GMO International Active EAFE Strategy commentary for the fourth quarter ended December 31, 2015.
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Performance
The International Active EAFE Strategy underperformed the MSCI EAFE index by 0.5 percentage points in the fourth quarter; the strategy gained 4.2% net of fees and the benchmark rose 4.7%. The strategy beat its benchmark by 6.9 percentage points for the year 2015, returning +6.1%.
GMO - 2015 Review and 2016 Outlook
Good equity investment analysis requires a healthy mix of skepticism and optimism. Th is is especially true for the value investor who searches for businesses with the potential to outperform low expectations by the market. Optimism helps remind the stock picker that things are oft en not as dire as they seem, while skepticism protects him from a bad business that is getting worse. When to modulate between these two competing and contradictory impulses is learned through the experience of many markets and cycles. The year 2015 was certainly one in which the members of the International Active team had to be both pessimists and optimists. In the first half of the year, the portfolio benefited from owning equities that were geared to an improving European economy. We believed that a cheaper euro and weaker commodity prices would accelerate the pace of the European recovery while market valuations implied more modest expectations. Holdings such as Peugeot, Mediaset, and Taylor Wimpey are all good examples of undervalued exposure to the European recovery.
In the second half of 2015, it was our skepticism of Chinese economic growth that served us well. We have long held the view that China was in the midst of an epic credit cycle, fueled with the money creation enabled by its currency peg. Credit booms usually don’t end well, and this one isn’t likely to either. The first signs of stress occurred in the Chinese equity market, which suffered significant losses in June. Then in August, the Chinese authorities weakened the currency, causing further anxiety. All of this was consistent with our view that the Middle Kingdom is in the bust phase of this cycle. The portfolio outperformed during these periods of China-related concern. We have tried our best to insulate the portfolio from further deflation of the Chinese credit bubble and the resulting economic weakness.
As we look toward 2016, we continue to be optimistic about the investments we are finding in Europe and Japan, and skeptical of many emerging market valuations despite their apparent cheapness. The positioning of value around the world implies that in 2016, like 2015, our opportunity for alpha will be in careful stock picking. With this as the backdrop, we want to take this opportunity to remind investors of the core principles ingrained in our stock selection process.
GMO - Cash-in/cash-out Investing
The investment philosophy of International Active is anchored by four criteria. We require that companies generate positive free cash fl ow, distribute some cash back to shareholders, have strong balance sheets, and sell at a discounted valuation to the market provided an appropriate adjustment for the quality of the business.
Why the obsession with cash flows and distribution? We define free cash fl ow as the cash profi t produced in excess of the cash investment required to maintain and grow the business. Our view is that consistent positive free cash fl ow is strong evidence of a healthy, well-run business. It is usually the result of one or more of the attributes we look for in our investments, such as a strong competitive position, high barriers to entry, stable industry dynamics, and management talent.
However, it is not enough to just produce free cash fl ow. We also require that management teams be willing to share some of the surplus cash with shareholders. We define cash distribution as dividend yield plus share buybacks net of share and debt issuance. A company that is issuing debt to pay its dividend would not be returning cash to shareholders in our view.
History shows that cheap companies that pay a dividend outperform those that don’t, even in price performance terms. Aft er torturing the data, the conclusion we draw is that most companies are bad capital allocators. Investors like to believe that companies are re-investing in positive NPV projects, but the reality is that most investment is poorly conceived. We worry about mal-investment, especially in Europe and Asia, where corporate managements are oft en compensated via status rather than financial rewards. In that world, they are incentivized to make their companies bigger and making the extra acquisition or launching a new production facility is usually where the glory is, regardless of the soundness of the decision to do so. Returning cash is simply evidence of a management team that is more disciplined, and a business, we believe, that will more readily improve its ROI over time.
So, our sweet spot is cash generative and cash distributive businesses that sell at reasonable valuations. Oft en these companies are cheap because market expectations are simply too low. Sometimes their cheapness is the result of the business being a little dull. Either way, such stocks should quietly compound value over time and provide returns in excess of the market averages.
Now that we’ve explained performance for the last year and provided a reminder of our investment philosophy, let’s turn toward our expectations for the future.
GMO - Thoughts on Europe
We begin with Europe, which continues to grind out an economic recovery. Despite political uncertainty and the ongoing debate over austerity, the underlying forces of labor reform, capacity rationalization, and deleveraging are still in progress. With the inception of negative rates and aggressive QE from the ECB, monetary policy has become meaningfully accommodative. The euro has weakened signifi cantly and commodity prices are in decline, both of which must be positive for economic activity in Europe. The Greek crisis seems to have stabilized for now and the recovery process in the periphery, especially Spain, has surprised to the upside. While not completely out of the woods, the existential risks and dire economic predictions of just a few years ago are increasingly remote.
Th at said, we have taken profi ts on some of our holdings in the European domestic recovery story. The portfolio particularly benefited from holdings in automobiles, U.K. house builders, and media. For the cases in which our investment thesis was fulfi lled, we redeployed the capital into undervalued opportunities primarily in telecommunications, insurance, and pharmaceuticals.
In the telecommunications sector, the portfolio owns Deutsche Telekom, Telecom Italia, Vodafone, and Telefonica Deutschland. Our investment thesis for this sector is that profitability in markets such as Germany and Italy will improve as regulators allow more consolidation and competition becomes less intense. Th is market repair story is still in its early days, and we believe these companies should continue to surprise with strong growth in cash fl ow.
European insurance companies continue to produce good cash fl ow, despite the low interest rate environment. For example, Allianz, our core European insurance holding, has struggled to make money on its investment portfolios and so has become more focused and disciplined in its core business of pricing risk. The market has ignored the growth in cash fl ow and dividends and preferred