, 2013. Performance shown prior to the inception of Class C shares reflects the performance of Class I shares restated to reflect Class C expenses.
