GMO

International Active Update

Third Quarter 2014
Performance
The International Active EAFE Strategy underperformed the MSCI EAFE index by 2.0 percentage points in the third
quarter; the strategy fell 7.9% net of fees and the benchmark lost 5.9%. Country and stock selection were both negative.
The strategy lagged its benchmark by 4.7 percentage points for the first three quarters of 2014, returning -6.1%.
Performance (Year by Year %)
GMO International Active Performance
(Through September 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 -6.1 -1.4 -4.7 +8.3 +10.7
+11.8 +9.1 +2.7 +11.3 +10.2
Compound Annual Rate of Return (33 Years, 4 Months)
GMO
Value Added Int'l Active
MSCI
EAFE
S&P
500
GMO Bonds
AAA/AA
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
GMO
International
Active
3,984.8%
MSCI EAFE
1,696.3%
GMO
International Active Update
Third Quarter 2014
A Letter to Clients
First, I want to thank you for your patience and support.
Despite the challenging performance in the International
Active EAFE Strategy this year, we believe the companies
we own offer compelling opportunities for excess return in
the long run. I wanted to take this opportunity to describe
some of the key ideas in the portfolio and why we believe
they offer such compelling upside.
The key detractors from performance this year have been
J apanese banks, Russian holdings, and our European
recovery stocks. We continue to have strong conviction
in all of these positions and, with a couple of exceptions
in Russia, we continue to hold them. Somewhat offsetting
these positions have been our holdings in tobacco and
our overweight position in small cap companies, both of
which have added to relative performance.
While detracting from performance this year, we believe
J apanese banks offer a compelling long-term risk/reward
profile. Our thesis is that the market is being lazy and
myopic by fixating on the recent profitability of the banks
and consequently missing a very important concept: bank
margins are unsustainably low due to interest rates being
artificially compressed by central bank manipulation.
The market is ignoring that J apanese banks have been
able to achieve ROEs around 10%, loans are growing,
and prices on new loans have stabilized. We believe that
margins will increase without the distortionary effects of
the Bank of J apans quantitative easing policy. Given the
short-term maturity of the majority of bank loans, in our
opinion, the increase could be significant. In addition,
if the inflation currently evident in the economy is
sustainable then interest rates are negative and the yield
curve has much further to rise, yielding even more upside
for the banks.
Another detractor from performance has been the
portfolios exposure to Russia. The portfolio was invested
in the secular growth of the Russian credit market via two
holdings, Sberbank and TCS Group. Given the uncertain
long-term effects of sanctions, the credit trends in Russia
are delayed and, as a result, we exited both positions.
However, we continue to own indirect Russian exposure,
either in the form of companies with assets in the country
or companies for which Russia is an end market. We
continue to hold these companies because we believe their
risk in Russia is mitigated by strong businesses elsewhere.
We continue to have conviction in Europe where solid
and improving companies are selling for cheap valuations.
While the recovery in Europe is spotty, its banking system
has a stronger balance sheet, labor competitiveness is
improving, and the weakening euro should boost exports.
The European Central Bank has been shrinking its balance
sheet since 2012, but this could reverse, pulling equity
markets up in the same manner as it appears to have done
in the U.S. and J apan.
The market also has yet to take into account the corporate
restructuring and M&A activity occurring in Europe that
is resulting in lower costs, better balances sheets, and
sustainable free cash flow generation. In our view, the
improvement in efficiency and profitability quietly being
achieved in Europe must eventually be rewarded by global
equity investors. We are well positioned to benefit when
the markets realize how much stronger corporate Europe
has become.
This is not the first time the markets have tested our
resolve. We have been alone on our investment island
before. In the cases where our holdings performance has
been lower than expected, we are confident our investment
theses remain intact. History shows that investors with the
willingness and patience to take the long view are well
rewarded.
As always, we would be happy to talk with you about
these positions or answer any other questions you may
have. Please contact your Client Relationship Manager if
you would like to set up a phone call or a meeting. Thank
you.
- Drew Spangler
GMO
International Active Update
Third 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 Portugal and France, as both markets underperformed
MSCI EAFE in the quarter.
1
Currency dominated returns for the quarter as every
benchmark currency fell against the U.S. dollar. When
combined with the Feds increasing interest rates, the euro
weakened as a result of expectations around ECB action,
and BOJ Governor Kurodas tacit open-ended extension of
monetary easing in J apan knocked a chunk of the relative
value out of the yen/dollar rate.
While many of the European markets struggles were
attributable to currency effects, the economic recovery
there is not gaining steam. In Germany and France, macro
conditions have deteriorated, and with this, investor hopes
around the recovery have faltered. Russia also continued
to be a drag as implications are still being felt by European
companies.
In J apan, the conversation has shifted from when will
J apanese exports recover to if exports will recover at
all given the degree of off-shoring of manufacturing. A
weakened yen was thought to be universally positive for
an export led exit from two decades of economic torpor.
With this axiom now in doubt, all eyes are on the central
bank and the degree of commitment and time frame
Kuroda has for hitting his stated 2% inflation target.
The U.S. market held reasonably steady in the quarter as
investors begin to digest the prospect of higher interest rates
in 2015 (causing the dollar to strengthen against all major
currencies), as well as reduced growth expectations for
global growth. All economically sensitive and commodity
exposed sectors have sold off as a result. That said, the
September jobs report showed a strengthening labor
market and reduced unemployment.
1
Data is that of a representative account from within the Composite.
Stock Selection
Stock selection lagged the benchmark by 1.6 percentage
points in the third quarter. Holdings in Continental Europe,
the emerging markets, Japan, and the United Kingdom
underperformed. On the positive side, stock selection in
Australia helped returns.
1
Our holdings in Continental Europe underperformed
due to positions in Peugeot and Arkema in France, and
Rheinmetall in Germany. The weaker than expected
economic numbers in Europe caused some of the more
cyclical names to underperform during the month.
Auto company Peugeot was among these, as its sales
are primarily exposed to Europe. Arkemas stock
underperformed significantly as the second quarter
earnings came in below the markets expectations and
the chemical company took its full year guidance down.
Earnings were hurt primarily because of pricing pressure
from Chinese players in fluorochemicals and weak
demand in acrylic acid. We continue to own the stock
as we believe that the pricing pressure will abate over
the next few quarters, but we are closely monitoring
the situation. Finally, Rheinmetall, a provider of auto
components and defense equipment, underperformed
during the month due to the cancelation of its Russian
defense contracts. The war in the Ukraine has led to
many defense companies in Europe losing contacts.
Our holdings in the emerging markets were negative,
particularly in Korea, due to positions in Hyundai and
Samsung. Hyundai Motors underperformed because of
the managements decision to invest in property in Seoul
to build a global headquarters for the Hyundai Motor
group. Investors did not like the use of the companys
capital for a non-productive enterprise. However, we
feel that Hyundai is a fundamentally strong company
going into a new model cycle over the next two years.
After the current sell-off, it is the cheapest major car
manufacturer in the world. Technology company Samsung
underperformed due primarily to poor earnings in the
second quarter, which showed a marked deterioration in
China smartphone market share, negative impact from
appreciation of the Korean won, and a disappointing
lack of action with respect to increased returns to
shareholders. While we cannot deny that headwinds
currently exist for the business, we continue to find
the free cash flow yield attractive as compared to other
opportunities in the region and expect the stock to re-rate
higher as management announces action on increasing
GMO
International Active Update
Third Quarter 2014
the dividend. Further, we believe current valuations for
Samsung reflect unreasonably pessimistic near-term
expectations and fail to recognize the long-term earnings
power of the company. In both cases we are watching
capital discipline carefully.
J apanese stock selection underperformed in the quarter
due to holdings in glass maker Nippon Electric Glass
(NEG) and auto parts supplier Aisin Seiki. NEG is a
main supplier to TV panel manufacturer LG Display,
which enjoyed strong panel volume and shipment growth
over the last two quarters. This positive news was
extrapolated into NEG share price based on expectations
of higher volumes and the hope for better pricing.
However, market expectations were dashed by NEGs
release of weak numbers for the previous quarter owing
to yield issues in the new plant in Korea and related
cost increases in responding to LG Displays growth.
We remain convinced that better execution from NEG
is possible and feel the market is being too short-term
with regard to the companys efforts to cut costs while
growing margins by shifting production closer to LG.
Aisin Seiki is an important transmission supplier for
Toyota group and suffered due to an announcement that
Toyota was adjusting production in China. China remains
a strong growth and margin driver for the company, but a
short-term adjustment does not shake our faith in holding
a high quality supplier with low valuation multiples.
The U.K. portfolio was negatively impacted by a
position in the recruitment company Hays. The company
produced a robust fourth quarter trading statement in
J uly, but a slight tempering of the growth rate in the
United Kingdom was enough to trigger some lowering
of the higher forecasts in the market. Many investors
were clearly perturbed that the upgrade cycle for the
stock had ended and this triggered a sharp share price
fall. However, we still see value in Hays. As with several
cyclical stocks in the U.K. portfolio, we think the market
has de-rated the company to mid-cycle levels far too
early and underestimated the upside still available from
cyclical recovery (EBITDA at its U.K. arm fell from
137m to a 6m loss in 2012 and only amounted to
5.6m in 2013). There is also the likelihood of ongoing
special dividends. A position in BP also had a detrimental
impact on performance during the month. The company
actually produced very solid second quarter earnings
(10% above consensus estimates) but the market fretted
about the potential impact of sanctions on Russia, thanks
to the oil majors 19.75% equity stake in the Russian
producer Rosneft. BP saw fit to issue an explicit risk
disclosure in the results that sanctions could have a
material impact on the value of its Russian investments
and business and strategic objectives in the region. The
Rosneft stake is worth around $13bn or circa 8% of BPs
current market cap.
Our stock selection in Australia added value during the
quarter. Our Australian logistics positions are starting
to pay off, with both Asciano and Toll outperforming.
During their fiscal 2014 results briefing, port and
rail operator Asciano guided for slightly higher-than-
expected EBIT growth and an increase in the dividend
payout ratio, indicating their confidence in the increasing
free cash flows that we have been awaiting. Toll, in
classic value stock fashion, released results that were
not as bad as forecast, and the stock price moved higher.
Since then, Toll announced the re-signing of a major
contract in Singapore that it was widely forecast to lose.
While the company still faces many challenges, the
sentiment tide seems to be turning.
Currency and Hedging
As mentioned above, the U.S. dollar was extremely strong
in the quarter. In Europe the U.K. pound fell 5.2% and the
euro dropped 7.8%. In the Pacific region the J apanese yen
declined 7.7% and the Australian dollar lost 7.3%.
The strategy was unhedged in the quarter.
GMO
International Active Update
Third Quarter 2014
GMO Parameter Profile
Actual P/BK, P/E, P/CF, and Yield
September 30, 2014
Region/Country
GMO* 1.2 2.9%
MSCI EAFE 1.7 3.0%
GMO Premium/(Discount) -26% -5%
to MSCI EAFE
Price-to-
Book
Price-to-
Earnings
(weighted median)
Price-to-
Cash Flow
(weighted median) Yield
15.6
17.59
-12%
7.0
10.8
-35%
Sector Weights and Performance
September 30, 2014
Sector Third Quarter
Consumer Discretionary -8.5% -7.3% 12.2% 11.6%
Consumer Staples -7.0% -0.8% 5.7% 10.9%
Energy -11.3% 0.5% 11.8% 6.9%
Financials -4.7% -2.7% 28.5% 25.7%
Healthcare 0.4% 12.0% 0.0% 11.2%
Industrials -7.0% -4.4% 8.5% 12.5%
Information Technology -0.8% -0.2% 8.5% 4.7%
Materials -9.4% -5.7% 4.0% 7.7%
Telecommunication Services -5.2% -3.9% 4.2% 4.9%
Utilities -5.5% 8.0% 7.4% 3.9%
Sector Weight
September 30, 2014
GMO Int'l Active* MSCI EAFE YTD 2014
MSCI EAFE
Sector Performance
The above information is based on a representative account within the strategy selected because it has the fewest restrictions and best represents the implementation of the strategy.
The information above is supplemental to the GIPS compliant presentation that was made available on GMOs website in September of 2013.
GMO
International Active Update
Third 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 www.gmo.com. Actual fees are disclosed in Part 2 of GMOs FormADV and are also available in each strategys 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 (www.mscibarra.com).
MSCI EAFE Country and Currency Returns
Country
Israel 0.6% 0.0% 7.6% -7.0% 0.2%
Singapore 1.5% 0.0% 1.0% -2.2% -1.3%
J apan 21.0% 18.8% 5.8% -7.7% -2.3%
Hong Kong 2.9% 2.3% -2.4% -0.2% -2.6%
Finland 0.9% 3.3% 5.3% -7.8% -2.9%
Ireland 0.3% 0.0% 4.9% -7.8% -3.2%
Belgium 1.3% 1.1% 4.3% -7.8% -3.7%
Denmark 1.6% 0.0% 4.1% -7.6% -3.8%
Switzerland 9.2% 2.8% 3.0% -7.2% -4.4%
Netherlands 2.7% 0.0% 3.3% -7.8% -4.7%
Sweden 3.1% 0.5% 1.6% -7.3% -5.8%
MSCI EAFE 0.9% -6.8% -5.9%
United Kingdom 21.3% 15.7% -0.9% -5.2% -6.1%
Norway 0.8% 1.2% -3.1% -4.4% -7.4%
Spain 3.6% 7.4% 0.3% -7.8% -7.5%
Australia 7.5% 2.7% -0.7% -7.3% -7.9%
France 9.9% 13.6% -0.7% -7.8% -8.4%
Italy 2.5% 6.2% -1.1% -7.8% -8.7%
New Zealand 0.1% 0.0% 2.3% -11.0% -8.9%
Germany 8.8% 8.7% -3.7% -7.8% -11.2%
Austria 0.2% 0.0% -15.0% -7.8% -21.6%
Portugal 0.2% 1.0% -18.7% -7.8% -25.0%
Emerging Markets 0.0% 5.4%
Cash 0.0% 9.3%
September 30, 2014
MSCI EAFE
Return
in $US
2014 Q3
MSCI EAFE
Return in
Local Currency
MSCI EAFE
Currency
Return
MSCI EAFE
Weight
GMO
Int'l Active
Weight
Copyright 2014 by GMO LLC. All rights reserved.
GMO
International Active Update
Third Quarter 2014
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