October 2022 Newsletter
The Moving Political Storm Clouds
pol·i·tics
/ˈpäləˌtiks/
noun
noun: politics
the activities associated with the governance of a country or other area, especially the debate or conflict among individuals or parties having or hoping to achieve power.
2022 has been a very challenging year on many fronts. Inflation affects everyone, and virtually the entire World is experiencing a higher level of inflation than it is accustomed to. War grips Ukraine, and refugees have been displaced, and families torn apart. The concerns of investors may seem to pale in respect of these considerations. Yet the mood of international investors is probably as poor as at any time in the last few decades. What has made investing conditions so treacherous outside the U.S. during 2022 has been that miscalculating and or being sanguine about political scenarios has had enormous ramifications.
Political risk for International investors set the tone for 2022 with Putin’s invasion of Ukraine in February. Regardless of whether we should have all seen it coming, what is now clear is that Putin was making calculations about his domestic and international power that befuddled the West. While investors were caught off guard, they were not completely unnerved. The thinking went that monetary policy and inflation were the real issues to be dealt with. If inflation was peaking, Putin’s war, while devastating for Ukraine, need not be the central reason to go to cash. However, as the months have dragged on, it has become clear that the War has added significantly to inflation pressures, pressures that have now been around for long enough to feel possibly deeply embedded. As a consequence, the U.S. Federal Reserve has remained quite hawkish despite several 75 basis point hikes, and investors risk appetites were weaker in late Summer than in late February.
Faced with inflation, the mood of everyday people has been sour in 2022, and rarely are people more downbeat than in England. The Tory party grew tired of defending Prime Minister Boris Johnson from every side in this dour climate, and turned on him by mid-year. In the beauty pageant for Tory leadership that followed, Liz Truss promised the most, and won. We all know now how this worked out in very quick fashion with the disastrous “mini budget”, but markets did not shrug this off as political theater. Risks surfaced that were not well understood. Markets were much more unforgiving than they had been in relation to the War in Ukraine. Risk premia for UK assets would have to rise, significantly. See below. The biggest equity market impact was felt amongst domestic UK companies, and this is why we have used the iShares FTSE 250 ETF (ticker: MIDD) below, which incorporates the next 250 largest companies after the 100 largest, i.e. companies 101-350. Almost all of these FTSE 250 companies are largely dependent on the UK for their revenues. If the domestic UK economy has to suffer, these would be the companies expected to weaken. The FY1 Price to earnings ratio fell from roughly 80% of the S&P 500 multiple to 70% of the S&P multiple, in less than two months.
UK Cost of Equity increasing
IShares FTSE 250 Valuation relative to S&P 500 (last six months)
Source: Factset
In China, the long awaited 20th Congress of the CCP was due to take place in October. While this event was scheduled for years, and political risk should have been low as a consequence, information flow from China through channels that were previously established has become much weaker in recent years. Part of this was due to travel limitations due to COVID policies. The lack of preparation and understanding was clear with the reaction from foreign investors to takeaways from the Congress. Investors suddenly sensed that the business climate would deteriorate significantly in President Xi’s desire to consolidate power, and that Chinese and Hong Kong assets were less investable, or possibly uninvestable. The selling of assets on Monday October 24th, 2022 that could be connected to China was more severe the further you were from Beijing. For example, Hong Kong stocks (-6.4%, Factset) sold off harder on 10/24/22 than those in Shanghai (SSE Composite -2%, Factset), and New York listed shares (Bank of New York ADR Index China – 13.7%, Factset) sold off harder than those of Hong Kong. See below. As in the UK, equity investors did not take long to demand a greater discount. The FY1 P/E for the iShares Core Hang Seng Index ETF (ticker: 9115), again relative to the S&P 500, fell from 60% (or a 40% discount) to 50% within a few weeks.
Hong Kong Cost of Equity Increasing
iShares Core Hang Seng Index ETF Valuation relative to S&P 500 (last three months)
Source: Factset
While trading will remain volatile for UK and Chinese assets, the cost of the selloffs of the past few months is quite clear. Valuations are lower, and cost of equity is higher. Any capital market financing for businesses and or individuals in these markets will be more expensive as a consequence, at least for the time being. And the costs have been far and wide. We at Ballina have had reasonable exposure to the UK and China/Hong Kong, not because we love the political situation on the ground, but because we screen for and analyze companies based in those markets with decent fundamentals and very depressed valuations. Remember that valuation is one of the most important indicators of long-term return potential. We had collective exposure to these markets of greater than 20%. Many International value oriented portfolios would have similar exposure. While we are bottom up investors, we cannot ignore these kind of country specific drawdowns. What can we do?
First, we can review our existing holdings in these markets to determine if they are worth continuing to hold. We have a sell discipline. We typically reserve it for a specific security, but if we believe we have to be more proactive in restoring diversification, we will use the sell discipline. Second, we have to consider where political risk may emerge next? For our portfolios, we have to first think about Japan, where we have meaningful exposure (more than 25% in each of our strategies as we write this). On the surface, Japan political risk seems quite low. Their politics are known for pragmatic consensus building, and the Liberal Democratic Party (“LDP”) has been in power almost continuously since 1955. While many are worried that the Bank of Japan Governor Kuroda is following too bold of a strategy, Kuroda is not power seeking in a similar fashion to what was observed in Russia, the UK and China. For that reason, it makes sense that markets will have a better handle on how to discount the risks. Central banking mistakes are not new. It still makes sense to review Japanese holdings, and we have been doing so.
In our review of existing holdings in the UK and China/Hong Kong, thus far we have come to both positive and negative conclusions. For example, we had positions in UK Housebuilding. Given the reaction of markets to the “mini budget” in the UK, mortgage rates skyrocketed. See below. While we believe the market will calm, we could not ignore the reality and risk to UK housebuilders, and we adjusted price targets and exposures accordingly. For Chinese and Hong Kong exposures, while there are stocks that have been removed from our rank sheet, we found ourselves largely perplexed. From the table above, you can see that Hong Kong listed stocks trade for ½ the multiple of the S&P 500, but for us, we own shares that are even cheaper than the Index. For example, Tianneng Power International (819:HK) is engaged in the new energy battery market, primarily for e-bikes and smaller vehicles. It trades for 4x consensus 2022 earnings (source Factset). The amount of cash on the company Balance Sheet exceeds the market capitalization of the equity by such an amount that unless this cash disappears in short order, it is not an exaggeration to say that the equity holder is getting the business “for free”. We can increase the risk premium for Tianneng, but we would find it difficult to see anything in the speeches at the 20th Congress that would cause us to sell. The selloff in late October was even more perplexing for WH Group (“WH”, HK ticker: 288). WH is the largest pork company in the world, and their #1 position in the U.S. includes brands such as Farmer John’s. While we are sure that the speeches at the Congress were impactful, we are less certain that they will have an impact on Americans desire to eat Hot Dogs and bacon! In all seriousness, we did have concerns about WH before the Congress took place, but this was more in regard to the current level of margins and whether they are sustainable. We believe it is also important to note that in a period where inflation is the greatest challenge confronting markets, China and Hong Kong, as well as Japan, have levels of inflation (2-3%) that are well below that of the rest of the world (World rate is 13%, source Factset). See CPI table for Asia and Europe on the following page.
UK BBA Mortgage Rate
Source: Trading Economics, Bank of England
This kind of portfolio review is not new for us. What is new is political risk in diverse pockets of the world being the driving force behind such portfolio reviews, all within the same year! We have been hoping that International markets would become more calm, but since our inception in 2017, turmoil has been the constant. Experiencing something unique and challenging will make you a better investor over time. Diversification is always our best defense against the “unknowns”, and this is never more true than at the moment. We’ll second guess ourselves to make sure that, while remaining true to our investment discipline, we retain the strongest possible diversification.
Source: Factset
Strategy Performance
International All Cap Value returned -0.3% on a gross basis, and -0.38% on a net basis, in October 2022 versus 3.41% for the benchmark. Year to date performance was -21.47% on a gross basis, and -22.12% on a net basis, versus -24.15% for the benchmark.
International Small Cap Value[1] returned 0.67% on a gross basis, and 0.59% on a net basis, in October 2022 versus 5.34% for the benchmark. Year to date performance was -19.41% on a gross basis, and -20.07% on a net basis, versus -23.88% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in October was Galliford Try PLC. The UK construction stock suffered with small cap UK equities during the Summer months, and when a bit of a recovery came in October, the stock rebounded to a position more in line with it’s fundamentals. The strategy’s top detractor was China Resources Gas Group. Investors remain cautious about sustainability of revenues given that property markets and local Government finances are in such poor shape at the moment in China. China Resources Gas Group is one of the largest owner and operators of local gas distribution networks and services in China.
International Small Cap Value’s top contributor in October was UK construction company Galliford Try PLC. As mentioned above, this was a recovery after a weak performance in the Summer. The strategy’s top detractor was 360 Digitech, the Chinese Fintech. Chinese sentiment became quite poor in October after the 20th Congress, and stock performance was especially weak for shares listed in the United States.
Disclosures:
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmarks being shown for comparison purposes are: a) for International All Cap Value - the Vanguard Total International Stock ETF (VXUS), and b) for International Small Cap Value - Vanguard FTSE All-World ex-US Small-Cap ETF (VSS). The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return.Data show is from a representative account of the International All Cap Value and International Small Cap Value Composites.All returns are Gross of Fees.Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented.The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the mea
[1] On October 17, 2022, the Global Small Cap Value strategy transitioned to the International Small Cap Value strategy. From this date forward the focus of the strategy will be on International Small Cap stocks. The benchmark changed on 10/17/22 to Vanguard International FTSE All-World ex-US Small-Cap ETF (VSS).
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