2nd Quarter 2010 Commentary - ASTON/Barings International Fund
2nd Quarter 2010 Commentary
Tough Quarter for Foreign Equities
It was a poor quarter for international equity markets, as a broad-based market decline hit across the globe as no region or sector generated a positive return. Europe ex-UK was the worst performing region of the world in falling more than 15%, followed by the UK which performed only slightly better. Japan was the best performing region for the second consecutive quarter, but still delivered double-digit losses. Currency moves featured heavily in returns as well, with the Japanese yen rising strongly against other currencies.
In terms of sector returns, Energy was the worst performing area—dropping more than 20%—owing primarily to the sharp fall in the stock price of BP following the drilling disaster in the Gulf of Mexico. The Materials and Financials sectors also delivered returns considerably weaker than the broader index. Consumer Staples was a relative bright spot, falling "only" 7.3% as the best performing sector.
The Fund outperformed its MSCI EAFE Index benchmark mostly on the back of strong stock selection during the period. Allocation by region was slightly positive owing to an underweight stake in the weakest area, Europe ex-UK, and cash holdings. Sector allocation was neutral overall, though an overweight stake in the battered Energy was the biggest detractor.
Stock selection within the Materials and Financials sectors was particularly strong. The portfolio's gold mining stocks all performed well. While in Financials the good relative performance stemmed from Asian focused financials, such as BOC Hong Kong and DBS Group, and from an underweight stake to European banks. Conversely, picks within Healthcare detracted from performance.
On a regional basis, stock-picking in the UK, Japan, and Pacific ex-Japan also contributed to the relative outperformance. Growth stocks in the UK such as Internet insurer Admiral Group and software provider Autonomy stood out during the period. Similarly in Japan, the Fund saw good performance from growth stocks Unicharm, Secom, Rakuten, and Kurita Water. These results were offset somewhat by weaker stock selection in Europe ex-UK. Spanish healthcare company Grifols and fertilizer producer Yara notably detracted from performance.
There were a number of portfolio changes during the quarter, mostly involving individual stocks, though there were two allocation changes of note. The Fund's Emerging Market holdings ended the quarter at a lower level, roughly 13% of assets as MSCI upgraded Israel to developed market status and adding it to the EAFE benchmark during the quarter. This resulted in Fund's holding in Israel Chemicals being moved from an Emerging Market stock to a Middle East holding. In addition, we reduced the portfolio's stake in gold mining holdings somewhat towards the end of the period following their strong performance, though our favorable long-term outlook for the gold miners has not changed.
Elsewhere, we downgraded the Materials sector and sold diversified miners Xstrata and Rio Tinto, and Japanese commodities trader Mitsui & Co. We believe the property price curbs and tighter monetary policy in China will lead to lower demand for industrial commodities. Neither factor prevented us from adding Australian uranium miner Paladin Energy to the portfolio at the end of the quarter, however. With substantial new capacity coming on stream during the next few years we expect uranium prices to strengthen over the medium term. At the time of purchase, we considered the stock to be trading at a discount to its net asset value despite conservative growth and price forecasts.
The Fund purchased French luxury goods company LVMH during the quarter. Almost two-thirds of the firm's sales are derived outside Europe, with strong exposure to growth in Emerging and Asian countries. We also added advertising agency Publicis, which enjoys leading positions in growth markets such as digital advertising and is highly cash generative. Following our analyst's upgrade, we added Japanese online retailer Rakuten to the portfolio as well.
The Fund sold its holding in Russian oil company Rosneft to fund a purchase of Chinese Internet company Tencent Holdings. The recent weakness in the Tencent share price provided an attractive price at which to purchase a growth stock with exposure to the Chinese domestic market. In addition, we also added Norwegian telecom provider Telenor to the portfolio. Telenor has significant positions in growth markets in Asia and Eastern Europe, while enjoying strong domestic markets.
At the end of the first quarter we wrote of our concerns about the risks that still remain for global equity markets. Several of these risks became more prominent in investors' minds over the course of the second quarter. Notably, fiscal tightening among developed economies is gathering pace as the UK and Germany have joined Ireland, Greece, Spain and Portugal in tightening government spending and raising taxes.
This choice has not been made voluntarily. A bond market revolt in Greece, Spain, Ireland and Portugal has led to significantly higher government bond yields for these countries. Other countries are on an unsustainable fiscal path and can see what the end game is if they fail to act now to avoid this outcome. The UK is a case in point. The recently elected Conservative-Liberal coalition government has announced a new austerity budget that is diametrically opposed to that of the former Labor government. This will undoubtedly cause some short-term pain for the UK economy in hopes of avoiding a full blown sovereign crisis similar to what Greece is being forced to endure.
The US has been more reluctant to follow this new path of austerity. By not renewing the stimulus programs of 2008 and 2009 and by letting the Bush-era tax cuts expire at the end of 2010, the US will to some degree also undergo fiscal retrenchment. Coupled with ongoing deleveraging by the household and financial sectors of the developed economies, the fiscal retrenchment, will be a significant headwind to the global economy.
Recently, leading economic indicators have started to confirm a weakening economic trend, and equity markets have even begun to discount the potential for a double-dip recession. While this is not our base case, it does highlight why our view of the past year and a half remains that real economic growth is going to be weak in the coming years, thus the imperative of loose monetary policy becomes even greater. We see no reason why this will change until there are signs of an autonomous western economic recovery or an inflation problem that is more dangerous than the economic problems that we are trying to solve—and we see neither at this point.
As we have written before, an environment of weak real economic growth with loose monetary policy is one that we feel is favorable for growth stocks. Finding and adding more of these to the portfolio remains our main focus. Companies with exposure to Emerging Markets remain interesting from a growth perspective. Emerging economies do not face the same fiscal difficulties as the Western economies and domestic demand here should show stable growth. We continue to look for companies with exposure to Emerging Market domestic demand growth. In addition, Japan remains an underweight position in the portfolio but, as was the case last quarter, we have continued to have success in finding interesting growth companies at reasonable prices here.
Finally, we continue to believe that the current environment favors equities over cash or bonds, and that growth stocks should outperform the broader market. But we are aware of two main risks to this view. The first risk is that the world suffers a renewed recession. This would likely be triggered by either a renewed property downturn in the US (residential or commercial) with associated banking problems, or else, by policy errors in China leading to weak Chinese economic growth. This scenario would probably still see growth stocks outperform the broader market but they would underperform bonds. The second risk is that we see a more widespread sovereign debt crisis that spreads to the US. This would lead to higher bond yields and effectively kill any economic recovery. To us, this is the scarier scenario in that both bonds and equities would underperform and cash could struggle to keep pace with inflation. While neither of these risks forms our base case, we are managing the portfolios with a more than normal awareness of the economic environment and the bond market.
Baring Asset Management
As of June 30, 2010, BOC Hong Kong comprised 1.76% of the portfolio's assets, DBS Group – 1.74%, Admiral Group – 1.63%, Autonomy – 1.55%, Unicharm – 1.80%, Secom – 1.52%, Rakuten – 1.58%, Kurita Water – 1.51%, Grifols – 1.31%, Yara – 1.30%, Israel Chemicals – 1.32%, Paladin Energy – 0.95%, LVMH – 1.58%, Publicis Groupe – 1.58%, Tencent Holdings – 1.44%, and Telenor – 1.56%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
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