August 2018 Letter
International equity markets have had to deal with heightened levels of country risk for much of 2018. Argentina, Turkey, South Africa and Italy – have all, to varying degrees, brought turmoil to both equity and fixed income investors. For the bottom up equity investor, elevated country risk can potentially bring trying times.
One approach to inoculating against country risk from those that are potentially flashing red is to simply sell securities listed in that market. Or at the very least sell the companies listed in that market that generate the majority of profits in those same markets. This effort may help. But for all investors, the more difficult exposures to understand are the “secondary” exposures. For example, there may be zero exposure to Italian securities in a portfolio. But, there may be exposure to Japanese, U.S., French or Spanish institutions with significant leverage to the carrying value of Italian assets. It was European debt exposures that brought down, of all things, MF Global – a U.S. futures brokerage firm – in the Fall of 2011. Given that these kinds of risks can “lurk underneath the water”, it may seem that macroeconomic risk is too difficult to see for Equity portfolio managers. After all, portfolios built from the bottom up are not expressly taking a view on the political future of the Italian state, or the monetary policy of Turkey.
However, portfolios that utilize proper bottom up fundamental research are very capable of handling country risk. One reason this is the case is that fundamental research can thoroughly understand the aforementioned “hidden” exposures. By understanding the fundamentals of each holding one by one, risks are no longer “hidden”. The sensitivities of the business are understood. Therefore, because of fundamental research, the country risk is more thoroughly assessed. This is important as we go through another phase of macroeconomic and political turmoil in 2018.
Of the countries mentioned at the top – Italy is probably the only country where exposure is possibly material for Ballina portfolios. Italy is a large economy, with a GDP (roughly $1.9 trillion) of more than 2x that of Turkey. Ballina owns shares in Poste Italiane (“PST”) - a Mail, Parcels, Payments, Financial/Insurance with enormous reach across the Italian saving and consuming economy. We did not choose to invest in PST because we loved the political outlook in Italy. We did not continue to own it because we were attracted to the spending promises of the populist Italian Government elected earlier this year. We have chosen to own the shares for the hidden strengths and increasing efficiency of Poste Italiane, combined with the all-powerful outputs of valuation.
It was actually the fiscal difficulties of the Italian state that allow us to invest in PST in the first place. The company was only partly listed in 2016 in order to help with the fiscal balance of the country. Since that time, the company has implemented a real restructuring and growth story. Italy has many difficulties in terms of the structure of its economy, yet PST is uniquely situated to profitably compete within the country. From its legacy position of nearly 13k postal offices, the group sells financial and insurance products to more than 34 million customers, and holds a greater than 20% share of the Italian life insurance market. Profits from Insurance and Financial Services account for nearly 90% of the total under the group’s plan by 2022. A new flexible delivery model agreed with unions allow for the group to better address an underpenetrated parcels market, and to strike a distribution arrangement with Amazon.
PST shares performed very well into early May of this year, reaching a level of more than 8 EUR/share. This was a full two months after the election in Italy. We took advantage of this strength to trim our holdings of PST. The shares were simply not as attractive. By the end of May, it was clear that the bond market was not sanguine about Italian risk any longer. Bond yields for Italy climbed, and as key budget dates have come closer and closer, they have continued to climb. They are now at spreads relative to Spain that rival those reached at the height of the European debt crisis in 2012. This is not a minor issue for PST, as their insurance subsidiary owns more than EUR90bn of Italian Government bonds, primarily in the Separate Accounts of their clients. The Solvency ratio of the Insurance subsidiary is under pressure, and could possibly need to be shored up. Management is at pains to point out that because the group is overcapitalized, it will be possible to move capital to the Insurance subsidiary and restore this ratio, if needed.
We believe at this time that the risks to PST shareholders are low, and we continue to hold our position. (We have even recently begun to add slightly to the position). We believe that the main reason that PST shares are still up more than 10% year to date are because of the strong combination of fundamental outlook together with valuation. It is at this intersection where Ballina will continue to concentrate efforts.
International All-Cap Value returned -2.61% (gross basis) in August 2018 versus -2.4% for the benchmark. Year to date performance was -6.83% (gross) versus -3.41% for the benchmark.
Global Small Cap Value returned 1.19% (gross) in August 2018 versus 1.3% for the benchmark. Year to date performance was 0.27% versus 5.16% for the benchmark.
 Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)