Commentary

International Equity Strategy

March 31, 2020

THE MARKET ENVIRONMENT
At the start of 2020, it appeared market activity would continue in familiar fashion and would largely support global benchmark levels achieved from prior bull market advances. However, by mid-January, developments concerning the coronavirus came to light. What began in late 2019 as an outbreak localized to China spread swiftly and by mid-March, the World Health Organization officially deemed the coronavirus a global pandemic. Equity markets declined precipitously in conjunction with increasingly dire news about the accelerating rate of illness.

The virus quickly disrupted economic activity across geographies and sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group gathering activities and orders by officials in many countries for citizens to stay home upended daily life. Even the 2020 Olympic Games were postponed. Unemployment began to rise, with the U.S. seeing a record three million jobless claims filed in a one-week period and the United Nations estimated that virus-prompted job losses could exceed 25 million worldwide. To stem the economic impact, policymakers around the world enacted significant economic stimulus measures and leaders of industrial nations vowed to work in tandem to support the global economy. Though some funding levels have already reached trillions, economists expect that even more stimulus may be necessary.

Over our decades of experience, we have witnessed other market-rattling crises, each uniquely different from each other. No one knows how this particular issue will be resolved as there is not enough data today to reach specific conclusions. Yet please be assured that our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity. In our assessment, equity share price declines have reached levels that are in excess of the actual value declines of businesses we hold. One proactive action we adopt under adverse circumstances is to rebalance our client portfolios. We take advantage of lower equity prices to increase share weightings of companies that, according to our estimates, have become even more undervalued. Although the current situation is changing rapidly, as long-term investors, we focus on rational decision-making and avoid making emotionally driven investing choices. Our investment team remains on vigilant watch for appropriate opportunities today that we believe can yield shareholder rewards over our typical five- to seven-year holding timeframe.

THE PORTFOLIO
Top Performers:
Fiscal nine-month results from Olympus included year-over-year sales growth of 2% that matched our expectations. Furthermore, operating profit advanced 281% to a record high level of nearly JPY 79 billion. Management attributed the significant operating profit increase to progress made reducing selling, general and administrative costs along with decreasing one-time expenses compared with a year earlier. Overall, results were ahead of management’s full-year guidance and our estimates. The share price of Olympus jumped past our sell target after the earnings release and we sold our shares.

Late in 2019, Prosus released its first set of financial reports and its share price rose early in the first quarter. The company also engaged in a high-profile bidding war to acquire Just Eat in recent months and in January, the company received positive reviews from some market analysts. We subsequently decided to exit this position in favor of other investments that we believe offer better upside potential.

Full-year results from ASML Holding precisely matched our estimates, driven by strengthening performance in the company’s fiscal second half. Sales rose 8% for the full year and fourth-quarter revenue reached EUR 4.04 billion, which surpassed both market expectations and management’s guidance. We sold our shares of the company in the middle of the quarter as the price exceeded our estimate of intrinsic value.

Bottom Performers:
Glencore’s full-year results included total revenue that missed market expectations and earnings per share that met market forecasts, while earnings (both EBITDA and EBIT) exceeded market projections. However, year-over-year total earnings declined as earnings from industrial operations fell 32.5% (EBITDA) to $8.96 billion and marketing earnings (EBIT) dropped 1% to $2.37 billion. The company finished the year with net debt of $17.56 billion and total capital expenditures of $5.37 billion, which were both larger than market expectations. Management stated the company remains focused on reducing total net debt to a range of $14-15 billion. From a production perspective, copper, coal and oil full-year output exceeded market estimates, while zinc and nickel output underperformed estimates. Management’s 2020 production guidance was also lower than market forecasts for copper, zinc and nickel. As we have remarked recently, market conditions for g have been challenging. We met with CEO Ivan Glasenberg and CFO Steve Kalmin during the quarter and learned that although metals pricing remains volatile, fortunately the coronavirus pandemic has not caused significant disruption to the company’s operations. We continue to believe Glencore is well positioned to provide shareholder benefits going forward.

BNP Paribas issued full-year results that we saw as solid. Revenue rose 4.9%, which surpassed our estimates, and increases of both operating income (+10%) and net income (+8%) aligned precisely with our forecasts. Pre-tax operating profit rose across domestic markets, international financial services and corporate banking by 31%, 43% and 26%, respectively, while operating expenses grew only 1.8% (at constant scope and exchange rates), which enabled BNP to generate operational leverage across all three segments. The company continues to benefit from its 2020 Transformation Plan, which has generated cumulative recurring savings of EUR 1.8 billion since 2017, and management expects incremental savings to continue in the current year. Capital generation was better than we had expected, owing to a sequential fourth-quarter decline of EUR 8 billion in risk-weighted assets, which propelled the common equity Tier 1 ratio to meet management’s target of 12.1%. Despite this positive performance, management reduced the 2020 return on tangible equity (ROTE) target for the second time in two years, citing pressure from negative interest rates. Even at the revised rate, the company’s ROTE forecast reflects an increase from the prior year, and we find the new rate acceptable.

Fourth-quarter results from Lloyds Banking Group fell short of market projections as revenue, underlying profit and pretax income all underperformed forecasts. For the fiscal full year, total revenue fell 4%, underlying profit fell 7% and pre-provision profit declined 3% from a year earlier, all of which were weaker than our estimates. The operating environment in 2019 was dominated by uncertainty surrounding Brexit and the formation of a U.K. government, which resulted in both corporate and individual investors postponing investment decisions. This circumstance pressured economic and loan growth and the Bank of England responded with keeping base interest rates low, putting further pressure on bank profitability. Along with the earnings release, management offered a more optimistic view of the U.K. economy. However, the coronavirus pandemic has created new concerns and we recently discussed these with CEO António Horta-Osório. In response to evolving events, Lloyds quickly implemented a contingency plan and now roughly 60,000 employees are able to work from home. In addition, Horta-Osório believes that coordinated efforts between the banking system and regulators will be directly helpful and reduce the need to increase the company’s capital level. Overall, we are comfortable with Lloyds’ approach to managing matters under its control.

During the quarter, we initiated positions in Alibaba Group and Prudential. We eliminated ASML Holding, Meggitt, Olympus, OMRON, Prosus and Willis Towers Watson from the portfolio.

Past performance is no guarantee of future results.