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Highlights from Causeway Convergence 2019

Causeway co-founders Sarah Ketterer, Harry Hartford, and Gracie Fermelia at Causeway Convergence 2019

Causeway co-founders Sarah Ketterer, Harry Hartford, and Gracie Fermelia at Causeway Convergence 2019

In March, 160 of our clients, consultants, advisors, academics, and Causeway professionals gathered in Laguna Beach, California for our third investment conference, Causeway Convergence. Against the backdrop of the magnificent Pacific Ocean, the Causeway research team applied our unique perspective of integrated fundamental and quantitative research to today’s most pertinent investment topics.

Conference guests exchanged ideas on issues impacting their professions and their constituents. Featured speakers, political scientist Ian Bremmer, former Central Bank of Ireland governor Patrick Honohan, and Stanford University economist Susan Athey shared their insights and visions for the future. The CEOs of UniCredit and Encana and the CFO of BP joined us for industry discussions.

Harry Hartford in conversation with Patrick Honohan

Harry Hartford in conversation with Patrick Honohan

Please enjoy these video highlights of our presentation topics.

Better Together: the Interaction of Fundamental and Quantitative Research in Stock Selection

Portfolio managers Joe Gubler and Steve Nguyen explain how we combine quantitative and fundamental research to benefit portfolios.

 

Causeway Analytics: Our Tools – Your Portfolio

How well do you know your managers’ portfolios? Senior research analysts Ryan Myers and Seung Han debut Causeway’s newly developed Risk Lens web application to reveal hidden exposures embedded in equity portfolios.

 

Pursuing Idiosyncratic Alpha in a Global Absolute Return Portfolio

Investors are finding that many absolute return and/or market-neutral strategies are failing to enhance returns and provide diversification. Portfolio manager Duff Kuhnert highlights how Causeway has achieved diversifying returns in our Global Absolute Return strategy, and shares analysis techniques that can help identify truly idiosyncratic absolute returns.

 

The Big Opportunity in International Small Caps – Causeway’s Quest for Diversifying Alpha

Portfolio manager Arjun Jayaraman examines the international small cap equity universe and reviews the benefits of using a quantitative, active approach to seeking alpha.

 

Value Opportunities in Information Technology

It may surprise some that there is a place for value investors in the information technology sector. Portfolio manager Jamie Doyle outlines our fundamental approach to evaluating legacy technology companies.

 

The Holy Grail and The Holy Grave of Investing in Cyclicals

Portfolio manager Jonathan Eng shares insights gained from more than two decades of value investing in cyclical businesses. He discusses what investors should seek, and just as importantly, what they should avoid.

 

Sharpening Our Tools: Emerging Markets Research from a Dual Perspective

Portfolio managers Arjun Jayaraman and Alessandro Valentini highlight the benefits of marrying fundamental and quantitative perspectives in search of alpha within emerging markets.

 

ESG and Alpha: New Concepts, and Global Evidence

“ESG” is attracting significant attention in the world of investing. Senior research analysts Mozaffar Khan and Victor Liu describe Causeway’s proprietary corporate governance and ESG assessment frameworks and underlying research, and discuss how a carefully constructed framework can impact risk-adjusted returns.

 

A Word about Causeway, from Sarah and Harry

Causeway’s co-founders and portfolio managers, Sarah Ketterer and Harry Hartford, discuss global stock market cycles, how fundamental and quantitative convergence benefits our clients, Causeway’s five-year plan, and how we maintain our culture while adapting to a rapidly changing industry.

Webcast: Causeway International Value Fund / Causeway Global Value Fund

Webcast: Causeway Emerging Markets Fund / Causeway International Opportunities Fund / Causeway International Small Cap Fund

But What If The Cycle Turns…?

No spring chicken, Director Kudlow may be right. However, what if he’s wrong? Cycles tend to turn when least expected. Clearly, the past decade of massive global monetary accommodation has produced side effects such as asset inflation, fiscal deficits, and rising levels of private and public sector debt. According to asset tracker Preqin, global private capital “dry powder“ (money not yet invested) has reached a record $2 trillion. Of that, committed—but as of yet undeployed—capital for private equity is estimated to be $1.2 trillion – over 20% of the $5 trillion of global private equity capital.

As the pace of monetary liquidity expansion slows, we expect rewards for those engaging in price discovery and identifying undervaluation.

Perhaps too much money is chasing too few (good) investments. We observe a similar excess liquidity effect in public equity markets, as investors generally appear indifferent to valuation in their efforts to gain exposure to growth. As the pace of monetary liquidity expansion slows, we expect rewards for those engaging in price discovery and identifying undervaluation.

The “New Normal” strikes us as abnormal. Those early in their careers in the US bond market have only experienced the term premium (the extra return investors demand to compensate them for the risk associated with a long-term bond) declining steadily for the past eight years. The US bond term premium is at a 15-year low. We believe this shrinking risk premium has helped depress equity market volatility and support higher equity valuations. Over the past decade to March 31, 2019, the MSCI USA Index has returned nearly 16% per annum, on average. This return is generous for a developed markets index, particularly given the shrinking risk, measured as volatility. The 10-year rolling realized annual US equity market volatility is now at its lowest point in history. The less technology-endowed, more cyclical MSCI EAFE Index has delivered about 10% per annum, on average, over the decade. In all regions, value stocks have underperformed growth stocks for much of this post-2008 period, resulting in historically wide gaps in characteristics between value and growth indices (See Fig. 1).

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Additionally, the earnings yield spread in the MSCI All Country World Index (“ACWI”), which measures the earnings yield of the cheapest stocks minus the earnings yield of the most expensive stocks, currently is historically wide, above the 90th percentile (See Fig. 2).

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At some point, extremely depressed valuations should inspire buyers to snap up the bargains.

By analyzing the MSCI ACWI stock universe since 2000, we see that the earnings yield spread differential has been correlated with future performance. When the earnings yield spread has reached extreme levels—90th percentile or above—cheap stocks have outperformed expensive stocks by over 40% in the next 12 months. At some point, extremely depressed valuations should inspire buyers to snap up the bargains. At the end of March 2019, the earnings yield spread was in the 93rd percentile (See Fig. 3).

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With the end of quantitative easing for this cycle, the US Federal Reserve Bank has reduced its balance sheet by about 11% from its peak of approximately $4.5 trillion. We expect that tapering liquidity growth will coincide with a rise in investor risk aversion, perhaps evidenced by a widening of global high yield bond spreads over US Treasury bills. The latter have a significant negative correlation with global price-to-earnings ratios. We believe the valuation gap in global equity markets will narrow as global monetary liquidity growth slows further, and as the debt service burden increases across much of the developed world and China. Public sector financing may crowd out private sector credit. Under that scenario, the cost of financing will rise.

Shrinking monetary liquidity—or any one of several possible macroeconomic shocks—could precipitate a recession in major economies globally. In our estimate, a moderate recession is already priced into many cyclical stocks. At present, value stocks tend to be cyclical, and cyclical stocks are trading at one of the largest discounts to defensive stocks in the past two decades. The most undervalued stocks in many markets globally trade at price-to-earnings and price-to-cash flow multiples consistent with a deteriorating economic cycle and structural disruption. Banks, much maligned in a period of falling interest rates, already discount some very bad news. This is reflected in the price-to-book value differential between bank stocks and the broader MSCI World Index (See Fig. 4). Energy stocks also are trading at historically depressed levels.

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Some industries are so unpopular, considered rife with structural change, that they have tumbled in valuation. For example, European automobile stocks are trading at meager valuations versus history and relative to other cyclical segments of the markets, such as capital goods (See Fig. 5).

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Stretched earnings yield spreads between cheap and expensive stocks suggest value is due for a resurgence, although timing cannot be predicted.

In our view, growth stocks with no (or negative) earnings, and no near-term prospect of profitability, may have more in common with venture capital than traditional publicly listed equities. We believe that valuation multiple expansion (especially price-to-sales) is unsustainable, as earnings revisions are turning negative in many sectors and regions.
In contrast with growth, the value factor commands a risk premium because market action does not typically re-price these stocks quickly to fair market value. Often, it takes years for a value stock to trade at fair market value. That requires patience, and makes timing of the value cycle difficult.

If history is any guide, when money is too cheap for a prolonged period, financial leverage rises, labor and capital resources get misdirected, and the financial system becomes even more vulnerable to any modest tightening. A steeper yield curve may lower recession concerns, but at the expense of higher volatility and lower valuation multiples.

From Causeway quantitative research, we see that value is not dependent on either the economic or market regime. Stretched earnings yield spreads between cheap and expensive stocks suggest value is due for a resurgence, although timing cannot be predicted. If interest rates do increase, reversing the trend after 2008, this would likely support value stocks, which tend to outperform growth when interest rates rise. For many growth stocks, earnings and cash flow are promised far into the future, which makes them the most sensitive to fluctuations in interest rates. In a rising rate environment, these long duration growth stocks typically swoon. As part of our fundamental research process, we encourage our portfolio companies to generate surplus cash flow, and return as much of that to shareholders as soon as possible. With the liquidity spigot turned lower, the markets may once again agree with our view.

This market commentary expresses Causeway’s views as of April 22, 2019 and should not be relied on as research or investment advice regarding any investment. These views and any portfolio holdings and characteristics are subject to change, and there is no guarantee that any forecasts made will come to pass. Any securities identified do not represent all of the securities purchased, sold or recommended by Causeway. The reader should not assume that an investment in any securities identified was or will be profitable. Forecasts are subject to numerous assumptions, risks and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented has been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy or completeness of such information.
The MSCI World Index is a free float-adjusted market capitalization index, designed to measure developed market equity performance, consisting of 23 developed country indices, including the U.S. The MSCI ACWI Index is a free float-adjusted market capitalization index, designed to measure the equity market performance of developed and emerging markets, consisting of 23 developed country indices, including the U.S, and 24 emerging market country indices. The MSCI World Value Index and MSCI ACWI Value Index are a subset of the MSCI World Index and MSCI ACWI Index, respectively, and target 50% coverage of the relevant index, with value investment style characteristics for index construction using three variables: book value to price, 12-month forward earnings to price, and dividend yield. The MSCI World Growth Index and MSCI ACWI Growth Index are a subset of the MSCI World Index and MSCI ACWI Index, respectively, and target the remaining 50% coverage. The MSCI EAFE Index is a free float-adjusted market capitalization weighted index, designed to measure developed market equity performance excluding the U.S. and Canada, consisting of 21 stock markets in Europe, Australasia, and the Far East. The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 631 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US. The indices are gross of withholding taxes, assume reinvestment of dividends and capital gains, and assume no management, custody, transaction or other expenses. It is not possible to invest directly in an Index.

MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.

 

Webcast: Causeway Global Absolute Return Fund

Causeway Funds Webcasts: 1Q2019

ESG MASTERCLASS

Causeway Brexit Scenarios

Brexit summary and key dates going forward
On June 23, 2016, Britons voted to exit the European Union (“EU”) by a vote of 52% to 48%. Article 50 of the EU treaty, which outlines the procedure for an EU member state leaving the union, was triggered in March 2017. The EU and the UK have until March 29, 2019 to agree on the terms of the separation. The UK Parliament must pass Prime Minister Theresa May’s Brexit deal. Ms. May presented a proposed deal to Parliament on January 15, 2019 and Parliament voted to reject the deal. Ms. May is expected to present a revised proposal to the House of Commons on February 13, 2019. With the exit date deadline approaching, Parliament has three primary options: 1) vote in favor of the revised deal (we believe this is most likely), 2) reject the revised deal and use a variety of alternatives to postpone the exit, or 3) exit with no deal. Given the negative consequences of a hard Brexit, we expect the UK to approve the deal or postpone a decision, but we do not expect a disorderly Brexit.

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Potential Brexit scenarios and estimated market response
The UK electorate’s June 23, 2016 decision to withdraw from the EU surprised most investors, including Causeway. The pound sterling decline impacted UK stocks broadly in the days following the vote. However, the stock returns were more differentiated over longer periods. UK-based businesses that generate substantial portions of their revenues outside the UK generally performed better than those with more locally generated revenues. Looking forward, we assess the different scenarios below.

We currently believe a soft Brexit is the most likely outcome.

Hard Brexit – the UK exits the EU without a deal in place on March 29, 2019
In the short term, a disorderly Brexit would be very disruptive to the UK economy and financial markets. The majority of UK Members of Parliament (MPs) have indicated they are against this outcome. We currently believe this scenario is unlikely, as the short term economic ramifications would threaten the Tory Party’s advantage.

Soft Brexit – scenarios include renegotiation of the Brexit deal and postponement of the Brexit process past March 29
We currently believe a soft Brexit is the most likely outcome. In order to extend the March 29 deadline, the UK would request an extension and all 27 EU countries would need to agree. Mervyn King, former Governor of the Bank of England, described the divisions within the UK government and the challenges in drafting a deal that receives the required support. These factors increase the probability of the UK requesting an extension past the March 29 deadline.

No Brexit – the UK cancels Brexit and remains in the EU
The European Court of Justice has ruled that it would be legal for the UK to unilaterally revoke Article 50, thereby cancelling Brexit. This would likely be proceeded by a second referendum. If the majority of UK citizens elect to remain in the EU, the government would have the public support needed to cancel Brexit and remain in the EU.

From a valuation perspective, we believe UK stocks already discount an uncertain future, including a hard Brexit.

Short Term – less than 1 week
In the short term, we believe that the pound sterling would weaken in a hard Brexit scenario.

Medium Term – up to 24 months
Even with a disorderly Brexit, we believe equity valuations will likely adjust to the new reality over the medium and long term. From a valuation perspective, we believe UK stocks already discount an uncertain future, including a hard Brexit. Over the medium-term, and longer, horizons, stock selection should be an important driver of performance regardless of the Brexit outcome.

As active managers continuously searching for attractive opportunities, our portfolio positioning changes over time. The various Brexit scenarios will present opportunities and risks. Our portfolios will evolve as we seek to take advantage of new opportunities on behalf of our clients.

UK Stocks: Compelling Valuations
UK stocks de-rated severely in 2018, and are currently trading at the cheapest levels in the past 25 years (except during the global financial crisis “GFC” in 2008-9) on a dividend yield basis. Many UK dividend yields are nearly equivalent to price-to-earnings (P/E) multiples. Measured by the earnings yield/bond yield premium, the UK stock market has only been cheaper twice in the past 100 years (during World War I and World War II)*. The decoupling of UK free cash flow yields from other developed markets is evident in the chart below.

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The UK exposures for both the Causeway representative portfolio and the MSCI ACWI Index are lower on a revenue basis than on a listing basis.

Within a Causeway Global Value Equity representative portfolio, the overweight to the UK versus the MSCI ACWI Index is more significant when measured by listing (15% overweight) than when measured by the revenue sources of the portfolio companies (3% overweight). Additionally, the UK exposures for both the Causeway representative portfolio and the MSCI ACWI Index are lower on a revenue basis than on a listing basis. UK-domiciled companies in sectors such as capital goods, energy, materials, pharmaceuticals, and food beverage and tobacco have diverse global operations and often generate most of their revenues outside the UK.

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Fundamental Brexit Risk Analysis
Of Causeway’s UK-domiciled holdings in its fundamental strategies – Global Value and International Value – we believe UK financials stocks may be most exposed to Brexit risk. For those holdings, we have evaluated the investment cases under stress tests that estimate the impact of a hard Brexit. Although we do not currently expect a disorderly exit, even in this scenario we have identified upside potential in current share prices.

We continue to monitor the political process, but believe that many UK stock valuations are attractive, especially relative to peers in others markets.

Banks
The Bank of England (“BOE”) performs annual stress tests that we believe are more nuanced than stress tests we could conduct internally, given the application of stress to different books of business. These test the banks’ entire books, not just the UK exposure. The BoE’s financial policy committee deems the Annual Cyclical Scenario “ACS” test performed to be sufficiently severe to encompass the disorderly Brexit scenario. Macroeconomic shocks in the ACS test include: UK gross domestic product falls by 4.7%, the UK unemployment rate rises to 9.5%, and UK real estate prices fall by more than 30%. The scenario also includes a sudden loss of overseas investor appetite for UK assets, a 27% fall in the sterling exchange rate index and the BoE’s Bank Rate rising to 4%. After conducting this stress test, the BOE noted the UK banking system’s resilience. We are comfortable with the capital positions of the UK bank holdings in our fundamental portfolios in this scenario.

Insurers
For the UK-listed insurers in Causeway’s fundamental portfolios, we are interested in the impact of stress on the companies’ ownership of bonds and credit instruments. Our primary focus is on what would happen to tangible book value and solvency ratios in case of a repeat of the bond default environment of 2001/2002 (which was worse than 2008, where most of the losses were on loan exposures) extended over three and five year periods. We believe the estimated declines in tangible book value will not require the insurers to raise capital. Despite the stress, solvency levels for these companies should still meet regulatory standards and are well within management’s target ranges. We believe these are draconian scenarios because even in a hard Brexit, credit default levels would not necessarily increase to the levels experienced in 2002.
We continue to monitor the political process, but believe that many UK stock valuations are attractive, especially relative to peers in others markets.

*Citi Research, January 3, 2019, “Global Equity Road Ahead”

This market commentary expresses Causeway’s views as of February 8, 2019 and should not be relied on as research or investment advice regarding any investment. These views are subject to change, and there is no guarantee that any forecasts made will come to pass. Forecasts are subject to numerous assumptions, risks and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented has been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy or completeness of such information.

Webcast: Causeway International Value Fund / Causeway Global Value Fund

Webcast: Causeway Emerging Markets Fund / Causeway International Opportunities Fund / Causeway International Small Cap Fund

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