Dear Investor,
The Altrinsic International Equity portfolio declined 1.5% during the first quarter, outperforming the MSCI EAFE Index’s 5.9% decline, as measured in US dollars.i Just as most nations began lifting COVID-related restrictions and returning to normal, tensions intensified amidst surging inflationary pressures, tightening policy measures in the US, lockdowns in China, and Russia’s invasion of Ukraine. Corporate earnings have been robust, but we expect these to come under pressure as the year progresses owing to slowing revenue growth, increasing cost pressures, and lofty embedded expectations. Tightening financial conditions and downward earnings revisions could also contribute to growing market volatility. We continue to see the most compelling investment propositions among attractively valued and well capitalized businesses with durable and achievable earnings prospects and among those going through underappreciated efforts to further strengthen their financial productivity.
Performance Drivers and Portfolio Positioning
Sources of outperformance were broad-based and led by investments in the financial, information technology, and consumer discretionary sectors. Positive attribution in the financial sector was led by several property and casualty insurance holdings (Zurich, Chubb, Tokio Marine, Everest Re) that rose in response to improving profit margins, driven by positive developments in competitive dynamics and rising bond yields. Investment income accounts for more than half of most non-life insurance companies’ profits and stands to become a tailwind after years of being a headwind. Positive attribution from our technology investments was primarily driven by rebounding revenue growth at Check Point and Cognizant. Our lack of exposure to high-growth technology stocks also contributed to the portfolio’s outperformance. Having been oversold during the onset of China’s regulatory measures last year, our investments in the consumer discretionary sector (Trip.com, Sands China) coupled with our relative underweight exposure to the sector were additive to relative performance.
Materials and energy holdings were the greatest sources of negative attribution. Within the materials sector, performance was hampered by a combination of our underweight sector exposure and the underperformance of paint producer Akzo Nobel, which is facing significant input cost inflation. Energy majors BP and TotalEnergies climbed 12% and 4%, respectively, but lagged peers due to their Russian exposure.
Investment activity was robust amidst the volatility, as we added four new positions: CRH plc (Ireland), Daimler Trucks (Germany), HDFC Bank (India), and Sekisui House (Japan).
- CRH produces infrastructure materials and building products in the US and Europe. Portfolio changes in recent years have structurally improved the company’s earnings resiliency, while continued infrastructure investment in Europe and the US should drive sustainable top line growth throughout the economic cycle.
- Recently spun out from Daimler AG, Daimler Trucks is one of the world’s largest truck manufacturers. Management has recently started a restructuring program with the goal of achieving best-in-class operating margins.
- As one of India’s largest banks, HDFC will continue to use its superior cost structure, customer service, underwriting, and technology advantage to gain share from its poorly managed state bank rivals. India’s low credit penetration, pent-up credit demand, and low banking product usage provide a favorable macro backdrop.
- Sekisui House provides home-ownership related services in Japan, from construction to renovations to apartment real estate management, with a growing focus on net-zero energy efficient solutions. Sekisui is the leader in zero-energy housing, and we expect this highly profitable business to grow strongly given commodity inflation and increased household environmental awareness.
We eliminated four positions – Booking Holdings (Netherlands), BT Group (UK), Credicorp (Peru), and Ericsson (Sweden). Booking shares, purchased during the depths of the COVID-19 crisis, rebounded significantly since that time. Current prices fairly reflect benefits from a travel recovery, improved pricing power, and better competitive discipline in the industry. We sold shares in favor of other opportunities with better risk/reward profiles. We sold BT Group as M&A speculation drove the shares toward our intrinsic value estimates. BT has solid infrastructure assets but valuations underestimate the pension, government, and regulatory hurdles. Credicorp was purchased during a period of political uncertainty and has subsequently rallied sharply, approaching our base case intrinsic value. Finally, Ericsson was sold after continued operational and governance missteps vastly reduced our confidence in the company’s management and outlook.
Table 1 provides a summary of our risk exposures to major industry groups and highlights our greatest sources of differentiation.
Perspectives
Structural Shifts
The decade-long tailwinds that have supported all asset classes – most notably the riskiest – appear to have made a structural shift that is contributing to market turbulence and weakness in global equities. This has been most evident in long-duration growth “story” stocks. The tailwinds have included the orderly decline in interest rates, quantitative easing, supportive regulatory environments, and easing tax regimes. All have entered a new and less accommodative stage. During the prior macro environment, company valuations carried less weight than the narratives surrounding long-term growth aspirations. Now, these companies’ share prices are going through valuation purgatory at varying speeds, either falling to levels that properly reflect underlying business quality or stalling until underlying earnings catch up (think: Cisco post-TMT bubble). Markets are increasingly skeptical of stories, instead assigning value based upon a company’s underlying fundamental quality. As Ben Graham famously said, “In the short term, markets are a voting machine; in the long term, markets are a weighing machine.” Fundamentals prevail in the long run.
Many market observers are referring to this market development as a “rotation from growth to value.” This misses an important nuance. Rather than simply a rotation in market leadership from one category of stocks to another, we view this shift as an overdue and long-lasting broadening out. It has become common to define “value” stocks by quantitative factors that offer little relevance to their true intrinsic value. For example, a highly leveraged and cyclical business that rarely earns its cost of capital should trade at a low valuation. Many banks, commodities, and low value-add industrial businesses fall into this category. Opportunity can arise in these businesses, but it usually occurs during recessions or episodes when margins and earnings are depressed. Currently, we see more risk than opportunity in these areas given the combination of high valuations, peak margins, and vulnerable earnings prospects (Chart 1)1. Although we have relatively modest exposure in cyclical industries, we remain deeply engaged, as an uncertain macroeconomic pathway could present opportunities. In the meantime, our greatest absolute and relative exposures remain in health care and nonbank financials. Each has upside potential for sustainable earnings growth, while not being highly dependent on strong economic conditions.
Corporate Earnings Estimates
Corporate earnings have been strong, only recently showing signs of weakness. In fact, much of the decline in stock prices this year was the result of P/E (valuation) contraction, as earnings have held up. This presents one of the greatest sources of risk as this year progresses. Charts 2, 3, and 4 illustrate the evolution of earnings growth estimates from 2016 through the 2023 forecast season in the US, Europe, and Japan. These snail charts graphically depict the COVID-19 collapse, the recovery to levels far above pre-COVID levels, and current analysts’ forecasts for this year and next. We view this as dangerous trend extrapolation given 1) how much demand has already been pulled forward due to COVID-inspired consumption changes and global fiscal and monetary stimulus, 2) high margin levels, and 3) the impact of inflationary pressures on both costs and end demand in many industries.
Inflation Renaissance
The risks to earnings and asset prices from policy error is elevated, as central banks attempt to temper inflation while fragile economies carry massive debts and deficits. Most developed markets have not experienced inflation since the 1970s. The current environment is serving as a crash course. There are a multitude of factors contributing to rising inflation; most are unpredictable, but in aggregate they range from short-term/cyclical dynamics (supply chain bottlenecks, war in Ukraine, stimulus and/or COVID-inspired demand shifts) to more lasting ones (underinvestment, malinvestment, regulatory interference, government imbalances, and/or excessive monetary policy). Thus far, most companies have been able to pass on inflationary cost pressures to customers through higher pricing. Many will not be able to continue this, increasingly pressuring margins.
Diverging Signals from Credit and Equity Markets
Over the last decade, corporate bond and equity markets have largely moved in sync, but in 2022, the relationship has begun to break down (Chart 5). The historically close relationship between these asset classes makes sense. Corporate credit yields are made up of the risk-free rate (used for the equity discount rate) and credit spreads (used as an assessment of risk). Now, however, global corporate bond yields are near decade highs, as credit investors appear more worried about central bank policy and stagflation than equity investors (Chart 6).
While the move has been violent, credit spreads have only expanded to 10-year average levels off a very low starting point. As shown in Chart 7, spreads could widen much further if economic conditions erode. At the same time, yield curves have flattened rapidly and in some cases have inverted, which can often signal changes in medium-term growth and the potential for a recession. Equity investors should be carefully monitoring these credit market dynamics.
We pay close attention to multiple elements of a company’s capital structure, including leverage and covenants, but we also watch for messages being sent from credit markets. Who is “right” this time remains to be seen, but it is hard to argue that the multi-decade tailwind of falling rates and low inflation will be repeated and that the structural shift will not have wide-ranging implications. This tailwind disproportionately benefited the two ends of the quality spectrum, namely leveraged deep cyclical businesses on one end and “quality growth” stocks on the other end. We continue to find compelling investments in between these two extremes among companies that have opportunities to improve returns on invested capital through cost efficiency, improving business models, and better capital allocation.
Heightened Influence of Geopolitics
Geopolitics have been playing a heightened role in markets during recent quarters, led by developments in Ukraine and China. Regarding Ukraine, we are shaken by the atrocities taking place and inspired by the country’s resolve. Clearly, Ukraine’s military was underestimated and Russia botched its invasion. It now appears that this war will persist with a material risk that Russia will deploy a tactical nuclear warhead as it draws from the military playbook seeking to “escalate to deescalate.” We have no direct exposure to the affected area, and our indirect exposure (measured as aggregate percent of underlying holdings revenues) is in the low-single digit range. Outside of the devastating human implications, the war has serious implications for energy and food costs. Heavy importers of these commodities, ranging from Western European countries to emerging markets including India, Turkey, and Northern Africa, are already experiencing significant pressure that we can expect to continue while the conflict wages on.
China has been closely observing developments in Ukraine as it weighs its options relating to Taiwan, including a possible invasion. Although unlikely in the near term, future developments in China-Taiwan relations will likely be influenced by how the conflict in Ukraine plays out. On the domestic front, China’s aggressive “common prosperity” and zero-COVID policies, alongside rising COVID-19 cases, are weighing on an already pressured economy. The Chinese government has been attempting to avoid falling into a middle-income trap and to address the massive risks in its heavily indebted property markets. Many of these risks are well known and reflected in asset prices, but the transition to a more balanced economy will be delicate. We have modest exposure (approximately 3.9% ii) in Chinese companies with attractive and sustainable long-term growth prospects.
Looking Ahead
There is a lot to unpack in global markets this quarter, and this commentary has barely scratched the surface. Suffice it to say, volatility is presenting opportunity and, as exhibited by our investment activity, we are actively pursuing it. However, mindful that Goldilocks tailwinds have shifted direction, we maintain a high regard for downside risk, or “margin of safety” as we refer to it internally. Most of our investments have theses that do not require a robust economic environment as a condition for success; instead, these companies have specific idiosyncratic drivers that will enable them to unlock value.
Thanks for your interest in Altrinsic. We would be delighted to discuss these or other matters of interest.
Sincerely,
John Hock
John DeVita
Rich McCormick