Commentary

International Equity Strategy

September 30, 2022

THE MARKET ENVIRONMENT

Major global markets continued to experience pressure and volatility in the third quarter as investors reacted to prevailing challenges facing economies across the world. Efforts by central banks to reign in elevated inflation by tightening financial conditions were at the forefront of financial discourse with investors reducing exposure to assets, such as equities, as interest rates climb at aggressive paces. In the U.S., the Federal Reserve raised its benchmark interest rate by 75 basis points in July and again in August to 3.00–3.25%. Importantly, rhetoric following each decision was noticeably hawkish as Fed Chair Jerome Powell looked to emphasize the Federal Open Market Committee’s commitment to regaining price stability with further rate hikes, even at the expense of economic hardship. The Bank of England, Bank of Canada and European Central Bank all increased their respective benchmark rates in September by 50, 75 and 75 basis points, respectively. China and Japan’s central banks opted for more accommodative policies. Major currencies including the pound, yen, euro, Australian dollar and Swiss franc all depreciated against the dollar throughout the quarter.

Late in the quarter, newly elected U.K. Prime Minister Liz Truss created some volatility in markets when she announced plans for an unfunded tax cut totaling GBP 45 billion per year in hopes of easing citizens financial burdens and spurring economic growth. The 30-year yield for a U.K. government bond jumped nearly 150 basis points in under a week to nearly 5% before settling at around 3.8%. The Bank of England reacted by purchasing gilts to stabilize the market and delayed its planned quantitative tightening program of selling gilts.

While we do not overlook the negative impacts the war in Ukraine, tightening financial conditions, energy crisis and volatile currencies will continue to have, we remain cognizant that a company’s value is derived from its longer term cash flows discounted back to the present day. As share prices fall across the board, we rely on our disciplined approach to identify exceptional businesses over penalized by share price activity. In our view, risk is not synonymous with owning equities during times of market turmoil. Rather, we believe owning companies that meet our rigorous criteria at discounted levels offers an attractive opportunity on a risk to reward basis.

THE PORTFOLIO

Top Performers:
Worldline delivered a solid set of second-quarter results, in our view. Merchant services, which accounts for 69% of sales, grew a robust 33% in the second quarter and 27% in the first half in spite of a 2.5% headwind from an exit of Russian operations. Strong operational performance is being driven by a post-Covid-19 recovery in purchase volumes, market share growth and growth in value-added services sold to merchants. The positive effects of operating leverage as well as the company’s cost mitigation efforts and ongoing synergy extraction from past deals should help offset near-term cost inflation and drive longer term margin improvement. To date, management has not seen any weakness in consumer spending, but we believe macro risk for the company is partially mitigated by the ongoing cash-to-digital payment shift that is at much earlier stages in Europe versus the U.S. The company should also complete the sale of its terminals business in the back half of the year, reinforcing the balance sheet. During our post-results engagement with management, we met new CFO Gregory Lambertie, who we think is a positive addition to the management ranks. Finally, management continues to see opportunity to participate in market consolidation in European payments and we believe the quality of the company’s technology assets, proven record of successful merger agreements, and financial flexibility make them a desirable suitor.

Axis Bank reported its first-quarter earnings in August, which included net income up 91% year-over-year; however, we recognize that these results included one-time items. Provision expenses declined 89% year-over-year due to loan upgrades as Axis has been taking excess provisions in past quarters. Asset quality remains sound, in our view. Net non-performing loans declined to 0.64% of total loans while coverage levels remained robust. Management used gains from lower credit revisions to cover trading book losses and to invest in growth initiatives ahead of revenue creation, which inflated operating expenses. We believe the trading losses will largely reverse as Axis has invested in high-quality credit with a short duration, which should revert back to par value over the coming years. Although operating expenses were a bit worse than had been expected, net interest income is tracking well on the back of both loan growth (+14% year-over-year) and net interest margin expansion (+14 basis points year-over-year and +11 basis points sequentially).

Restaurant Brands’ share price rose following a strong second-quarter earnings release where revenue grew 14%, led by Tim Horton’s Canada and Burger King International. Performance is being driven by location growth, which management continues to guide to returning to 2019 levels, and a rebound in same-store sales performance following investments in the business and the end of Covid-19 lockdowns. During the quarter, the company also announced its “Reclaim the Flame” investment program for the U.S. Burger King business. The plan includes a $400 million investment program across 2023 and 2024 and aims to improve same-store sales performance and franchisee profitability. The money will be spent on advertising, the mobile app, store remodels, and store equipment and technology upgrades. We like the approach of the investment program and the manager in charge of it. More broadly, although the Burger King U.S. investment program and quick service restaurants ongoing investments in Tim Horton’s will lower profitability in the short run, we believe these investments are the right strategic moves to drive long-term growth and value creation.

Bottom Performers:
In July, Continental warned that free cash flow for the quarter would come in below expectations due to a build-up of working capital related to supply chain issues, material cost inflation and higher receivables due to higher prices. The full release in August added more color for the tires segment, which had organic growth of 11.4%-16.7% of which came from price and product mix and a decline of 5.3%, which came from reduced replacement volumes across all regions. The company’s automotive business reported an operating loss during the second quarter, though margins are expected to recover in the second half of the year due to improving light vehicle production and the benefits of price increases with OEMs. Encouragingly, the company has realized more than EUR 6 billion in order intake in the second quarter, which, when combined with the company’s ongoing restructuring program, supports its medium-term targets. Despite a difficult environment, we believe Continental has undertaken significant action to improve results and that the company’s exposures across the automotive value chain along with its low valuation make it a compelling investment.

Credit Suisse expectedly delivered a set of disappointing first-half results due to both financial markets headwinds and company-specific factors. Despite this, we appreciated that the core wealth management franchise had strong performance and loan loss provisions are tracking well below estimates. Importantly, capital levels were a bit higher than had been expected with the company’s common equity tier 1 ratio at 13.5% and management expecting it to remain near that level for the second half of the year. The company is looking closely into its investment banking segment through a strategic review where it is likely to make substantial cuts to transform it into a capital-light, advisory led banking business with a reduced absolute cost base in the medium term. We appreciate management’s effort to reduce tail risk by shrinking and simplifying the investment banking segment and allocating more capital toward the higher returning wealth management franchise. In our view, the market is over-penalizing Credit Suisse due to its past errors, and on a forward-looking basis, we believe the franchise has attractive assets and an attainable path toward stronger performance that will benefit current shareholders.

Given the Chinese lockdowns and difficult macro environment, recent results for Alibaba Group were suppressed as well as for Chinese internet companies in general. Despite the difficult background, Alibaba Group’s first-quarter results beat consensus estimates for revenue and adjusted earnings. Last quarter, management noted its intentions to begin cutting costs and focusing more on quality growth and efficiency, which was evident in this quarter’s results. Losses in many businesses were reduced and margins increased 390 basis points sequentially. The company’s CFO stated that cost cutting would continue throughout the year and expectations are for earnings and margins to improve. We appreciate the steps management is taking to improve what they can control, while respecting that the company’s topline will remain uncertain given the tough environment. However, we believe the company is well positioned to grow per share value for shareholders over the long term.

During the quarter, we initiated positions in Ashtead Group, DSV, Fujitsu and Schindler Holding. We eliminated NatWest Group and Toyota Motor from the portfolio.

Past performance is no guarantee of future results.

The MSCI World ex U.S. Index (Net) is a free float-adjusted, market capitalization-weighted index that is designed to measure international developed market equity performance, excluding the U.S. The index covers approximately 85% of the free float-adjusted market capitalization in each country. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s International Equity composite as of 09/30/2022.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.