Virtus Emerging Markets Opportunities Fund
3Q 2016 COMMENTARY
- MARKET — After a disappointing 2015, emerging markets have been top performers throughout 2016, specifically in the third 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 helped some emerging market currencies recover lost ground relative to the U.S. dollar and stabilizing commodity prices helped a number of markets during the quarter.
- 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 Emerging Markets Index. Given the relative softness in the consumer staples sector, our large exposure weighed on overall returns. We increased exposure to e-commerce, specifically to Chinese companies. This 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. Over the past 12 months, we sold or trimmed a number of holdings in India as a result of either specific company issues or valuations. While India is performing well economically, some areas of the market have become expensive in our view
- OUTLOOK — We caution investors that, given our consistent focus on investing in high quality growth companies, the Fund’s 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.
After a disappointing 2015 (-14.92%, as measured by the MSCI Emerging Markets Index), emerging markets were top performers through the third quarter of 2016. Lower-than-expected interest rates in the U.S. continued to support demand for higher-yielding assets in the emerging world. Improved capital flows helped some emerging market currencies recover lost ground relative to the U.S. dollar. Stabilizing commodity prices also helped a number of markets during the quarter.
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. Monsoon season delivered near-normal precipitation and favored agricultural regions. Raghuram Rajan, the Governor of the Reserve Bank of India (RBI), left the bank in early September. In June, the announcement of his departure surprised markets. The new governor, Urjit Patel, has been an RBI deputy governor since 2013 and we believe will likely continue with similar policies. 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 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.
In Indonesia, GDP growth is recovering and inflation remains subdued. The country’s current account deficit and exchange rate remain stable. Bank Indonesia cut its benchmark rate during the quarter to spur additional growth. The MSCI Indonesia ND Index was up 9.5% (USD) for the quarter.
South Africa’s economic growth remained subdued following the poor performance of the African National Congress in local government elections. Over the longer term, political change is positive; however, it could be disruptive over the shorter term. In this environment, we find the outlook for consumer demand growth becomes less predictable.
The failed coup in Turkey created an uncertain political and economic environment. Two ratings agencies lowered the country’s debt rating during the quarter. Turkish stocks, bonds, and lira sold off following Moody’s September downgrade.
Brazil has suffered debilitating internal political and economic crises that culminated in the impeachment of President Dilma Rousseff during 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 is committed to implementing fiscal reforms, limiting the government’s ability to spend. 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.
While the Fund’s performance was positive for the quarter, it underperformed the benchmark MSCI Emerging Markets Index. Given the relative softness in the consumer staples sector over the quarter, our large exposure (41% of the portfolio) weighed on overall returns. The Fund’s consumer staples exposure has been above that of the market for a number of years, reflecting the attractive economics and diverse businesses we find selling into the growing middle class of emerging market consumers.
Consumer Staples — Two consumer staples companies, LG Household and Healthcare and Wal-Mart de Mexico (Walmex) were the weakest contributors to the portfolio return during the quarter. Walmex reported solid second quarter earnings and the share price continued to move within a range following strong performance in 2015. The stock was weak in USD terms largely due to the 5% fall in the Mexican peso against the dollar over the third quarter of 2016. LG H&H’s share price corrected on concerns related to the knock-on impact of the political dispute between China and Korea over the THAAD (Terminal High Altitude Area Defense) issue, impacting demand for Korean brands. While it is difficult to know the impact on travel spending (from duty-free sales) we believe that the impact will be shorter term in nature and that the company still has strong room for growth, particularly onshore in China through distribution of the already successful Whoo, and going forward, the Sum and belif cosmetic brands. Overall, we feel that Korean brands have strong credibility with Asian consumers in the skin care market.
Information Technology — Our investments in Chinese Internet names — Alibaba, Tencent, and NetEase — all performed well this quarter after releasing results that exceeded expectations. Alibaba’s performance was primarily driven by strong growth in mobile sales and rising monetization rates.Tencent enjoyed strong performance in mobile games, online advertising, and cloud services; the sharp rise of subscription-based revenue, in areas such as music and video, also contributed to performance. NetEase was supported by the successful launch of new mobile games as well as solid gains in online advertising. From a relative standpoint, our stocks in the information technology sector underperformed the benchmark due to the Fund’s lack of exposure to Samsung Electronics (represents 4% of the Index) and the weakness in our holding of Brazilian credit card merchant acquirer Cielo, whose second quarter results, while in line with consensus expectations, pointed to signs of cost pressure due to higher-than-expected marketing expenses. Our information technology holdings Tata Consultancy Services and Infosys also detracted from returns.
Financials — We have long held an overweight to India. In the quarter, our financials holdings Housing Development Finance Corporation and HDFC Bank, which represent approximately 10% of the portfolio, returned 13.5% and 10.0%, respectively.
No-to-Low Weightings — Our lack of exposure to utilities and underweight to telecommunication services and industrials also added to relative returns.
Bank Pekao SA (Financials) — The largest bank in Poland and one of the largest financial institutions in Central and Eastern Europe. We have not held an Eastern European business outside of Russia in quite some time. In our opinion, Bank Pekao is a well-run bank with a strong deposit franchise, high capital ratio, and operates with a strong lending discipline. Its return on equity (ROE) is currently in the 10% range, and we believe it will recover to 12% over the next few years.
United Overseas Bank (UOB) (Financials) — One of the three dominant banks in Singapore, deriving 56% of its revenues from the country. The rest of its business and its main growth potential are across the ASEAN markets. We feel that UOB's strong balance sheet should allow it to absorb temporary asset quality issues, and over the medium term its earnings growth should resume.
New Oriental Educational & Technology Group (Consumer Discretionary) — A Chinese for-profit education company that provides after-school tutoring for a number of subjects, English language training, and test preparation to domestic grades K-12 and overseas college entrance exams. New Oriental has grown revenues, driven by an increased number of schools. Importantly, higher capacity utilization and rising prices are driving higher margins as management has shifted its focus towards improving profitability. We see growth opportunities as China is a test-oriented culture focused on national exams for entrance to high school and college, where parents have a high propensity to spend on education.
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. 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, under this management team, in our view would be beneficial to shareholders. (For more on our view of ABI, see the “Investment Case Study” at the end of this commentary.)
We sold five positions over the quarter: Infosys Limited, as the company is struggling to hold its revenue growth momentum; Grupo Televisa, as Mexican TV advertising revenue is suffering as a result of rising Pay TV and Internet usage; BM&FBovespa due to its high valuation; and Randgold Resources Limited and Kotak Mahindra Bank Limited to reallocate capital to better opportunities.
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 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, price-to-earnings (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 its 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 is we continued to add to our Chinese e-commerce exposure. This 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, Tencent, and NetEase. 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 sharp 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.
We are closely watching U.S. monetary policy and its potential impact on emerging markets. Higher interest 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 a relatively high 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. We have held a number of our Indian investments for more than ten years and continue to believe there is a bright future ahead for well-run Indian firms with dominant market positions.
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 enterprise value (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 SAB was extremely attractive.
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