Market Overview
Capping another volatile period, exacerbated by the United Kingdom’s decision in late June to leave the European Union, emerging-market stocks were up slightly in the second quarter.
In Brazil, the senate voted to impeach President Dilma Rousseff, forcing her to step down to stand trial. Despite the continued political turmoil in the country, the MSCI Brazil Index delivered gains for the last three months.
Other factors impacting investor sentiment in emerging markets included commodity prices, especially those of oil, which closed the quarter considerably higher, although negatively affected by the “Brexit” news.
The Brandes Emerging Markets Value Fund outperformed its benchmark, the MSCI Emerging Markets Index, which returned 0.8% for the quarter.
Positive Contributors
Notwithstanding the political instability stemming from President Dilma’s impeachment process and her subsequent suspension, our holdings in Brazil represented major positive contributors. Notable performers included oil giant Petrobras and for-profit higher-education providers Estacio Participacoes and Kroton Educacional.
A bidding war for Estacio (BSP:ESTC3, Financial) erupted in early June after Kroton Educacional and Ser, two of Estacio’s peers, made non-binding merger offers for the company. In mid-June, Estacio’s chief executive officer resigned and was replaced on an interim basis by a member of the Zaher family. This development magnified the bidding war as there has been speculation that the Zaher family, which owns 14% of Estacio, is also considering a possible tender offer for 36%-61% of the company in order to acquire majority control.
While the situation is ongoing, shares of Estacio and Kroton (BSP:KROT3, Financial) have appreciated materially on the news of the potential acquisition. The merger between the two companies could produce meaningful synergies, including scale and operational improvements, especially considering Kroton’s margins are materially higher than Estacio’s.
Other positive contributors included Russian Sberbank, Hong Kong-based specialty retailer
Lifestyle International and Chilean chemical company Sociedad Quimica y Minera de Chile (SQM).
Lifestyle International (HKSE:01212, Financial) announced in April a proposal to spin off all of its businesses and investments in China as a separate entity in an effort to unlock hidden value. Lifestyle’s Hong Kong and Chinese assets have different growth paths, risk profiles and historical cash-flow generation properties. We generally view the spinoff as positive news as it may increase financial transparency, enable management teams to better focus on their respective businesses, and allow greater access to debt and equity markets.
In the quarter, SQM also saw a number of favorable developments, including increased pricing for lithium and production boost for potassium nitrate (specialty plant nutrient). The company has leading market shares for both products globally.
Performance Detractors
Performance detractors included a number of holdings in Latin America, most notably Panamanian airline Copa Holdings, Mexican cement company Cemex and Brazilian regional jet manufacturer Embraer.
After starting the year with strong performance buoyed by the currency strengthening of a number of Latin American countries in which it operates, Copa (CPA, Financial) saw its shares decline due to downward revisions to its 2016 guidance on revenue per available seat mile (or RASM, normally used to measure an airline’s efficiency) and operating margins.
For Embraer (ERJ, Financial), which derives the majority of its sales outside Brazil, the real’s appreciation continued to present a headwind. The company has also been experiencing margin compression, mainly due to the mature state of its current product mix ahead of the launch of its next-generation models expected in 2018. We see the challenges facing Copa and Embraer as temporary in nature and we continue to believe they represent attractive investment opportunities.
Also weighing on performance in the quarter was Erste Group Bank (WBO:EBS, Financial), an Austria-domiciled bank with a majority of assets in emerging Europe. European financial companies—Erste was no exception—were negatively impacted by the Brexit news due to increased fears of a euro break-up, prolonged macroeconomic uncertainty and more downward pressure on interest rates. Compared to other developing markets, emerging Central and Eastern European countries tend to have higher exposure to exports to the United Kingdom and the euro zone, as well as currencies that are more correlated to the euro. However, we believe Erste will be relatively resilient due to its strong capital adequacy and improving asset quality.
Select Activity in the Second Quarter
Given the continued strong share-price appreciation of several Brazilian companies, the Emerging Markets Investment Committee exited a select group of holdings that reached our estimates of their intrinsic value. These included electric utility Centrais Eletricas Brasileiras (Eletrobras), water utility
Companhia de Saneamento Basico do Estado de Sao Paulo (SABESP) and bank Banco Santander Brasil.
A long-time position in the Fund, Eletrobras (BSP:LIPR3) is a holding company that operates across the entire electricity value chain. The company is Brazil’s largest electricity provider, controlling 33% of the country’s generation capacity, mainly via hydro plants, and nearly 50% of the transmission grid.
In late April, Brazil’s Ministry of Mines and Energy announced very favorable compensation payment terms for the residual value of transmission assets built prior to 2000 (previously arbitrarily set to zero). The change marked a significant regulatory turnabout for Eletrobras and drove up its shares. The share-price increase, combined with a strong rally for Brazilian securities in general, led us to believe that the risk/reward tradeoff no longer warranted an investment in Eletrobras.
We’ve highlighted our investment in SABESP (SBS) in past commentaries when economic fear in Brazil, coupled with a severe drought, brought the market valuation for the company down to what we considered attractive levels. However, there have been a number of incremental positives for SABESP over the past year, including:
- Rainfall: Thanks to the long-awaited rainfall, the water reservoirs in Sao Paolo region have improved—albeit still low—from the critical levels observed a year ago.
- Lower financial leverage: More favorable investor sentiment in Brazil and the real’s appreciation against the U.S. dollar have helped SABESP reduce its financial leverage ratios as the company has exposure to foreign currency-denominated debt.
- Increased market appreciation: In contrast to when we first purchased the company, the market now seems to give more credit to SABESP’s defensive nature as a water utility with an inelastic demand and a fair regulator.
As a result of these factors, in what was a surprisingly quick turnaround, SABESP’s share price appreciated to a level where the offered fundamental value was no longer attractive in the opinion of the investment committee.
In the quarter, the investment committee initiated positions in two Thailand-based banks: Bangkok Bank and Kasikornbank (formerly Thai Farmers Bank).
Founded in 1944, Bangkok Bank (BKK:BBL) is the largest commercial bank in Thailand with assets, loans, and deposits all commanding over 15% in market share. Bangkok Bank offers a universal banking platform with a full range of consumer, small-/mid-enterprise and corporate financial products and services. Additionally, the company boasts a strong franchise with nearly 1,200 domestic branches, 39 international branches and over 9,000 ATMs.
Established a year later in 1945, Kasikornbank (BKK:KBANK) is Thailand’s fourth-largest bank. The company provides a broad range of consumer, commercial and corporate banking services, including lending, deposit-taking, credit-card services, international-trade financing, custodian services, asset management, investment banking, life insurance and leasing. Moreover, Kasikornbank is the leader in Thailand’s small-/mid-enterprise lending market, which offers higher margins than retail and corporate lending segments.
The Thai banking industry is in the midst of a credit cycle where asset quality started deteriorating in 2015 due to the slowing economy. In descending order of credit risk, small-/ mid-enterprise lending has represented the highest level of non-performing loans, followed by retail and corporate lending. However, we believe both Bangkok Bank and Kasikornbank are well positioned in the market and offer a margin of safety at their current prices—even after adjusting for further credit deterioration over the next few years.
Bangkok Bank applies conservative lending policies and has higher asset quality than the majority of its peers. Moreover, while not as profitable historically, the bank has the highest level of excess capital and provision coverage in the industry, providing downside protection in our opinion.
Meanwhile, Kasikornbank has higher structural profitability than most Thai banks due to its exposure to the small-/mid-enterprise lending market and its success in fee-income generation. We also appreciate Kasikornbank’s competent management team, which has a history of transparency and clear disclosure.
Both banks offer attractive valuation levels, in our view, as they traded near 10x earnings on a forward basis at quarter end.
Year-to-Date 2016 Briefing
The Brandes Emerging Markets Value Fund outperformed the MSCI Emerging Markets Index, which returned 6.6% for the six-month period ended June 30, 2016.
Positions in Brazil helped performance, as did a number of holdings that rebounded from a poor 2015 performance. Notable contributors included metals and mining companies POSCO and Ternium, as well as Brazilian food product company Companhia Brasileira de Distribuicao, SABESP and Estacio Participacoes.
Meanwhile, detractors for the period were similar to those for the second quarter, including Erste Group Bank and Embraer. Automotive manufacturers China-based Dongfeng Motor and South Korean Kia Motors also weighed on returns so far in 2016.
Current Positioning
Despite the increased activity in the quarter, there have been minimal changes in the Fund from a country and sector/ industry perspective. As always, our allocations are driven by our bottom-up analysis of companies, not a product of a top-down evaluation of countries, sectors or industries.
The sales of a number of Brazilian holdings resulted in a lower allocation to the country, although it remained the Fund’s largest country weighting and overweight compared to the benchmark at quarter end.
From a sector/industry standpoint, we continued to find value in consumer discretionary, especially automotive manufacturers and components companies based in South Korea and China. Furthermore, the addition of Bangkok Bank, Kasikornbank and
Banco Latinoamericano de Comercio Exterior (BLADEX) led to an increased allocation to the financials sector, in which we ended the quarter with a slight overweight vs. the index for the first time in a number of years.
Meanwhile, companies in China, Taiwan and India continued to represent underweight positions as of June 30, along with allocation to information technology.
We remain convinced that the Brandes Emerging Markets Value Fund is well positioned and we appreciate the continued trust you have placed in us.
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.
Because the values of the Fund’s investments will fluctuate with market conditions, so will the value of your investment in the Fund. You could lose money on your investment in the Fund, or the Fund could underperform other investments. The values of the Fund’s investments fluctuate in response to the activities of individual companies and general stock market and economic conditions. In addition, the performance of foreign securities depends on the political and economic environments and other overall economic conditions in the countries where the Fund invests. Emerging country markets involve greater risk and volatility than more developed 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.
