From Jamie Doyle, portfolio manager at Sarah Ketterer (Trades, Portfolio)'s Causeway Capital
The global macroeconomic consensus forecast is like Los Angeles rush hour traffic—sluggish short-term prospects against a murky horizon. Political confusion in Europe does not help the problem of slack demand, one that the International Monetary Fund managing director, Christine Lagarde, called the “new mediocre,” and former US Treasury Secretary, Larry Summers, dubbed “secular stagnation.” In the wake of the Brexit referendum, disgruntled voters in a variety of countries might continue to upset the status quo. In November, many US citizens will go to the polls to select their next president, and the result, either way, will likely have anti-trade ramifications. In our ideal scenario, governments embrace pro-growth policies, specifically structural reforms to unleash productive capacity. Newly installed leaders, such as Great Britain’s prime minster, Theresa May, must forge a compromise between desires for immigration control and free trade—while staying in office. We also hope to see some propitious pan-European deregulation resulting from the various UK-EU negotiations ahead. And although it may take years, the ensuing reduction in EU bureaucracy should prove economically beneficial for all of Europe. In the meantime, central banks cannot perform miracles indefinitely. Unconventional monetary policy in the West and in Japan has sent interest rates to pitifully low—and even negative—levels. This hurts fixed interest savers, widens wealth inequality via rising asset prices, and stunts growth in bank and insurance revenues. At some juncture, G7 countries will likely run out of other options and enact reforms including infrastructure spending and changes to tax systems. Imagine the combination of those reforms with IT-related productivity, innovation, and (in the United States) the deployment of over $1 trillion of corporate cash. This might offset the gross domestic product drag from aging populations, massive public sector debt and all the other impediments we blame for slow growth.
Clearly, our clients cannot wait for policy nirvana. Global equities need to deliver expected returns in the near term. The post 2008-9 global financial crisis rebound in economies and equity markets propelled the performance of Causeway portfolios versus their respective benchmarks for several years. Today, several major stock markets have set new highs, not lows, and valuations differ greatly between perceived moderate risk, long duration stocks and those with more near-term, cyclical challenges. Beyond identifying the cheapest stocks, we have deliberately embedded a “self-help” theme – described below – in Causeway portfolios. To clarify what some corporate managements are doing to boost earnings and cash flow in a tough economic environment, we spoke to portfolio managers, Jamie Doyle and Conor Muldoon, and senior research analyst, Brian Cho.
Jamie, Causeway’s global and international equity portfolios appear considerably more overweight versus the MSCI World and MSCI EAFE indices in the telecommunications and information technology sectors than in prior years. Why?
JD: We seek the highest risk-adjusted return stocks we can find for our portfolios, regardless of index weights. In part due to sustainable and generous dividend payouts, the mobile telecommunications stocks not only remain attractively valued, but we also expect them to continue to deliver satisfactory performance and temper overall portfolio volatility. Our largest holding is an Asian telecommunication operator, and we have met with management several times this year. The team and I have become even bigger fans of management’s ability to extract returns from that country’s mature telecom industry. Smart self-help moves by this company’s CEO and his team have led to significant improvements in operations. Management controlled capital expenditures and operating costs, created innovative value added services, and introduced popular data plans, taking advantage of supportive regulation.
As for our technology stocks, Brian Cho and I have faced plenty of skepticism regarding the portfolios’ “legacy” tech companies. Despite their valuable proprietary technology, these companies have fallen into the dinosaur category, heading for eventual extinction according to sell-side analysts. We disagree.
BC: Market pessimism gave us, as value managers, a chance to buy world-class firms in the process of transitioning to newer technologies. Examples include an enterprise software company transitioning from an on-premises licensing model to a cloud-computing subscription-based model, and a semiconductor company progressing in mobile wireless technology from one generation to the next, and in memory and display. In our research, we recognize the value of highly competitive intellectual property – even if management has stumbled and operated the business ineffectively. In the US market, in particular, there is a greater presence of activist investors. These investors often catalyze other impatient shareholders to uproot poor managements and replace them with more capable and proactive leaders. One of our global portfolio companies, a US-based large manufacturer of semiconductors and telecommunications equipment, needed to upgrade its board of directors, communicate clearly with shareholders and deliver a consistent, conservative message to the marketplace. It sounds simple, but when previously high-flying growth companies eventually mature, some fail to implement these more sophisticated company practices. Last year was a transition year for this manufacturer. With considerable self-help efforts, the company finally began to deliver: its latest quarterly results were consistent with our expectations for a return to earnings-per-share-growth, and its targets for the September 2016 quarter indicated continued improvement in its business fundamentals. Admittedly, overall end-market demand in the company’s products remains muted, and there are some risks outstanding (e.g., competitors gaining market share and a regulatory investigation into the company’s business practices). However, the company’s initiatives appear to be working and we believe they can lead to above-market growth. The stock still trades at a substantial discount to its global peers, and as the company continues to improve operationally, we expect the valuation discount to narrow.
This “catch up rally” has occurred recently from value tech stocks with above market average dividend yields.
JD: One of our recent successes is another Asian technology company which has innovated through its product cycle and regained considerable market share. In our internal research presentation in July 2015, our two-part investment thesis was (1) the memory industry has consolidated, and the technology/scale leader should benefit, and (2) investors might be too bearish on the company’s smartphone business. Overall, the company’s end markets are still cyclical, but one of its product’s cycles is approaching the trough while another is entering an upturn. This company enjoys a cost advantage due to its technology and scale leadership, which should make it more defensive than its peers. At the same time, the company reinvests a substantial part of its free cash flow in research and development and capital expenditures, which have helped it continue to widen its technology leadership in end-markets.
Conor, what parallels do you see between the Causeway approach to technology and telecommunications stocks compared to banks?
There are a lot of similarities. In our global and international portfolios, we have a sizable overweight relative to benchmarks to European (including UK) banks. In a sustained low interest rate environment, clients ask us, why own these stocks? We know that the primary reason, undervaluation, is insufficient. Like the typical Causeway technology stock, these banks have embarked on a dramatic program of internal restructuring of operations, shedding low return assets, cutting costs, reinvesting in higher return areas operationally and geographically, and staying ahead of the changes in technology. Importantly, our two-year share price targets do not require interest rates to rise from today’s low levels. We believe that a hint of economic recovery and an even modestly steeper yield curve would, as history has proven, make the banks and life insurance stocks strong performers in their respective markets.
The UK banks dropped sharply in price after last month’s Brexit referendum. Why did Causeway continue to hold UK banks?
CM: We assume an uptick in bad debt provisions in the next two years, but not to the extent seen in the 2008 global financial crisis or the early 1990s recession. The UK’s HM Treasury published a detailed Brexit scenario analysis in May this year. The Treasury envisioned a level of uncertainty on par with the early 1990s recession when the cost of risk for UK banks expanded to 1.5-2.0% (cost of risk is the ratio of loan loss provisions to risk-weighted assets). While we think a UK recession is likely given the post-referendum damage to business and consumer confidence, the UK banking system has consolidated and conformed to comprehensive regulatory oversight. We do not currently model for a bad debt provision increase of prior crisis magnitudes. The current environment of lower interest rates, slower recent credit growth, and tighter risk controls suggests a more benign uptick in bad debt provisions compared to conditions that prevailed in the past. Despite the lack of crisis, investors have abandoned these banking stocks. UK banks trade below book value (in some cases, less than 50% of book), yet have the balance sheet strength to return a rising percentage of profits to shareholders through dividends and share repurchases. As a comparison, in what we consider similar consolidated banking markets, namely Australia and Canada, the four largest banks in each of those markets trade at average price to book value of 1.7x. That is quite a valuation gap.
Beyond the UK, why hold any European banks in a period of negative interest rates?
Amazingly, the Stoxx Europe 600 Banks Index constituents are cheaper in price-to-book value ratio than in the crisis periods of 2008 and 2011. Of course, low interest rates impact bank revenues, but they also support debt service. UK and European bank loan books are skewed toward mortgages with low levels of loans-to-value, and pre-provision profits should be more than enough to protect book value. With few excep-tions, European banks hold the highest level of capital in their history – helped by a regulatory push after 2008 to counter the tail risk that an unexpected event such as Brexit brings.
All of our banks started “self-help” at least a year ago, by cutting costs aggressively, shrinking capital-intensive low return activities, and shifting toward fee income. One of our UK banks provides a prime example of beneficial restructuring: it announced it will begin selling its ownership stake in another bank, accelerate the rundown of non-core assets (which improves the overall bank profit mix), and focus on its strength as a transatlantic consumer, corporate and investment bank.
Although they cannot control monetary or fiscal policy, many of the banks that get the attention of our research team can implement waves of reforms internally. Given the abundant levels of bank capital, we believe that our clients will benefit from their patience over the long term.
Important Disclosures
The Firm, Causeway Capital Management LLC (“Causeway”), is organized as a Delaware limited liability company and began operations in June 2001. It is registered as an investment adviser with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. Causeway manages international, global, and emerging markets equity assets for corporations, pension plans, public retirement plans, sovereign wealth funds, superannuation funds, Taft-Hartley pension plans, endowments and foundations, mutual funds and other collective investment vehicles, charities, private trusts and funds, wrap fee programs, and other institutions. The firm includes all discretionary and non-discretionary accounts managed by Causeway.
Causeway claims compliance with the Global Investment Performance Standards (GIPS®).
The International Value Equity Composite (“International Composite”) includes all U.S. dollar denominated, discretionary accounts in the international value equity strategy, which do not apply a minimum market capitalization requirement of $2.5 billion or higher ($5 billion or higher prior to November 2008), permit investments in South Korean companies after October 2003, do not regularly experience daily external cash flows, and are not constrained by socially responsible investment restrictions. The international value equity strategy seeks long-term growth of capital and income through investment primarily in equity securities of companies in developed countries located outside the U.S. From June 2001 through November 2001, the International Composite included a non-fee-paying account with total assets of approximately $2 million. This was the sole account in the International Composite from June through September 2001. The account was included in the International Composite at account inception because it was fully invested at inception. The benchmark is the MSCI EAFE Index.
Market Commentary
This market commentary expresses Causeway’s views as of August 11, 2016 and should not be relied on as research or investment advice regarding any investment. These views and any portfolio holdings and characteristics are subject to change, and there is no guarantee that any forecasts made will come to pass. Any securities referenced do not represent all of the securities purchased, sold or recommended by Causeway. The reader should not assume that an investment in any securities referenced was or will be profitable. Forecasts are subject to numerous assumptions, risks and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented has been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy or completeness of such information.
