Market Overview
Emerging markets continued to move higher in the face of volatility fueled by concerns over China’s economic slowdown and its implications for the global economy. It was not a smooth ride, however, as the MSCI Emerging Markets Index was down double-digits in January before reversing course.
One of the first quarter’s strongest performers was Brazil, even as it remained mired in political instability amid President Dilma Rousseff’s potential impeachment and former President Lula da Silva’s return to the limelight. Brazilian equities, as measured by the MSCI Brazil Index, gained over 28% in U.S. dollar terms. Oil-price stabilization also helped equities of oil exporters such as Russia.
The Brandes Emerging Markets Value Fund outperformed its benchmark, the MSCI Emerging Markets Index, which returned 5.8% over the last three months.
Positive Contributors
Holdings in Brazil, which have collectively accounted for the Fund’s largest weighting over the last 18 months, contributed positively to performance. The Brazilian real was one of the best-performing currencies in emerging markets in the first quarter and its appreciation vs. the U.S. dollar aided returns. Notable contributors included water utility provider SABESP and food retailer Companhia Brasileira de Distribuicao (CBD, Financial), as well as all of our commercial bank holdings (Banco do Brasil, Banco Bradesco and Banco Santander Brasil).
Panamanian airline Copa Holdings (CPA, Financial) and Mexican cement company Cemex also generated strong returns as they recovered from poor performance in 2015. Other contributors included steel manufacturers South Korean POSCO (PKX, Financial) and Luxembourg-domiciled Ternium (TX, Financial), whose majority of assets are in Latin America.
Beyond these holdings, the Fund’s significant underweight to China enhanced relative returns. As of March 31, the Fund had less than 7% allocated to Chinese companies, compared to the near 24% weighting in the MSCI Emerging Markets Index.
Performance Detractors
Several holdings in China, including Yingde Gases (HKSE:02168, Financial) and Dongfeng Motor Group (HKSE:0089, Financial), hurt performance. Brazilian regional jet manufacturer Embraer (ERJ, Financial) also weighed on returns as the real’s appreciation presented a headwind for the company, which derives the majority of its sales outside Brazil. Moreover, Embraer’s 2015 earnings indicated margin compression and the company issued guidance that was lower than market expectations. Pressure on the defense segment also hurt performance.
The margin compression was not surprising to us given the product transition that is underway in Embraer’s commercial aircraft division. With regard to the defense segment, we see the issue as temporary as it is driven by a cut in the Brazilian defense budget and we believe Embraer will generate more defense revenue from abroad over the longer term. Accordingly, it is our view that the long-term investment thesis for Embraer remains compelling.
Additionally, Austria-domiciled Erste Group Bank (WBO:EBS, Financial) and U.K.-based Standard Chartered Bank (XNEP:SCB) detracted from performance. While domiciled in the United Kingdom, Standard Chartered has meaningful risk exposure to Asia and Africa, as well as to commodities, weighing on returns in the near term. However, we believe the risk/reward tradeoff warrants a modest allocation as the company traded at 50% of tangible book value at quarter end.
Select Activity in the First Quarter
Fund activity was light in the quarter. The Emerging Markets Investment Committee exited positions in APR Energy and Ceska Telekomunikacni Infrastruktura (CETIN). APR was acquired by a group of private equity firms and the transaction was completed in February. Meanwhile, investment group PPF, which had already owned 90% of CETIN, proceeded with its plan to buy all of CETIN’s remaining shares, ending its short run as an independent company. CETIN was created in June 2015 as O2 Czech Republic decided to spin off its infrastructure assets. Shortly thereafter, PPF, which was already O2’s majority owner, announced its plan to acquire the then-new company.
Current Positioning
The objective of the Brandes Emerging Markets Value Fund is to seek capital appreciation over the long term. Although the last year or so has been difficult for value investors in emerging markets, we have started to see our conviction and discipline bear fruit. This focus enables us to pursue potentially undervalued opportunities, just as it equips us to avoid potentially overvalued areas. For example, we have long been skeptical about the valuation levels and what we considered lofty market expectations for many Chinese companies. As such, we have found relatively less value in China, resulting in a significant underweight relative to the benchmark. In recent quarters, this underweight has contributed positively to our relative performance.
We remain convinced of the potential offered by our holdings in Brazil. As of March 31, over 20% of the Fund was allocated to Brazilian companies, with no positions exited during the quarter. On the contrary, India and Taiwan, where we have been underweight for the last few years, continued to represent areas where we have not uncovered much value potential. The same was true for technology and consumer staples companies, which overall have exhibited significantly higher valuations than the benchmark average.
Unsurprising in a time where fear drives investor sentiment, emerging-market equities continue to appear attractive, with the MSCI Emerging Markets Index trading at 1.4x price-to-book ratio as of March 31—a level we’ve observed few times in the last two decades. However, as undervalued as we believe the asset class remains as a whole, it is important to note that not all areas are appealing. With the diversity of emerging-market companies and their varying fundamental strengths, “simply being there” is not the best way to access opportunities within the asset class. Rather, it is our view that investors can be best served by applying a selective, flexible investment approach that an actively managed strategy, such as the Brandes Emerging Markets Value Fund, offers.
Thank you for your continued trust.
