Virtus Emerging Markets Equity Income Fund
2Q 2016 COMMENTARY
The Fund produced a positive return for the quarter, outperforming broad emerging markets equity markets.
At the industry level, the Fund’s outperformance was driven by stock selection in retail, telecom, and capital goods. At the country level, China, Malaysia, and Korea had the largest positive impact on performance.
The biggest change to the portfolio in the quarter came when MSCI increased the weighting in “overseas” stocks listed in U.S. exchanges but domiciled in China, such as Alibaba and Baidu. As most of the stocks involved pay little to no dividends, we reduced the Fund’s exposure to China considerably to marginally overweight. This was rebalanced into countries such as Thailand, Malaysia, and India.
The MSCI Emerging Markets Index rose 0.7% during the second quarter. While the U.K.’s decision to leave the European Union caught investors off guard, fueling global volatility and a risk-off sentiment that caused significant gains in precious metals, emerging markets shrugged off “Brexit” as a non-event. Futures market participants priced out any interest rate hike in the United States until 2017, taking the pressure off monetary policy makers across the region. Defensive industry groups such as household & personal products, food, beverages, & tobacco, and commercial & professional services were the strongest performers given heightened global uncertainty. Technology bounced back following the April profit warning from Apple as investors were buoyed by expectations of a possible earnings surprise from Samsung Electronics. Cyclical industry groups such as retailing, capital goods, and transport struggled on a relative basis.
Asian equities rose by 0.3% in the quarter. China was virtually unchanged although investors remained concerned about the sustainability of the recent economic recovery. China A shares were not included in the MSCI benchmark indices due to concerns over quota allocations, capital mobility, and trading suspension rules. India gained 3.7% after the Parliament passed the Insolvency and Bankruptcy Code, a key reform that will make it easier to do business in India, and which will also enable banks to recover bad loans. The decision of the RBI Governor not to seek a second term in September did, however, raise concerns over the prospects for further reforms in the financial sector. The Philippines gained 5.8% as interest rates were cut and a new government was appointed. Taiwan rose by 0.7% as investors initially responded to the profit warning from Apple though prices rebounded in June as the central bank cut interest rates in order to support growth. Korea was down 1.2% despite the fact that the Bank of Korea cut the policy rate to record lows and the Ministry of Finance announced a $17 billion stimulus package to spur growth. Indonesia gained 4.1% following the fourth interest rate cut in 2016 as inflation fell to a six-year low.
Europe, the Middle East, and Africa (EMEA) had a difficult quarter, declining by 1.3%. Initially Greek equities recovered following the announcement of a new deal with the IMF, however, the rally was short-lived as the Brexit vote raised concerns over the future direction of peripheral bond spreads. Greek equities ended down 14.0% over the quarter. Other markets with significant exposure to core Europe also struggled, with Poland down 17.5% and the Czech Republic declining by 6.1%. South Africa gained 1.6% as it benefited from a recovery in the rand, while Russian equities gained 4.0% as interest rates were cut by a further 0.5%.
Latin America was the best-performing region, registering a rise of 5.3%. Brazilian equities gained 13.9% on expectations of a new political equilibrium, rising earnings revisions ratios, and higher commodity prices. The lower house voted to impeach President Dilma Rousseff and the motion has moved to the Senate. Mexico declined by 7.0% as the central bank raised interest rates by 0.5% in order to arrest the sharp slide in the currency. Peru gained 18.2% while Colombia was up 2.9%.
From a style perspective, investors were once more drawn to growth stocks at the expense of value. Growth outperformed value in each of the three regions and was particularly strong in Latin America and EMEA. Given the general acceptance that global interest rates are likely to stay lower for longer, dividend yield was in demand, outperforming in both Asia and Latin America although it struggled in EMEA. Large-cap stocks generated the strongest returns over the quarter, particularly in Asia and EMEA, while quality was rewarded by investors given the risk-averse environment. The Fund returned 1.69% (Class A NAV) in the quarter, compared with the 0.66% return of the benchmark MSCI Emerging Markets Index (net).
INDUSTRY GROUP ANALYSIS
Relative stock selection contributed positively to performance in retail, telecom, and capital goods.
Retail – Home Product Centre gained 6.7% as same-store sales improved in Thailand due to air conditioner sales. Higher foot traffic during the holiday season, when customers bought household goods rather than only home improvement products, also contributed positively to results. The company is a key beneficiary of rising urban consumption and an expanding middle income class in Thailand. End-user home improvement demand tends to be relatively resilient in an economic downturn. Lojas Renner rose 27.6% as investors sought refuge in this high-quality asset with a seasoned management team that continues to generate market share gains by sustaining superior execution versus peers. The credit division is expected to benefit from rate increases implemented during the first quarter. The company has successfully decoupled from the challenging macro environment affecting the apparel retail sector in South Africa.
Telecom – Telekom Indonesia rose by 22.2% as the stock responded positively to the news that tariffs were to be increased across its cellular data packages, with an average tariff increase of 12.5%. The company remains in a sweet spot, benefiting from benign competition in the mobile space and untapped growth opportunities in the fixed broadband space. There is also upside to the dividend yield given the underleveraged balance sheet position. China Communications Services gained 14.3% as free cash flow has improved significantly at the company due to successful cash management. The company is the largest service provider for the three main Chinese telecom operators, helping them to build up base stations, lay out fiber, and maintain networks.
Capital Goods – Sinopec Engineering registered a rise of 13.8% as the company is well positioned to benefit from the teapot refinery upgrade cycle, as nearly 75% of China’s teapot refineries do not have the capability of producing China V standard auto fuel. Sinopec Engineering has also made a breakthrough in the Middle East due to its improved track record in overseas projects and less aggressive competition from Korean companies while the expected recovery in engineering and construction projects will benefit the company’s order book. Sinopec Engineering has maintained its debt-free balance sheet.
Relative stock selection detracted from performance in technology hardware, software, and materials.
Technology Hardware – The underweight position in Samsung Electronics detracted from performance as it rose 7.8%. The stock has benefited from relatively robust Galaxy S7 sales and the high S7 Edge weighting. A fading Galaxy S7 effect may weigh on smartphone earnings in the future, however, the semiconductor division will be helped by better supply/demand conditions as supply growth remains low, offsetting sluggish PC and smartphone DRAM demand. Pegatron declined by 9.8% as the stock was hurt by weaker-than-expected iPhone destocking following Apple’s aggressive inventory building in Q4 2015. Apple’s inventory adjustment is likely to continue as it prepares for the next generation products.
Software – The underweight position in Tencent detracted from performance as it registered a rise of 11.4%. In a world of low nominal growth, investors continue to be attracted to the largest social communications platform in China. Tencent has successfully converted popular PC games to mobile games while it also stands to benefit from a much higher monetization in advertising. NC Soft declined by 7.6% as the share price came under pressure following the release of Blade and Soul Mobile in China due to negative sentiment caused by the popularity of competitor Blizzard’s Overwatch and a lack of new title releases during the quarter. Demand is likely to recover in the coming quarters with the release of Lineage based mobile games. The imminent launch of more mobile games will transform growth and margin profiles over the next few years.
Materials – Anhui Conch Cement declined by 7.9% as cement prices declined in the east coast where Conch has 48% capacity exposure due to the traditional weak season in the region. Prices are expected to recover starting in September given a good property demand recovery and strong infrastructure development. Overall market momentum has been gradually improving as the industry is now characterized by low inventory levels and strong shipments. Nan Ya Plastics declined by 9.9% as MEG spreads were pushed towards zero due to the surging cost of ethylene.
Relative stock selection contributed positively to performance in China, Malaysia, and Korea.
China – China Construction Bank gained 10.3% as quarterly results came in line with expectations with better cost control and stronger fee income growth. The bank maintains a strong capital base and provision level with a relatively safe loan portfolio and better than peer profitability. CCB is focusing on mortgage and infrastructure loans, both relatively safe segments during economic downturns. CCB has slowed its corporate loan growth, to avoid industries with overcapacity issues and the risky wholesale and retail sectors. Benefiting from similar trends, ICBC gained 5.3% over the quarter. Netease registered a rise of 37.1% as it offers a very strong mobile game pipeline. While the company offers a broad range of service offering including online portals, email, etc., online games are now the main revenue generator, representing 76% of total revenue. It is one of the most prudent and market friendly companies among the China internet players and is the only large-cap Chinese Internet stock to pay a quarterly dividend. The underweight position in Baidu contributed positively to performance as it declined by 13.5% after the company was forced to reduce revenue guidance due to increased uncertainty in the healthcare segment. More than 50% of the company’s medical advertisers have temporarily reduced spending on Baidu as they await clarification from regulatory authorities on their review of online marketing practices in the sector. China Shenhua Energy gained 19.9% as the company benefited from government plans to force coal mines to cut capacity by 16% and operate 276 days annually rather than 330 days previously. The decline in raw material production will more than offset the expected decline in demand.
Malaysia – AirAsia rose by 39.4% following the release of very strong quarterly results. Passenger traffic grew by 26% year on year while average fare rose by 11% year on year and ancillary revenue per passenger was up by 5% year on year. The rise in average fare and ancillary revenue were surprising given that most other airlines in the region suffered yield declines. The operating environment is positive with low for longer fuel prices and a strong top line.
Korea – KT&G gained 23.1% as the stock continues to benefit from the better than expected domestic tobacco volume recovery and tobacco exports. The red ginseng business is also enjoying strong new product momentum with growing demand from Chinese travellers. The company is likely to increase its dividend based on earnings growth. S1 Corp gained 20.7% as the downturn in sales per subscriber has slowed as efforts to attract new subscribers have eased with all three security companies focusing more on profitability. The government is also promoting the corporate housing rental market and this should underpin the lease business at the company. Hanon Systems gained 12.8% as quarterly earnings were boosted by margin improvement driven by cost savings efforts particularly labour costs and indirect costs. The company has the potential to become the largest beneficiary of the fast growing thermal management market.
Relative stock selection detracted from performance in India, South Africa, and Taiwan.
India – Infosys declined by 4.6% as the most recent management update highlighted short term speed bumps in the healthcare and life sciences segment due to business pressures caused by patent expiry while the retail segment weakened somewhat in North America and Europe. Indian IT companies all have a material exposure to the UK and Brexit created additional downward pressure on the group. Brexit impacts the companies in two ways, currency impact due to sterling weakness and through slower overall IT spending. Infosys generates 6.7% of its revenues in the UK while Tata Consulting generates almost 15% in the UK. Tata emphasised issues in the telecom sector but did not see any significant slowdown in the retail or healthcare segments. Tata Consulting registered a decline of 0.1% over the quarter.
South Africa – MMI declined by 8.9% as high interest rates and the mix of new business are expected to put downward pressure on the value of new business. Earnings are likely to be hurt by weak markets, the restructuring of its health and investment businesses and continued investment in diversification and new business initiatives. FirstRand declined by 6.8% despite the fact that credit loss trends have remained relatively benign even though arrears are rising in line with management expectations. The company is likely to invest excess capital in high return business lines countering some cyclical pressure on profitability. Truworths was down 12.0% as it was adversely impacted by the Brexit vote. The UK business will be hurt by weaker consumer spending in an already challenging apparel market while the decline in the value of sterling will negatively impact earnings. The underweight position in gold stocks also detracted from performance as they benefited from the heightened level of global uncertainty and risk aversion. AngloGold recorded a rise of 31.4% while Gold Fields was up 22.4%.
Taiwan – Asustek was down 8.3% as earnings came under pressure due to weaker PC demand in China and in other Asian markets, lower selling prices for mobile handsets and uncertainty in Europe. The company is due to launch new smartphones, notebooks and convertibles next quarter and this should improve average selling prices and margins. Asustek has a very strong cash position with cash representing 44% of its market capitalization and continues to generate stable cash flow. Merida declined by 5.3% as sales have been disappointing due to the prolonged downturn in China and weak demand in the U.S. Management is confident that sales have bottomed and expects order growth to pick up from here. There has been heavy discounting in the U.S. due to the high level of bike inventory.
CHANGES OVER THE QUARTER
The biggest move in the quarter came when MSCI increased the weighting in “overseas” stocks listed in U.S. exchanges but domiciled in China, e.g., Alibaba, Baidu, etc. They originally introduced these stocks in Q4 2015 at 50% of their potential weight. In May of this year they brought these stocks up to 100% weight. This increased China’s weight in the MSCI EM Index by a couple of percentage points. As most of the stocks involved pay little to no dividends, we reduced our exposure to China considerably to marginally overweight. This was rebalanced into countries such as Thailand, Malaysia, and India.
In the EMEA region we made some small changes, the biggest of which was a sale of Czech Republic and South African holdings, while we increased exposure to Hungary and Poland.
We continued to add to Brazil in Latin America. Here we are finding plenty of companies that display strong dividend characteristics, while we are becoming more concerned with dividend sustainability in countries such as Mexico, Chile, and Colombia.
Largest Stock Trades of Note
Asia – We continued to adjust our IT-related holdings in Asia. In technology hardware, we reduced Hon Hai Precision and increased our position in Delta Electronics. With the changes in the MSCI EM Index from the “overseas” additions, we added HCL Technologies (India) and increased Netease (China) to cater for the increased weight allocated to software & services. Asia telecoms is an industry group where we made a couple of noteworthy changes, dropping two Philippine stocks, Philippine Long Distance Telephone Company and Globe Telecom Inc. Due to dividend sustainability worries, we found no replacements and invested the proceeds across the rest of the portfolio.
EMEA – We made a few changes in financials. Komercni Banka (Poland) was decreased substantially, and we used the proceeds to build up positions in OTP Bank (Hungary) and Dubai Islamic Bank.
Latin America – Our main changes occurred in the materials sector. We dropped Sociedad Quimica (Chile) and added Cementos Argos (Columbia).
Dividend Yield – On a total portfolio level, dividend yield ended the quarter slightly below the level at which we started the quarter. Dividend yield has been a very strong factor especially in Asia over the past 12-18 months. However its effectiveness has begun to deteriorate and we have reduced our exposure somewhat to counter its decline.
Dividend Growth – In contrast, we’ve aggressively increased our exposure to dividend growth. We’ve noticed over the past 6-9 months that dividend growth levels are slowing considerably and this continued in the second quarter. This is no surprise given concerns over the global economy and volatile stock markets. In all regions we’ve been able to increase our relative dividend growth exposure over the MSCI EM Index despite the slowdown. We believe that companies that can grow their dividend in this environment can outperform over the longer term.
Quality – Another focus over the quarter was maintaining the valuation measures in our portfolio but also to preserve a solid base of efficient and profitable companies. We managed to increase our quality exposure relative to the MSCI EM Index while sacrificing little on the valuation front.
Debt to Equity – Net debt to equity continues to be an area of focus. The overall portfolio figure turned negative in the quarter, indicating that the companies we own have more cash than financial debt. This is primarily as a result of the Asian region where many of our holdings are sitting on large cash piles and little to no debt. This may not be such a bad thing given the uncertainty around the economic outlook. Sitting on cash piles is not always adding value, but we see this as major potential for increased payouts given the high levels of cash on balance sheets. Thankfully we are witnessing this via the increases in dividend growth rates achievable in the Fund.
The outlook for emerging markets during the coming quarter will be dominated by two broad themes, namely liquidity and growth. While the U.K. vote was in many ways a sideshow for emerging markets, it will have longer term implications. The vote will heighten global economic uncertainty, meaning that interest rates are likely to stay lower for longer and that rate hikes, when they do occur, will be even more gradual than previously expected. This should take some of the pressure off emerging market equities as policy makers across the region will be able to adopt an even more accommodative monetary stance while the upward pressure on the U.S. dollar should subside somewhat.
On the flip side, however, global growth will be negatively impacted, particularly in Europe and the U.K., with EMEA bearing the brunt of the downward adjustment within emerging markets. Earnings may consequently come under downward pressure, although it must be pointed out that earnings thus far are holding up much better than last year given the relatively stable dollar and the rebound in commodity prices. Companies have also successfully reduced capital expenditure and appear to be more right-sized for the current low growth environment.
China still needs to be watched very carefully as undoubtedly the impact of the liquidity injections during the first quarter abated over the last few months, with banks adopting a less aggressive lending stance. China is trying to come to terms with over-capacity issues in certain industries, and supply-side reforms will be an important catalyst for shares in the near future. Progress on such reforms would boost market confidence and would drive an increase in overall risk appetite. The market is already concerned about non-performing loans in the banking sector, and it seems unlikely that more clarity on the size of the non-performing loan problem would put further downward pressure on the banking sector. On the contrary, it would help dispel uncertainty and could potentially remove the ceiling on banks’ valuation.
More generally, a number of the significant headwinds that have restrained emerging markets over recent years have abated and in some cases turned into tailwinds. The likelihood that the recent outperformance can continue has therefore increased. Indeed, we believe there is now a good chance that the period of material underperformance has ended, and with better macro and micro management, the conditions are in place for further relative gains.
Directly relating to the Fund’s strategy, we continue to see a large number of companies passing our screens, with healthy levels of cash-flows and earnings to cover the dividends they are paying. We are also observing that emerging market corporates, by and large, have lower levels of debt on their balance sheets than their developed world counterparts.
One of the key market inefficiencies that we exploit is the mispricing by investors of the earnings growth delivered by companies with a strong dividend discipline. This mispricing is particularly evident in emerging markets where investors chase growth over value/income. What it does mean is that we will typically have a value tilt in our portfolio (but we are never deep value). We have witnessed a period in the recent past where the outperformance of growth stocks over value stocks has been significant (globally this level of divergence in performance between these style factors has not been seen since the early 2000’s tech, media, & telecom levels). We would expect that there will be a rotation within markets to normalise this divergence over the short to medium term.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk.
Geographic Concentration: A fund that focuses its investments in a particular geographic location will be highly sensitive to financial, economic, political, and other developments affecting the fiscal stability of that location.
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.