After strong first-quarter performance, global equity markets continued their upward march during the second quarter. When looking at countries and sectors, there is often disparity in performance and the second quarter proved no exception. China catapulted (we discuss this in more detail in our Emerging Markets updates), while India retraced following an extended period of strong performance. When looking at market performance in Asia during the second quarter, it seemed the further south one moved on the globe the worse the performance was. Japan, China and South Korea topped the table, while the Philippines, Taiwan and New Zealand were among the laggards.
Europe performed strongly as the benefits from quantitative easing†† and an economic recovery flowed through the system. While the turmoil in Greece is creating volatility and uncertainty in the short term, we believe any contagion effect will be limited as the eurozone is in a stronger position. In the United Kingdom, stocks rose over 10% in part due to a much better than expected election outcome. David Cameron was re-elected as prime minister and the Conservative Party now holds more seats than it did before the election.
The Wasatch International Growth Fund gained 6.78% in the second quarter of 2015, outpacing the 4.22% return of the MSCI All Country World Ex-U.S.A. Small Cap Index.
During the quarter, we increased our weight in Europe from 35% to 39% and the Fund is now in line with the Index. There are two key reasons for our increased weight: 1) our investment team traveled to the region completing due diligence on a number of investments; 2) the economic data in Europe has turned positive, which should provide a tailwind for companies, notwithstanding any issues that may emerge from Greece.
We have been watching the early stages of an economic recovery unfold across the continent spurred by quantitative easing. According to a report published by UBS, March 2015 was the first month that Europe has seen positive earnings revisions in four years. Given all the issues that Europe still faces, the next logical question is, “How significant and sustainable will this economic recovery be?” No one knows the answer to this question and we do not try to forecast the future. As famously quoted by Yogi Berra: “It’s tough to make predictions, especially about the future.”
Instead, what we can do is adapt to changes that are actually happening. When we look through the data for Europe, it appears to us that corporate and domestic spending are set to drive the next leg of growth. Capital spending is at record lows, as is net debt, and with low interest rates, European companies have the capacity to spend. Our investment team traveled to four European countries during the quarter (Switzerland, Italy, France and Spain). The mood on the ground and from the management teams we met was one of increased optimism. Companies are starting to invest again for growth. They are hiring new employees, funding new projects and investing in capital spending. Companies typically only commit to these types of initiatives when they feel confident about the future, which gives us increased confidence that this economic recovery will be sustainable.
Even in recent years when there has been economic uncertainty we often have met with the management teams of growth companies that we believe are high quality in the core of Europe (Germany, Switzerland and France) who are investing in their businesses for growth. It has been much less commonplace to find this type of behavior in peripheral Europe. The biggest positive surprise from our recent trip came from our meetings in Spain.
Spain has seen its fair share of challenges in recent years and a theme we repeatedly heard from company executives in Spain was the rationalization and consolidation of industries. The strongest companies have gotten stronger and look well-positioned to thrive from any upturn in the economy. On the ground, Spain had a buzz we haven’t seen there for many years.
The managers of a leading media company we met with said advertising spending was coming back in a meaningful way. The Spanish stock exchange is on track for a record number of initial public offerings (IPOs)‡ this year, and Spanish companies are raising equity to recapitalize their balance sheets and invest in their businesses. Alsea, which is owned in the Wasatch Emerging Markets Small Cap Fund,‡‡ is a Mexico-based restaurant company with operations in Spain. During its most recent quarter, the company saw 9.7% growth in same-store sales in Spain due mainly to “commercial strategies and the environment of economic recovery underway in the country.”
However, just benefiting from an economic recovery is not enough of a reason for us to invest in a company. We look to buy long-duration growth companies that have leading market positions, that have invested throughout the downturn and that have improved their operations. We believe that these types of companies have outstanding potential to grow earnings cycle-to-cycle and that an economic upturn will solidify their strong positioning. These characteristics were what led us to invest in a new portfolio company—Distribuidora Internacional de Alimentación S.A. (DIA).
DIA is Spain’s leading local discount food market (somewhat like a convenience store) that differentiates itself from competitors on proximity and price. The company was listed in 2011 after spinning out from Carrefour‡‡ and has seen the benefits of being independent with an improved corporate culture. Management has sold operations in underperforming countries like France and Turkey and has focused its effort and capital allocation on Spain, Brazil and Argentina. Unlike most other developed markets where three or four major players are dominant, the Spanish supermarket industry is still very fragmented and is in the beginning stages of consolidation. We believe DIA is well-positioned to capitalize on this opportunity.
We added to our investment in Yoox S.p.A., which has been a long-term winner for the International Growth Fund. Yoox is a leading online retailer and online partner for luxury brands based in Italy. The company is in the process of merging with a key competitor, Net-a-Porter, and we had the opportunity to speak with both companies. We feel their businesses complement each other well and when combined will be a luxury e-commerce powerhouse putting what were already two great businesses in an even better position. We believe the opportunity is significant as e-commerce growth is burgeoning. Luxury brands have less than 2% e-commerce penetration as a percentage of total sales versus general apparel retail at over 10%.
Global spending on luxury goods has slowed down in the last couple of years due to anti-corruption campaigns from the Chinese government, but recent earnings results for the industry indicate luxury sales are now stabilizing. Salvatore Ferragamo Italia S.p.A., another long-term holding, saw sales grow 9.4% in the first quarter of 2015 and this is expected to accelerate as the year progresses. We added Moncler S.p.A. to the portfolio. Moncler is a well-established luxury outerwear brand also based in Italy that is embarking on a global expansion strategy. The company’s sales grew 38% in the most recent quarter as it has been witnessing strong growth in the Americas and Asia, two underpenetrated regions.
While we have increased our exposure to economically sensitive businesses in Europe, we also added two European health-care companies to the Fund. Ipsen S.A., based in France, is a pharmaceutical company focused on peptides and toxins in the areas of endocrinology, neurology, and urology-oncology with two successful drugs on the market. Tecan Trading AG, based in Switzerland, designs diagnostic testing machines for life-science companies. As these machines become more complex, more life-science companies are outsourcing the design and manufacturing and focusing on their core competency of developing reagents and tests. Tecan has invested heavily in research and development, but new products have been delayed. The new CEO, appointed in 2013, has sharpened Tecan’s operations and is very growth focused. In addition to new product launches, the company is also looking to acquire new technologies and expertise.
Our Japanese holdings as a group outperformed those in the Index. However, two of our Japanese holdings reported weak earnings and were a drag on performance. Cosmos Pharmaceutical Corp. implemented a new pricing strategy, which impacted short-term results, but we believe the earnings hiccup was temporary and the long-term growth dynamics are still in place. Broadleaf Co. Ltd. also reported disappointing results, as license sales were weaker than expected. (Current and future holdings are subject to risk.)
As discussed above, we have become more positive on the eurozone. We will continue to closely monitor data as it evolves and our investment team plans to return to the continent in the third quarter. We continue to be even more bullish§ about Japan as an investment destination and finished the second quarter with 29% of our portfolio invested in Japan, in line with last quarter, but up from about 22% a year ago. Along with improving economic growth, the positive changes we are witnessing in Japan are at the micro level, where we believe corporate behavior is changing for the positive. As we were writing this commentary, our investment team was in Japan for a month visiting companies.
While we spend most of our research efforts on individual company analysis, we are also cognizant of the macro environment. In Japan, there is a lot of talk about the Japanese yen, which has been weakening for more than two years. Some investors think a weakening yen is automatically bad for non-Japanese shareholders because their holdings are denominated in a currency that’s losing value. But the reality is not so clear-cut. Currency movements can have complicated ramifications. For example, a declining currency may make imported raw materials increasingly expensive, but may also improve the attractiveness of a country’s finished-goods exports. Moreover, Japanese companies have many manufacturing facilities in other countries, which adds another layer of complexity to the analysis of currency movements. What we do know, however, is that Japanese stocks have generally performed strongly—even for foreign shareholders—during the past two and a half years as the yen has declined. Based on our fundamental research, we’re optimistic regarding our Japanese holdings going forward, regardless of whether the yen continues to weaken or strengthens from current levels. Additionally, companies’ focus on return on equity§§ is a strong positive for Japanese equities.
Thank you for the opportunity to manage your assets.
Roger Edgley, Linda Lasater and Kabir Goyal
**The MSCI AC World Ex-U.S.A. Small Cap Index is an unmanaged index and includes reinvestment of all dividends of issuers located in countries throughout the world representing developed and emerging markets, excluding securities of U.S. issuers. This index is a free float-adjusted market capitalization index designed to measure the performance of small capitalization securities.
†The MSCI World Ex-U.S.A. Small Cap Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed markets, excluding the United States.
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The Wasatch International Growth Fund’s investment objective is long-term growth of capital.
††Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
‡An initial public offering (IPO) is a company’s first sale of stock to the public.
‡‡As of March 31, 2015, the Wasatch Emerging Markets Small Cap Fund had 0.7% of its net assets invested in Alsea S.A.B. de C.V. The Wasatch International Growth Fund was not invested in Alsea S.A.B. de C.V. or Carrefour S.A.
§Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects.
§§Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.