The last three months proved to be a continuation of challenging conditions for emerging markets, with the asset class generating the worst quarterly returns since the third quarter of 2011.
News on China’s slowing economic growth intensified worries on its ramifications to the global economy. The renminbi devaluation, although relatively minor, generated fears of potential spillover to other emerging countries. In late August, the Shanghai Composite and the Shenzhen Composite indices lost a combined $1.2 trillion in market capitalization over the course of four days, putting a stop to their upward trajectory that started in late 2014. The selloff prompted the People’s Bank of China to cut its interest rate and lower reserve requirement for banks—in the hope of easing market concerns about the slowdown.
Meanwhile, investor sentiment took a turn for the worse in Brazil as the country continued to face political and economic challenges, including falling commodity prices and rising inflation. The Brazilian real lost over 20% (vs. the U.S. dollar), making it one of the worst-performing currencies in the quarter. The MSCI Brazil Index fell over 30% in the last three months and more than 40% year to date (in U.S. dollar terms). Despite the general market decline, Brazil remains home to select companies with what we view as attractive valuations and appealing long-term prospects.
Another headwind during the quarter was oil prices, which continued to drop due to a weak outlook for the global economy and continued high supply from major oil producers. Uncertainties surrounding the world economy also compelled the Federal Reserve to keep U.S. interest rates unchanged in its September meeting, causing questions about the potential rate-hike timing to remain.
For the quarter, the Brandes Emerging Markets Value Fund underperformed its benchmark, the MSCI Emerging Markets Index, which fell 17.8%.
Performance Detractors
The Fund’s Brazilian holdings declined in the last three months and negatively impacted performance. Integrated oil company Petrobras (PZE, Financial) weighed heavily on returns as it struggled to recover from the corruption scandal involving the company, and investors appeared increasingly concerned about the firm’s debt burden. See our commentaries from the first and second quarter of 2015 for more details on our view of Petrobras. Other significant detractors included commercial banks Banco do Brasil, Banco Bradesco and Banco Santander Brasil, as well as Companhia Brasileira de Distribuicao, a Brazilian food retailer with a significant stake in Via Varejo (the country’s largest consumer electronics retailer).
Steel manufacturer POSCO and airline Copa Holdings also hurt performance. South Korea-based POSCO (PKS, Financial) saw its share price fall due to investor fears of slowing economic growth in China, one of the company’s revenue sources. We have factored China’s slowdown into our valuation for POSCO and believe the company offers competitive advantages that may not be fully reflected in its share price. For Panamanian Copa Holdings (CPA, Financial), the share-price decline could be attributed primarily to weak demand and currency depreciation in a number of its end markets, especially Brazil, Venezuela and Colombia. Additionally, overcapacity, which we consider a near-term challenge, has negatively affected the airline industry in Latin America in general.
Another major performance detractor during the quarter was Indonesian telecommunication services provider XL Axiata (OTCPK:PTXKY). In March 2015, the company announced a new business strategy which included a shift in focus from customer volume to service quality. Effectively, the company raised the price of starter SIM packs while aiming to upgrade its data services—a move which may stifle volume in the near term but could potentially boost longer-term profitability. Since the announcement, the market has reacted negatively to the fact that XL Axiata’s 2015 revenue and EBITDA will likely remain stagnant compared to last year as the company seeks to clean up its subscriber base and attempts to reprice. We view the company’s action as a bold but sensible strategy to generate greater long-term value.
Positive Contributors
During the period, O2 Czech Republic (LSE:O2CZ, Financial) contributed positively to performance. The telecommunication services company finalized the spin- off of its infrastructure assets into a new entity in early June and its share price moved higher in the third quarter as its majority owner, PPF, continued its buyout of the company. In August, PPF disclosed that it owned nearly 85% of O2 Czech Republic and confirmed that it would not attempt to raise its stake above 90%.
Other contributors included South Korean autos, specifically Kia Motors (KXRK:000270, Financial). On a relative basis, the Fund’s significant under-allocation to China-based companies aided performance. Additionally, the Fund benefited from its position in Hong Kong-based Yue Yuen, whose share price increased after it announced strong results for the first half of 2015. Yue Yuen is the world’s largest manufacturer of athletic and casual footwear, operating as an original equipment manufacturer (OEM) and original design manufacturer (ODM) for major brands such as Nike, Adidas, Reebok, Asics, New Balance and Puma.
Select Activity in the Third Quarter
In the third quarter, the emerging markets investment committee initiated a position in Sociedad Quimica y Minera de Chile (SQM, Financial). Founded in 1968 and headquartered in Santiago, Chile, SQM produces and distributes specialty plant nutrition solutions, potassium fertilizers, industrial chemicals, iodine and its derivatives, as well as lithium and its derivatives.
For much of 2014 and 2015, SQM’s reputation has been marred by governance concerns. In March 2015, Canada-based PotashCorp withdrew its board members after clashing with controller Julio Ponce over the handling of a tax probe and allegations of payments to politicians by SQM.
In May 2014, Production Development Corporation CORFO, a Chilean government agency, initiated arbitration against SQM. CORFO alleged that the company was underpaying a lease at its Atacama site, where some of SQM’s best mining assets are located, and was not in compliance with certain technical requirements. In June 2015, CORFO asked for early termination of the lease agreement and the lease payments that would have been paid plus punitive damages. Arbitration proceedings are in process.
We believe the negative pressure provided a good entry point for an investment in SQM. Year to date through September 30, the company’s share price fell over 30%. While the governance concerns present a near-term challenge, we believe the risk/reward proposition in the shares is favorable. Main features that made SQM an appealing investment candidate to us include:
- Attractive market share: SQM has a leading global market share in the production of iodine, nitrates and lithium (inputs used in a variety of chemicals and fertilizers).
- Cost advantage: SQM’s minerals are of good quality and have been inexpensive to extract because most are located very close to the surface.
- Geographic diversification: The company sells its products in 110 countries, with no individual client accounting for more than 10% of revenues. Sales are well diversified among Latin America, Asia, Europe and North America.
- Valuation: As of September 30, 2015, SQM’s shares traded at 1.6x price-to-book value and less than 8x cash flow. Both valuations were near their five-year lows.
Other major Fund activity included the full sale of Chemical Works of Gedeon Richter (BUD:RICHTER), a Hungary-based manufacturer of both branded and generic pharmaceutical products. In recent years, the company has been transitioning its business model to become more of a “specialty pharma” with a stronger emphasis on branded drugs, an area that requires more research & development (R&D) effort but historically has been more profitable.
We began purchasing Gedeon Richter during the first half of 2014. At the time, geopolitical concerns in Russia, Ukraine and other member countries of the Commonwealth of Independent States (CIS), which collectively accounted for over 40% of Gedeon Richter’s revenue, appeared to be overly discounted for in the company’s share price. We took comfort in Gedeon Richter’s long history of local operations in the region, including local manufacturing in Russia, which should support its foothold there. Moreover, we believed the market underappreciated the prospects offered by Gedeon Richter’s women’s health division, its diversified exposure to regions with positive secular growth potential, as well as its R&D optionality.
Gedeon Richter performed well over our holding period. Market concerns about its Russia/Ukraine exposure appeared to be moderating, its operations and profitability remained strong, and the company started to see some positives from its branded pharmaceutical business. In the quarter, Gedeon Richter, in partnership with Allergan, received U.S. FDA (Food and Drug Administration) approval for VRAYLARTM (cariprazine), which is used for the treatment of bipolar disorder and schizophrenia. Its original branded drug for the treatment of uterine fibroids, ESMYA®, has also been gaining share in Europe, the CIS region and Canada. Given these developments and the resulting share-price appreciation to our estimate of intrinsic value, we exited the position in the quarter.
During the quarter, we also took advantage of the decline in Brazilian equities to selectively add to a number of our positions there, including in government-owned water utility Companhia de Saneamento Basico de Estado de SĂŁo Paulo (Sabesp) (SBS).
Sabesp provides public water and sewage services to a broad range of customers in São Paulo, Brazil’s richest and most populous state. São Paulo has recently been grappling with the worst drought in 80 years. Water levels in the Cantareira system of reservoirs, which normally supplies roughly half of the 20 million residents, have fallen to just 5% of capacity. In our view, the necessary cutbacks on water deliveries will result in Sabesp earning below its regulated rate of return. This will likely continue until the drought is over or the company is able to supplement the state’s water supply. While the investment committee cannot predict the weather, we feel that Sabesp remains an attractive investment opportunity that merits a continued inclusion in the Fund.
Year-to-Date 2015 Briefing
Year to date through September 30, 2015, the Brandes Emerging Markets Value Fund underperformed the MSCI Emerging Markets Index, which declined 15.2%.
Holdings in Brazil, namely Petrobras, Sabesp and Banco do Brasil, were the main detractors for the nine-month period. As was the case for the quarter, Copa Holdings, POSCO, and XL Axiata negatively impacted returns for the year. Moreover, while our underweight to Chinese companies aided returns in the quarter, it weighed on performance relative to the benchmark for the year to date.
Contributors during the period included holdings in Russia, led by Surgutneftegas and Sberbank. O2 Czech Republic and Ceska Telekomunikacni Infrastruktura also helped performance, along with Austria-based Erste Bank and Hungarian Gedeon Richter.
Current Positioning
In the midst of significant volatility in emerging markets, the Fund composition has not changed dramatically in the quarter. As noted, we added to several of our positions in Brazil, and the country remained the Fund’s largest overweight as of September 30, 2015.
Although the Chinese equity market—as represented by the MSCI China Index—declined over 20% in the quarter, it has still been one of the better-performing emerging markets in recent years. We remained cautious on the valuations of many China-based companies and continued to hold a significant underweight at quarter end, especially since we did not own any Chinese financials, which made up approximately 40% of the benchmark’s China allocation.
The past year has not only been difficult for the Brandes Emerging Markets Value Fund, but for value investing in emerging markets in general. For the 12 months ended September 30, 2015, the MSCI Emerging Markets Value Index underperformed the MSCI Emerging Markets Growth Index by 6.6%, representing one of the worst relative performances for value investing since the inception of both indices in 1997.
In our opinion, current valuation levels for the MSCI Emerging Markets Index, such as price-to-book and price-to-cash flow ratios, indicate that emerging markets is one of the most undervalued asset classes. As of September 30, 2015, the Brandes Emerging Markets Value Fund presented attractive valuations vs. the benchmark—with 0.7x price-to-book ratio vs. 1.4x for the MSCI Emerging Markets Index.
Looking ahead, we believe company fundamentals, while seemingly obscured by the market’s preoccupation with volatility, will eventually gain investor recognition. In the current market environment, we hold the view that selectivity, discipline and a focus on margin of safety remain paramount as we invest in companies worthy of inclusion in the Brandes Emerging Markets Value Fund.
As always, 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.
Prior to January 31, 2011, the Fund was a private investment fund managed by the Advisor with policies, guidelines and restrictions that were, in all material respects, equivalent to those of the Fund. Class A and Class I shares commenced operations on January 31, 2011, while Class C shares commenced operations on January 31, 2013. 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.) The Class I performance information shown for periods prior to January 31, 2011 is that of the private investment fund managed by the Advisor that is the predecessor of the Fund, not adjusted for Fund expenses. Performance shown prior to January 31, 2011 for Class A shares reflects the performance of the private investment fund shares adjusted to reflect Class A expenses. Performance shown prior to the inception of Class C shares reflects the performance of the private investment fund for periods prior to January 31, 2011 and the performance of Class I shares for the period from February 1, 2011 to January 30, 2013 restated to reflect Class C expenses.
The Advisor has contractually agreed to limit the operating expenses through January 31, 2016. The Expense Caps may be terminated at any time by the Board of Trustees upon 60 days notice to the Advisor, or by the Advisor with the consent of the Board. Investment performance reflects fee waivers and/or reimbursement of expenses. In the absence of such waivers/reimbursements, total return would be reduced.
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.
The fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company, and may be obtained by calling 800.395.3807, or visiting brandesfunds. com. Read carefully before investing.
Mutual fund investing involves risk. Principal loss is possible.
Diversification does not assure a profit or protect against a loss in a declining market. One cannot invest directly in an index.
The margin of safety for any security is defined as the discount of its market price to what the firm believes is the intrinsic value of that security. Cash Flow: The amount of cash generated minus the amount of cash used by a company in a given period.
EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization. Price/Book: Price per share divided by book value per share.
The renminbi is the official currency of the People’s Republic of China.
The MSCI Brazil Index is designed to measure the performance of the large and mid cap segments of the Brazilian market. With 67constituents, the index covers about 85% of the Brazilian equity universe.
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 MSCI Emerging Markets Index with gross dividends measures equity market performance of emerging markets.
The MSCI Emerging Markets Growth Index with gross dividends measures equity market performance of emerging markets. The attributes for growth index construction are long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.
The MSCI Emerging Markets Value Index with gross dividends measures equity market performance of emerging markets. The attributes for value index construction are book value-to-price ratio, 12-months forward earnings-to-price ratio, and dividend yield.
The Shanghai Stock Exchange Composite Index is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The Shenzhen Composite Index is an actual market-cap weighted index (no free float factor) that tracks the stock performance of all the A-share and B-share lists on Shenzhen Stock Exchange.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
The foregoing reflects 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.
The Brandes Emerging Markets Value Fund is distributed by ALPS Distributors, Inc.
