An excerpt from an interview with Matthew Benkendorf, Vontobel’s chief investment officer and portfolio manager of the Virtus Foreign Opportunities Fund.
The International Equity strategy slightly outperformed the MSCI EAFE Index in the second quarter. Can you discuss what drove returns?
Our long-standing overweight to the consumer staples sector was a significant contributor to returns over the quarter. The stability and consistency of earnings of tobacco companies were well sought by investors after the risks and uncertainty that resulted from the Brexit vote. Our investments in British American Tobacco and Philip Morris International were drivers of absolute and relative performance. Reckitt Benckiser and Nestlé also helped performance.
Navigating the financials sector in a tough environment has continued to aid relative returns. Our stock selection has been critical in this space as our financials holdings were one of our best performing sectors, although it was the second worst performing sector in the benchmark. Our focus on non-bank financials, such as Link REIT in Hong Kong and Daito Trust in Japan, helped the International portfolio.
Our Indian financials holdings, Housing Development Finance Corporation and HDFC Bank, performed well this quarter. We continue to maintain our conviction in these holdings, which have been long-term investments in the International Equity strategy. HDFC Bank, with a conservative approach to lending, has outperformed its state-owned peers. With low non-performing loans and consistent loan growth, it is continuing to take share of the market. Housing Development Finance Corporation’s (HDFC) share price also increased over the quarter as the market was relieved to see that its loan growth remained solid around 14%, as well as being reminded of the value of HDFC's other businesses following the sale of a 9% stake of HDFC Standard Life Insurance to its JV partner Standard Life and announcing plans for a possible IPO of this unit. We believe HDFC’s future growth will benefit from the long-term demand growth for mortgages as India urbanizes and rising incomes.
Sometimes what we don’t own can hurt the portfolio from a relative standpoint. Energy and commodities continued to strengthen over the quarter, and our lack of exposure to energy hurt the strategy, particularly as energy was the best performing sector in the quarter in the Index. We maintain the same view as we have in the past. We find that most cyclical companies, mainly in the energy, materials, and industrials sectors, are known for their commoditized businesses, high capital intensity, and some of them may be heavily impacted by movements in commodity prices. They typically have volatile, unpredictable earnings, and pose a greater risk to absolute returns.
What changes have you made to the positioning of the portfolio?
Similar to our other portfolios, the International Equity portfolio is concentrated. We are finding some new companies, but at the same cadence that we've found names historically. These moves are more glacial, and evolutionary, as we try to optimize our capital. We initiated a position in TenCent Holdings, a Chinese information technology company sometimes referred to as “China’s Facebook.” We’ve held this position across some of our other portfolios. Consistent with our bottom-up approach, we are not taking a view on China, but rather buying a strong business that we believe will benefit from increased trends in consumer spending and online advertising, despite persistent negative headlines on the Chinese economy. We increased our industrials exposure, with new positions in Aena (Spain), DCC (Ireland), and Canadian National Railways.
Lastly, we exited our position in health care company Bayer over the quarter due to its proposed merger with agro-chemical company Monsanto. We generally tend to shy away from large, transformative acquisitions and this deal in particular appears to be dilutive to earnings for at least the next few years. We also trimmed our position in drug company Novo Nordisk due to generic competition in its long-acting insulin product line as well as a higher valuation.
You are always looking for companies with low capital expenditures, real pricing power, and high return on equity. Are those types of opportunities abundant at this time?
Our universe is relatively similar in size and opportunity to what it has been in the past. Valuations still look attractive, even though investors generally have to pay more for a business today than three or four years ago. But, as long as we can still get attractive underlying earnings growth and solid dividend yields which lead to attractive total returns, I think opportunities do still exist. Today, realistically speaking, investors will not get the multiple expansion that they have enjoyed over the past few years. This isn't just indicative of our portfolio, it’s indicative of the broader market. But, if we find high-quality businesses with true competitive advantages or economic moats, growth should be visible, predictable, and it should be delivered so we can translate it into investment returns.
What is your view on Japan, especially since over the last few years you have had a very low weight to the country?
Historically, Japan has been more of a trading-oriented market. I think that's because there have been serious economic headwinds there for a long period of time, and there have been some subpar businesses. I think that's more or less the stance today. We evaluate the businesses in Japan and ask ourselves: What can we get in terms of growth, what are we going to pay for them, and why is that better than something else we can buy elsewhere around the world?
Japan is multifaceted. And it isn't just about lower return businesses. I think a lot of it can be cultural. Japan has full employment and it's a harmonious society. Most people would view these attributes as positive. But, we look at it from an investment perspective. We question the economic returns of the business, the type of growth it can deliver, and what it is valued at. And, if it's a better opportunity for our investment capital than elsewhere, then we'll invest in that business. We need real investment opportunity.
Did you position your portfolio for a specific outcome of the Brexit vote? What kind of stocks would you buy to prepare for Brexit or some other macroeconomic event that could immunize the portfolio against negative returns?
Brexit is quite extraordinary in that it is such a binary time-specific event that has a very large impact on asset prices and people's views, and not to mention people's lives in the U.K. and the political future of the entire European Union. It's rare we get these types of events in the investment world. Tentatively, the market tries to speed up the happening of events, but they realistically unfold over longer periods of time. It's more of a slow burn, but in this instance there was a long build-up to one specific time event, which was over in the course of 24 hours.
We didn’t specifically position our portfolio for or against Brexit. When we evaluated our U.K. businesses, while we never thought about Brexit as a possible risk years ago, we always thought about how the businesses would perform in a recession, and if there is a significant currency risk. So that's really our best defense for an event that we would have never seen coming years ago. But now that it has happened, we were well prepared for it just because of our underlying investment philosophy and how we evaluate businesses.