International Active Update
Second Quarter 2014
The International Active EAFE Strategy underperformed the MSCI EAFE index by 1.1 percentage points in the second
quarter; the strategy gained 3.0% net of fees and the benchmark rose 4.1%. Country and stock selection were both
negative. The strategy lagged its benchmark by 2.9 percentage points for the first half of 2014, returning +1.9%.
Performance (Year by Year %)
GMO International Active Performance
(Through J une 30, 2014)
1981 (Jun-Dec) +5.8 -1.0 +6.8 -4.6 +2.0
1982 +2.4 -1.9 +4.3 +20.3 +42.5
1983 +32.1 +23.7 +8.4 +22.6 +6.3
1984 +8.7 +7.4 +1.3 +6.3 +16.9
1985 +65.1 +56.2 +8.9 +31.8 +30.1
1986 +57.4 +69.4 -12.0 +18.7 +19.8
1987 +9.7 +24.6 -14.9 +5.3 -0.2
1988 +21.2 +28.3 -7.1 +16.6 +10.7
1989 +27.4 +10.5 +16.9 +31.7 +16.2
1990 -10.7 -23.4 +12.7 -3.1 +6.8
1991 +13.9 +12.1 +1.8 +30.5 +19.9
1992 -4.0 -12.2 +8.2 +7.6 +9.4
1993 +41.2 +32.6 +8.6 +10.1 +13.2
1994 +5.9 +7.8 -1.9 +1.3 -5.7
1995 +13.8 +11.2 +2.6 +37.6 +27.2
1996 +14.6 +6.0 +8.6 +23.0 +1.4
1997 +6.8 +1.8 +5.0 +33.4 +13.0
1998 +13.9 +20.0 -6.1 +28.6 +10.8
1999 +28.6 +27.0 +1.6 +21.0 -7.4
2000 -6.5 -14.2 +7.7 -9.1 +12.9
2001 -10.1 -21.4 +11.3 -11.9 +10.6
2002 -6.1 -15.9 +9.8 -22.1 +16.3
2003 +41.4 +38.6 +2.8 +28.7 +5.3
2004 +22.4 +20.2 +2.1 +10.9 +7.9
2005 +13.5 +13.5 -0.0 +4.9 +5.9
2006 +27.6 +26.3 +1.2 +15.8 +3.2
2007 +10.5 +11.2 -0.6 +5.5 +2.6
2008 -41.2 -43.4 +2.1 -37.0 +8.8
2009 +25.5 +31.8 -6.2 +26.5 +3.0
2010 +5.0 +7.8 -2.7 +15.1 +12.4
2011 -11.7 -12.1 +0.5 +2.1 +18.0
2012 +14.9 +17.3 -2.4 +16.0 +10.7
2013 +24.1 +22.8 +1.3 +32.4 -7.1
YTD 2014 +1.9 +4.8 -2.9 +7.1 +9.6
+12.1 +9.3 +2.8 +11.4 +10.2
Int'l Active
GMO Bonds
Compound Annual Rate of Return (33 Years, 1 Month)
Value Added
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
International Active Update
Second Quarter 2014
Region Commentary
The J apanese banking system was at the center of one
of the most famous equity and real estate bubbles in
history. After peaking in 1989, the ensuing collapse
saw land prices drop 87% and drove the banking system
to virtual insolvency. We would argue that 25 years of
asset deflation and de-levering has culminated in a new
bubble of pessimism, making J apanese banks among the
cheapest in the world. During the grinding deflation, the
market worried about a deluge of bad loans, but today
the banks have strong balance sheets dominated by stable
but low yielding assets. Given the flat yield curve and
correspondingly compressed net interest margins, any
increase in interest rates should have a powerful effect on
the bottom line.
We believe the Bank of J apan’s (BoJ ) extraordinary
monetary policy has artificially and temporarily suppressed
the J apanese yield curve, impairing the normal pricing of
credit in the economy. The path to recovery for BoJ
Chairman Kuroda remains through negative real rates,
nominal rates that are lower than changes in CPI, intended
to spur consumption and investment. With the CPI rising
at 1.5%, Kuroda appears to be winning, but negative real
rates are hard to maintain in the long run as lenders should
eventually demand a risk premium. If one applies a pre-
quantitative easing yield curve to the present loan book,
the impact of higher rates on earnings is substantial.
We think downside risk is limited. There are two key
features of loan books in J apan; high composition of short
duration assets and low contracted loan rates. Over 80%
of outstanding loans mature in less than one year and are
contracted at just 82 basis points. Banks have been hit
by a rapid decrease in net interest income as contracted
loan rates continue to fall with competitors undercutting
each other and borrowers rolling their loans to lower
rates. Recently, the Tokyo Interbank Bank Offer Rate,
a reference rate used for pricing a majority of short-term
loans, stabilized at 13 basis points, which we believe
signals a bottom. With the BoJ offering 10 basis points
for excess reserves, rate compression must decelerate as
almost all of the limited spread has already been squeezed
We believe potential for upside is significant. Sustained
inflation creates two avenues for banks to improve
earnings. The first is through the loan book. If
inflationary expectations increase, short-term rates will
rise and borrowers will extend their loans into longer
dated maturities at higher interest rates. These repriced
loans will increase bank margins and profitability quickly
because of the short maturities of the majority of bank
assets. Something similar happened from 2003 to 2006,
when the Topix Bank index quadrupled due to a steeper
yield curve and stronger net interest margins. The second
way for banks to improve earnings is by moving excess
deposits out of cash into higher-returning, long-duration
assets. J apan has ¥220tn excess savings, almost half of
GDP; in periods of deflation, cash is rewarded by sitting
still, but inflation compels savings to seek a return in
riskier assets. Banks are the conduit for this rebalance.
They can earn fee income on transactions and movement
from cash into other assets while at the same time their
balance sheets become more efficient by the removal of
excess deposits.
Our position on J apanese banks is based upon the macro
event of credit normalization on the back of a steepening
yield curve. To capture that factor, our holdings are
concentrated in three banks. SMFG gives us exposure
to credit growth in small- and medium-sized enterprises
where interest rate rises are traditionally passed smoothly
onto the borrower and are highly earnings accretive.
MUFJ provides exposure to overseas loan growth via
ownership of Union Bank and holdings in Morgan Stanley.
Both banks are well capitalized, providing a strong margin
of safety and increased capacity for delivering shareholder
value back in the form of dividends or buybacks. Lastly,
we own Resona Bank, a regional mortgage lender that
still bears the scars of the bubble and is on an accelerated
track to finish paying back the ¥2.1trn of government
money injected in 2003. Resona provides a tangible
demonstration of a deflationary mindset: 85% of all
mortgages are contracted at variable rates. Should rates
rise and inflationary expectations take hold, we would
expect a dramatic shift in higher margin fixed rates.
Furthermore, Resona is a purely domestic lender and
is required to hold less capital on the balance sheet and
therefore enjoys higher ROE than the other banks. With
the company on track to return government capital, we
expect management to initiate shareholder return policies
that get reflected in higher multiples.
International Active Update
Second Quarter 2014
Country Selection and Market Update
Country selection was 0.4 percentage points behind
the benchmark. Our positioning in Continental Europe
subtracted from returns, particularly overweight positions
in Italy and France, which underperformed in the quarter.
While the European news in the quarter was again
dominated by Putin and the Ukraine, the region saw signs
of economic stabilization. It appears that the economies
have, for the most part, stabilized at a lower level. While
consumer sentiment was up, it was not reflected in
earnings, in part due to the strong euro and weak emerging
market currencies.
In the United States, markets struggled to find direction
as investors assessed the pace of Fed tapering and the
potential for rising interest rates. Investors continue to
brace for the prospect of higher interest rates and oil
prices, while waiting for growth to accelerate. Valuation
levels are elevated but not to excessive levels, given high
levels of cash generation, balance sheet capacity, and
corporate profitability.
After a tough start to the quarter, the J apanese market
turned around. Abe came back with more credibility on
his third arrow and worries around the consumption tax
increase seem to be quelled as it was less punitive than
expected. Elsewhere in Asia the noteworthy events of
the past quarter were largely political. The BJ P victory
in the May Indian election appears to be a strong vote for
economic change in the form of reviving infrastructure
investment, scaling back government subsidies, and
improving the fiscal deficit. In less democratic fashion,
the Thai Military declared martial law in May in an
apparent attempt to calm political tension between the
ruling government and its critics.
We continue to focus on individual companies and their
valuations. We still find interesting pockets of value such
as the position in J apanese banks discussed above. We
are also seeing opportunity in European energy companies
that are not only attractive on valuations, but are beginning
to displaying greater capital discipline which, in turn,
should lead to material improvements in free cash flow
Data is that of a representative account from within the Composite.
Stock Selection
Stock selection lagged the benchmark by 0.7 percentage
points in the second quarter. Holdings in the United
Kingdom and Japan underperformed. On the positive side,
stock selection in Continental Europe helped returns.
In the United Kingdom, Travis Perkins and Domino
Print Sciences hurt performance. In the case of
builders merchant Travis Perkins, the market appears
fearful that because of the speed of the U.K. economic
recovery, interest rate rises are imminent and this could
temper the strong rebound being witnessed in the U.K.
housing market. On these concerns Travis has been
de-rated, however, we think the market has misread
the cycle and underestimates the recovery potential
in the markets Travis serves given the collapse in
U.K. housing transactions during the recession. U.K.
mortgage approvals, for example, are currently running
at 61,707 a month compared to a sustainable level
(given U.K. demographics) of 110,000-120,000 and
155,000 at the peak in 2007. We believe that Travis still
offers strong recovery potential, and because Travis is
rapidly de-gearing, on debt adjusted measures, by 2016
the company will be moving toward trough multiples.
Domino Printing Sciences fell heavily after the company
warned that profits in 2015 would see little growth
on 2014 profits when the market had been expecting
substantial year-on-year growth. The company blamed
three factors for the warning – the strength of sterling;
aggressive pricing by competitors in the Far East, which
was impacting gross margins; and the need to increase
R&D spending to bring new products forward to counter
this aggressive pricing by competitors. Considering
the company operates in an oligopoly – with only two
serious competitors in many of its markets – we do not
expect this pricing ill-discipline to continue indefinitely.
It should also be noted that recently Domino’s share price
arguably got somewhat ahead of itself on enthusiasm
about the potential growth at the company as European
economies recover. In fact, the company did deliver a
very robust top-line performance, but unfortunately this
is now unlikely to translate into profit growth – at least
in the short-term – because of the margin pressures.
However, we view this more as a hiccup rather than a
serious change in Domino’s competitive position, and
the company reassuringly retains a very strong balance
International Active Update
Second Quarter 2014
As discussed above, we are invested in J apanese banks
for their low valuations, solid dividends, and potential
upside with any change in the yield curve. Unfortunately,
in the second quarter the expected quantitative easing
from the BoJ didn’t materialize, and our holding in
Sumitomo Mitsui underperformed. Performance was
also hurt by Sony, which we hold because we believe
it is turnaround story. After a decade of losing money
in various consumer electronic hardware categories, the
company has been in a constant grind of restructuring.
Up until this year, restructuring efforts appeared timid
and behind the curve, making the stock easy for us to
avoid. However, a turning point appeared to come when
the company announced an exit from the PC business
and spin out of the beleaguered TV operations. After
years of being rudderless, it seemed that Sony had
finally gotten over its dysfunctions by appointing a new
CFO with a mandate for change. We bought into those
expectations and suffered as the company announced a
larger-than-expected write-off for the exit of PCs, casting
serious doubt over the company’s ability to turn around/
exit other hardware segments. We believe the pockets of
value are obvious. The company is an odd conglomerate,
but they do bring you Spiderman, have you humming
Daft Punk, playing PS 4 games while enabling all sorts
of high quality image capture – from iPhones to movie
cameras – and boast a highly profitable life insurance
arm. There is excellence in this company. Claiming
that the hardware weakness has been contained, it has
mapped a path to higher profitability. After countless
disappointments, the market is right to be skeptical and
we are forced to remind ourselves that value is found in
low expectations and, at times, uncomfortable places.
Continental Europe outperformed, led by positions in
Alstom in France, Outokumpu in Finland, and Eni in
Italy. Alstom, a provider of equipment and services
for power generation and rail transportation, rose
dramatically on a potential takeover bid from GE and
Siemens. Outokumpu, one of the largest stainless steel
producers in Europe, also outperformed after it raised
equity to restructure its balance sheet. We bought this
stock after the capital raising for three reasons. First, the
improved balance sheet and change in maturity profile
made the company more of a going concern. Second, the
company is making significant capacity closure, which
will improve the utilization rate for the whole stainless
steel industry. Third, the ban on Indonesian nickel ore
has made Chinese stainless steel exports to Europe less
attractive. Eni, the Italian integrated energy company,
benefited as violence in Iraq has pushed the oil price
higher and the company’s stock price moved with it.
The company has an attractive yield and the new CEO’s
claims of positive change potential in its assets structure
are also beginning to interest investors.
Currency and Hedging
Benchmark currencies in the Pacific region once again
climbed relative to the U.S. dollar, with the J apanese yen
gaining 1.6% and the Australian dollar rising 1.9%. The
U.K. pound was also strong, jumping 2.6%, while the euro
declined 0.7%.
The strategy was unhedged in the quarter.
International Active Update
Second Quarter 2014
GMO Parameter Profile
Actual P/BK, P/E, P/CF, and Yield
June 30, 2014
GMO* 1.4 2.9%
MSCI EAFE 1.7 3.0%
GMO Premium/(Discount) -18% -3%
(weighted median)
Cash Flow
(weighted median) Yield
Sector Weights and Performance
June 30, 2014
Sector Second Quarter
Consumer Discretionary 3.3% 1.2% 13.5% 11.9%
Consumer Staples 6.0% 6.7% 6.6% 11.1%
Energy 11.3% 13.2% 13.1% 7.3%
Financials 2.5% 2.1% 24.5% 25.3%
Healthcare 5.5% 11.5% 4.7% 10.5%
Industrials 2.3% 2.8% 10.2% 12.7%
Information Technology 1.0% 0.6% 8.5% 4.4%
Materials 3.4% 4.1% 4.0% 8.0%
Telecommunication Services 3.7% 1.4% 4.1% 4.9%
Utilities 6.7% 14.3% 9.9% 3.9%
Sector Weight
June 30, 2014
GMO Int'l Active* MSCI EAFE YTD 2014
Sector Performance
*Data is based on a representative account selected because it has the fewest restrictions and best represents the implementation of the Strategy. This information is supplemental
to the GIPS compliant presentation of the strategy that has preceded this report in the last 12 months or accompanies it. GIPS compliant presentations of composite performance are
also available at
International Active Update
Second Quarter 2014
Performance data quoted represents past performance and is not predictive of future performance. Returns are presented after the deduction of a model advisory fee and a
model incentive fee if applicable. Net returns include transaction costs, commissions and withholding taxes on foreign income and capital gains and include the reinvestment
of dividends and other income, as applicable. A GIPS compliant presentation of composite performance has preceded this presentation in the past 12 months or accompanies
this presentation, and is also available at HYPERLINK "" Actual fees are disclosed in Part 2 of GMO’s FormADV and are also available
in each strategy’s compliant presentation. Fees paid by accounts within the composite may be higher or lower than the model fees used.
Performance is shown compared to the MSCI EAFE Index, a broad-based securities market index that measures large capitalization international stocks. Broad-based indices
are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly into an index.
Information about the composite is as of the period-end noted above, subject to change without notice and not intended as investment advice.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any formand may not be used as a basis for or a
component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or
refrain frommaking) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any
future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use
made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively,
the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement,
merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability
for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (
MSCI EAFE Country and Currency Returns
Norway 0.9% 1.3% 12.6% -2.4% 9.9%
Hong Kong 2.8% 2.3% 8.2% 0.1% 8.3%
Spain 3.7% 5.3% 7.9% -0.7% 7.2%
J apan 20.2% 17.7% 4.9% 1.6% 6.7%
United Kingdom 21.4% 18.7% 3.4% 2.6% 6.1%
Singapore 1.4% 0.0% 4.8% 0.9% 5.7%
Belgium 1.2% 1.2% 5.7% -0.7% 5.0%
Finland 0.9% 3.7% 5.1% -0.7% 4.4%
MSCI EAFE 3.4% 0.6% 4.1%
Denmark 1.5% 0.0% 3.7% -0.5% 3.2%
Australia 7.7% 2.5% 0.9% 1.9% 2.8%
Israel 0.5% 0.0% 0.4% 1.8% 2.2%
Switzerland 9.0% 4.3% 2.5% -0.4% 2.1%
France 10.1% 15.1% 2.4% -0.7% 1.7%
Germany 9.3% 10.9% 2.3% -0.7% 1.6%
Netherlands 2.7% 0.0% 1.2% -0.7% 0.5%
Italy 2.6% 8.1% 0.5% -0.7% -0.1%
Austria 0.3% 0.0% 0.1% -0.7% -0.6%
Sweden 3.0% 1.1% 2.2% -3.0% -0.9%
New Zealand 0.1% 0.0% -2.1% 0.9% -1.2%
Portugal 0.2% 1.1% -1.9% -0.7% -2.6%
Ireland 0.3% 0.0% -8.4% -0.7% -9.0%
Emerging Markets 0.0% 5.8%
Cash 0.0% 0.8%
June 30, 2014
in $US
2014 Q2
Return in
Local Currency
Int'l Active
Copyright ©2014 by GMO LLC. All rights reserved.
International Active Update
Second Quarter 2014
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