Market Overview
Equity markets weathered another volatile period, enhanced by the United Kingdom’s decision in late June to leave the European Union, to close the second quarter with mixed performance. Worries over slowing global growth, the direction of interest rates and commodity-price fluctuations were exacerbated by concerns over the macroeconomic and geopolitical repercussions of “Brexit.” In an effort to reassure investors, central banks across the globe offered to make funds available and intervened in currency markets. Toward quarter end, equity markets on both sides of the Atlantic and Asia recovered some lost ground.
Stocks of European financial companies were among the hardest hit by Brexit, which was not surprising to us considering the sensitivity of their profitability to the global economy.
The Brexit news also negatively affected oil prices, although they closed the quarter considerably higher. Meanwhile, in Brazil, the senate voted to impeach President Dilma Rousseff, forcing her to step down to stand trial. Despite the continued political turmoil that contributed to market volatility, the MSCI Brazil Index delivered gains in the second quarter.
Against this backdrop, the Brandes Global Equity Fund underperformed its benchmark, the MSCI World Index, which rose 1.0% in the second quarter.
Performance Detractors
The Fund’s holdings in capital markets and U.K. food & staples retailers primarily weighed on returns. Following their strong performance in the first quarter, J Sainsbury and Tesco (TESO, Financial) declined during the quarter as the market became concerned about a potential recession in the United Kingdom following the Brexit vote. While a potential recession may be a negative for the grocers in the near term, there is also some potential for positive developments from the Brexit decision. The pound’s significant weakening after the vote and the potential subsequent monetary easing by the Bank of England may help stoke inflation, which could benefit U.K. grocers as it may alleviate challenges resulting from recent food-price deflation.
Additionally, Switzerland-based financial services firms UBS (UBS, Financial) and Credit Suisse (CS, Financial) declined as markets became concerned about Brexit’s impact on European financials in general. While the market has reacted negatively given the many unknowns about the depth and breadth of Brexit’s repercussions on European banks, we continue to believe UBS and Credit Suisse are appealing investment opportunities as the majority of their value comes from attractive fee-based wealth management businesses. However, we remain cautious on many traditional European banks despite their apparent cheap headline valuation metrics, as we evaluate their capital positions, which aren’t nearly as strong as their U.S. counterparts.
Other detractors included European telecommunications equipment company Ericsson and Brazilian airplane manufacturer Embraer.
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 second-generation models expected in 2018. We see the challenges facing Embraer as temporary in nature and we continue to believe the company represents an attractive investment opportunity.
Positive Contributors
The Fund’s most significant performance contributors were holdings in the oil & gas and pharmaceutical industries.
European integrated oil companies BP and ENI both appreciated during the quarter as oil prices moved back toward $50/bbl.
Several pharmaceutical holdings performed well, including the Fund’s two largest holdings—France-based Sanofi and U.K.-based GlaxoSmithKline.
Select Activity in the Second Quarter
In a fairly light period for portfolio activity, we purchased shares of Finland-based Nokia.
Nokia (NOK, Financial) has evolved quite significantly over the past few years, divesting several businesses while integrating and acquiring others in an effort to improve its scale and competitive positioning. Historically known as a mobile phone manufacturer, Nokia sold this business to Microsoft for $7.2 billion in 2013. The company also sold its HERE mapping business to a consortium of German carmakers for € 2.55 billion in 2015.
Nokia largely retained its mobile technology patents after selling off its phone business. As a result, the company now has a patent/technology licensing business which has generated close to $1 billion/year in high-margin revenue. The company is also working to license non-essential patents.
Nokia acquired Siemens’ stake in Nokia Siemens Networks in 2013 and management did a good job restructuring the business and restored profitability to an industry-leading level. More recently, Nokia acquired Alcatel-Lucent. These acquisitions resulted in a market consolidation for wireless infrastructure, with Ericsson, Huawei and Nokia as the top three vendors.
Additionally, the moves have a number of potential benefits for Nokia, including:
- Improve Nokia’s scale and positioning in the network infrastructure market: The acquisitions of NSN and Alcatel-Lucent help improve the combined company’s scale and strengthen its internet-protocol and software-defined-networking portfolios.
- The new Nokia has a fully converged networking solution:
This means the company can now offer carriers a full end-to-end networking solution.
- Restructuring and synergy potential: The two acquisitions have led to significant synergies for Nokia, including a reduction of over $1 billion in annual operating expenses.
Many investors have been concerned about the current demand environment for wireless infrastructure. The wireless network market has seen flat overall spending for five years, with the exception of the interest generated during the deployment of long-term evolution (LTE, used for high-speed wireless communications for mobile phones and data terminals) across developed markets and Asia. Moreover, the outlook for the next few years for wireless infrastructure is poor, with China’s LTE spending having peaked.
In addition to these industry-wide challenges, Nokia’s share price has also been affected by worries over merger-integration risk. Nevertheless, in our view the risks are outweighed by the company’s positive attributes, which include:
- Its solid competitive position driven by growing long-term demand for wireless networking equipment
- A good track record of portfolio streamlining and operational rigor over the past five years
- A strong balance sheet and capital-usage plan.
Year-to-Date 2016 Briefing
In the six months ended June 30, 2016, the Brandes Global Equity Fund underperformed the MSCI World Index, which rose 0.7%. Performance drivers were fairly similar to those for the second quarter.
The most significant return detractors were holdings in the financial sector (Credit Suisse, UBS, U.K.-based Barclays and U.S.-based Citigroup), the auto industry (Honda Motor, Nissan Motor and Hyundai Motor), as well as Embraer and U.S.-based Western Digital.
The largest positive contributors were U.S. electric utility, Exelon, as well as oil holdings Lukoil (Russia) and BP, and several large pharmaceutical holdings (Japan-based Daiichi Sankyo and U.K.–based GlaxoSmithKline).
Current Positioning
At quarter end, the Fund exhibited more attractive valuations, in our opinion, and higher dividend yield than the MSCI World Index (3.68% vs. 2.66% for the MSCI World Index).
Over the last year, we continued to find value in emerging-market businesses and integrated oil companies, where we have been increasing the Fund’s allocations. On the flip side, our weightings to Japan and consumer staples have declined.
It has been difficult to find value in the consumer staples sector where many companies are regarded as being less volatile than the market and therefore perceived as “safer” investments with typically above-average yields. In what appears to be a yield-starved environment, many of these stocks traded at what we believe to be lofty valuations. In many cases, higher valuations were evident even among companies with declining earnings or sales, and at the very least those with very limited growth prospects. In this environment, a focus on price vs. value and selectivity remains paramount, in our view. Despite the market’s perception that consumer staples represents a safer/less volatile sector, Brandes’ disciplined focus on individual companies leads us to conclude that the area may actually expose investors to increased risk, which we define as the likelihood of permanent capital loss, due to the current optimistic prices in the market.
As of June 30, the Fund’s largest overweight positions versus the benchmark were in emerging markets and the United Kingdom, as well as in the banking & capital markets, pharmaceuticals, oil & gas, food & staples retailing and automobile industries. The U.S. market remained the Fund’s largest underweight position. On the sector level, significant underweights were in industrials, materials and consumer staples. As always, we anchor our allocation decisions on a fundamental, bottom-up investment approach focused on seeking the most attractive value in all corners of the globe.
Looking ahead, investor concerns on global growth and the extent of Brexit’s impact may keep volatility elevated, at least in the short term. However, from a valuation standpoint, times like these—when uncertainty runs high—tend to enable disciplined value investors to take advantage of mispricing opportunities, as indiscriminate selling may send prices of fundamentally sound companies lower than our estimates of their true worth. While financial-market turmoil typically tests investors’ mettle, in our view it is important to focus on value and remain patient in the pursuit of 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.
The foregoing Quarterly Commentary reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. The information provided in the commentary 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. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that the securities sold have not been repurchased. The actual characteristics with respect to any particular account will vary 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 exigencies at the time of investment. Unlike bonds issued or guaranteed by the U.S. government or its agencies, stocks and other bonds are not backed by the full faith and credit of the United States. Stock and bond prices will experience market fluctuations. Please note that the value of government securities and bonds in general have an inverse relationship to interest rates. Bonds carry the risk of default, or the risk that an issuer will be unable to make income or principal payment. There is no assurance that private guarantors or insurers will meet their obligations. The credit quality of the investments in the portfolio is not a guarantee of the safety or stability of the portfolio. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Securities of small companies generally experience more volatility than mid and large sized companies. Although the statements of fact and data in this report have been obtained from, and are based upon, sources that are believed to be reliable, we cannot guarantee their accuracy, and any such information may be incomplete or condensed. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Please note that all indices are unmanaged and are not available for direct investment. Past performance is not a guarantee of future results. No investment strategy can assure a profit or protect against loss. 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 regulatory environment may have a negative impact on future performance. The declaration and payment of shareholder dividends are solely at the discretion of the issuer and are subject to change at any time.
