"While we do not see much evidence to support an optimistic view of economic fundamentals in our primary markets, we do see evidence developing that could change investor sentiment."- Cedar Street Asset Management LLC
Market in Review
Growth prospects in Europe dimmed further during the third quarter as key geopolitical uncertainties weighed on corporate investment activity and consumer confidence. Impacts from the U.S. trade war with China hit Germany particularly hard due to its export dependency, especially within the automobile industry. During the quarter, it became clear that manufacturing weakness was now spreading to logistics and services sectors in Europe’s largest economy. In addition, Germany, along with the rest of the European continent, is struggling with lingering uncertainty related to a potential no-deal Brexit from the U.K. As the latest Brexit deadline approaches on October 31, 2019, prospects for any resolution seem rather dim, in our view. As has been the typical response of economic policy makers in Europe, the European Central Bank engaged in additional monetary policy loosening with more negative interest rates, while also resuming bond market purchases in a resumption of Quantitative Easing (QE). Equity markets have responded to lower rates by bidding up shares of companies that are deemed less sensitive to swings in economic cycles, such as Real Estate, Utilities, and many Consumer Staples businesses, as well as select Information Technology businesses that are deemed to have high revenue growth prospects due to the markets in which they participate.
We believe this trading activity is largely carried out by factor-based quantitative strategies that are isolating specific quality, momentum, and low volatility factors, with little to less regard for the valuations of the securities being targeted. The impact on the Fund from this activity is twofold: 1) Fund holdings exposed to positive momentum factors and generating higher levels of return on equity experienced tailwinds; while 2) Fund holdings exposed to negative momentum, higher levels of volatility, and flat or declining margins experienced significant headwinds. Given the Fund’s strong value orientation, headwinds were more pervasive than tailwinds during the quarter.
In the third quarter of 2019, the Harbor International Small Cap Fund (Institutional Class) returned -3.75%, underperforming its benchmark, the MSCI EAFE Small Cap (ND) Index, which returned -0.44%.
We believe the current market environment is being largely driven by factor-based quantitative activity – buying on quality, momentum, and low volatility factors – that is becoming increasingly focused on perceived downside risk protection that correlates to low bond yields, while simultaneously selling or shorting earnings volatility, negative momentum, and high volatility, with almost no regard for individual security valuation. Due to the portfolio’s heavy exposure to value factors, the portfolio lagged the benchmark during the quarter.
One of the more frustrating, and we believe short-term, aspects of the current environment is the seemingly large and growing disconnect between operating company fundamentals and factor-based stock price reactions, which became more pronounced during the quarter. The overall revenue and earnings growth of the Fund’s holdings are in line with or better than the benchmark, from our statistical review, but the impact from factor investor activity has expanded valuation multiples for favored factors and simultaneously caused multiple contraction for shorted factors. For holdings in the Fund, our review of earnings results announced during the quarter and subsequent discussions with management teams indicates steady progress is being made in most cases that is consistent with our expectations. We continue to remain confident that operating fundamentals for these businesses will ultimately rule the day.
Contributors and Detractors
The top contributor during the quarter was Cobham, a U.K.-listed aerospace engineering firm. Cobham received a buyout offer from Advent International, a U.S. private equity firm, that included a 44% premium. Although the takeout valuation was below our estimate of the long-term intrinsic value of the business, we exited the position due to concerns about the viability of the deal given the high level of scrutiny it is likely to face.
Another contributor during the quarter, Tower Semiconductor, is an outsourced communications chip manufacturer. Tower reported better than expected revenue and earnings during the quarter as its main customers are beginning to ramp up orders related to 5G implementation.
The biggest detractor during the quarter was CYBG, a U.K.-listed challenger bank. The company reported a higher than expected level of claims related to a faulty Payment Protection Insurance (PPI) scheme. CYBG’s level of provisioning was insufficient relative to the claims submitted at the August 31 deadline. As a result of increased provisions, CYBG’s solvency ratios were reduced but still well secured, in our view, but investors who had counted on CYBG paying its first dividend were disappointed.
Tarkett is a global commercial flooring and sports surfaces manufacturer based in France. During the quarter, the company announced a decline in quarterly earnings that took investors by surprise. Tarkett had been implementing cost increases with customers for several quarters to slowly offset the impact of cost inflation stemming from transport costs and rising commodity input pricing. However, due to negative product mix, the benefits of rising prices were diluted, causing margin compression. Investors are concerned about near-term margin weakness and overall commercial market uncertainty, we believe.
Buys and Sells
During the quarter we initiated positions in both Siltronic in Germany and Sumco in Japan. The companies are two of the top manufacturers of semiconductor wafers. Although we typically do not invest in semiconductor businesses because of what we believe are high valuations ascribed to market leaders and the volatile cycles of the industry, the current environment provided what we believe is a unique opportunity to invest in the two leading, independent manufacturers of wafers at very attractive valuation levels. Due to the increasing complexity of semiconductor manufacturing, wafer quality and purity have become increasingly important, in our view. We believe, as a result, fewer companies have the technical expertise to maintain their position in the market. Consolidation has also led to the implementation of long-term supply agreements between wafer suppliers and customers, which has reduced some of the earnings volatility of Siltronic and Sumco. Given what we believe are improving structural dynamics and historically low valuations, we entered into both names during the quarter. The immediate impact to the portfolio was: 1) improved overall return on equity metrics and portfolio quality; 2) sector diversification; and 3) maintenance of below-average valuation metrics.
During the quarter we also exited two positions in very different businesses but for very similar reasons. Cobham is a U.K.-listed defense electronics company while Osram Licht is a German lighting and sensors company. We exited both after they received compelling buyout offers from private equity firms that caused short-term share price spikes greater than 30%. Our views on these buyouts are mixed. On the one hand, we are pleased that strategically minded, value-focused buyers are recognizing the same long-term value that we do in these businesses. On the other hand, although we are pleased to unlock some shareholder value in the short-term, the buyout offers still represent what we believe are a significant discount to our estimate of long-term intrinsic value; our preference would have been to recognize more of this value over a longer time horizon.
There were no major changes to country allocations during the quarter. We continue to remain underweight in our two largest markets, Japan and the U.K., for different reasons. In Japan, we are very satisfied with the productivity, diversity, and valuation of our current holdings. Most new Japan names that populate our new idea screens are either operating in sectors that are still experiencing distress, such as automotive manufacturing, brick-and-mortar retail, or regional banks, or have structural issues around corporate governance that make them unattractive in our view. The implementation of a new consumption tax hike, from 8% to 10%, in October has also made us cautious due to the sell-off that was inspired by the previous tax hike in 2014.
For the U.K., we are maintaining a neutral to slightly underweight position to guard against any drastic Brexit-related moves in the market. The high levels of corporate and consumer uncertainty that have been inspired by Brexit indecision have not caused extreme distress in the operations of Fund holdings or of the overall U.K. economy, but valuation multiples in the U.K. have contracted severely, in our view. Until such time as a resolution is reached, either with a deal or without, we will continue to retain our neutral positioning as long as valuations remain depressed.
There were no major changes to our positioning in the rest of Europe or Asia.
In our view, factor positioning has consistently driven most market activity during the course of this year; the only thing that has changed since the beginning of the year is the extremes of the corresponding moves. We believe factor positioning is largely a response to lower bond yields resulting from monetary policy and quantitative easing (QE) implemented by developed market central bankers in an overall challenging macroeconomic environment that seemed to deteriorate in the third quarter.
While we do not see much evidence to support an optimistic view of economic fundamentals in our primary markets, we do see evidence developing that could change investor sentiment. In Europe, a stronger case is being made for implementing some form of fiscal stimulus, even in Germany, as the limits of monetary policy are reaching their practical limits, in our view. The tax hike in Japan is now in place. And a U.K. Brexit resolution now seems likely to happen within a short period of time. Meanwhile, uncertainties in the U.S. continue to mount: the trade war with China, impeachment inquiries and the 2020 elections, earnings recession, and slowing economic growth. The U.S. has been the dominant equity market over the past decade due to solid earnings growth, in our view, providing a healthy dose of multiple expansion during the past few years. But we believe margins and valuation multiples have a way of reverting to the mean over time as capital flows to its most productive uses globally. As a result, our base case indicates capital may now flow to equity markets outside the U.S. on valuation grounds and due to rebalancing.
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The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions. These views are not necessarily those of the fund company and should not be construed as such.
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