1) September 2015
Below is the latest commentary from Pacific Life Fund Advisors LLC, the investment advisor to the Pacific Funds SM .
Don’t Get Caught in the Tourist Trap
Tourist traps. Every major city around the world has them. There’s the famous restaurant where the food is actually mediocre
or a street market hawking pretty trinkets that fall apart as soon as they are bought. Most of us have fallen prey to tourist traps,
so we know the common theme is that cheaper and better-quality products can be found elsewhere. You just need somebody
“in the know” to tell you where to go.
Investing outside the U.S. is similar. The “tourist trap” analogy
may be particularly apt in Europe. There are European equities
that present attractive opportunities for U.S. investors. To
separate the stocks that represent true bargains from the
ones that only appear to be, an expert is needed.
This is a fundamental turnaround from the past several
years. During the 2008 financial crisis, many stocks plunged
to valuations that proved to be unsustainably low. In that
environment, bargains were easy to find. Since then, stocks
have generally risen, and today there is a greater dispersion
of valuations.
For example, take the price-to-book ratio, which is a
balance sheet driven metric. There is a widening spread
between high and low price-to-book ratios for the stocks
within the MSCI Europe Index.
Exhibit A: There is a greater dispersion of valuation
metrics, such as price-to-book, within European equities
â—¾ espite recent price action, the European
D
economic recovery is gaining traction due to
powerful monetary stimulus provided by the
European Central Bank (ECB), and we believe
this provides attractive investment opportunities
in European equities.
â—¾ perating margins of European companies
O
have just begun to trend upward. We believe
improving margins could extend outperformance
of European stocks relative to equities of U.S.
companies, whose margins have begun shrinking.
â—¾ iven the rising dispersion in valuations of
G
European equities, and generally elevated
MSCI Europe Index Price-to-Book Spread
16
Key Takeaways
volatility, a bottom-up fundamental approach to
14
pinpoint the stocks that are attractively priced is
Spread (%)
12
required, in our view, and this necessitates the
10
use of active management.
8
6
4
2
0
2000
2005
2010
2015
Source: Bloomberg, as of August 31, 2015.
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2) September 2015
Considering that many stocks have recovered from their low
valuations, investors now need to be more selective. Not
all European stocks with low valuations may be deserving of
them. The same holds true for those with high valuations,
especially as European stocks recover from their recent stumble.
Incidentally, although year to date, the broad MSCI Europe
Index is down 0.56% in U.S. dollars, the Russell 3000 Index,
a similarly broad benchmark representing 3000 U.S. stocks
is down 2.61% (through 8/31/2015).
Recognizing Bargains in a Crowded Bazaar
Passive investing in a fund that tracks a European equity index
is equivalent to blindly buying all of that index’s constituents.
The index does not cull stocks that may be overvalued or
the overweight undervalued ones. It’s fair to ask: Is passive
investing in a European equity index at this juncture like
entering a tourist trap? What gives you better chances
of getting a good deal on a quality item: an indiscriminate
shopping spree through that raucous Spanish bazaar or having
a local guide carefully select goods from trusted merchants?
Of course, all investing has its downside risks. Consider that
the European recovery remains turbulent. It has alternated
between anemic growth and bouts of recession amid the
absence of fiscal reform and broad-scale monetary measures.
That has made European equities volatile. However, this year
the recovery has gained meaningful ground in our view. The
2015 Greek debt crisis wound up being a minor blip (despite
the headlines). Greece has become simply an unfortunate
exception to the fiscal reform and not a source of contagion
to other European countries. Following Greece’s 2011 debt
crisis, major European financial services firms and other large
companies have taken steps to insulate themselves against
Greece. Similarly, the current panic gripping both domestic
and European markets, driven primarily by concerns about
a slowdown in China and falling commodity prices, appears
overblown to us. China accounts for just 4.08% of Europe’s
global exports. Meanwhile, the commodity slump should
benefit the region as it’s a net consumer.
Recent and unprecedented monetary stimulus by the ECB
is starting to fuel bank lending and economic growth.
Additionally, less developed, smaller economies like Spain
and Portugal (also referred to as the peripheral countries) are
following through on fiscal reform.
We expect many European stocks to benefit from the
aforementioned structural reforms, but a rising tide will not
lift all boats equally—especially as some boats have holes that a
tourist won’t notice until they’re halfway across the Aegean Sea.
Prospects of many European companies have only just started to
regain positive momentum. We believe it’s important to analyze
the financial statements of individual firms to determine whether
their balance sheets and growth prospects justify their stock
valuations. Operating profit margins of large firms in Europe
have started to rise. This is seen in Exhibit B, which depicts
the trend of operating profit margins of firms represented
in the Euro Stoxx 50 ® Index, an index of large-cap stocks in
Europe. In contrast, the operating profit margins of the firms
within the S&P 500 ® Index have started to decline. Given
European economic growth, we believe operating margins of
well managed companies should continue to trend upward.
Exhibit B: Operating margins of European companies
could extend their recent upturn
15
Operating Margins of Euro Stoxx 50 Index and the S&P 500 ® Index
13
Operating Margin (%)
We believe price-to-book is a more durable metric than
price-to-earnings as earnings tend to change more than a
company’s capital structure over short periods.
11
9
7
5
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Euro Stoxx 50 Index
S&P 500® Index
Source: Bloomberg, as of August 31, 2015.
In contrast, operating margins of U.S. companies began an
uptrend in 2009 along with the U.S. economy in general.
Improvement in corporate profit margins in the U.S. seems to
have moderated along with the growth of the U.S. economy.
It’s important to note that equity markets follow economic
cycles, which show the sharpest gains during economic
recoveries, which then settle into economic expansions.
We put Europe in the former and the U.S. in the latter.
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3) September 2015
S&P 500 ® Index Performance Through Business Cycles1
20
Annualized Returns (%)
10
5
0
–5
–10
–15
–20
Expansion
Contraction
Recovery
Source: Bloomberg and The Centre for Economic Policy Research,
as of June 30, 2015.
The three phases, expansion, contraction, and recovery are defined
and calculated based on the The Centre for Economic Policy Research
methodology which builds on the methodology put forth by the
National Bureau of Economic Research.
1
Good Reasons for an Extended Visit
1.40
1.35
8
1.30
6
1.25
4
1.20
2
1.15
0
1.10
–2
1.05
Jan
Mar
May
Jul
2014
Sep
Nov
EU Exports to Non-EU Countries (Left Axis)
Jan
Mar
May
2015
Jun
EUR/USD Spot (Right Axis)
Source: Bloomberg, as of June 30, 2015.
From a broader perspective, gross domestic product of
the European Union (EU), which has 28 member countries,
has been a quarterly uptrend since the third quarter of 2014
through second quarter 2015. In that period, unemployment
has fallen from 9.9% to 9.4%, and is expected to drop to 9% by
the second quarter of 2016. The average economist forecast
for the EU’s 2015 Gross Domestic Product (GDP) of around
2.0% would put that region’s GDP at its highest since 2011.
Exhibit E: The eurozone’s GDP growth has been rising
while its unemployment has been falling
Rising European Union GDP and Falling Unemployment
2.5
11.0
2.0
10.5
1.5
10.0
1.0
9.5
0.5
9.0
0.0
8.5
–0.5
Eurozone Unemployment Rate (%)
There are favorable conditions for Europe’s recovery. The
massive liquidity pumped into the market by the ECB’s
quantitative easing program (under which the ECB is buying
government and private sector securities) has driven the
euro dramatically lower against the U.S. dollar. That should
boost prospects of European multinationals with large U.S.
customer bases by making their products cheaper to buy.
Examples are plentiful, like cosmetics maker L’Oreal SA,
Belgian beer producer Anheuser InBev NV, and drug maker
Bayer AG.
EU Exports versus Weakening EUR/USD
10
EUR/USD Spot Exchange Rate
15
EU Exports (Seasonally Adjusted, Year Over Year) (%)
25
Exhibit D: The EU’s exports have risen as the EUR/USD
has weakened
Eurozone Real GDP (%)
Exhibit C: Stocks have posted their largest gains
during economic recoveries
8.0
–1.0
Dec-12
Jun-13
Dec-13
Jun-14
Dec-14
Jun-15
Dec-15
Jun-16
Eurozone Real GDP Year-over-Year Growth (Left Axis)
Eurozone Unemployment (Right Axis)
Source: Bloomberg, as of June 30, 2015.
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4) September 2015
The Value of an Expert Guide
A dynamic and diversified portfolio will take into account
changing economic cycles globally. In our view, Europe’s
recovery is gaining traction and creating a more attractive
equity landscape, especially versus that of the U.S., which
is in a moderate economic expansion.
However, since the financial crisis, we believe that Europe’s
equities have recovered to the point that simple valuation
metrics alone won’t tell you the stocks that will be winners
or losers. Fundamental analysis of individual companies is
more prudent than passive, index investing, in our view.
An index fund may be the cheaper option, but it’s no better
than visiting a country and using a generic guidebook to find
the best deals. One may get a bigger bang for one’s buck
paying just a little more to be guided by a savvy local.
The EURO STOXX 50 Index provides a blue-chip
representation of supersector leaders in the eurozone.
The index covers 50 stocks from 12 Eurozone countries:
Austria, Belgium, Finland, France, Germany, Greece, Ireland,
Italy, Luxembourg, the Netherlands, Portugal, and Spain.
The EURO STOXX 50 Index is licensed to financial
institutions to serve as the basis for a wide range of
investment products such as Exchange Traded Funds (ETF),
Futures and Options, and structured products worldwide.
The MSCI Europe Index captures large and mid-cap
representation across 15 Developed Markets countries
in Europe. With 441 constituents, the index covers
approximately 85% of the free float-adjusted market
capitalization across the European Developed Markets
equity universe.
The Russell 3000 Index is a stock market index of
U.S. stocks. This index measures the performance of
3,000 publicly held U.S. companies based on total market
capitalization, which represents approximately 98% of
the investable U.S. equity market.
The S&P 500 ® index is a market capitalization-weighted
index of 500 widely held stocks often used as a proxy for
the stock market. S&P 500 is a registered trademark of
Standard & Poor’s Financial Services LLC.
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5) September 2015
About Pacific Life Fund Advisors
Established in 2007, Pacific Life Fund Advisors LLC (PLFA) provides multi-asset and balanced allocation solutions through its asset
allocation, manager research, and investment risk-management functionalities. PLFA is an SEC-registered investment adviser and
a wholly owned subsidiary of Pacific Life Insurance Company (Pacific Life). As of June 30, 2015, PLFA managed approximately $41
billion in total assets.
A publication provided by Pacific Funds. These views represent the opinions of PLFA and are presented for informational
purposes only. These views should not be construed as investment advice, the offer or sale of any investment, or to predict
performance of any investment. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed.
The opinions expressed herein are based on current market conditions, are as of September 2015, and are subject to change
without notice.
All investing involves risk, including the possible loss of the principal amount invested.
You should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus
and, if available, the summary prospectus contain this and other information about the fund and are available from
your financial advisor or www.PacificFunds.com. The prospectus and/or summary prospectus should be read carefully
before investing.
Third-party trademarks and service marks are the property of their respective owners.
Pacific Life Fund Advisors LLC (PLFA), a wholly owned subsidiary of Pacific Life Insurance Company, is the investment advisor to the Pacific Funds.
PLFA also does business under the name Pacific Asset Management and manages certain funds under that name.
Effective December 31, 2014, Pacific Life Funds and its family of mutual funds changed its name to Pacific Funds. In addition, individual funds were also
renamed. For more information, please visit www.PacificFunds.com.
Mutual funds are offered by Pacific Funds. Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary
of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third-party broker/dealers. Pacific Funds refers to
Pacific Funds Series Trust.
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Mailing address:
P.O. Box 9768, Providence, RI 02940-9768
(800) 722-2333, Option 2 • www.PacificFunds.com
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