Charles Brandes Q3 Commentary - Emerging-Markets Concerns Rising — So Are Select Opportunities

Uncertainties Create Potentially Attractive Valuations for Stock Pickers

Executive Summary

• Weakness in emerging-market equities has created attractive investment opportunities at the company level.

• Investor preference for index funds and exchange traded funds in emerging markets has resulted in some pronounced valuation distortions—providing a lush landscape for active managers.

• The current negative environment in emerging markets underscores the importance of a going-against-the-herd mentality.

• As recent valuations in emerging markets have become more attractive, we have been slowly adding select positions to our Brandes International Equity Strategy and Brandes Global Equity Strategy.

As true value investors, Brandes oft en moves against the crowd amid markets' constantly changing performance cycles. Take the recent equity market weakness in a number of emerging market (EM) countries for example. Over the last year, while macroeconomic and geopolitical concerns cast a cloud of uncertainty over the asset class in general, we started to see some interesting investment opportunities at the company level as a result of such market weakness.

We believe the recent material outfl ow from EM funds, and the resulting adverse impact on the performance of the MSCI Emerging Markets Index, highlights the importance of active stock selection.1 It also reveals the pitfalls in treating EM—or any market, country, sector, industry or risk factors (such as low-volatility strategies which seek to be less volatile than the underlying index they attempt to replicate) for that matter—as one homogenous group via indexing or exchange traded funds (ETFs). In our view, amid constantly fl uctuating markets, focusing on individual company fundamentals and the price paid to acquire these investments remains the greatest drivers of long-term investment outperformance.

Short-Term Macroeconomic Concerns Contributed to YTD Declines in Emerging Markets

Y! ear to date through September 30, 2013, the MSCI Emerging Markets Index followed a bumpy path and ended down 4.1%, with many of the larger-weighted countries of Brazil, Russia, India, Indonesia and China experiencing weakening currencies and/or equity markets. A number of factors contributed to market concerns:

• Fears of the Federal Reserve tapering its quantitative easing program

• Economic slowdown in China

• Existing and growing structural issues that vary materially from country to country—including large trade imbalances and rising debt levels (especially short- term borrowings)

• Worries over a replay of the Asian fi nancial crisis of the 1990s

After years of strong performance, emerging markets have recently underperformed developed markets (DM), as shown in Exhibit 1.

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Recent Emerging-Markets Concerns, Fund Flows and Concentration of Indexes

Th e cautious view of investors is evident in the $11.7 billion (USD) massive outfl ow of invested funds from EM year to date through August 30, 2013.2

Over the last 10-plus years, a signifi cant amount of the assets that fl owed into EM was increasingly allocated to index funds and ETFs. In 2002, passive investment strategies accounted for only 11% of EM investments. By year-end 2012, that percentage had grown to 51%.3 In our view, a key drawback to applying a passive strategy in emerging-market investing is the risk of overconcentration, as illustrated in Exhibit 2. Here we show the level of concentration of the fi ve largest companies in Brazil, Russia, India and China2 (BRIC countries) is high compared to the level of concentration in the United States. This overconcentration may limit investors' opportunity set.

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Additionally, particularly in the BRIC countries, the largest fi ve companies tend to be! long to t! wo sectors: financials and energy. As of September 30, 2013, roughly 75% of the total capitalization of the five largest companies in each of the BRIC countries was in these two sectors.4

As a specific example, an EM index fund (or ETF) would have allocated 9.4% to the consumer staples sector during the second quarter even though the top 10 largest EM stocks in this sector were trading at a loft y average price-to-earnings (P/E) ratio of 28x.5 The Brandes Emerging Markets Equity Strategy as well as the Global Equity Strategy and International Equity Strategy had zero allocation to these top 10 names as of September 30, 2013.

Pronounced Valuation Distortions Underscore Importance of Stock Selection

As index funds and ETFs experience large inflows, investors in these passive strategies may be essentially purchasing concentrated holdings without considering price or the possibl