Commentary

International Equity Strategy

June 30, 2020

THE MARKET ENVIRONMENT
Major global markets finished higher for the second quarter, despite pockets of volatility dispersed throughout the reporting period. Businesses continued to grapple with the effects of the coronavirus pandemic on economic activity in the second quarter. In the U.K., gross domestic product sank 20.4% in April following a 5.8% decline in March. In Germany, industrial output dropped a record 17.9% in April after an 8.9% descent in March. In June, the International Monetary Fund (IMF) lowered its previous forecast for a 3.0% global economic contraction to a 4.9% global economic contraction for full-year 2020. The IMF also anticipates that the Japanese economy will shrink 5.8% in 2020, which is in excess of the 5.4% contraction the country experienced in 2009.

By the end of June, confirmed global coronavirus cases topped 10 million and global deaths from the virus surpassed the grim 500,000 mark. The U.S. accounted for over 25% of both global cases and deaths, with more than 35 states experiencing an increase in new cases by the end of June. Daily cases in the country eclipsed the 40,000 mark multiple times during the second quarter. Brazil trailed only the U.S. in both cases and deaths at more than 1.3 million and 55,000, respectively.

Meanwhile, heightened recognition of racial inequities and injustices prompted large-scale protests (and, in several cases, riots) to break out around the world. Surging protest activity that lasted weeks interrupted newly reopened businesses just emerging from pandemic-induced shutdowns, which led to further market volatility. The widespread call for change caused many organizations to publicly implement practices to fight racism, emphasize diversity, and eliminate offensive images, symbols and product brand names.

As is the case in any period of volatility, we find that the price of a business is an important aspect of what makes a stock attractive. Investing in a business at a fraction of what we think its underlying value is presents an opportunity to create value for our shareholders. In times like these, we look for high-quality companies with over-penalized share prices as investors disregard strong balance sheets and free cash flow and instead base investment decisions on market sentiment.

THE PORTFOLIO
Top Performers:
Glencore’s share price finished the second quarter higher than the first quarter even though first-quarter production of copper, cobalt, coal and ferrochrome was lower than a year earlier, while zinc, nickel and oil output increased. Management reduced full-year production guidance across commodities and elaborated on the state of the business given effects of the coronavirus. Operational disruptions were slightly ahead of what we had expected. However, in our assessment, owing to the level of assets impacted, the effects will not be material. Furthermore, we found it surprising that overall costs declined when we had expected them to increase. The combination of cost-cutting efforts, lower input prices (particularly diesel fuel) and currency exchange rates helped reduce the cost position across a number of operations, which led to management decreasing full-year capital expenditures guidance to $4-4.5 billion compared to the original guidance of $5.5 billion. Later, reports in June indicated the company would supply Tesla with up to 6,000 tons of cobalt per year for two new car plants in China and Germany. Despite the challenging operating environment, we think Glencore’s balance sheet is much improved, leaving the company well positioned to withstand a downturn.

BNP Paribas delivered strong first-quarter earnings results, including revenue (EUR 10.89 billion vs. EUR 10.79 billion) and net income (EUR 1.28 billion vs. EUR 908.0 million) results that bested consensus estimates. Sequential loan growth of 4.4% and origination strength in the corporate and institutional banking segment drove underlying revenue growth, which would have reached 2.8% year-over-year without the drag of two one-time items totaling EUR 568 million. On an underlying basis, operating expenditures sank about 2%, and management announced it is looking to recognize additional cost-cutting opportunities of EUR 300-500 million. Importantly, BNP believes these cost savings can be retained as the business increasingly moves online to the company’s more efficient platforms. BNP also noted significant savings potential from a reduced real estate footprint as the company incorporates greater work-from-home intensity following what it deemed as successful productivity during the work-from-home era of the pandemic.

Daimler’s first-quarter earnings report bested market expectations as exhibited by revenues (EUR 37.22 billion vs. EUR 34.18 billion) and adjusted earnings (EUR 719 million vs. EUR 648 million). Management confirmed its previous outlook for a decline in total revenue and earnings for 2020 compared to the year-ago period. The company also noted it planned to gradually accelerate production. To that point, Daimler resumed manufacturing passenger cars in two German plants at the end of April. We recently spoke with CEO Ola Källenius and CFO Harald Wilhelm and discussed some short-term measures enacted to boost profitability, which include utilizing a short-time work program in coordination with the German government to reduce payroll expenses. Importantly, management committed to not postponing any projects that are important for the future of Daimler, including production of the new Mercedes-Benz S-Class vehicle (which accounts for 3-4% of volumes and 15% or more of profits) and electrification (Daimler’s battery plant in Germany is the only plant globally that has never shut down, despite coronavirus challenges). In our determination, management has a solid plan for the future and we believe the investment can continue to provide value for our shareholders over the long term.

Bottom Performers:
At its annual shareholder meeting in May, Rolls-Royce Holdings stated expectations for a significant net cash outflow during the second quarter. The company did not provide full-year guidance owing to the substantial disruption to the global aerospace industry caused by the coronavirus pandemic. Earlier in the year, management implemented a number of measures intended to produce a cash flow benefit of at least GBP 750 million. At the meeting, management indicated the company had made better progress than anticipated and now expects to deliver up to GBP 1.0 billion of cash savings in 2020. While we are encouraged that management is taking considerable actions to counter current circumstances, we think the pandemic may result in a long-lasting disruption to the company’s civil aerospace business, which generates roughly half of its total revenue. Fortunately, Rolls-Royce has other businesses, namely power systems and defense, which combined are nearly the same size as its civil business and have seen much less coronavirus-related disruption. Although we revised our earnings forecast to be lower for the company’s civil business, we believe the market’s reaction was overdone and did not take into account the total value of the entire business.

Lloyds Banking Group’s first-quarter results included net income and underlying profit that declined 11% and 74%, respectively, from the prior year period and also far undershot market expectations. Although quarterly underlying profit missed our estimates by roughly 7%, after adjusting for a number of one-time items, we assessed that underlying profit is in line with our full-year expectations. Along with the earnings release, CEO António Horta-Osório commented that owing to current challenging and uncertain economic conditions associated with the coronavirus pandemic, the company’s original full-year guidance is no longer appropriate. We later spoke with Horta-Osório who sees scope for material cost savings by redirecting resources and eliminating other expenses, such as travel. We believe that numerous positive factors should help the company’s net interest margins over the medium term and current coronavirus-related challenges are transitory in nature. In addition, in our view, net interest margins could benefit from lower liability costs and the U.K. government’s 100% guarantees on incremental small- and medium-enterprise loans that provide attractive interest rate spreads for lenders. Overall, we find that Lloyds is trading at a large discount to our estimate of the company’s intrinsic value.

Grupo Televisa issued weak first-quarter results that far undershot our estimates. Total revenue was relatively unchanged from the same period last year. However, the company reported a net income loss of MXN 9.65 billion compared with the gain of MXN 541.7 million realized a year ago. The content segment continued to struggle due to underperformance from the advertising business where revenue declined 28% year-over-year. Considering ongoing impacts from government advertising spending cuts and the coronavirus pandemic, we lowered our estimates for full-year advertising revenue growth. Conversely, revenue growth strengthened from network subscriptions and licensing and syndication, which advanced 9% and 11%, respectively. Sky revenues rose 2%, mainly from broadband services growth, and cable revenues increased 9% as revenue- generating units grew 6% and average revenue per unit grew 3%. Even though Grupo Televisa is facing some challenges from an uncertain macro environment, our investment thesis for this company stands.

During the quarter, we initiated positions in Amadeus IT Group and Compass Group. There were no final sales.

Past performance is no guarantee of future results.