Virtus Emerging Markets Equity Income Fund
3Q 2016 COMMENTARY
The MSCI Emerging Markets Index continued its recent uptrend, registering a rise of 9.0% during the third quarter of the year. Global equity markets were aided by the decision of the Federal Reserve not to raise rates in September while commodity prices were supported by the OPEC agreement on production cuts. Cyclical stocks outperformed defensive stocks in general, with the best performing sectors being software, technology hardware, and semiconductors. Banks and materials also performed strongly over the quarter. The laggards included household and personal products, utilities, and healthcare equipment.
Asian equities were up 10.5% on the quarter. China gained 13.9% as the China Insurance Regulatory Commission allowed mainland insurers to invest in Hong Kong shares via the Shanghai-HK Connect. The market was also buoyed by positive earnings surprises as the country reaped the benefits of prior monetary easing. Taiwan rose by 11.7% as the technology sector benefited from a quarterly earnings beat from Apple and from the iPhone 7 launch with pre-orders exceeding expectations. Korea advanced by 11.0% as Samsung Electronics survived a slump following a series of mobile phone explosions by virtue of a timely product recall. India gained 5.9% following the passage of the Goods and Services Tax Bill in the parliament although the gains were capped by cross border tensions with Pakistan towards the end of the quarter. Indonesia recorded a rise of 9.5% as the central bank cut interest rates by 0.25% to 5% and collections from the first phase of the tax amnesty program exceeded expectations. The Philippines declined by 5.3% dragged down by the falling peso as investors concerns about political uncertainty escalated.
Europe, the Middle East, and Africa (EMEA) gained 5.7% on the quarter. Turkey had a particularly torrid time, registering a decline of 5.3%. Turkey started the quarter with a thwarted coup attempt and ended with its downgrade to junk status by Moody’s. The central bank continued to provide significant monetary support and has now cut lending rates for the last seven months in a row. While political uncertainty remained an issue in South Africa, the recovery in global commodity prices enabled the market to post a rise of 6.3%. Russian equities advanced by 8.4%, buoyed by rising commodity prices and by the decision of the Bank of Russia to cut interest rates by 0.5% as inflationary pressures continued to subside.
Latin America registered a rise of 5.4%. Brazilian equities rose by 11.3% as expectations of improved earnings, economic growth, and policy reforms supported the recovery from recent troughs. The country also witnessed the impeachment of former President Dilma Rousseff. Mexico had a difficult quarter, declining by 2.2% as the peso weakened due to increased political uncertainty created by the U.S. presidential election. The central bank was forced to raise rates by 0.5% in order to arrest the slide in the currency and to control domestic inflation.
Growth-oriented stocks outperformed value-style stocks over the quarter, and was particularly strong in Asia. Value stocks did, however, outperform growth by a considerable margin in Latin America. High yielding stocks underperformed in each of the three regions and was especially weak in Latin America. Quality performed broadly in line with the benchmark. Large-cap stocks generated the strongest returns over the quarter, with mid-cap stocks struggling on a relative basis. In EMEA, small-cap stocks posted the strongest gains. The Fund rose 7.37% (Class A NAV), thus underperforming the benchmark MSCI Emerging Markets Index (net) which returned 9.03%.
INDUSTRY GROUP ANALYSIS
Relative stock selection detracted from performance in software, automobiles, and transportation.
Software – Infosys declined by 10.6% as it was adversely impacted by the cancellation of the RBS deal and by softness in a few clients due to Brexit. Investors were also concerned by a number of senior management exits however the company stated that the departures were forced and were due to performance issues. Management believes that the issues facing the industry are transitory not structural. Tata Consultancy Services declined by 3.4% as overall macro caution has resulted in certain discretionary projects being held up or delayed. While the company has not seen a blanket ban on spending they are seeing varying degrees of caution among key clients. The underweight position in Alibaba detracted from performance as it registered a rise of 33.0%. Accelerating core e-commerce revenue growth, top of the class positioning of its cloud and media businesses along with increased financial transparency convinced investors to look beyond the cyclical perception of the company. The company is already trading on 35 times earnings and does not pay a dividend. The underweight position in Tencent also hampered relative performance as it rose by 21.0%. The stock is benefitting from the sharp rise in subscription based revenues in areas such as music and video. The cash cow smartphone business has also demonstrated stronger than expected momentum with continued strength in its mobile games business much of it driven by players versus player titles.
Automobiles – Dongfeng Motor declined by 19.3% as investors responded to disappointing interim sales. While sales were strong at Dongfeng Nissan and Dongfeng Honda they came in well below analyst expectations at Dongfeng PSA. However overall sales and earnings momentum is likely to improve with new model launches over the coming months although investors are concerned about the impact on sales from a tax rate hike of 2.5% in 2017.
Transportation – Grupo Aeroportuario de Pacifico declined by 5.7% as the stock was hit by the possibility of a Trump victory in the presidential election. The candidate has proposed to build a wall along the southern border, to deport illegal immigrants, block remittances and to erect barriers to free trade. The transportation sector is highly dependent on GDP growth and on the overall business environment.
Relative stock selection contributed positively to performance in banks, diversified financials, and telecoms.
Banks – Chinese banks had a relatively strong quarter as they continue to place more emphasis on growing mortgage lending given its much better asset quality than corporate lending. The recovery in the property market will enable banks to improve their asset quality as rising asset prices will mean that collateral values on mortgage loans and corporate loans will be re-priced upwards enabling banks to liquidate collateral more easily. Agricultural Bank of China gained 16.8% as business mix continued to improve with higher contributions from non-interest income and retail loans. The bank outlined a clear business direction and a solid capital position that will sustain dividend payout. ICBC rose by 11.8% as the bank has a strong retail deposit franchise and a superior IT infrastructure relative to peers. The bank also undertook its first ever NPL asset backed security issuance. Banco do Brasil gained 33.3% as management clarified concerns over capital and highlighted that the capital target will be achieved by focusing on higher return on equity, risk weighted asset management, moderate loan growth and a minimum payout of 25%. Management discarded the necessity to sell stakes in revenue generating assets because they are essential for the bank’s profitability.
Diversified Financials – Fubon gained 26.4% as the aggressive increase in its overseas bond position provides superior growth momentum in realised gains from AFS financial assets thanks to rising bond prices hence supporting earnings growth. Fubon provides one of the lowest liabilities costs along with one of the highest recurring yields in the industry while its life investment and products are positioned for rates to remain low.
FirstRand rose by 12.6% as management can afford to slow credit growth and reduce risk as surplus provisions and unrealised private equity gains are at its disposal. While earnings were broadly in line with expectations management were very conservative with provisioning allowing room for manoeuvre next year if conditions deteriorate.
Telecoms – China Communications Services rose by 24.1% as top line growth accelerated while the revenue mix also improved. The company has gained market share in the domestic operator market and is becoming less reliant on the capital expenditure cycle of Chinese telecom operators. Free cash flow has improved significantly as the company has shifted from revenue growth to cash earnings, free cash flow and accounts receivable management. The company raised its payout ratio in 2015 and further increases are likely in the coming years.
Relative stock selection detracted from performance in Korea, India, and China.
Korea – KT&G declined by 3.2% as export sales were disappointing during the second quarter although management are confident they will recover in the current quarter. There is some concern over the possible launch of a vapour product in 2017 while the company’s overall market share remains below 60% and is lower than the level achieved before the tobacco price hikes. However KT&G enjoys stable cash flows with very little need for facility investment and this will enable it to increase dividend payouts. The underweight position in Samsung Electronics also detracted from performance as it gained 17.3%. Despite some weakness towards the end of the quarter due to a Galaxy Note recall Samsung Electronics had a very strong quarter in general. Galaxy Note issues are likely to prove temporary and will shift sales into 2017. The component business is performing strongly as a result of better pricing, solid demand across major applications and improved demand/supply conditions. Coway declined by 4.3% as the stock came under pressure due to traces of nickel in an ice-making water purifier. A joint probe however revealed that while some metal plating had peeled off due to faulty ice makers, the amount of nickel found was proven not to be harmful to humans in the short or long term. The company subsequently announced that it had decided to cancel 1% of its outstanding shares.
India – Wipro declined by 13.3% as the company has significant exposure to two verticals undergoing structural fundamental challenges communications and energy, natural resources and utilities which account for 7.6% and 13.2% of sales respectively. Infosys and Tata Consultancy were the other main contributors to poor relative performance in India.
China – The underweight positions in Alibaba and Tencent were the main contributors to poor relative performance in China. Want Want China declined by 11.6% as the company will be negatively impacted by the sharp increase in milk powder prices as its entire line of dairy products is sourced from imported milk although it does maintain a 6 month milk powder inventory. Despite this challenge management will continue to reward shareholders with a cash dividend or share repurchase on the back of its strong internally generated cash. Sinopec Engineering declined by 3.2% as profitability at China’s refiners and petrochemical plants shrank recently due to softer demand and competition from teapots. The company’s backlog provides decent sales visibility while a high cash balance, attractive dividend yield and rising oil prices should limit further downside in the stock.
Relative stock selection contributed positively to performance in Taiwan and Indonesia.
Taiwan – Pegatron rose by 28.7% as there were signs that Apple could no longer simply rely on squeezing suppliers to maintain its own margins. Pegatron is already improving on its execution in order to deliver margin expansion and the company also revealed faster than expected de-stocking in the first half of the year while it is also likely to benefit from a larger order allocation from Apple. Foxconn gained 30.0% as it benefited from stronger than anticipated iPhone 7 Plus demand. The higher average selling price of the iPhone 7 Plus casing due to the more complicated surface treatment for the jet black version will benefit Foxconn as it is the sole supplier of the jet black casing.
Indonesia – United Tractors rose by 21.7% as heavy equipment orders from the mining sector are recovering. China’s low coal inventory has caused it to increase coal imports from Indonesia and now coal inventory is also low in Indonesia. The coal price increase will lend support to better volume and pricing in the mining contracting segment. The refurbishment cycle is likely to boost spare parts and services revenue. Astra International gained 12.6% as robust four wheel sales growth was attributed to MPV’s the Toyota Calya and Daihatsu Sigra which were launched at end July and both of these models are classified as low cost green cars.
CHANGES OVER THE QUARTER
There were very few major country moves during the quarter. Our largest move was into South Africa in the EMEA region while selling out of Qatar and the Czech Republic.
In Asia, we added to our Thailand weight and sold down our positions in Indonesia and Malaysia.
We stopped adding to Brazil in Latin America and maintained our position in Mexico. The main country reduction in this region was Chile.
Largest Stock Trades of Note
We continued to adjust our materials related holdings in emerging markets during the quarter. In Asia, we added Hyosung Corp (Korea) and Siam Cement (Thailand) and dropped Nan Ya Plastic (Taiwan) from the portfolio. In EMEA, we added a sizeable position in Sibanye Gold from South Africa.
Information technology is a sector where we made a number of changes. We solidified our positions in Indian software by increasing both HCL Technologies and Infosys and removed NCSOFT Corp in Korea. In technology hardware we increased Catcher Technology and reduced Hon Hai Precision.
Other notable trades during the quarter included adding Korea Electric Power and removing Petronas in the utilities sector. We also sold down Rosneft and added to Gazprom in Russia.
Dividend Yield – On a total portfolio level, the dividend yield ended the quarter in line with the level at the start of the period. 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 consciously reduced targeting excessive yield in the portfolio.
Dividend Growth – We’ve aggressively increased our exposure to dividend growth. We’ve noticed over the past 9-12 months that dividend growth levels are slowing considerably and this continued in the third quarter. This is no surprise given the 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 benchmark index despite this absolute 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 value exposure relative to the index while sacrificing little on the quality front.
Debt to Equity – Net debt to equity continues to be an area of focus for us. While much more of a developed world problem the growing level of corporate debt needs to be monitored. Over the quarter we were content to allow the debt level to increase in our EM portfolio. However this is from an extremely low base and is primarily a result of the Asian region. Lots of our holdings within Asia are sitting on large piles of cash and with little to no debt. This may not be such a bad thing given the uncertainty around the economic outlook. Hoarding cash is not always adding value but we see this as major potential for increased payouts given the high levels of cash sitting on balance sheets. We are witnessing this via the increases in the Fund’s dividend growth rates.
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.