From The Desk HSBC GIF Euroland Equity Smaller Companies Q3 review How did the markets perform? October 15 th, 2009 The rally accelerated in Q3 with broad signs of normalisation in leading economic indicators, narrowing credit spreads and a reversal of the profit downgrade cycle. The MSCI EMU Small Cap index rose by 27 over the period. However, the best returns were concentrated in the very small cap stocks. The following graph displays the entire euroland equity universe split by market cap deciles ranging from highest to lowest market cap. The bottom decile is mainly comprised of market capitalisations below 800 million euros. 60 Returns by market cap decile 50 40 30 20 10 0-10 -20 top 5 1st 2nd 3rd 4th 5th 6th 7th 8th 9th Bottom Source: Citigroup Global Market, European Sector Strategist, 9 October - from end 30-06-2009 to 30-09-2009 Fund Performance Month 3 Months 2009 YTD 12 Months 3 Years Since Inception Fund return 5.8 21.8 51.8 15.5-7.7 154.3 Benchmark return 8.4 27.0 53.9 14.0-13.5 133.9 Difference -2.6-5.3-2.1 1.5 5.8 20.4 [All returns in the table above are provided by HSBC Global Asset Management France] Returns calculated before deduction of management fees and operating expenses TER: 1.85 ( A, retail share) 1 Inception of Strategy on 31 January, 2003, Benchmark: MSCI EMU Small Cap (NR) index. The performance shown refers to the past and should not be seen as an indication of future performance.
Q3 review Over the quarter the biggest positive return contributors were: overweight semis (early cyclicals, valuation lows); underweight utilities (regulatory pressure); underweight defensives (Foods, retailing, pharma). The biggest single most negative return contributor was the fact that the average market capitalisation of the portfolio was about 1.7 billion compared to $1 billion for the market index. The smallest caps significantly outperformed in the rally. Moreover, the following factors had a negative impact on returns: Cash position (necessitated by market illiquidity ); Underweight real estate (4 Austrian real estate cos skyrocketed after being saved from bankruptcy); Overweight Energy (Oil prices stable over period); Underweight banks (Irish banks surged after government bail out); Overweight Healthcare Equipment (too defensive). Performance Drivers Stock level over the quarter The table below shows the top positive and negative stock contributions to performance for the quarter. Positive Return Relative Impact Negative Return Relative Impact Stock Weight Stock Weight Yit-Yhytma J 75.71 1.71 0.72 Bank of Ireland 102.97-1.04-0.69 Aalberts Industries 64.05 1.94 0.72 Solarworld -0.62 1.62-0.53 Alpha Bank 61.74 2.01 0.60 Vossloh AG -9.49 1.23-0.49 Randstad 49.70 2.06 0.40 Immoeast AG 135.75-0.57-0.44 Ubisoft Entertainment -25.40-0.46 0.34 Fresenius AG 3.57 1.70-0.41 [HSBC Global Asset Management 30 June 2009 to 31 September 2009] Benchmark: MSCI EMU Small Cap (NR) index. The performance shown should not be seen as an indication of future performance.
Developments in investments Best contributors over the quarter Yit-Yhytma : Exposure to underdeveloped Russian residential construction market has boosted the stock in the wake of a huge recovery of the Russian stock market and economy. Aalberts Industries: the company bounced back from distressed valuations after successfully renegotiating its loan agreements with banks. Since covenants are based on Net Debt/EBITDA ratios, lower profits mechanically affect debt covenants. Alpha Bank: Alpha Bank benefited both from the re-rating of banks and the outperformance of the Greek market. Randstad: benefited from a significant stabilization in its core markets of the Netherlands, France and Germany. And last year s integration of Vedior is on schedule to meeting the company s objectives, mainly in terms of cost synergies. Ubisoft Entertainment: We benefited from not owing Ubisoft. The stock suffered from pressure on the pricing of games, reduced guidance from management and piracy in its casual game market. Worst contributors over the quarter Bank of Ireland: We were penalized by not owing the Bank of Ireland. The Irish government created a defeasance structure buying back the bad debt of all the key Irish banks at a discount. This saved the banks and they subsequently surged from bankruptcy valuation levels. Solarworld: Solarworld suffered from concerns that the German government would reduce subsidies to the alternative energy sector. Chinese competition for their Solar panels has also pressured the stock. Vossloh AG: One of the world's leading suppliers of points and crossings for railway, metro and tramway networks in France and throughout the world suffered from its status as a defensive stock and the fact that it lost out in a bid for a big Chinese contract against a local Chinese competitor. Immoeast AG: We did not own Immoeast. Immoeast is in Austrian real estate company with a major exposure to the Eastern European. It rebounded after avoiding a near bankruptcy after facing a a liquidity squeeze during the financial crisis. Fresenius AG: Fresenius is a diversified and defensive healthcare company with hospitals and clinics in Germany, equipment for transfusions, and dialysis diagnostics through its medical care subsidiary. The stock underperformed in a rally led by cyclicals.
Sector Level over the quarter The table below shows the major sector contributions to performance for the month. The sector weightings and corresponding contributions result entirely from our stock selection approach. Positive Sector Return Relative weight Impact Negative Sector Return Relative weight Impact Utilities 0.14-1.06 0.31 Cash 5.44 0.00-2.25 Semiconductors 109.1 0.68 0.31 Real Estate 44.54-2.14-0.32 Pharma & Biotechnolog 5.68-0.16 0.22 Energy 16.16 2.82-0.29 Food Beverage & Tobacco 21.58-3.60 0.20 Banks 43.22-1.80-0.27 Food & Staples Retailing 14.07-1.02 0.12 Health Care/Services 12.39 0.87-0.17 [HSBC Global Asset Management 30 June 2009 to 31 September 2009 Benchmark: MSCI EMU Small Cap (NR) index. The performance shown should not be seen as an indication of future performance. Fund positioning The table below shows the biggest 10 positions at the end of the month: Top positions Weight Relative weight SGL Carbon 3.8 3.1 Allied Irish Banks 3.1 1.9 Yit-Yhtyma 2.7 2.0 Eurler Hermes 2.2 1.9 Wacker-Chemie 2.2 2.2 Alpha Bank 2.1 2.2 Catalana Occidente 2.1 1.8 Infineon 2.1 2.1 Randstad 2.0 1.1 Fugro 2.0 2.1 [HSBC Global Asset Management 30 September 2009] Benchmark: MSCI EMU Small Cap (NR) index.
SGL Carbon: quality play in metals/mining (rise in aluminum demand). Allied Irish Banks: Major Irish bank (probable bankruptcy avoided by Irish government debt buy back). Yit-Yhtyma: Exposure to underdeveloped Russian residential construction market. Euler Hermes: French reinsurance company, specialized in non-payment risk will benefit from lower than expected corporate defaults in Europe. Wacker-Chemie: Produces silicon for solar and semis industry where demand is picking up and restructuring benefits are paying off. Alpha Bank: improving risk aversion for undervalued but well capitalized Greek bank. Catalana Occidente: Spanish reinsurance company benefited from government subsidies. Infineon: De-leveraged balance sheet and pick up in demand for microships, particularly in different end industries: recent growth generated by its I-phone chip. Fugro: Attractively valued seismic technology leader serving oil service industry for both off and on shore exploration. Sector The table below shows the largest overweight and underweight sector positions at the end of the month: Overweights Weight Relative weight Underweights Weight Relative weight Insurance 6.52 4.01 Tech Hardware 0.00-4.67 Energy 5.95 2.45 Retailing 0.00-2.57 Staples & Materials 12.56 2.27 Real Estate 5.48-2.18 Transportation 4.56 2.23 Consumer services 0.33-1.62 Capital Goods 22.24 1.50 Consumer Durables 1.72-1.61 [HSBC Global Asset Management 30 September 2009] Benchmark: MSCI EMU (NR) index. Although our approach resides purely in stock selection, the strategy does not seek sector neutrality. Sector fundamentals sometimes contribute to our selection of specific stock holdings.
Risk data Fund metric Value Target range/number/limit Tracking error* 6.9 (3 8) Number of positions 56 Target 50-60 Average market cap 2 bn. versus 1.1 bn. for benchmark 1-3 bn. Beta (ex ante) 1.09 (0.9-1.1) [HSBC Global Asset Management 30 September 2009] * ex-ante tracking error at 30 September 2009 ** calculated using annualised excess return over 3 years divided by average monthly ex-ante tracking error over 3 years Benchmark: MSCI EMU Small Cap (NR) index. The performance shown refers to the past and should not be seen as an indication of future performance. Economic backdrop Industrial production improved in all Euro area countries. Italy led the pack with a jump of +7 (m/m) after +2.4 (m/m). Germany and France were respectively up +1.7 and +1.8. On a quarterly basis, industrial activity is likely to rise significantly in the 3rd quarter for the first time since Q1 2008. Outlook for investments Now that the earnings cycle has just turned, the question remains, What will the amplitude and duration of the earnings recovery be after the 47 decline since end 2007? In Europe, the average earnings decline from peak to trough has been about 35. The average subsequent recovery in earnings has posted growth of 27 in the first year and 24 in the second year. In general, sharper declines are followed by stronger recoveries: the strongest earnings recovery during the first year was 45 in the early 2000 s. Currently the consensus forecast is for 25 earnings growth in Europe over the next 12 months. Moreover, 25 growth implies a 12 month PE of only 12.9x which is still very attractive. In fact, Europe is the cheapest of the developed markets. In spite of the huge rally year to date the European Small and Mid caps segment trades at a reasonable valuation multiple of 1.6x book value, at a discount to the European large cap market of 1.7x. Profitability is slightly lower than large caps, but upside to GDP growth in the next year would stand to benefit the small cap segment more than large caps. In the below, we have established that Europe ex UK still offers very attractive cyclically adjusted earnings yields (green line), much higher than that of the US (gray) line. In fact, the current yield is higher than the average that prevailed during the average of the 1970 to 1980 periods when valuations were low and inflation was rampant in contrast to the low interest rates of today.
14 Cyclically adjusted Earnings Yields - US and Europe ex UK 12 10 8 6 4 Source: Datastream, Halbis calculations 2 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Cyclically adjusted Earnings Yield, MSCI US Cyclically adjusted Earnings Yield, MSCI EU ex UK US average 1970-1980 EU ex UK average 1970-1980 Finally, now that we have established that the European market is attractively valued in absolute terms and versus the US, we want to know whether Europe deserves this value status. We ve seen in the past that trend profitability in Europe was lower than the US, particularly in the 1970 s. In the last decade profitability levels have practically converged. European companies have made great strides in improving their competitiveness, undistinguishable from their US counterparts. We believe this convergence in profitability levels is here to stay. In conclusion, the current valuation discount in Europe should eventually go away. Stock market levels should be boosted by PE re-rating as well as an earnings recovery that could very well surprise the consensus on the upside. Liquidity has remained on the sidelines as few investors have really had the opportunity in participate in the rally. These flows should return so long as market valuations remain intrinsically and relatively attractive, and no major crisis erupts on the short term horizon. Two major risks that we see is a faltering earnings recovery or else a further big decline in the US dollar which would adversely impact the world s stock markets.
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