Lazard International Strategic Equity Portfolio Q2 2024 Commentary

Market Overview

After a strong six-month rally, international equity markets were broadly flat in the second quarter.

• While corporate profits were generally better than expected, investors focused more on short term macro and political concerns
• Japan underperformed in dollar terms as local market performance was overwhelmed by continued yen weakness
• Emerging Markets outperformed developed markets, both in the quarter, and now year to date, led by China which rose 7.1%
• The European Central bank lowered their policy rate 25 basis points (bps), ahead of the US Federal Reserve

International equities digested some of their recent gains in the second quarter. The MSCI EAFE Index fell 0.4% while the MSCI ACW ex-US Index rose 1.0%. Consensus estimates for 2024 and 2025 earnings rose modestly through the second quarter earnings season as companies, on balance, reported better-than-expected results. While corporate earnings for developed markets are only expected to grow 4% in 2024, that growth rate is expected to accelerate to 9% next year.

Despite the fact that the Bank of Japan raised short term interest rates for the first time in 17 years in March, the yen fell more than 6% during the second quarter, bringing the year-to-date loss for the currency to over 14%. While local Japanese returns have been strong due to rising inflation and improving corporate governance, USD returns have been negatively impacted by the currency weakness.

As the market shifted away from Japan, emerging markets outperformed developed markets the most in a quarter since 2016. Chinese equities led the way rising 7.1% in the quarter, due to continued government stimulus and dramatically lowered market expectations already reflected in valuations.

With inflation subsiding, the European Central Bank pivoted and cut rates 25 basis points this quarter. While future rate cuts are still a debate in the market, the central bank has signaled that the aggressive rate hiking cycle is over, which should provide increased confidence for investors. As the US Fed continues to push out rate cuts, the ECB is leading the rate cutting cycle for the first time in 25 years.

Portfolio Review

We have been talking about how the extreme environment, led by either expensive growth or low quality, should transition to a more fundamentally-driven market benefitting our portfolio. This was certainly the case for the six-month period of fourth quarter 2023 and first quarter 2024. However, the current short- term focus of the market on elections and central bank policy decisions has led investors to simply rely on what has worked in the recent past as opposed to focusing on the quality of the business and its long-term earnings power. Stocks with high price momentum, have been, by far, the largest driver of performance in international equity markets this year. The spread in performance between the MSCI EAFE Momentum Index (which aims to reflect performance of stocks with high price performance over the past twelve months) and the MSCI EAFE Index is the largest in 20 years, outside the extreme COVID rally in 2020. This has led the larger stocks in the MSCI EAFE Index to outperform which, in turn, has led to a nearly 5% spread in YTD performance between the MSCI EAFE index and the MSCI EAFE Equal Weighted index -the largest spread in more than 20 years. We strongly believe this is unsustainable and the average stock should close the gap with the Index going forward.

In the second quarter, Lazard International Strategic Equity Portfolio (MUTF:LISIX) fell 3.2%, underperforming the 0.4% depreciation of its benchmark, MSCI EAFE. (Portfolio return is measured net of fees and in US dollar terms.)

We still believe the international equity market continues to be driven by fundamentals as opposed to style, which should be supportive for our relative value strategy over the medium to long term. However, during the second quarter, the market has been more focused on short term concerns like elections and lingering pandemic-driven supply chain issues, rather than the long-term earnings power of great businesses.

We have substantial weights in many of these great companies but still have room to add when companies indicate the short-term pressures have lifted and normal order patterns have resumed. For instance, AON and Ryanair (RYAAY), two long-term holdings in the portfolio, have experienced some short-term pressures due to slower than expected growth. While we have not added to these compounders on the pullbacks yet, we are watching for the turn and hope to add when the fundamentals reaccelerate. Accenture is another long-term high-quality compounder that has experienced short-term cyclical pressure. In their recent quarterly report, they indicated that order growth has resumed and their book to bill metric had improved, and as a result, we added to our position.

We have added capital to some companies we view as mispriced where the short-term view is weighing on their valuation and where we expect that short-term pressure to dissipate, enabling the valuation to lift. One example is the Italian bank, UniCredit (OTCPK:UNCFF), which is generating significant excess capital and returning it to shareholders through significant stock buybacks.

We have trimmed some compounders where valuations have become more stretched, such as RELX.

Positives

While some of our industrial holdings such as Ryanair, which is discussed below, declined on short term pressure, others performed well, helping offset underperformance in the sector. Shares of ABB (ABBNY, 2.2% weighting) rose after the Switzerland-based industrial-technology company reported better-than-expected first-quarter results, highlighted by orders that came in 3% ahead of consensus expectations and full-year guidance that was maintained for +5% organic revenue growth. Margins continued to improve under the direction of ABB’s CEO, who was appointed mid-2020. We trimmed the Portfolio’s position.

Shares of RELX (3.3% weighting) rose after the US-based information and analytics provider reported better-than-expected first- quarter results and maintained its full year guidance. Management referenced the improving growth trajectory for their business long term as analytics software tools grow in the mix. These results are supportive of our investment thesis, which is predicated on data and analytics driving sustainable organic growth acceleration as RELX shifts towards these higher ‘value add’ analytics products, and away from print and low growth reference products. Additionally, we believe generative AI will drive further product innovation and support continued mix shift. RELX’s analytics products are embedded at key decision points in the workAow, which makes the business highly recurring and enables strong pricing power. RELX is the number one or two player in all of its markets, with strong barriers to entry and scale economics. Highly recurring, mid-high single-digit organic growth, operating leverage, and limited capital requirements drive high financial productivity. We trimmed our position.

Stock selection in the information technology sector positively contributed to relative returns.

Domiciled in Japan, Advantest (OTCPK:ATEYY, 0.9% weighting) is the leading supplier of semiconductor testing equipment globally. Testing is an important step in the semiconductor manufacturing process that helps ensure reliable operation of the end-device as per design specifications. Recent share price weakness on the back of concerns regarding smartphone volume recovery gave us the opportunity to buy the market leader in semiconductor testing equipment (high share defensibility) with high exposure to the fast-growing high-performance compute segment. Medium term, the company should benefit from the structural growth of AI and an improving returns profile over the coming years. After holding the stock for just over a year and +100% gains we sold the name in February as its valuation reached our target. More recently, we took advantage of the roughly 30% share price pullback since we sold and re- initiated a position. On a c. 23x forward PE for c. 30%+ earnings compound annual growth rate (‘cagr’) over the next 3 years and double-digit topline growth over the cycle, we still see attractive relative value and the stock has risen over 25% since reinitiating the position.

Shares of Taiwan Semiconductor Manufacturing Company (TSM, 1.0% weighting) rose after the Taiwan-based contract chipmaker reported better-than-expected first-quarter results and management reiterated its growth expectation. Lack of inventory- related commentary indicated how far the industry is moving past the previous downturn and artificial intelligence continued to be an important growth driver. We trimmed the Portfolio’s position after a period of strong performance.

Negatives

High conviction companies where market was focused on short term: Shares of Aon (2.4% weighting) declined after the Ireland-based global Insurance broker reported first-quarter results that saw organic growth came in below consensus expectations. Long term, we believe our investment thesis remains intact. As a broker and an asset-light company in a fairly consolidated industry, Aon generates strong returns on capital which we believe will be sustained due to strong pricing power (particularly in its insurance brokerage business) and cash flow generation and may benefit from margin expansion opportunities longer term as it digests the acquisition of middle market property and casualty broker. We maintained our position.

Based in Italy, BFF Bank (1.0% weighting) is a specialty finance firm whose business model and risk profile, we believe, are misunderstood by the market. To the casual observer, BFF looks, and trades like, an Italian Bank when in reality, BFF operates as the scale player in a niche market with attractive organic growth potential. BFF primarily undertakes non-recourse financing for the pharmaceutical companies who do not have the patience to pursue collection of receivables from their public creditors. It has very low credit risk as the company’s main borrowers are primarily governments. BFF has a competitive edge on acquiring receivables attributable to its long history of relationships with customers, broad network and its ability to claim recovery costs (BFF fought at the court for five years in order to obtain its right to charge late payment fees to the government, which no other competitor has the ability to do). Recently, shares have underperformed on news that dividend distributions were being halted by the Bank of Italy.

Following this regulatory change, we met with the company and remain convinced our investment thesis remains intact. BFF remains a high-quality business that is able to generate lots of capital for shareholders that has underperformed on fears that regulatory changes will lead to lower returns that are misunderstood by the market. We took advantage of this pullback to add to our position.

Ireland-based discount airline operator Ryanair (1.9% weighting) saw its stock price fall on lower fare growth assumptions for the first half of 2025, which in part, is due to the timing of Easter, and slightly higher non-fuel cost inflation driven by Boeing delays. Overall, we believe Ryanair can continue to grow earnings per share (‘EPS’) well into the double digits and is long-term an attractive business to own as the low-cost intra-European airline that continues to gain share.

Quality compounder facing short-term cyclical pressures: Domiciled in Ireland, Accenture (ACN, 2.2% weighting) is one of the highest quality IT services companies benefitting from the global transformation of digital infrastructure. They continue to lead customers through digital disruption taking place in all industries and this differentiation coupled with their unique vertical capabilities are enabling strong growth and market share gains. Cost discipline, gained through leverage in winning a bigger share of existing customers wallets, which requires less expense for Accenture than seeking out new business, and pricing power in digital offerings enables margin expansion and cash flow growth. Strong and consistent cash flow has enabled a robust capital allocation framework built on opportunistic acquisitions in addition to dividends, buybacks and reinvestment in the business are all driving strong double digit eps growth. Shares have underperformed on near-term industry softness however recent results highlight book to bill has turned and we believe IT spending should improve as we move through the year and remain optimistic on the structural growth of the industry.

2024Q2 Portfolio Trade Rationales

Buys

Domiciled in Japan, Advantest (1.0% weighting) is the leading supplier of semiconductor testing equipment globally. Testing is an important step in the semiconductor manufacturing process that helps ensure reliable operation of the end-device as per design specifications. Companies designing the semiconductor device (fabless/IDMs) decide on the test methods, configurations, test policy and electrical specifications of the end device. Semiconductor manufacturers (foundries) then purchase the testing equipment based on the recommendations from IDMs and fabless design companies. Testing equipment demand is a function of semiconductor capacity and chip complexity. As such, the testing industry has seen growth substantially improve in recent years driven by four key factors: 1) Data compression and parallel testing have reached their productivity limit as miniaturization improvements have significantly increased the number of transistors on each chip that need to be tested, 2)The adoption of advanced packaging techniques also increases testing intensity, 3) Stringent quality (zero-defect) and power requirements for auto and industrial semiconductors should support demand growth as should the trend towards shorter R&D cycles and the introduction of new chip architectures, and lastly, 4) Testers are no longer viewed as a cost burden, but rather as a tool to improve development time and time to market. Advantest, with a 55% market share, is a duopoly in the testing market (with Teradyne).

Margins are high and sustainable driven by their market position, scale, and technology leadership. Product development and SG&A costs do not scale with revenue. Given the low capital expenditure needs, free cash Aow conversion is high. Recent share price weakness on the back of concerns regarding smartphone volume recovery gave us the opportunity to buy the market leader in semiconductor testing equipment (high share defensibility) with high exposure to the fast-growing high-performance compute segment. Medium term the company should benefit from the structural growth of AI and an improving returns profile over the coming years. After holding the stock for just over a year and +100% gains we sold the name in February as the stock reached our valuation target. More recently, we took advantage of the roughly 30% share price pullback since we sold and re-initiated a position. On a c. 23x forward PE for c. 30%+ earnings CAGR over the next 3 years and double-digit topline growth over the cycle, we still see attractive relative value.

Domiciled in Germany, Infineon (OTCQX:IFNNY. 0.6% weighting) is a leader in the structurally growing semiconductor market with a focus on the automotive industry. Infineon is well positioned in power-semis providing a good long-term investment on increasing electrification of autos. The auto semiconductor industry is differentiated from consumer technology/smartphones by longer product cycles, larger barriers to entry and long-term structural content growth supported by legislation around emissions. A power semiconductor is used wherever electrical power is generated, transmitted, or used. They manage the flow and amount of power going into a system in order to make that system more efficient. With today’s focus for higher energy efficient solutions across applications, demand is high and growing and the business is less cyclical. Auto semis are a major growth driver as the shift to EV drives increasing semi content per car. On average, a battery electric vehicle contains up to 4x higher semi content compared to an internal combustion engine car. The transition to EVs is a large driver of demand for chips that go into EV inverters (where Infineon has the leading market share). Semi chip makers have been adding incremental capacity to cater to this higher demand. Securing stable, long-term chip supply is among the top priorities for leading car OEMs – this is driving capacity reservation agreements/long-term supply agreements between OEMs and chip makers, which has improved both volume and pricing visibility for auto semi manufacturers. After a recent meeting with management, de-risked guidance, and increased focus on their AI server power solutions, we re-initiated a position in this quality asset trading on a 16x 2025 PE and a 15% ROE.

Mitsubishi Electric (OTCPK:MIELY, 1.1% weighting) is a Japanese industrial conglomerate comprised of a wide range of business units, including HVAC, automotive, factory automation (‘FA’), building systems, and infrastructure among others. Of all Japanese conglomerates, Mitsubishi Electric has historically been the most reluctant to reform corporate governance practices, with no desire to focus their portfolio, and a lack of attention to margins and financial productivity. This all changed in the last couple of years. The current CEO and CFO are intent on improving the business and we believe they have potential to do so with solid underlying assets in Factory Automation and HVAC as a foundation, which combined equate to more than 50% of operating profit. Management has been meeting with shareholders regularly and hearing investor concerns. Our thesis is centered on management restructuring the company, meaningful asset disposal, a focus on higher quality business units with improved margins and using excess cash to fund share buybacks. They have expressed goals of improving pricing strategy (especially in regard to their pricing of custom work), being more selective on order intake, and being more selective on the businesses they own (even within areas like FA which are relatively high performing already). We believe the introduction of ROIC as a KPI to measure top management and business unit heads is a further sign that management wants to improve. Attractively valued with an estimated 15% 2026 ROIC (from 6% in 2023) for a 13x 2026 PE, and a net cash balance sheet we initiated a position.

National Grid (NGG, 0.2% weighting) is a UK-based utility company. National Grid has historically traded at a comfortable premium to their RAB (regulatory asset base) driven by stable regulation in both the UK and the US and the market’s belief that they can beat the regulated return while growing their asset base. The growth in National Grid’s asset base is set to grow significantly going forward, driven by the need to put capital into the ground to protect an ageing grid, and at the same growing renewable connections and delivering on large scale projects that increase the grid connectivity. National Grid’s recent equity raise was done at a time with high regulatory uncertainty, with the UK election one month away and a regulatory review in the UK right around the corner. National Grid used this equity raise to be fully funded in advance of the regulatory decision on the UK Electricity Transmission regulated returns. This allows them to engage with the regulator demonstrating they have the capital available to do the large step up in investments that they target and that they need an adequate return to do so. Ofgem, the regulator, is traditionally a sensible regulatory body that is viewed as best in class globally and so our expectation is that the regulatory review comes out rationally. However, should this not be the outcome, National Grid can demand a review by the Competition & Markets Authority (‘CMA’) into the regulatory allowed returns if they are not deemed adequate. This offers a backstop of protection to the potential that the regulator would want to leave investors short changed while ultimately National Grid can choose to invest into the US instead. Going early in raising capital and increasing their capex budget allows National Grid to get ahead on the global race for suppliers. The second point is that we are one month away from a General Election in the UK with the current premise that the government will change from Conservatives to Labor. There is little to suggest that the Labor party has any plans to change the current regulatory set up, but the market wants to question why raise equity ahead of this rather than letting things settle first. All of this combines to create a level of uncertainty to depress the share price to a suitable entry point. We took this as an opportunity to buy a utility that is fully funded to 2031 with a step up in capex to drive around 10% per year RAB growth in an environment that wants to use more electricity on an ageing grid.

Sells

We exited our position in National Bank of Canada (OTCPK:NTIOF) following the company’s acquisition of CWB which put into question their capital discipline and broke our investment thesis. Tokyo Electron (OTCPK:TOELY) is a Japanese semiconductor equipment manufacturer (semicap). We exited our position after a period of strong performance in order to allocate capital to other relative value ideas.

Major Transactions & Current Strategy

Buys

Domiciled in Japan, Advantest (1.0% weighting) is the leading supplier of semiconductor testing equipment globally. Testing is an important step in the semiconductor manufacturing process that helps ensure reliable operation of the end-device as per design specifications. Companies designing the semiconductor device (fabless/IDMs) decide on the test methods, configurations, test policy and electrical specifications of the end device. Semiconductor manufacturers (foundries) then purchase the testing equipment based on the recommendations from IDMs and fabless design companies. Testing equipment demand is a function of semiconductor capacity and chip complexity. As such, the testing industry has seen growth substantially improve in recent years driven by four key factors: 1) Data compression and parallel testing have reached their productivity limit as miniaturization improvements have significantly increased the number of transistors on each chip that need to be tested, 2)The adoption of advanced packaging techniques also increases testing intensity, 3) Stringent quality (zero-defect) and power requirements for auto and industrial semiconductors should support demand growth as should the trend towards shorter R&D cycles and the introduction of new chip architectures, and lastly, 4) Testers are no longer viewed as a cost burden, but rather as a tool to improve development time and time to market. Advantest, with a 55% market share, is a duopoly in the testing market (with Teradyne).

Margins are high and sustainable driven by their market position, scale, and technology leadership. Product development and SG&A costs do not scale with revenue. Given the low capital expenditure needs, free cash Aow conversion is high. Recent share price weakness on the back of concerns regarding smartphone volume recovery gave us the opportunity to buy the market leader in semiconductor testing equipment (high share defensibility) with high exposure to the fast-growing high-performance compute segment. Medium term the company should benefit from the structural growth of AI and an improving returns profile over the coming years. After holding the stock for just over a year and +100% gains we sold the name in February as the stock reached our valuation target. More recently, we took advantage of the roughly 30% share price pullback since we sold and re-initiated a position. On a c. 23x forward PE for c. 30%+ earnings CAGR over the next 3 years and double-digit topline growth over the cycle, we still see attractive relative value.

Domiciled in Germany, Infineon (0.6% weighting) is a leader in the structurally growing semiconductor market with a focus on the automotive industry. Infineon is well positioned in power-semis providing a good long-term investment on increasing electrification of autos. The auto semiconductor industry is diPerentiated from consumer technology/smartphones by longer product cycles, larger barriers to entry and long-term structural content growth supported by legislation around emissions. A power semiconductor is used wherever electrical power is generated, transmitted, or used. They manage the Aow and amount of power going into a system in order to make that system more efficient. With today’s focus for higher energy efficient solutions across applications, demand is high and growing and the business is less cyclical. Auto semis are a major growth driver as the shift to EV drives increasing semi content per car. On average, a battery electric vehicle contains up to 4x higher semi content compared to an internal combustion engine car. The transition to EVs is a large driver of demand for chips that go into EV inverters (where Infineon has the leading market share). Semi chip makers have been adding incremental capacity to cater to this higher demand. Securing stable, long-term chip supply is among the top priorities for leading car OEMs – this is driving capacity reservation agreements/long-term supply agreements between OEMs and chip makers, which has improved both volume and pricing visibility for auto semi manufacturers. After a recent meeting with management, de-risked guidance, and increased focus on their AI server power solutions, we re-initiated a position in this quality asset trading on a 16x 2025 PE and a 15% ROE.

Mitsubishi Electric (1.1% weighting) is a Japanese industrial conglomerate comprised of a wide range of business units, including HVAC, automotive, factory automation (‘FA’), building systems, and infrastructure among others. Of all Japanese conglomerates, Mitsubishi Electric has historically been the most reluctant to reform corporate governance practices, with no desire to focus their portfolio, and a lack of attention to margins and financial productivity. This all changed in the last couple of years. The current CEO and CFO are intent on improving the business and we believe they have potential to do so with solid underlying assets in Factory Automation and HVAC as a foundation, which combined equate to more than 50% of operating profit. Management has been meeting with shareholders regularly and hearing investor concerns. Our thesis is centered on management restructuring the company, meaningful asset disposal, a focus on higher quality business units with improved margins and using excess cash to fund share buybacks. They have expressed goals of improving pricing strategy (especially in regard to their pricing of custom work), being more selective on order intake, and being more selective on the businesses they own (even within areas like FA which are relatively high performing already). We believe the introduction of ROIC as a KPI to measure top management and business unit heads is a further sign that management wants to improve. Attractively valued with an estimated 15% 2026 ROIC (from 6% in 2023) for a 13x 2026 PE, and a net cash balance sheet we initiated a position.

National Grid (0.2% weighting) is a UK-based utility company. National Grid has historically traded at a comfortable premium to their RAB (regulatory asset base) driven by stable regulation in both the UK and the US and the market’s belief that they can beat the regulated return while growing their asset base. The growth in National Grid’s asset base is set to grow significantly going forward, driven by the need to put capital into the ground to protect an ageing grid, and at the same growing renewable connections and delivering on large scale projects that increase the grid connectivity. National Grid’s recent equity raise was done at a time with high regulatory uncertainty, with the UK election one month away and a regulatory review in the UK right around the corner. National Grid used this equity raise to be fully funded in advance of the regulatory decision on the UK Electricity Transmission regulated returns. This allows them to engage with the regulator demonstrating they have the capital available to do the large step up in investments that they target and that they need an adequate return to do so. Ofgem, the regulator, is traditionally a sensible regulatory body that is viewed as best in class globally and so our expectation is that the regulatory review comes out rationally. However, should this not be the outcome, National Grid can demand a review by the Competition & Markets Authority (‘CMA’) into the regulatory allowed returns if they are not deemed adequate. This oPers a backstop of protection to the potential that the regulator would want to leave investors short changed while ultimately National Grid can choose to invest into the US instead. Going early in raising capital and increasing their capex budget allows National Grid to get ahead on the global race for suppliers. The second point is that we are one month away from a General Election in the UK with the current premise that the government will change from Conservatives to Labor. There is little to suggest that the Labor party has any plans to change the current regulatory set up, but the market wants to question why raise equity ahead of this rather than letting things settle first. All of this combines to create a level of uncertainty to depress the share price to a suitable entry point. We took this as an opportunity to buy a utility that is fully funded to 2031 with a step up in capex to drive around 10% per year RAB growth in an environment that wants to use more electricity on an ageing grid.

Sells

We exited our position in National Bank of Canada following the company’s acquisition of CWB which put into question their capital discipline and broke our investment thesis. Tokyo Electron is a Japanese semiconductor equipment manufacturer (semicap). We exited our position after a period of strong performance in order to allocate capital to other relative value ideas.

Outlook

• ECB rate policy could provide the bump quality cyclicals need
• Geopolitical risk shifts from international to US
• International valuations remain near all-time lows compared to the US
• As international risks subside, investors should shift focus to deeply discounted valuations and longer-term earnings power

Style extremes have eased over the past year but more recently investors have been too focused on short-term issues and less willing to recognize the attractive valuation and earnings power of some high-quality cyclicals. As a result, the market has become more narrowly focused on simply what has worked in the recent past driving the price momentum factor to extreme levels. We think this will change.

Global economic growth is low, but positive. Interest rates, which are at a more normal level than they were during the pandemic, are broadly stable to heading lower, not higher. And in this environment, we have been able to find many great investments across the three alpha buckets of compounders, mispriced, and restructuring stories. Compounders have generally done well but some cyclicals have lagged due to the market’s focus on short-term concerns. We believe these companies can, and will, perform better as investors shift their focus away from short term noise. As the ECB has already begun to lower rates, and international elections are behind us, we believe many of these mispriced international equities with deeply discounted valuations and significantly higher earnings power can outperform.

We believe our portfolio is well-balanced for the different market outcomes. Having this balance should enable stock selection to drive performance. We still expect that outperforming stocks will broadly come from companies with strong pricing power, companies that can deliver in-line or better than expected margins and companies with less levered balance sheets. And the extremely discounted valuations for international stocks should provide support for international equities going forward.

Click to enlarge

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.