- Significant exposure to emerging markets, China in particular, as well as cyclical stocks weighed on portfolio performance.
- While trade-related uncertainty is currently swamping solid small company fundamentals, we continue to look for contrarian and differentiated opportunities to generate alpha.
- A brief September value rally illustrated how major shifts in monetary and fiscal policy have the potential to spark a rotation into the stocks and sectors favored by the portfolio.
Volatility continued as the dominant theme in the third quarter, as international markets declined in the first two months only to be followed by a sharp September reversal. Though trade and political uncertainty persisted across headlines, investors exited the quarter looking forward to progress on Sino-U.S. trade discussions as well as Brexit in the coming months. Overall, the benchmark MSCI EAFE Small Cap Index was relatively unchanged at -0.44% for the quarter, though the International Small Cap Strategy underperformed largely due to its cyclical value tilt.
From a pure factor standpoint, value underperformed by an average of 200–300 basis points over the quarter as defensive companies were favored over cyclically-oriented and financial equities (-2.6%). Economically dependent sectors such as energy as energy (7.1%), basic materials and industrials (-2.6%) lagged, presenting strong headwinds to the portfolio which is overweight these sectors. Flattening yield curves and lowered earnings expectations also pressured our holdings in banking and insurance shares. Conversely, utilities (+3.2%) and real estate (+6.1%) mirrored the rally in bond prices and outperformed strongly.
Short-term price momentum presented a similar factor headwind to the portfolio. Price momentum is challenging because it tends to benefit cap-weighted benchmarks whose market cap maximums reach into the mid-cap space, at the detriment of dedicated small cap active portfolios like ours.
Regionally, trade war concerns and deteriorating economic growth particularly hurt small cap value stocks in Europe and emerging markets. Within emerging markets as measured by the MSCI Emerging Markets Index (-4.3%), China was a notable underperformer, as protests and a political crisis in Hong Kong worsened into September with little sign of resolution. Along with uncertainty surrounding trade negotiations, this led to a nearly 5% drop in mainland Chinese markets.
Accordingly, the portfolio’s significant exposure to emerging markets was a main source of underperformance, particularly Chinese industrial names which continue to be impacted by the country’s moderating economic growth. For example, CIMC Enric, a Chinese manufacturer of liquified natural gas (LNG) and chemical storage tanks, suffered from slower LNG imports tied to weaker manufacturing activity. While there remains some uncertainty in the near term, we believe demand will improve as we move into the seasonally stronger back half of the year. Longer term, natural gas adoption and infrastructure buildout remains a high priority for the Chinese government. The country is the world’s second largest natural gas consumer but only has enough infrastructure to store 5% of its annual needs (versus peers 10-30%). This strong demand backdrop will give CIMC Enric runway to deliver double-digit earnings growth for the foreseeable future.
"Certain nations like Vietnam could become net beneficiaries of the new rules of trade sparked by the Sino-U.S. trade war."
European small caps also had a challenging quarter, owing to the heavy manufacturing and export dependence of the region. While our holdings are not immune to macro pressure, we are confident that each of our names has unique catalysts which can drive meaningful re-rating. Deutz, a leading global manufacturer of off-highway engines, was forced to warn on profits this quarter after the bankruptcy of a supplier impacted its supply chain. Although the German company has secured alternative supply, overall orders have slowed from recent years as machinery and automotive customers continue to reduce inventories. Looking forward to 2020, however, Deutz will be ramping new customer projects with partners like German truck manufacturer Kion and Swiss equipment manufacturer Liebherr, as well as expanding its business in China. At 8x earnings, an attractive discount to its own history and peers, we believe the market has not ascribed any benefit to these upcoming earnings catalysts.
While the investment backdrop of paralyzing uncertainty has been challenging, we continue to look for contrarian and differentiated opportunities to generate alpha. A good example is the portfolio’s strong performance in the Asian region this quarter. While much of the focus on the Sino-U.S. trade war has been its detrimental effects, we believe investors have been slow to consider the flip side of the coin – that certain nations could become net beneficiaries of the new rules of trade. Taiwan and Vietnam are both examples of countries benefiting from net investment capital inflows as an alternative to China. Thus, in our portfolio, a strong compounder has been Vietnam Enterprises Investments, an investment fund focused on supporting the growth of young Vietnamese businesses benefiting from the country’s rapid economic rise. Man Wah, a major Chinese furniture manufacturer, has also seen strong performance in its shares recently as the market begins to recognize how its early investments in manufacturing capacity in Vietnam have now become a competitive advantage. Both stocks were strong performers in the quarter, and we continue to look for similar contrarian opportunities globally.
Positioning and Outlook
Global asset markets have reached a level of herding that is historically on par with previous secular or generational shifts in the underlying investment landscape. Investors have crowded into a relatively small number of stocks, which has fueled the current dominance of growth and momentum. According to work by the researchers at Morgan Stanley, growth exposure of all equity funds is in the 97th percentile while value exposure is in the bottom decile (Exhibit 1). In addition to herding, there is also a worrying record-high correlation of a broad basket of factors such as growth, quality, low volatility and bond proxies. The relative performance and valuations of these closely linked asset cohorts are also at generationally wide levels, especially when compared to value stocks. When this dynamic begins to display the present extreme conditions, the odds of a phase change or transition rise significantly.
Exhibit 1: Factor Valuations Historically Skewed Toward Growth
While the exact timing and specific catalysts of the coming shift are difficult to predict, we can begin to observe some reasons why the “herd” could soon begin to stir. First, we are on the cusp of the most profound change in the overall monetary policy environment since Paul Volcker raised rates by 11 percentage points in 1980–81. As record investor flows into bonds has driven yields into negative
territories, politicians and policy makers are now being forced to confront the inability of lower rates to generate broad economic growth or the desired level of inflation. The inevitable path forward is a coupling of fiscal and monetary policy where central banks directly finance government spending. Central bank balance sheets will expand with the intention of funding targeted fiscal policies to put money into the real economy as opposed to primarily inflating asset prices.
After two weeks of strong value stock performance in September the financial media was buzzing with stories that it was “just a blip.” But as researchers at Goldman Sachs pointed out, “Sharp momentum drawdowns similar to the one that has taken place in the last two weeks usually mark the end of the momentum rallies rather than tactical buying opportunities.” This conclusion was based upon their study of the 14 most significant momentum drawdowns since 1980. Looked at from the perspective of the outperformance of value stocks, the reversal relative to momentum was the largest since the market lows of 2009. We believe this is an early sign of the coming long-term shift in market leadership. As a disciplined and focused international value manager, we are well-positioned for such an environment.
Consistent with prior quarters, our portfolio retains a pro-cyclical bias with overweights in basic materials, industrials, and energy. Defensive and growth sectors, including real estate, technology, health care, and consumer staples, continue to be under represented in the portfolio, as their inflated valuations appear unattractive to our process. Geographically, emerging markets remains our largest regional exposure, particularly China, Brazil, and South Korea. As the Federal Reserve continues to cut interest rates and reverse balance sheet normalization, dollar strength is likely capped which should bode well for emerging market securities. Overall, on a bottom-up basis, we continue to focus on improving the long-term upside, margin of safety and current income profile with every portfolio decision. Our sense is that the policy, economic and corporate profit environment is on the cusp of a profound shift that will favor international value stocks. The herding evident in the markets could lead to value being one of the last truly diversifying asset classes with high return potential left in this extended cycle.
The ClearBridge International Small Cap Strategy underperformed its MSCI EAFE Small Cap Index benchmark for the third quarter. On an absolute basis, the Strategy had gains in four of the 11 sectors in which it was invested. The primary contributor to performance was the communication services sector while the leading detractor was the industrials sector.
In relative terms, overall stock selection and sector allocation detracted from performance. Stock selection in the industrials sector had the most significant impact on relative results. Stock selection in the financials, utilities, consumer discretionary and real estate sectors also hurt results as did an underweight to real estate and an overweight to materials. On the positive side, stock selection in the energy and communication services sectors contributed to relative performance.
On a regional basis, stock selection in emerging markets, Europe Ex UK, Japan and the United Kingdom hurt results while stock selection in North America and Asia Ex Japan proved beneficial.
On an individual stock basis, Avance Gas, Entertainment One, Sun Frontier Fudousan, Man Wah Holdings and China Lesso Group were the greatest contributors to absolute returns during the quarter. Positions in Deutz, Roots, CYBG, CIMC Enric and publity were the largest detractors from absolute performance.
In the third quarter, we initiated a number of new positions, the largest being Sanwa Holdings and
MaireTecnimont in the industrials sector, Sopra Steria Group in the IT sector, Elior Group in the consumer discretionary sector and Plus500 in the financials sector. We also closed a number of positions, the largest being Entertainment One in the communication services sector, Takeuchi Manufacturing in the industrials sector, K. Wah International Holdings in the real estate sector and BrightSphere Investment Group in the financials sector.