International Portfolio Client Letter

Year-to-Date and Third Quarter 2015
Lauretta Reeves, CFA

“May you invest in interesting times,” I thought, mentally mangling a supposed Chinese curse. Well, this is certainly an interesting time to invest in the U.S. or abroad as the economies become ever more intertwined.

Expected global growth, especially in China, remains a major reason cited for equity jitters. China is a growing market for many international companies and a source of demand for many basic materials. Unsurprisingly, as demand remains muted, energy and materials prices trade below their long-term averages and stocks in these industries, which are big parts of the international index, are generally depressed. In addition, other emerging markets such as Brazil and Russia are stressed, with both markets’ countries boasting questionable leadership.

In the meantime, investors in interest-rate sensitive industries such as utilities and banks were kept guessing as the Fed remained indecisive over raising interest rates, which also impacted the currency markets. Even more defensive industries, such as healthcare, were under pressure as Presidential candidate Hillary Clinton voiced support for controlling drug prices – and valuations of biotechnology stocks compressed.

In total, as represented by the MSCI ACWI ex-U.S. net index, international stocks fell 8.63% from the beginning of the year to September 30 and 12.17% during the third quarter of 2015. Net of fees, the Frigate Folio, our large cap International ADR portfolio, fell 7.25% and 11.05%, respectively. Frigate’s modest outperformance was achieved despite owning a now divested position in Volkswagen, which admitted installing flawed emission equipment; and a retained position in Syngenta, which refused a takeover bid by Monsanto. Frigate benefitted from its position in the eyeware manufacturer Luxottica, which was sold when it reached my targeted selling range. Positions in other long-held healthcare holdings such as Smith and Nephew, Sanofi and Novartis also outperformed on a relative basis during both periods. China National Offshore Oil Corporation (CNOOC) and Banco Bradesco detracted from performance. CNOOC was replaced in Frigate by the more diversified China Petroleum and Chemical, and Banco Bradesco is being monitored closely. In other Emerging Markets, Indian IT companies Wipro and Infosys contributed to both absolute and relative positive performance as well.

Outside of the changes mentioned above, we also sold the U.K. utility National Grid early in the year (but kept it in Treasure Harbor) and later, South32, the small spin-off from BHP. Throughout the year, Frigate added positions in U.K. communications company SKY PLC and pharmaceutical company Shire. Fresenius, the German- based dialysis provider was also added. Frigate remains well diversified across industry and countries. The largest sector exposures are healthcare, 25.3%; banking, 16.5%; and consumer discretionary, 12.5%. Continental Europe is Frigate’s largest geographic exposure – the UK makes up 21%; Japan, 8% and Emerging Markets, 13.5%. There is also additional exposure to Canada, Israel, Australia and New Zealand.

Our International Dividend Yield portfolio, Treasure Harbor, participates in an asset class that has faced considerable challenges, as stocks in industries typically paying out high dividends, such as energy and materials, were under great pressure for the same reasons discussed above. Indeed, Treasure Harbor’s custom benchmark fell 17.48% year-to-September 30th, and 17.84% during the third quarter. Treasure Harbor was down 11.72% and 10.49% during those periods, respectively. Emerging market exposure weighed on the benchmark performance, and although utilities closed the quarter as the largest sector, the developed market’s energy stocks also likely contributed negatively.

For Treasure Harbor our underweight exposure to energy was beneficial versus the benchmark but on an absolute basis our positions in Canadian Oil and Gas, ARC Resources – which was divested, Royal Dutch Shell – purchased early in the year – and legacy Canadian Pembina Pipeline Corp were detractors. On the hand, through the year and third quarter, U.K. stocks United Utilities, National Grid and Unilever were positive contributors on a relative basis.

At the end of the quarter, Treasure Harbor remained well diversified over region and sector. U.K. and Europe were the largest exposure, followed by Canada. Emerging markets make up 10% of Treasure Harbor and there was additional exposure to Australia, New Zealand and Japan. The largest sector exposures were telecommunications, banking and energy, although the portfolio also has exposure to utilities, materials, healthcare, consumer staples and discretionary. This diversification buffers Treasure Harbor somewhat from energy price fluctuations. However, although likely Treasure Harbor will participate on the upside when there are sharp upticks in oil, it may underperform the benchmark during subsequent sector rotation.

Our International Small/Mid-Capitalization Yellowtail portfolio did better year-to-September 30, returning a positive return of 1.24% versus a -4.8% return of the benchmark VSS, an international small-cap ETF. Major detractors in Yellowtail included Japanese precision manufacturer Sumitomo Heavy, Swiss-based duty-free retailer Dufry and African food manufacturer Tiger Brands. German specialty glass manufacturer Gerresheimer AG, French nursing home operator Orpea, and Japanese food manufacturer Nichirei Corp were positive contributors. Not surprising, Yellowtail has a different industry exposure than our large cap international portfolios. Industrials make up over 1/3 of the portfolio, with food and healthcare the next largest sectors – so there is no direct exposure to oil companies, and within the materials sector, just one chemical company. Almost 70% of the stocks are domiciled on continental Europe while Japan and U.K. are the next largest markets.

Considering the recent pressure on international stocks, throughout October, I engaged in an exercise that helps me prioritize my research on current and prospective holdings. For each stock, I record consensus earnings per share and yield estimates, compare prospective valuations with historical averages and calculate a projected return. This exercise yields a couple of benefits: stocks whose estimates differ greatly from mine are flagged for further research, and an estimated return for the portfolios can be calculated.

Based on this exercise, the prospective average annual return for stocks in Treasure Harbor is 14%; for Frigate, 15% and Yellowtail, 11%. This is just an exercise – currency isn’t considered and those estimates and stocks prices are changing daily – so actual results will definitely vary. Still, it does help me focus my research; and indeed, I have already purchased airline tickets for Europe early next year and have started to plan company meetings. I am sure it will be an “interesting” trip.

As a postscript: entering the year’s final quarter, markets fluctuated but generally improved on the heels of international central banks’ intentions to maintain stimulus programs, while the Fed moderated its concerns over the US economy.

Updated unaudited performance for our international portfolios: Frigate since inception (6/28/2013) is +8.24% and Year-to-date (YTD) is -1.78% versus the Vanguard comparable ETF, symbol VEU, (index data is not available) which performed +2.69% and -3.09%, respectively.

For Treasure Harbor, performance since inception (9/30/2013) was -6.61%; and YTD, -6.33%. This is versus the benchmark performance of -17.37% and -13.01%, respectively.

For Yellowtail, since inception (11/11/2014), performance was +6.49% and YTD, +6.37%. This was versus its benchmark performance of -.21% and -4.45%, respectively.

Please write or contact me if you want to discuss our international investment further, and thank you for investing along side your IIM portfolio managers.

Disclaimer: This post in no way constitutes investment advice. The performance figures above are unaudited. Past performance is no guarantee of future results, and future results of the portfolios discussed herein are likely to differ from their past performance. Comparisons to indices are provided for illustrative purposes only.

About Retz Reeves

Portfolio Manager of the Frigate and Treasure Harbor Folios.

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