China’s market was certainly turbulent in the third quarter, and there has been a lot of negative news flow. We believe China is undergoing a transformation toward maturity, and we expect to see the country’s economy grow well below the 7% growth rate we are seeing today1.
The property bubble and subsequent sell-off hit government expenditures. A weak property market in China means less government revenue to fund counter-cyclical spending, particularly on infrastructure.
With Chinese corporate profits slowing, Chinese consumer spending decelerated. As corporations adjust to the “new normal,” earnings revisions are continuing to be negative. The good news for the short- to medium-term is that China’s economy appears to be rebounding.
With the market pulling back, we are finding opportunities in China, particularly in the consumer staples space as valuations were hit. The pullback in China allowed us to add a new name to the portfolio — Kweichow Moutai (1.11% of Invesco International Growth Fund as of Sept. 30, 2015). Moutai is the premier brand in Chinese spirits and is an integral part of Chinese culture. The business was started during the Qing Dynasty hundreds of years ago, and today the company has a 58% share 2 of the high-end spirits market in China. The company is net cash, has best-in-class margins with an operating margin of over 70% and was trading at a significant discount to its own history and to global peers at only 8x 3 its estimated enterprise multiple for 2016. The sell-off in local shares provided an opportunity to initiate a new position.
Brazil pursues improvements, but recession likely to continue
We believe President Dilma Rouseff’s economic policies were a key factor in destabilizing the Brazilian economy since becoming president in 2011. Her misguided populist expansionary policies threw the country into a deeper-than-expected recession, with Brazil’s fiscal spending at the center of its troubles. Weak industrial growth and consumer spending have reduced the tax revenues needed to balance the country’s fiscal account.
Today, however, we now believe that President Rouseff is generally trying to make better policy decisions. She has, in our opinion, appointed a market-friendly finance minister whose focus is on fiscal austerity; however, one of her biggest impediments appears to be political. With her approval rating falling to single digits, she lacks the political clout to push through the necessary reforms required, in our view. Her popularity and her ability to govern is so low that many have been calling for her impeachment. So today, President Rouseff’s attempts to pass a meaningful fiscal package have proven largely futile.
With the political chaos and the weak economic backdrop, Brazil’s sovereign debt was downgraded to junk status.4
Brazil’s currency, the real, has appeared to be in a state of free fall amid a macro backdrop that has gotten worse by the day. The real depreciated 27%1 in the third quarter alone, and inflation is now at highs which were last seen more than a decade ago in Brazil’s tumultuous past. We expect gross domestic growth will recover, but the recession will likely be extended another year.
Staying focused on quality gives us conviction in these types of environments. Risk does exist, but we are weighing it daily. Presently, given our belief that valuations already reflect Brazil’s weak economy, we are content with the weighting and positions we have there today.
Proving to be resilient is BM&F Bovespa, Brazil’s equites and derivatives exchange (1.36% of Invesco International Growth Fund as of Sept. 30, 2015). And we also hold BR Foods, Brazil’s largest processed protein producer (0.70% of Invesco International Growth Fund as of Sept. 30, 2015), which benefits from the weaker currency.
Valuations present opportunities
As the dust settles after the tough third quarter, we are using this opportunity to improve the quality of the portfolio where we see dislocations in pricing.
To give you an idea about the attractiveness of our markets and how quickly they have changed, the MSCI Asia Pacific Growth Index was trading at 13.1x its estimated price-to-earnings ratio for the next 12 months at the end of June. At the end of September, that fell to 11.7x — a drop of over 10%.5 The drop in emerging markets was even more pronounced. So, our markets are clearly more attractive now versus just three months ago.
We have high conviction in our long-term EQV (earnings, quality, valuation) approach, which is based on bottom-up stockpicking and company fundamentals. We believe this is the right approach for the long term.
1 Source: Bloomberg 2 Source: Macquarie, Oct. 5, 2015 3 Source: Bloomberg Consensus 4 Source: S&P S&P Sept. 9, 2015
Book value is a company’s total assets minus liabilities and intangible assets. Enterprise multiple is a company’s enterprise value divided by EBITDA (earnings before interest, taxes, depreciation and amortization).
Operating margin is a margin ratio used to measure a company’s pricing strategy and operating efficiency.
Price-earnings (P/E) ratio, also called multiple, measures a stock’s valuation by dividing its share price by its earnings per share.
Negative developments in the Consumer Staples sector will affect the value of your investment more than would be the case in a more diversified investment.
The performance of an investment concentrated in issuers of a certain region or country such as China and Brazil is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
Holdings listed are not buy sell recommendations and are for educational purposes only.