Pensions & Investments sat down with Sarah Ketterer, co-founder and CEO of Causeway Capital Management, headquartered in Los Angeles. She and her team managed more than $46 billion in international and emerging markets equities as of June 30.
Ms. Ketterer talked about how Causeway as a value investor is outperforming in the higher inflation environment, why China can't be ignored despite a weakening economy, the U.S. dollar's trajectory and what pension funds worry about.
Q: Since your focus is international and emerging, which markets do you see benefiting as a result of central bank rate hikes peaking?
A: We're very much global focused. Our job is to scour the world for great investment opportunities. The situation of monetary tightening is prevalent just about everywhere but China, and the situation in China looks a little fragile.
Q: You're a value investor, a style which is back in favor.
Think of the value investing part of our business as finding stocks where the market has mispriced the securities, where the current price is far lower than fair value or intrinsic value. In any economic downturn, often that means investors will sell off stocks that are economically sensitive. That gives us a chance to buy them at bargain prices or great entry points. So it's not that we want downturns, but if there are downturns, we take advantage of them.
Q: Talk about some of your bigger holdings and what's your investment process?
A: Think of our process fundamentally as entirely bottom-up. So we search the globe for interesting stocks. We use quantitative screens to identify companies likely to outperform, and then do intensive research. We identify those we think have at least a two-year upside potential, risk-adjusted, that's really attractive vs. all the other candidates. The highest risk-adjusted return ranking stocks are the ones most likely to be represented in our mutual funds and institutional portfolios.
The highest-ranking stock we've had over the last couple of years is U.K.-listed aerospace company Rolls-Royce. Rolls' claim to fame is commercial aircraft engines, namely for wide-body aircraft. We bought the stock pre-pandemic during a period when they had an engine that had failures. We liked the CEO at the time, assumed that these companies will overcome their problems, and that both earnings and cash flow would recover.
But instead, what happened was a pandemic, and wide-body, along with all the other aircraft, were grounded. This was absolutely terrible for this company. Not only did they go cash flow negative, but it started to stress the balance sheet. My colleague, Jonathan Eng, who heads up our industrials portfolio management, pushed the company hard to start doing whatever it takes in terms of cost-cutting.
So this is active management, the interaction or the engagement between us and our portfolio companies. All of this led to the chairwoman appointing a new CEO, an individual who's extremely capable. That CEO, we believe, is implementing a plan — now that aircraft are back in the skies — that takes advantage of the cash flow from more engine flying hours, and also negotiate much better contracts with clients, higher pricing, efficiency and cost-cutting that this company really should have had from the start.
That's one reason why the stock keeps delivering. The share price is up over 65% year to date and had a great year last year. Another large holding would be the South Korean consumer electronics and semiconductor company Samsung Electronics. People say, "It's always a cheap stock." Well, it isn't really. It moves within price-to-book value bands, and my colleague Brian Cho heads up our technology portfolio management, is very aware where Samsung is in the cycle. He noticed the semiconductor cycle started to weaken and especially memory, which is Samsung's area of expertise. If you normalize earnings and look at the business over a longer period, especially given demand for memory chips associated with artificial intelligence, this high-bandwidth memory, where Samsung and its peer in South Korea, SK Hynix, have over 85% market share, that's another big driver.
Anyway, none of this was priced into the stock. So I look at Samsung from a low price-to-book basis and then re-rating it to a more normal price-to-book, which is its typical pattern. That gets us a big return.
Q: Explain why it is that higher interest rates or inflation is positive for value.
A: We're not investing in stocks trading at massive multiples. This is not some sort of chasing growth. Value is we are very careful about what we pay, and what we believe is that as interest rates are permanently higher in the cycle, we're going to have positive real interest rates, unlike the situation since the global financial crisis. In fact, for the U.S., we'll have higher short rates than when we began Causeway 22 years ago. All of that means that valuation matters more now.
Think of a stock as the present value. Its share price should be the present value of all the cash you can generate into perpetuity discounted to present. But if the discount rate is near zero, the stock could be worth quite a lot. That stream of cash flow, the longer duration it becomes, the more it's worth.
Now, flip that on its head. Discount rates are rising. So, investors should favor cash today over cash tomorrow, (and) a shorter-duration stock actually looks really appealing. Those are the big dividend payers. The companies are purchasing shares or, in the case of many of our companies, doing both. They're returning a lot of capital to shareholders now, and is now valuable. Now, valuation matters, and it may matter for the next decade. It's hard to say how long rates will remain higher because of the threat of inflation.
Q: What's going on in the U.K.?
A: The U.K. had some terrible inflation problems. My colleague Conor Muldoon, who covers financials and real estate, he's careful to remind us that Brexit was a bad idea, and now we're finally seeing why. If you can't get EU labor into your country, you're not part of the EU any longer, that means they have exacerbated a labor shortage and therefore pushed up wages. That's difficult, sticky inflation to deal with.
So the U.K. could be grappling with this for a while, which means higher rate rises. There are ways to take advantage of that. There are some U.K. banks, like Barclays, that we like, with strong commercial business, good investment banking business. Net interest margins are typically how banks make money, on the spread between what they loan out at and what they have to pay for funds, often what they pay depositors. As long as that gap remains large or gets larger, it's usually good for financial institutions. Given how prominent banks are in a value approach, again, that speaks well to what we do.
Q: What companies do you own in China?
A: Some 15% to 20% of revenues of companies in (our) benchmark are probably in emerging markets, and China's probably a very large portion of that. Especially for European companies, they have a significant exposure to China through their revenues. It's not as if you could just say, "Let China self-immolate." That's not helpful for major trading partners in which we find companies to invest. China's important in that respect.
We have an office in Shanghai. We have six Causeway employees there, five of whom are investment professionals, and their job is to keep looking for opportunities and mispricing. It's a massive market. The China ADRs trading in the U.S. have been sold off since 2001. They've been kicked in the shins over and over again for good reason because the equity risk premium for China's higher. Investors are skeptical, in many cases suspicious, that the Chinese Communist Party doesn't understand the private sector, which is the source of all the prosperity in China. Although now the party is claiming that they welcome foreign investment. Any increase in regulation, what looks like capricious and hard-to-explain clampdown on the private sector really does unnerve investors.
In China, we own a stake in Tencent, which is this world-class social media, gaming, internet phenomenon. It's an incredibly well-managed company with valuable external holdings. They're strong in payments. But we have to accept that valuations may not return for these Chinese companies to where they were in 2001 for a long time because the credibility of the government has dropped.
Q: What is your expectation for the Chinese government's rescue for the real estate sector?
A: It's a necessary rescue, a problem they brought upon themselves; a quarter or more of the Chinese economy is related to real estate. So this is a move of desperation. China may be on the cusp of a liquidity trap, where no matter how they try to stimulate, there won't be any demand for credit or very little. That's hard to know. We saw this in Japan 20 years ago.
Q: Given U.S.-China tensions, what are the geopolitical risks? Does that change the way you've invested?
A: To the degree geopolitical risk can be quantified, we attempt to do so and put that in our China equity risk premium, or think of that as we're willing to pay a lower valuation multiple for China risk, whether that's directly investing in Chinese stocks or maybe even in companies that have large exposure to China, and the capriciousness of regulation makes us concerned. One way or another, we're willing to pay less for the stream of earnings that's connected to China. But that's OK if prices fall further because that just means that the opportunity is still there. It's just at a different and lower valuation.
Now, in the eurozone, Russia's invasion of Ukraine has really lifted not only inflation, but also, it's forced countries to rejigger their supply chains.
Q: Does the war in Ukraine mean higher inflation for longer, and how does that play out in your portfolios?
A: We think of supply chain augmentation, rather than the supply chains are so complicated and so elaborate. Most companies tell us they are adding, attempting to supplement what they already have with, say, additional manufacturing in other countries, especially diversifying out of China. But it'll take years, and it's costly. So yes, if you think about it as an additional operating expense, if it can be passed on, if a company ... For example, let's take a retailer working to augment supply chain and has to add cost. If they can pass it on to their consumers, then it's inflationary in the whole economy. If they don't, it's margin compression. One way or another, it's negative.
Q: Causeway International Value Fund is your flagship, your largest fund. But you also have an emerging markets fund and global value fund. Is there a boom or a significant rally coming in emerging markets?
A: What works for us in emerging markets that's especially effective is the combination of small cap and value. So that's where we've been making a lot of money in emerging markets, and lately, Taiwan has been doing well in small cap. International small cap has been having a tremendous last couple of years and particularly this last year. The factor approach we're using, especially with an emphasis on value, has been very effective. So we're taking advantage of value tailwinds, and then the top-down part of our approach in emerging markets helps inform what we do fundamentally. So if we want to own a Brazilian bank, for example, which we have in both international and global, we get all the Brazilian top-down macro information from our quants. So we use and weigh that along with the other investment data we have.
Q: You're investing in Taiwan. Can you tell me which companies? Are you worried at all about some of the, again, geopolitical risks?
A: Yes. Well, TSMC (Taiwan Semiconductor Manufacturing Co.) would be the largest and the most significant. But yes, you have to be worried. After all, what happened with Russia, I've never in my career seen a significant emerging market go to zero almost overnight. That was pretty shocking.
Q: Now, so what do you foresee might happen in Taiwan?
A: I was trying to skirt the Taiwan issue, but there's no way around! If you invest in emerging markets, you have China at 30% of the benchmark and then Taiwan another 10%. China is not even fully weighted in the MSCI Emerging Markets benchmark. So China will be even more of a force.
We have a what we call paper portfolio — we're testing a portfolio without China. We own more of everything else. But China is the second-largest economy globally. It's a tremendous force when it comes to areas like renewable energy production or equipment. Their social media/internet companies are by far as good or better than ours … I don't think you want to take China out of your portfolio.
Q: What about India?
A: In our quantitative emerging market portfolio, we are exposed to India; it's just an expensive market. India has taken some of China's business. Apple's probably a great example of attempting to diversify there. But again, ultimately, whether it be our emerging market strategy, our international, our global, our small-cap, whatever the strategy, at Causeway, we care about the price we pay. That's why India makes me a little bit concerned.
To the degree the growth continues, investors will be very willing to pay up. But think about valuation multiples as a risk spectrum. Now, this used to be heretical, but I can say it now. The higher the multiple, the more risk. The lower the multiple, the less risk, because low multiples usually don't go lower unless something's really wrong. That's where good research and due diligence helps. That might be India. Just very, very high expectations.
Q: Your funds' outperformance has been stellar. Consumer staples have helped?
A: We're pretty concentrated. We keep somewhere between 50 and 60 stocks or thereabouts in those portfolios. It just takes a few to make a big difference. We have stocks like UniCredit with their massive return of capital to shareholders and re-rating from a pitifully low price-to-book value to something that's more reasonable, or Rolls-Royce that is delivering structural improvements on top of the cyclical from what was a valuation that made no sense to us, or the Samsungs or the whole array of other stocks, including consumer you brought up earlier. We have more staples in the portfolio than we've had in the last decade.
There are interesting companies mispriced, like Reckitt Benckiser, household personal goods and other consumer products based in the U.K., operating globally, or Danone, based in France.
InBev (Anheuser-Busch InBev) has got all kinds of PR problems. But these are great companies that deliver what we call quality cash flow, meaning it's consistent and not cyclical. There's an opportunity for us to buy these now because consumer staples have been big underperformers in the last 12 months. Investors have wanted tech, communication service, discretionary. They've not been that interested in staples, which is odd because typically staples do well on the cusp of a recession
Q: What about that recession?
A: We don't see how the yield curve could be so significantly inverted everywhere, again, barring China, and we have such monetary tightening and money supply, and M2 (money supply) shrinking. All of that is pretty severe stuff and usually leads to economic slowing, just but with a lag. We're waiting. Maybe first half of 2024, we get maybe two quarters of negative growth.
Q: What are pension funds worried about?
A: The uncertainty about the economic environment ahead. I have no doubt geopolitics weigh into that because the U.S.-China relationship is unnerving many. They've all got emerging market allocations with a big chunk of that in China, and they know what I've been saying earlier, that the rest of their portfolio isn't immune. Next order of worry: What if we can't as a society endure a reset, any type of recession? What if we're just politically incapable of doing that? Then we might end up in an environment where we get more financial rescues, but they do end up being inflationary. That could be very problematic.
Our clients are some of the largest institutions globally and with an emphasis on U.S. They've got very long-term liabilities, and with rates rising, many of them have decided to increase their allocations to fixed income and use equity as a source of funding. At Causeway we've outperformed so significantly over the last two years. So they happily take it from us.
Q: That brings us to your trajectory for the U.S. dollar. Many countries now buy oil and gas in their local currencies.
A: We're not currency experts. However, the dollar has backed off from its tremendous strength exhibited last year. Ultimately, the driver will be real interest rate differentials and real growth differentials. Even if the U.S. has an economic setback, it looks well-placed to continue to grow in a rate-competitive world, if not better than many of the other developed world countries, and all that speaks to a stable dollar. The currency that could be a bit of a wild card is the Chinese yuan. I keep coming back to China. They're just on their own cycle, and it's a closed capital account. So that currency is managed. But I and our team believes there's a lot of downward pressure on it right now.
Q: Why is that?
A: Because the economy is so weak. Think about real growth differentials. Theirs is slow, maybe slower than they're admitting, and they probably can't afford to raise rates. That's analogous again to Japan, the Japanese Central Bank. The Bank of Japan's very uncomfortable with removing their yield curve control. They want their 10-year at zero. They actually would like to have some inflation for the first time in two decades. China could be in a situation where they can't actually raise rates either. It would be too much of a decelerant for their economy. So if you can't raise rates and your economy's slowing, your currency isn't worth as much.
Q: What does that mean for the euro?
A: Well, the eurozone is fragile. The eurozone forever and always will grapple with the fact that its constituents, its members grow at different economic speeds. But the companies there that we're investing in are doing business globally. So we're not as concerned if the eurozone can just keep from falling apart.
