Investor Letter: Our International Portfolios in 2015

By Retz Reeves, CFA

Central Bank willies, currency fluctuations, commodity depression and terrorist acts all conspired against international equity investors in 2015.

The Swiss Central Bank kicked off the currency disarray in January when it unhooked the franc from the falling Euro – the franc subsequently jumped almost 30% and many Swiss stock prices went in the other direction – although some regained lost ground. Also in January, terrorists bombed the Paris office of Charlie Hebdo and finished the year by several other bombings around Paris. In addition to absorbing the horror of such loss of life, investors were sensitized to the effect terrorism has on global tourism, the travel industry and luxury shopping, especially in Paris – the mecca for wealthy travelers, including those from China.

Chinese stocks rallied during the early part of the year, but then in the backdrop of slowing domestic growth, crashed in the summer. Still the Shanghai Index ended positive for the year although the currency dropped almost 5%.

The yuan wasn’t the only falling currency in 2015. Among emerging markets the Indian rupee dropped a mere 4.8% versus the U.S. dollar while the Russian ruble dropped over 21% and the Brazilian real, over 50%. Even developed market currencies weren’t safe; for instance – the British pound fell over 5%, the euro over 10% and the Canadian dollar over 20%. Weakening currencies can benefit international companies by increasing their competitiveness but it may have negative impact on U.S. investor investors in two ways: 1) a stronger U.S. currency exacerbates pressure on already weak commodity prices, and 2) it lowers the price of international stock prices when translated into U.S. dollars.

During 2015, the international MSCI ex-U.S. net index fell 5.66% versus Frigate, our Large Cap International ADR Folio, which fell 6.07%* net of fees. There were some bright spots – defensive stocks such as Israeli generic drug manufacturer Teva, German dialysis company Fresenius and UK pay TV provider SKY turned in positive returns; as did representative technology holdings German SAP and Indian Wipro and Infosys. These couldn’t offset, however, the various negative factors outlined above.

Although faring better than its benchmark, Treasure Harbor, our International Yield Portfolio fell 12.47%, versus its custom benchmark** which returned a negative of 18.16%. Stocks especially under pressure were those involved in the energy sector such as Royal Dutch, reasons for which were explored in other IIM client letters; basic material sectors, such as BHP Billiton, which have similar industry dynamics to energy stocks and emerging markets, such as AMBEV, the largest beer maker in Latin America and Spanish Banco Santander, which has a large exposure to Brazil. Versus its benchmark, Treasure Harbor likely benefitted from its diversification into other defensive sectors with stocks such as German based Deutsche Telekom and UK based personal care company Unilever. Although Treasure Harbor did do better than its benchmark, its absolute performance was disappointing.

Yellowtail, our international small/mid-cap portfolio, did much better, returning 10.6% for the year versus the benchmark we are using VSS***, which fell 2.5% in 2015. Yellowtail benefitted from its relatively low exposure to materials, energy and emerging markets and from good stock selection. Swiss stocks in aggregate and a position in African Tiger Brands were the greatest detractors, but these were offset by very good performance from such French positions as business service companies Elior, nursing home operator Orpea and appliance manufacturer SEB and Germany specialty glass manufacturer Gerresheimer.

I would have preferred all of our international Spoke Funds to show positive returns, but I was pleased to see that their performance was not perfectly correlated, and thus provided diversification opportunities within this asset class. Although it may not be the case as this year commences, I am hopeful they will continue to offer this diversification opportunity due to their different complexion. Each is invested across several regions and industry classes, but Frigate has a higher exposure to defensive healthcare stocks than Treasure Harbor, which would likely benefit more from an improvement in commodity prices. Yellowtail seems to swim in its own stream. I also believe these international portfolios will work well with our domestic portfolios, which have an even higher sensitivity to oil prices. That is one of the reasons I personally have invested in each of IIM’s Spoke Funds. I will gladly share with any of our investors the risks and performance statistics of my total portfolio.

It is difficult to say when the trajectory of international stock prices will change, but history indicates that it likely will. The current situation, I do not believe, is as serious as the 2008-2009 financial crisis – when major financial institutions needed to be bailed out by their own governments. Instead this is more reminiscent for me of the 1990’s. The “Tequila Crisis” began in 1994-1995 when Mexico’s financial problems spilled over into other South American countries and then to Asian and other Emerging Markets. The real Asian financial crisis started in 1997 in Thailand with the collapse of the baht and subsequent slumping currencies across Southeast Asia and Japan. Oil and other prices fell drastically devastatingly impacting the economy and currencies of other Emerging Markets such as Russia. Yet, just like other crises before and since – the global economy recovered and the aggregate equity markets reached new highs.

There is no guarantee that markets will rebound and reach new highs soon, but I believe select equities will do well over the next several years. Many stocks are trading at valuations attractive not only to investors but to other companies, and with interest rates near zero in Europe, cheap financing is available for mergers and acquisitions. For instance, one of our Treasure Harbor companies Royal Dutch Shell is on track to buy British Gas, a Frigate holding. Also within Frigate, several companies have been courting agrichemical company Syngenta. And some of our holdings using are this opportunity to make accretive acquisitions. Frigate company Shire is completing the merger for Baxalta to make it a leader among pharmaceutical companies that target rare diseases. Even smaller companies are taking advantage of valuations and cheap financing – indeed, Yellowtail French nursing-home Orpea just announced its expansion into Poland with the acquisition of MEDI-system. I truly believe that we will see more M&A going forward that will underpin share valuations.

In the meantime, early in January, I repeated the exercise I performed in October which helps me prioritize my research on current and prospective holdings. For each stock, I record consensus earnings per share and yield estimates, compared prospective valuations with historical averages and calculated projected returns. 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 projected average annual return for stocks for both Frigate and Treasure Harbor is around17% and for Yellowtail, 10%. These are just estimates; projections and outlooks will change and the actual average returns will vary. Still, I believe it is reasonable to anticipate better returns in aggregate over time for our international portfolios than compared to the previous twelve months.

I use consensus estimates as a check to my own projections for companies, and make portfolio decisions based on my own fundamental research. So despite the uncertain international environment, I have already bought my tickets for Europe and plan on visiting some of our holdings and candidates – with the recent movement in the market, there are plenty of candidates.

So wish me luck as I pack my bags and navigate what will surely be very interesting border controls. I’ll update you on my outlook on international markets on my return from my upcoming trip, and in the meantime, please reach out to me with any questions.

Thank you again for investing alongside your IIM portfolio managers.

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* All return calculations for IIM portfolios and benchmark indices are estimated and unaudited.
** 15% SPDR S&P Emerging Market Dividend ETF; 35% S&P International Dividend ETF
*** Vanguard FTSE All-World ex-US Small-Cap ETF

About Retz Reeves

Portfolio Manager of the Frigate and Treasure Harbor Folios.
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