For the three months ending September 30, 2022, the iMGP International Fund fell 13.43%, underperforming both the MSCI EAFE Index and MSCI ACWI ex USA Index, which lost 9.36% and 9.91 %, respectively. The average peer in Morningstar’s Foreign Large Blend category dropped 9.32% for the quarter.
Since its inception on December 1, 1997, iMGP International has returned 5.25%, annualized. Over the same period, it has outperformed MSCI EAFE, MSCI ACWI ex USA Index and the Morningstar Foreign Large Blend category, which have generated an annualized return of 3.89%, 4.22% and 3.15%, respectively.
Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.imgpfunds.com. *There are contractual fee waivers in effect through 4/30/2023.
Brief Discussion of Performance Drivers for the Third Quarter
It is worth remembering the fund’s overall positioning is driven by the managers’ stock picking. As a result, stock selection is always the main driver behind the fund’s absolute and relative performance. Attribution analysis over a given time period may however show other factors also explain relative performance.
Stock selection detracted value during the third quarter. Selection within the health care, industrials, utilities were among the largest detractors. Selection in the technology and materials sectors added value. Energy stocks performed the best during the quarter—the fund’s underweight detracted value.
Portfolio Breakdown as of 09/30/2022
|Health Care & Pharmaceuticals||11.84%|
|Australia/ New Zealand||0.0%|
|*Cash is excluded from calculation|
Quarterly Market and Portfolio Commentary from Managers
David Herro, Harris Associates
Another difficult quarter for non-US equity markets as recession fears grew, inflation remained at elevated levels, the US dollar strengthened, and financial conditions continued to tighten. This situation was made even more challenging by continued COVID-19 lockdowns in China and the continued hostilities in Ukraine. Despite this difficult macroeconomic backdrop, our portfolio companies have mostly reported acceptable operating results to date. We do expect the upcoming earnings season to be more challenging as the impact of on-going supply chain issues and tightened financial conditions start impacting supply/demand. However, over our forecast horizon (five years) we do expect global economic conditions to improve and companies we own to resume growing at pre-COVID levels. At current equity price levels, we are enthusiastic about our portfolio’s mid- to long-term return potential.
We established a new position in Fresenius this quarter. Fresenius is the largest non-US provider of healthcare services and hospital products. The company is undergoing a management change and we think the market’s concern over the weak Fresenius Medical segment is masking the operational progress in their Kabi and Helios segments. Several portfolio companies experienced price weakness during the quarter on the concerns outlined above. We took advantage of the equity price volatility to re-position the portfolio to optimize expected return among existing holdings. We sold our position in Grupo Televisa in favor of other portfolio names, that in our view, offer more upside potential. While the coming quarters may experience more mixed fundamental progress, due to tighter financial conditions and ongoing economic/geo-political disruptions, we think the long-term fundamental trend across our portfolio companies remains positive and should lead to higher equity prices.
Mark Little, Lazard Asset Management
Following an already challenging start to the year, international markets fell sharply in the third quarter as the level and sustainability of elevated inflation continued to surprise investors. The resulting higher interest rate environment along with some rolling COVID lockdowns drove very weak equity markets for international investors. The already strong dollar appreciated another 7.1% in the third quarter on sustained interest rate differentials and its perceived safe-haven status. European stocks and currencies were particularly weak in the wake of the strong dollar and stocks in the region fell on the energy crisis and a controversial UK budget from its new Prime Minister. Notably, the deeply discounted valuations of international benchmarks relative to the US have supported outperformance versus the US in local terms. Weaker currencies contributed to a 10%-12% headwind for international equities, a
level that now represents the largest headwind to local performance over the past 20 years.
The extreme style dominance that had so significantly impacted the market for much of the past two years began to dissipate during the second quarter and this carried into the third quarter. The magnitude of the difference between growth and value, and high and low quality, was more benign.
Amid a backdrop with relentless negative macroeconomic news, investors have begun to focus more on company fundamentals and less on themes and styles. In this new regime, we believe Relative Value, the combination of financial productivity and valuation, is in the sweet spot.
Throughout the first three quarters of 2022, higher costs, exacerbated by war, and resulting rate rises have driven significant economic fears and earnings risk. A deeply inverted yield curve suggests recession in many regions if not globally over the next year. This is known by equity markets which are discounting mechanisms and ultimately leading indicators of earnings growth and economic growth, both of which are slowing and likely to fall.
Normally during periods of slowing growth, central banks work to stimulate growth by easing monetary policy, but this time is different. Most central banks, including the US Federal Reserve and the European Central Bank, are raising rates significantly to reign in rapidly rising inflation before it becomes systemic. The US Federal Reserve has been leading the move to higher rates within developed markets and this, coupled with its perceived safe-haven status, has been a major source of fuel for the US dollar’s strength.
Dollar strength has been a major headwind for international investors this quarter and year. Perhaps surprisingly to many investors, in local terms, international markets are outperforming the US this year due in part to their deeply discounted valuations and the higher interest rate environment which generally favors value and International versus growth and the US.
Those relatively better local returns over the past year have been masked by the largest headwind from currencies in the past 20 years – a level from which that headwind has become a tailwind in the past. Over the past year, the strength of the dollar has reduced the local returns on the MSCI EAFE Index by over 15%.
In Europe, the currency weakness coupled with the energy crisis has driven markets there down nearly 30% year to date. Investors fear the more limited gas supply in Europe and therefore exposure to European companies. Yet that fear is beginning to generate a variety of extremely attractive investment opportunities. The exposure of our portfolio to Europe appears significant when looking only at the country of domicile. But we believe it is more important to look at where a company is doing business and generating revenue and earnings as opposed to simply where it is domiciled. With this in mind, while we have a significant absolute weight to European-domiciled companies in the portfolio, many of them are global businesses that will benefit from a cheaper currency and stronger dollar. When looking at the revenue exposure of the portfolio, it is much less exposed to Europe, while relative to the benchmark it is roughly in line. The portfolio’s exposure to European revenue is significantly smaller than its domicile.
The European gas crisis has surely added to the pressure on European valuations and sentiment. While there is no doubt the situation is tense, there are potential positives. Many companies are rapidly switching from natural gas to alternative sources of fuel that are easier to transport such as oil and/or coal when they can. Companies we speak with have been preparing as much as possible for this winter and market participants are extremely well aware of the stakes. European countries have been storing gas at higher levels than they have in the past 5 years, and in many cases, storage heading into winter is full. Gas inventories are rising and if the weather is normal this winter, preparation from industry and storage levels may be sufficient.
For much of the past year, the portfolio has been, and currently remains, overweight stocks we think of as Relative Value: those stocks with the combination of higher financial returns and lower valuations, while remaining underweight the extremes of expensive growth and the cheapest stocks. We believe this positioning has begun to benefit the portfolio and will provide meaningfully positive performance as we move forward.
In this environment where the market, in our opinion, is expecting a contraction in earnings, we are finding an increasing number of Relative Value opportunities. Many are high quality compounders whose valuations have fallen enough in our estimation due to higher interest rates. And others are very inexpensive, but higher quality cyclicals whose valuations, in our view, are already discounting pressure to earnings. We believe the portfolio is well balanced within Relative Value, between more defensive compounders and higher quality cyclicals, and we continue to avoid the extremes of still expensive growth and low quality.
Higher inflation and interest rates have changed the investment landscape. We are encouraged by the improvement in relative performance year to date but still have work to do. As we move forward, we anticipate a much broader set of Relative Value ideas, enabling stock selection to drive performance amid an environment no longer conditioned by dominance of the extremes, but rather by Relative Value and thus by stock selection.
From an asset class perspective, we believe international stocks look very attractive compared to the US. Valuations remain at a steep discount of nearly 30% and have provided support for the local returns of international stocks compared to the US. The strong dollar having been an exceptional headwind to USD returns for international stocks over the past year now could become an additional tailwind.
Todd Morris and Daniel Fields, Polen Capital
High inflation and tight labor markets prompted further central bank actions to tighten financial conditions in the third quarter in many countries around the world. Increasing costs of capital and diminishing liquidity trends remain in motion today with many risk assets experiencing above average declines in the third quarter. Given this backdrop we feel it is important to maintain exposure to companies that provide the Portfolio with ballast. Companies offering ballast are durable businesses that persistently grow earnings and cash flows. Such companies often sport lower valuations than the rest of the portfolio. We own a collection of businesses that in aggregate grow their earnings faster than the broader market, but we also seek to hold companies that can deliver on growth aims predictably and trade at more reasonable valuations. Some of our largest weightings today fit this description. Maintaining such exposures drives more persistent earnings growth for the portfolio over time. We remain focused on competitively advantaged companies positioned to produce generally consistent long-term growth in earnings.
Worldline (David Herro)
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.
We appreciate Worldline’s position as a leader in European payments, and believe it has a long growth runway ahead due to Europe’s lower cashless penetration and higher levels of bank payment in-sourcing when compared to the U.S. We believe the payments industry is structurally attractive with high recurring revenues, low customer churn and strong free cash flow generation. In our view, Worldline’s revenue acceleration, which is driven by e-commerce business, travel recovery and synergy opportunities, is underappreciated by the market.
Israel Discount Bank (Mark Little)
Israel Discount Bank is seeing rising net interest margin from the rate cycle. The Israeli economy is in poor health, and we don’t think they will have a bad debt issue, so Israel Discount Bank should see rising ROE’s and is still inexpensive based on price/book and price/earnings valuation, in our view.
MercadoLibre (Polen Capital)
We own MercadoLibre because it is Latin America’s largest e-commerce platform operator. Supporting the e-commerce platform are a now formidable digital wallet, other tech-enabled financial services, and logistics capabilities. These offerings enhance user experiences for both merchants and consumers, while also driving loyalty to the platform: a powerful combination. Navigating Latin America’s e-commerce and fintech markets at scale requires sound strategic thinking and consistent execution, two attributes we feel MercadoLibre’s management brings to the business. Today, we feel the company is going from strength to strength after successfully enduring COVID-19 disruptions and heightened competitive challenges on all sides of its business. In the quarter, MercadoLibre again reported greater than 50% revenue growth (in US dollars) across its three largest markets: Brazil, Argentina, and Mexico. Gross margins were also strong. These enable ongoing investments in new product development and customer engagement initiatives which both serve and grow the large userbase and ecosystem. Beyond these initiatives, the company produced higher than expected profitability for the period. At less than five times expected 2022 revenue, and with steady margin progress funding new initiatives, we think MercadoLibre can continue to compound sales at a near thirty percent rate for three years. Margin progress could produce faster profit growth over the same period. We feel the business is compellingly valued given the strength of its offering and high expected growth rates.
CAE (Mark Little)
CAE missed in the quarter on margins within their defense business after they took a provisional on one of their fixed price contracts. The client (the US Navy) utilized the training device more than the 80% that the company had provisioned for and hence they had to take extra costs. This was disappointing; however, we think the 2% underlying margin in defense is not indicative of the profitability of the business going forward. We visited the company in Montreal and have come away comforted by the company’s explanation. We believe that the civil business is firing on all cylinders post-COVID and is taking market share and is a better business today than the past. We don’t think the share price is taking any notice of this.
Credit Suisse (David Herro)
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 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. Operating expenditures were elevated due to several factors, although management reiterated its belief that it will reach its goal for the medium-term, aided by its anticipated savings of CHF 650 million from digitalization initiatives and over CHF 200 million from procurement initiatives. The company also announced the departure of CEO Thomas Gottstein who will be replaced by its former head of asset management, Ulrich Korner. In addition, 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 managements 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.
Despite the resignation of CEO Tidjane Thiam, we believe changes implemented by him and his team made Credit Suisse Group a stronger and vastly improved organization and paved the way for further progress. As restructuring costs normalize and divestments of non-core assets are completed, we expect a meaningful improvement in reported profitability. In our assessment, Credit Suisse Group’s balance sheet reflects a solid and growing capital position, and we believe the company is capable of generating significant free cash flow going forward.
Adidas (Polen Capital)
We own Adidas because it is one of only two globally scaled athletic footwear and apparel companies. Adidas consistently allocates more than 10% of sales to brand building initiatives which drive customer awareness of what the brand stands for, what products look like and where they can be purchased. As simple as this sounds, the scale at which Adidas runs this program can only be matched by its US peer, Nike. All other companies in the category produce far smaller sums with which to campaign globally. Despite this durable trait, Adidas shares were down in the quarter. Adidas’ struggles in the period could largely be attributed to weakness in its China business. Given the lockdowns around China’s restrictive “Zero COVID” policies, Adidas has seen declining revenue growth in that segment for two consecutive quarters (50-60% of stores are in cities that are locked down in some way) while Adidas’ businesses in other countries continues to perform well. These challenges are not limited to Adidas and while an unfortunate headwind in the short-term, this does not change our positive long-term view around the company’s innovative product developments and its shift from wholesale distribution to direct-to-consumer, which should drive a significant margin benefit. Also, in the quarter current CEO Kasper Rorsted announced an intention to step down in the next year after a successor is picked. Adidas shares trade at a less than one times sales and 15x next twelve months earnings. We continue to believe the brand equity forged over 98 years of athletic shoe production underpins continued messaging about the impact Adidas can have on individuals and teams as they achieve in sport. This messaging can find a resonance and drive earnings growth at a mid-teens rate over the long term.