A Difficult 2018
The MSCI All Country Index entered bear market territory (i.e., down over 20% from its previous peak) in December. On December 24, the U.S. market experienced its biggest Christmas Eve decline ever by a factor of nearly four times. On Christmas Day, the previously stalwart Japanese stock market suffered its own mini-crash. For all of 2018, Chinese stocks, as measured by the CSI 300, dropped 27%. The only two emerging market stock indexes to be up for the year were Brazil and Russia, and the best performing developed market, the tiny New Zealand exchange, lost money, as did all other MSCI developed market indexes. Obviously, it was a challenging year, and the Oakmark Global Fund felt its downward drag.
The Fund lost 19% in 2018, which compares to the MSCI World Index loss of 8.7% in the period and the Lipper Global Fund Index’s loss of 10.7%. For the December quarter, the Fund lost 16.7%, which contrasts to a 13.4% decline for the MSCI World Index and 13.1% for the Lipper Global Fund Index. We are happier to report that since inception in 1999, the Fund has achieved a compound annual rate of return of 9.0%, which compares to 4.2% for the MSCI World Index and 4.7% for the Lipper Global Fund Index.
For the calendar year, India, China and the Netherlands contributed the most to investment return, while the U.K., U.S. and Switzerland detracted most. The leading contributors were Mastercard (U.S.), USG (U.S.), MTU Aero Engines (Germany—sold), CarMax (U.S.—sold) and Live Nation Entertainment (U.S.). The largest detractors were Daimler (Germany), Credit Suisse (Switzerland), CNH Industrial (U.K.), Julius Baer Group (Switzerland) and Lloyds Banking Group (U.K.).
During the most recent quarter, India was the only country to contribute positively to return, while the U.S., U.K. and Switzerland were the largest detractors. Axis Bank (India) and General Motors (U.S.) were the only stocks with positive outcomes in the period, while Citigroup (U.S.), Credit Suisse, CNH Industrial, National Oilwell Varco (U.S.) and Julius Baer Group detracted most from Fund return.
Corporate Fundamentals Outperforming Share Prices
The past year proved difficult and volatile for equity investors, ourselves certainly included. But did this downward price movement accurately reflect a change in the fundamentals of the Fund’s investments? We think not. We focus on cash flow generation, balance sheet strength, management’s deployment of capital, private market transactions, corporate insider buying and a host of other factors, which help us measure the intrinsic value per share of our holdings. Businesses with growing intrinsic value per share and declining share prices are opportunities for additional investment. Two such holdings in the Fund portfolio are Lloyds Banking Group and General Motors (GM).
Lloyds is the Fund’s second-largest international holding. The company’s share price declined 25% in 2018, resulting in a negative return contribution of 112 basis points. Despite the poor performance of the stock price, the company’s earnings and capital generation were actually in-line with expectations and its underlying fundamentals remain strong and are expected to improve further in 2019. Lloyds is the largest retail bank in the U.K., commanding a market share of nearly 25% of the consolidated U.K. banking market in which the top four participants control nearly 80% of the market, combined. Additionally, the company’s management team has improved operational efficiency, reduced exposure to more economically sensitive asset classes and built excess capital. For instance, Lloyds’ commercial real estate exposure has fallen to only 3.6% of group loans and its underwriting remains quite conservative, as evidenced by the company’s residential mortgage book, which boasts an average loan to value of 43.5%. Meanwhile, Lloyds has maintained an excess capital position of approximately two billion pounds, despite returning GBP 3.2 billion to investors during 2018. We expect the company to generate an underlying return on tangible capital in the mid-teens for 2018, despite its excess capital position and we believe that additional cost efficiencies could boost underlying returns even further. We estimate Lloyds will report a return on tangible equity of roughly 13% for 2018. However, this metric is being restrained by provisions for the mis-selling of legacy payment protection insurance products. This liability will sunset in August of 2019, and as a result, we believe the company’s reported profitability should improve in both 2019 and 2020.
We recognize that uncertainties surrounding Brexit could create a softer economic environment. To analyze this risk, we have factored in various adverse scenarios to gauge the potential effects on Lloyds’ earnings and its capital, and as a result, we believe that the company will be able to navigate any short-term headwinds because of its strong earnings generation, conservative underwriting and large excess capital position. We estimate conservatively that Lloyds is trading at 5-6x reported 2020 earnings and approximately 0.8x its 2020 tangible book value. This is a highly discounted valuation for a best-in-class financial institution.
Financial industry holdings, such as Lloyds, impaired portfolio return in 2018, and the consumer durables industry, including automobile manufacturers, was another that meaningfully detracted. We continue to believe that the automotive sector is attractively priced and that its business fundamentals are far outperforming share price outcomes. GM is the Fund’s fifth-largest holding, which we purchased long before the company’s late 2016 acquisition of Cruise Automation, its autonomous vehicle unit. In May, Softbank announced a $2.25 billion investment in Cruise to obtain an approximately 20% interest in that subsidiary. Given that GM had only paid $1 billion for this business, the implied increase in value in less than two years was nothing less than extraordinary. But Softbank was not the last to make such an investment. In October, Honda Motor also made an investment in Cruise at a price that implied an even larger valuation of the subsidiary: $14.6 billion. This value exceeds 20% of the total market value of GM, and all this for a business that has yet to produce revenues or earnings. GM now trades around the price as when it went public in 2010 ($33). Since then, the company has cumulatively earned more than $33 per share and paid out nearly $7 per share in dividends. Additionally, management has simplified the product lineup, exited poorly performing international markets and reduced the company’s excess assembly capacity. Critics of the stock will point to economic cycle maturity, tariffs and the long-term threat from autonomous vehicles and ride-sharing. We think these concerns are overstated. By our estimate, nearly 75% of the company’s earnings come from pickup trucks and large sport utility vehicles where GM has a dominant and protected competitive moat. We believe this segment is worth more than the current stock price even before giving credit for Cruise or the company’s valuable China business. Selling at a very modest multiple of 2019 earnings and offering an attractive and well-supported dividend yield, GM remains a particularly compelling investment opportunity, in our view.
We initiated one new position in the quarter and eliminated two holdings. The new addition, Taiwan Semiconductor Manufacturing Company, controls over 50% of the semiconductor foundry market and commands an even greater share in technologies that require advanced process nodes. Foundry is a business with significant barriers to entry due to significant capital requirements, in-depth technological expertise and a customer-centric business model. Taiwan Semiconductor is one of only a few companies that possesses the attributes necessary to lead the industry for the long term. In addition, we think the company’s growth should outpace the overall semiconductor industry due to its greater exposure to quickly expanding end markets, a rapidly growing client base, continued outsourcing activity and impressive market share gains. Furthermore, for the past five years, Taiwan Semiconductor has returned 80% of its excess cash to shareholders through dividend payments. Finally, the company has recently boosted its free cash flow, which management will likely use to reward shareholders further.
We eliminated two holdings, CarMax (U.S.) and Baidu (China), for price reasons and to raise funds to reinvest in more attractive opportunities.
We defensively hedge a portion of the Fund’s exposure to currencies that we believe to be overvalued versus the U.S. dollar. As of quarter end, we found only the Swiss franc to be overvalued and have hedged approximately 26% of the Fund’s franc exposure.
Thank you for being our partners in the Oakmark Global Fund. Please feel free to contact us with your questions or comments.
David G. Herro, CFA
Clyde S. McGregor, CFA
Anthony P. Coniaris, CFA
Jason E. Long, CFA