Market review

Global equity markets experienced another relatively good quarter, albeit with more modest performance than in the first quarter (Q1). Looking at the indices in US dollars – on a total return basis the S&P 500 Index gained 4.3%, the MSCI World Index gained 4.2% and the MSCI Emerging Markets Index, lagged again, closing 0.7% higher this quarter. The surprising decline in long dated developed market government bond yields, which started in Q1, did not subside. Yield on US 10 year maturity bonds declined from 2.4% at the end of Q1 to 2.0% at the end of Q2 and the yield on 10 year German bonds declined from -0.1% to -0.3%.

In late June, the Federal Reserve (the Fed) indicated that it might cut interest rates sooner than previously thought by cutting the word ‘patient’ out of its policy statement. It added that it would ‘act as appropriate’ to sustain economic expansion. President Trump has often taken to Twitter to share his exasperation with the Fed’s previous rate increases.

Prime Minister Theresa May announced that she would step down as leader of the ruling Conservative Party in the United Kingdom after successive failures to deliver an acceptable Brexit deal. Boris Johnson and Jeremy Hunt are in the race to replace May as leader. Both Johnson and Hunt have claimed that they can renegotiate the withdrawal deal with the European Union and get it through Parliament before the expiry date of 31 October 2019.

Portfolio and performance review

The fund performed well this quarter, and year to date, largely thanks to the United States (US) which was the largest contributor to the positive return. India, Europe and the United Kingdom (UK) were the largest detractors.

Although we invest “bottom-up” (i.e. we have a stock picking philosophy), in a low growth, low interest rate environment the macroenvironment plays a significant role and we continuously assess the environments in which the companies we are invested in operate.

At the moment the largest geographical investments of the fund are the US (37%) and then around 10% each in India, the UK and Europe.

The US banks and insurers have done very well for us and are reporting good results, but Europe has lagged so much and has become so undervalued that we have decided to switch a bit of the US into the best positioned opportunities in Europe (ING, Kruk and NLB).

ING is one of the best banks in Europe and a leader in digitalisation strategies, Kruk is a leading debt collector (based in Poland) and has been buying up books to collect at significant discounts whilst NLB is domiciled in Slovenia (and has operations in Slovenia and surrounding higher growth countries) and due to being a fairly new and unknown listing is trading on a 10% dividend yield.

The combination of quality and very attractive valuation makes us want to add to our UK holdings (especially One Savings Bank and Legal and General), but we don’t want to increase our position until we see how Brexit plays out.

India is experiencing a liquidity scare after a few real estate developers defaulted in 2018 and 2019. Hence we decided to reduce exposure to banks potentially affected and invest in HDFC. Over many years and through many crises we’ve learnt that in times of uncertainty there is a flight to quality banks and insurers and hence it is better to sit on safe ground whilst the crisis plays out. We did consider selling out of India totally but it is one of the few countries in the world that can still grow at 5%+ and the financial sector is the oil that is vital to facilitate such growth and benefits from it.

Outlook

The financial sector is currently ignored by investors and unloved, and based on the increased regulatory complexity and negative press about low interest rates we understand that emotion. However, the market misses the fact that the sector has largely dealt with the regulatory burdens and focused on cutting costs and unprofitable units (Deutsche Bank is one of the last that is finally being forced to do this).

What the market really misses is that in times of change there are winners and losers and we’re finding that the managements (and countries) that were on the front foot are taking market share and have improved their return on capital. Two examples are our top holdings, JP Morgan and Essent (both in the US), but the best example is Tinkoff Credit Services (TCS) which has grown its market share from almost zero to 12% over the past 10 years by being one of the most technologically advanced financial services players in the world (I recommend you Google TCS and see for yourself).

Finally, we are encouraged by the fact that Warren Buffett (with a 50 year track record of substantially outperforming the markets) has increased Berkshire Hathaway’s investment in the financial sector to about 70% (refer our article on our website on this topic). Like Warren, we take longer term views and focus on shareholder value growth, but we have the advantage that we have a much larger pond to fish in being able to invest in smaller challengers (like TCS and Essent) and also in faster growing emerging markets such as India and Indonesia.

You have to go back a long time to find when last the sector was this undervalued. It’s important to remember that, when investing for the long term, it’s usually best to be patient and let the compounding shareholder value growth work for you. Even in this tough environment, the average annual growth in shareholder value of our portfolio is around 12% per annum - and investors are getting this at a discounted valuation.

Market review

Global equity markets recovered strongly from the sell off last year (and particularly at the end of the year). In the quarter to 31 March 2019 the S&P 500 gained 13.1%, the MSCI World gained 11.9% with the MSCI EM lagging slightly, gaining 9.6% (all % in US$). The most surprising development in markets was the sharp rally in long dated developed market government bonds; the yields on US 10yr maturity bonds declining from 2.69% at year end to 2.41%. The yield on 10yr German bonds declined from 0.24% to -0.07%.

This view (expressed by the bond market) that the USA might be at the end of its interest rate hiking cycle boosted EM currencies and banks (in our case specifically Indonesia and Russia) but at the same time US financials also bounced sharply (11%).

This bounce in USA financials is perplexing to many investors (financials seldom rally when interest rates fall) but we ourselves used the sell-off in Q4 as a buying opportunity because: .

-On 1 January 2019 they were 20% cheaper than they were on 1 January 2018 (US bank share prices declined 17% during 2018 whilst earnings and shareholder value grew - refer our December 2018 quarterly report).
-Banks and insurers have worked hard at changing the drivers of earnings and are a lot less interest rates sensitive than in the past,
-But most importantly, we increased the exposure to banks that derive a large part of their earnings from emerging markets (eg Citigroup and BBVA).

Portfolio Review

The companies we are invested in reported good financial results, in particular TCS, Essent, Adira and TBC (4 of our largest holdings) but also others like One Savings Bank, Credicorp, Renaissance Re, Signature Bank, JP Morgan, etc confirming our view that the companies the fund is invested in have adapted to the new lower growth, low interest rate environment and taking market share from slower moving, still challenged competitors.

In terms of the fund the investments that contributed most to the strong performance this quarter were Essent (USA mortgage insurer), Yes Bank (India), Adira (Indonesia), Citigroup (USA) and Sberbank (Russia) whilst the investments that detracted were the more defensive holdings like Berkshire Hathaway, ICE and our investment in Norwegian savings banks with the largest detractor being Raiffeisen Bank (Asutria/CEE) which is being accused of money laundering charges (which are old and have been dealt with by the regulators).

Going forward a weaker $ will be good for most emerging market currencies, especially those countries that increased interest rates in 2017/2018 (particularly Indonesia and India) whilst the most challenged geographical area remains Europe where, despite seemingly attractive valuations, the fund has limited investments.

Besides increasing the investment in Citigroup we gradually divested from Bradesco in Brazil (as the market became over confident about new president Bolsonaro’s ability to push through reforms) and increased the funds’ investment in India to almost 13% bringing the funds’ total investment in emerging markets to 43%.

The investment in emerging markets sounds like a high risk call, in fact it is not. We know and have visited most of the companies we are invested in annually since 2003 and they have consistently grown shareholder value but due to the 2017/8 EM sell-off are undervalued. More importantly, a weaker US$ removes the risk of currency declines which normally is the biggest risk when investing in emerging markets. Important to note however is that the EM countries we are invested in generally have a combination of low debt/GDP, low budget deficits and positive or acceptable trade balances.

Globally the financial sector is at a low both in terms of absolute and relative valuation and hence we continue to e of the opinion that the current environment provides a good investment opportunity.

Performance review

The good performance of the majority of the holdings of the fund in the past quarter was undone in three sections in the fund:

- European banks were sold down due to Turkey and Italy. ING was down the most (10% this quarter and 28% year-to-date in Euro) - due to its exposure to Turkey and a fine related to money laundering (6-8 years ago in amongst others it’s Curusao business).
- Despite the rising oil price, Russian banks declined due to fears about the effect of further sanctions against the country.
- But the biggest loss was caused by Yes Bank (one of the smaller private sector banks in India) when the Reserve Bank of India (RBI) refused to extend the tenure of the CEO (Rana Kapoor). The RBI decision was based on his age (or rather length of tenure) and his lack of adhering to good corporate governance. Having said that, for three years in a row extensive audits by the RBI did not result in reclassifications of non-performing loans (NPL’s). Our stance has been that indeed, Yes Bank has grown its loan book aggressively, but this was done whilst the public sector banks were (and remain) in turmoil.

At times like this, we question why we invest in companies like these but in the end it’s a risk-return decision. It’s important to remember that the market has a tendency to overreact to both negative and positive news, and most of the time the event has only a very small effect on the ability of the company to grow shareholder value.

For example: The fine in ING’s case, and the write-offs from their Turkish exposure are relatively small and once-off. Similarly, sanctions against Russia will have limited effect. The upside in Yes Bank and Rana Kapoor’s track record was just too attractive to ignore and so the answer lies in the size of a position and the valuation. Hence, for the past few years we have focussed on reducing risks considerably (for example, at the end of 2017 we reduced the funds’ investments in Turkey to less than 1%).

Also, the subsequent returns are significant and repay one for the risk (as visible in the track record of the fund), and finally, the risks taken are always part of a diversified portfolio. Fortunately the fund’s investments in US banks, European insurers, Norwegian banks and smaller positions delivered good operational results and strong gains in their share prices. These positions include, amongst others, the Warsaw Exchange, Berkshire Hathaway (gained 14.7%), Essent and MGIC (two US mortgage insurers gaining 23%). Q3 was a bad quarter for emerging markets, yet Bradesco (the second largest Brazilian bank) as well as our investment in Mexican banks performed very well (Bradesco being amongst the top 10 performers this quarter).

Portfolio changes

Based on historical valuations and the track record of the companies sold down, the selloff in many cases was unwarranted - providing rational long-term investors good opportunities to invest and benefit from their short-term driven emotional peers. The most important trait in investing is to have the emotional strength to not get shaken out at the bottom when everybody around you is negative. In fact, successful fund managers focus on the long-term track record of how management grew shareholder value, measured against the current valuation. Hence we’re using the sell-off to increase the fund’s holdings in several Indian private sector banks and also Kruk (Poland). Kruk is one of the best debt collectors in the world, but now trades at its lowest valuation in 10 years after one of its competitors ran into financial problems. The market is incorrectly (in our opinion) assuming that Kruk has similar financial problems.

Going forward

After 30 years of falling interest rates, the US 30 year bond market is signalling that the period of low interest rates has ended and a long period of normalisation to higher interest rates has started. This ushers in a new environment which will bring about significant change, which on the whole should be positive for the financial sector. Jamie Dimon (CEO of JP Morgan) says banks are entering a golden age.

In fact, US banks and European insurers have started reacting to this, gaining around 10%. We expect this trend to continue for a number of years as interest rates normalise.