Virtus Foreign Opportunities Fund
3Q 2016 COMMENTARY
- MARKET — Over the third quarter, equity investors saw generally low volatility and positive markets globally. Global markets were supported by solid economic performance in the U.S. and the outlook for higher interest rates. Elsewhere, returns were driven by the U.K. equity market’s bounce back from the Brexit sell-off, continued loose monetary policy in developed markets, and performance of key emerging markets, such as China, India, Korea, and Taiwan.
- PERFORMANCE — While the Fund’s performance was positive and style-consistent for a quality growth-focused strategy, it underperformed the strong performance of the MSCI EAFE® Index in the quarter. Weak performance in the consumer staples sector weighed on the Fund's overall returns. In many sectors, P/E ratios are now towards the high end of their historic ranges. There is a risk that valuations could pull back when interest rates rise. We are cognizant of this environment and evaluate the P/E ratio of each of our holdings relative to its own history. Over the course of this year, we trimmed back some positions that had reached our price targets. Our sector weightings haven’t changed significantly from the previous quarter. One notable change is that we further added to our U.S. and Chinese e-commerce exposure. Our Chinese exposure does not reflect a top-down view on China, rather a deepening of our conviction of the long-term growth potential of some leading Chinese e-commerce companies.
- OUTLOOK — We caution investors that, given our consistent focus on investing in high quality growth companies, our relative performance could suffer from continued flows into cyclical areas or a further appreciation in oil or commodity prices. Through our in-depth, fundamental research, we continue to find new opportunities.
International markets were driven by a rapid recovery from the Brexit sell-off, continued loose monetary policy in developed markets, and strong performance of key emerging markets, such as China, India, Korea, and Taiwan. Sentiment of exhaustion of expansionary monetary policies impacted interest rate-sensitive sectors, spurring a rotation into financial stocks (banks and insurers) and out of consumer staples, telecommunications services, and utilities.
The European recovery continues, with the jobs market appearing to have stabilized. Unemployment was 8.6% in July, down from 9.4% in July 2015 (Source: Bloomberg).Structural reforms continue to support private sector activity, and significantly reduced labor costs have improved the competitiveness of some companies and the external position of some countries. Economic and business sentiment improved during September, following three months of negative or flat sentiment. Valuations across Europe remained attractive although Europe’s banking challenges were spotlighted during the quarter. Sagging bank profitability owes much to the staid pace of economic growth, the flat yield curve, and ultra-low (sometimes negative) interest rates. All are rooted in the European Central Bank’s (ECB) efforts to boost inflation.
The U.K. economy was not significantly impacted following Brexit. Political clarity was improved when Theresa May was appointed prime minister, economic stimulus was applied when the Bank of England cut rates, and markets moved higher as the pound dropped about 13% against the U.S. dollar (USD) (Source: Eurostat, based on EU28). In addition, the new chancellor indicated a different approach to fiscal policy is ahead. The Autumn Statement is expected to include stimulus measures, such as tax cuts and/or accelerated infrastructure spending.
Over the quarter, the Bank of Japan (BOJ) announced the decision to implement yield curve controls, intending to maintain 10-year Japanese government bond yields at zero percent. Many analysts had expected the central bank to take short rates deeper into negative territory. Some believe the new policy is a stealth tightening. The MSCI Japan Index returned 8.60% (USD) during the quarter.
After a disappointing 2015 (-14.92%, as measured by the MSCI Emerging Markets Index), emerging markets were top performers through the quarter. Lower-than-expected interest rates in the U.S. continued to support demand for higher-yielding assets in the emerging world. Improved capital flows have helped some EM currencies recover lost ground relative to the U.S. dollar, reducing the cost of imported goods and supporting the domestic consumer. Stabilizing commodity markets also helped during the quarter.
Brazil has suffered debilitating internal political and economic crises that culminated in the impeachment of President Dilma Rousseff in the quarter. On August 31, Michel Temer became Brazil’s new president. He hails from the opposition PMDB (Partido do Movimento Democrático Brasileiro, the Brazilian Democratic Movement Party) and has indicated he is committed to implementing fiscal reforms. Despite Brazil’s deep recession and economic contraction, it was one of the best performing emerging markets during the quarter, up 11.3%, as measured by the MSCI Brazil Index.
India’s growth slowed year-over-year during the second quarter, but the country continues to expand its economy far faster than other nations. Inflation came in below expectations during the period, which opens the door to more stimulative central bank policy, and business confidence improved in September. Markets reacted positively to the Indian government’s passing of the Goods and Services Tax Bill (GST) which overhauls much of the current mix of central and state taxes. It is expected to reduce double taxation, bring parts of India’s large informal economy on the books, and lower the cost of doing business across state lines. The MSCI India ND Index returned 5.9% (USD) for the quarter.
China’s economic growth appears to have stabilized. Chinese e-commerce companies continue to deliver strong growth, taking market share away from traditional retailers and supported by the surging use of mobile. Over the quarter, Chinese authorities approved the Shenzhen-Hong Kong Connect. The new Connect will give Hong Kong investors greater access to technology companies, which comprise approximately 20% of the Shenzhen Exchange. The MSCI China ND Index returned 13.9% (USD) for the quarter.
While markets increased over the quarter, risks persist. Political risks have created a new and significant overhang in Europe. The Brexit vote appears to have galvanized populist sentiment and anti-establishment, anti-immigration political groups. Banking issues have contributed to the vulnerability of Italy’s prime minister, Matteo Renzi, ahead of December’s constitutional referendum. And the failed coup in Turkey created an uncertain political and economic environment.
While the Fund’s performance was positive in the third quarter, it underperformed the MSCI EAFE® Index. The Fund’s relative outperformance for the first half of 2016 was largely driven by our significant overweight to consumer staples and underweight to banks in Europe and Japan. In the beginning of 2016, the U.S. Federal Reserve tempered interest rate hike expectations, and the European Central Bank (ECB) and Bank of Japan (BOJ) cut rates. Consumer staples stocks, with their higher dividend yields, performed well, while financials, primarily banks and insurance companies, performed poorly due to the continued impact of low yields and thin margins. Midway through the second quarter, this trend appeared ready to reverse as investors expected the Fed to raise rates in June, while the BOJ and ECB remained on hold. However, concerns surrounding Brexit and heightened global risk put the Fed on hold, which resulted in the continued attractiveness of consumer staples and unattractiveness of banks.
This trend did reverse in the third quarter. As Brexit concerns eased, riskier assets performed well and higher-yielding, lower-volatility stocks relatively underperformed. This was exacerbated by the perception that the Fed, BOJ, and ECB have run out of flexibility to cut rates. Thus, our allocations to consumer staples and financials meaningfully impacted the Fund’s relative short-term performance.
Consumer Staples — In the consumer staples sector, our holding Reckitt Benckiser gave back performance in the third quarter after its run-up towards the end of the second quarter following the Brexit vote. Reckitt reported mixed 1H16 results, which were impacted by an exceptional charge relating to a humidifier sanitizer issue in South Korea. Even before the results were released, the ex-head of Reckitt Korea was indicted on this issue. Reckitt’s Korean sales have fallen as its humidifier sanitizer product was linked to causing respiratory disease, leading the product to be removed from the market and weighing on the company’s share price. Outside of the Korean issue, the company continues to execute well and Korea isn’t that large of a market for the company.
Financials — In the financials sector, our Indian holdings Housing Development Finance Corporation and HDFC Bank rebounded over the quarter, returning 13.9% and 9.6% respectively, which together represent approximately 9% of the portfolio. However, their positive performance was overshadowed by our relative underweight to the sector.
Health Care — Our holdings in health care also detracted from returns, driven by Novo Nordisk and Roche. Novo Nordisk released weaker-than-expected revenue guidance. The principal reason was intensifying competition in the U.S. insulin market with the impending launch by Eli Lilly of a biosimilar basal insulin. Novo’s growth rate over the next few years may be lower than it had been in the past, but is still better than that of most other pharmaceutical peers. While we reduced our position size earlier this year due to short-term uncertainty, over the long term we believe Novo Nordisk’s structural drivers remain intact. Roche announced the failure of the GOYA trial for its drug Gazyva, but the impact was only moderate in the context of the overall business. The company also reported solid sales growth in the second quarter, though underlying earnings fell somewhat short on increased marketing and R&D. However, we believe this upfront investment is prudent given its growing pipeline of late stage drugs.
Information Technology — Our information technology holdings contributed to returns, specifically Germany’s SAP SE, which released strong second quarter results. We saw significant growth in S/4HANA, SAP’s real-time database, and believe there is still room for further penetration. Management’s statement of only “tuck-in” acquisitions in the future leaves the opportunity for increased buybacks/dividends.
MasterCard and Alphabet were also top performers. MasterCard posted solid second quarter results, supported by strong pricing and the delivery of new services. The stock outperformed as it saw solid processed transaction and cross-border volume trends driving a slight upward revision to FY16 guidance to low double-digit revenue growth. MasterCard continues to gain market share in consumer debit, commercial, and prepaid segments. We are positive on the company’s acquisitions in the automated clearing house (ACH) space, such as Vocalink, which allows access to new payment flows, better customer engagement, and expanded payment ecosystems. MasterCard and PayPal also announced an expanded partnership aimed at enhancing the consumer experience at each company. Alphabet’s share price was strong leading up to announcing its second quarter results and soared after releasing earnings that exceeded consensus expectations. The company’s results were supported by solid revenue growth, driven by mobile advertising and YouTube, and paid click growth. Operating margins rose due in part to operating leverage on the cost side. We believe the share continues to be a good value with the cash component and YouTube business not priced in at current levels.
No-to-Low Weightings — Our lack of exposure to telecommunication services also added to relative returns.
Alibaba (Information Technology) — Internet names continued to surprise on the upside this quarter, driven by social media advertising. In China, the tailwind from e-commerce and mobile commerce penetration is still in its relatively early stages. We took the opportunity to capitalize on this trend and purchased Alibaba, China’s leading e-commerce platform operator, for the Fund. Alibaba enjoys dominant market share based on overall gross merchandise volume (GMV), which is significantly larger than JD.com, the second biggest player in China. In our view, Alibaba’s key competitive advantage is that it has a significant number of vendors, which attracts a massive pool of buyers. Alibaba provides its customers with access to the widest available inventory at the most competitive prices in almost any category. Other markets, such as Japan and the U.S., have shown us that it is difficult to displace a company with such a significant supplier/merchant advantage. Alibaba’s shares soared this quarter after it delivered FY1Q17 results that exceeded consensus expectations. China retail revenue — the pure e-commerce segment — grew 49%, on the back of GMV growth of 24%, the fastest revenue growth since the company’s IPO in 2014. Growth has been driven by an improvement in Alibaba’s monetization rate, with mobile monetization now marginally overtaking PC at 2.8%.
Anheuser-Busch InBev (ABI) (Consumer Staples) — The world’s largest brewer that dominates the beer market in most of the countries in which it operates. Globally, it has roughly one fourth of beer volumes and close to one half of global beer profits. We believe ABI is best in class on costs, among consumer staples companies, not just brewers. Synergies should result from combining the SABMiller-ABI businesses, such as a sales increase from distributing ABI’s global beer brands (Corona, Stella Artois and Budweiser) through the legacy SABMiller distribution in faster growing emerging markets. While we typically shy away from large acquisitions, ABI’s management team has historically executed extremely well on its acquisitions, being prepared before deals close with many of the important decisions needed for a smooth integration. Once SAB is digested and the debt reduced, ABI is likely to generate high levels of free cash and will either decide to do another accretive acquisition or return large amounts of cash to shareholders, either of which, in our view, would be beneficial to shareholders. (For more on our view of ABI, see the “Investment Case Study” on the last page.)
Sodexo SA and Shimano Inc. (Consumer Discretionary) — We found two new opportunities in the consumer discretionary sector. Sodexo is a French multinational corporation that provides on-site services, benefits and rewards services, and personal and home care services. The catering business is highly repeatable with retention rates of 94%. The longer term shift to outsourcing is a key driver in the global food management market, while the potential facilities management market is twice the size of food services and is equally under-penetrated. While organic revenue growth is only 3.5%, we believe the story is attractive given the runway of improving margins after Sodexo began focusing on efficiencies in late 2012, and has since seen margins expand.
Shimano, a Japanese multinational manufacturer of cycling equipment, has dominant market share and a strong brand associated with quality components and technology. Demand growth is moving from Europe and the U.S. to emerging markets, especially China. Shimano is benefiting from the trend of consumers in emerging markets looking to spend more disposable income on health and leisure activities. The penetration of bikes with gears is still small when compared to developed markets and the average price of bikes sold in China is one-sixth of those in developed markets. Historically, Shimano has also been successful in raising prices in developed markets through innovation. We estimate that Shimano can deliver EPS growth in the mid-teens, excluding FX volatility.
Over the quarter, we sold PayPal Holdings as we rotated into MasterCard, which provided a similar end-market exposure, but is a higher quality company. We also exited Persimmon Plc. Although we maintain our belief that Persimmon is still among the best homebuilders in the U.K. and is a well-run company growing at an attractive rate, we sold it due to the increased long-term uncertainty due to the effects of Brexit and the difficulty in predicting its impact on the U.K. residential housing market.
PERSPECTIVE & OUTLOOK
Our Valuation Discipline
Regardless of the market environment, we uphold our rigorous philosophy and process that focuses on identifying high quality businesses around the world. We own a concentrated collection of businesses that are strong franchises with good economic returns and prospective earnings growth potential. While uncertainty persists from quarter to quarter, either driven by specific events or a difficult macroeconomic environment, we continue to focus on being very selective in adding new names and reallocating capital among our names.
We believe we have a strong valuation methodology that is predicated on our ability to invest in companies where we can accurately forecast sustainability of long- term earnings and dividend growth potential, while paying what we believe is a sensible price relative to our estimate of the fair value. There are three reasons that cause us to sell a stock: 1) a deterioration in the fundamentals of a business as we believe the stock prices of companies with declining earnings can be harshly punished in uncertain markets, 2) a stock price reaches our estimate of intrinsic value, or 3) a significant event, such as M&A activity, results in a change to our investment thesis.
In many sectors, P/E ratios are now toward the high end of their historic ranges and can reverse as interest rates rise. We are cognizant of this environment and evaluate the P/E ratio of each of our holdings relative to their own history. Over the course of this year and even in the third quarter, we trimmed back some positions that had appreciated and gotten closer to, or reached, our price targets.
While we scaled back some positions, we increased exposure to others. One notable change over the quarter is that we further added to our U.S. and Chinese e-commerce exposure. Our Chinese exposure does not reflect a top-down view on China, rather a deepening of our conviction of the long-term growth potential of the leading Chinese e-commerce companies, Alibaba and Tencent. We increased exposure in businesses that we believe will deliver reasonable levels of returns and growth, even with a slowing macroeconomic environment in China.But, by and large, our sector weightings haven’t changed significantly from last quarter. For example, we continue to maintain our meaningful overweight to the consumer staples sector.
Calm Before the Storm?
Over the third quarter, equity investors saw generally low volatility and positive markets globally, a stark contrast to the sharp declines that rattled markets last August. This has partly been a result of the slowdown during the summer months, but also due to investors’ anticipation of changes in global monetary policy. We would not be surprised to see market nervousness pick up as we move into the last few months of the year.
We caution investors that, given our consistent focus on investing in high quality growth companies for an absolute return, we will often underperform the market during market upswings, as occurred this quarter. Looking into the fourth quarter, relative performance could suffer from continued flows into cyclical areas or a further appreciation in oil or commodity prices.
U.K. equity markets performed well in the three months after the initial shock of the U.K.’s decision to leave the European Union (EU). Since the vote, most of the data coming out of the U.K. has been fairly positive, which we see as a calm before the storm. The formal process of leaving the EU has not yet started. When negotiations start, we feel there could be a rise in bitter EU/U.K. rhetoric that could shake European and U.K. market confidence at times until a final exit package is established.
This could provide a difficult backdrop for the European banking system to sort out its long festering problems. As a result of these issues, as well as a number of national elections including France and Germany, we do not expect, or look for, strong demand growth across Europe over the coming year or two to drive earnings growth within the portfolio. We therefore are largely invested in companies that have drivers separate from low-growth European GDP.
We are closely watching U.S. monetary policy and its potential impact on emerging markets. Higher rates in the U.S. generally create headwinds for emerging markets, making their assets relatively less attractive to investors seeking yield. We are concerned about the Fed’s impact on emerging markets countries with weak current account deficits and budget deficits, such as Turkey and South Africa.
We maintain exposure to India. India has benefited from low commodity prices as a net importer, but also from the sensible economic reforms the BJP government is slowly enacting alongside a steady hand at the central bank. India has a number of high quality and dominant listed companies, but is also a difficult market for new competitors as barriers to entry are often high. For businesses on the inside of these barriers, the outlook can be attractive and offer a long runway of growth, given the early stage of India’s consumption. The other benefit from investing in India is its diversifying effect. We believe the outlook for our holdings in India is minimally impacted by China’s investment cycle or commodity global reference prices, if at all.
In Brazil, President Dilma Rousseff was impeached in August, clearly an important political development. The Senate voted 61 to 20 to convict Ms. Rousseff on charges of manipulating the federal budget in an effort to conceal the nation’s mounting economic problems. Michel Temer, the interim president who served as Ms. Rousseff’s vice president, has set an aggressive agenda for budget control and investment infrastructure. We are positive on the direction of the economic policy; yet cautious because those measures still need to be approved by Congress and the economy is still working through a deep recession. While Brazilian equities rallied this quarter in the midst of hope and euphoria, realistically, there are still some painful financial measures that need to be put into effect. We do believe the economy should improve in the long run, but the turnaround in Brazil will be slow.
As bottom-up investors, the quality of the franchises we own and their ability to deliver is paramount to our investment process. While some businesses we own have come under pressure, we are confident in our portfolio holdings and their ability to deliver high single-digit to low double-digit earnings growth over time. And, through our in-depth, fundamental research, we continue to find new opportunities.
INVESTMENT CASE STUDY
Our View: Anheuser-Busch InBev Takeover of SABMiller
On July 29, SABMiller’s (SAB) board approved an increased cash offer by Anheuser-Busch InBev (ABI) of £45 per share. On September 28, SAB shareholders backed the takeover by ABI, laying the foundation for one of the biggest corporate mergers in history. We voted against the deal.
We have been long-term investors, and at 3Q16 quarter-end, held over 1% of the outstanding shares in SAB. We have been invested in SAB for more than five years, well before ABI’s attempt to purchase the company. It is our opinion that as a standalone company SAB is capable of delivering attractive returns to shareholders for decades to come, driven by low to mid-teens earnings growth and a healthy dividend. Not only is this a highly unusual company in terms of potential growth, but it is also rare given the predictability of its business. In a recession, demand for cars or new homes may fall, but beer sales historically remain stable.
As the world’s second largest brewer, SAB has dominant market positions in countries where per capita consumption of its beverages are extremely low. The company operates in more than 80 countries, with close to 70% of its earnings in the last year coming from developing markets where, as the middle class develops, we expect rapid growth in demand for the company’s products alongside a demand for higher-margin premium beer. In Colombia, for example, its market share is above 90%, in a country where per capita beer consumption is a third lower than Brazil, which itself is still growing. And in Sub-Saharan Africa (excluding South Africa) per capita consumption is just a small fraction of Colombia’s low level. We see decades of beer consumption growth ahead in many of its geographies, especially those in Latin America, Africa and Asia.
Nothing in the takeover price reflected these realities. Worse: As a result of the surprise Brexit vote and due to its London listing, the value of the offer in Pounds Sterling fell sharply in U.S. dollar terms between the time the deal was first announced and the time shareholders will receive their cash. As SAB generates roughly 98% of its revenue outside the U.K., the value of the business has been largely unaffected by Sterling’s fall. Thus, the valuation of the deal became even less attractive. Furthermore, the value of other Consumer Staples stocks has expanded, while SAB’s was been held back by the cash offer.
In October 2015, SAB’s board rejected the third offer from ABI of £42.15 saying it “very substantially undervalues SABMiller.” Both on a price-to-forward earnings and EV/forward EBITDA basis, the current cash offer is worse than the original offer, which was by the board’s admission very substantially undervalued.
While we think the SAB board made the right decision to recommend to the court to view its shareholders as two separate classes, we still think that it has made a misstep by accepting this insufficient offer. Since the deal was first announced, there have been changes in currency, rising valuations for Consumer Staples companies and rising underlying earnings at the company, none of which has been taken into account. We strongly believe the long-term trajectory of a standalone SABMiller was extremely attractive.