International Active Update

Second Quarter 2015

PERFORMANCE
The International Active EAFE Strategy outperformed the MSCI EAFE index by 2.8 percentage points
in the second quarter; the strategy rose 3.4% net of fees and the benchmark gained 0.6%. Positive stock
selection was offset somewhat by slightly negative country allocation. The strategy beat its benchmark by
3.7 percentage points for the first half of 2015, returning +9.3%.
Performance (Year by Year %)

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

(JunDec)

GMO
Int'lActive
5.8
2.4
32.1
8.7
65.1
57.4
9.7
21.2
27.4
10.7
13.9
4.0
41.2
5.9
13.8
14.6
6.8
13.9
28.6
6.5
10.1
6.1
41.4
22.4
13.5
27.6
10.5
41.2
25.5
5.0
11.7
14.9
24.1
11.0

YTD2015
9.3
CompoundAnnualRateofReturn(34Years,1Month)
11.6

MSCI
EAFE
1.0
1.9
23.7
7.4
56.2
69.4
24.6
28.3
10.5
23.4
12.1
12.2
32.6
7.8
11.2
6.0
1.8
20.0
27.0
14.2
21.4
15.9
38.6
20.2
13.5
26.3
11.2
43.4
31.8
7.8
12.1
17.3
22.8
4.9

GMO
ValueAdded
6.8
4.3
8.4
1.3
8.9
12.0
14.9
7.1
16.9
12.7
1.8
8.2
8.6
1.9
2.6
8.6
5.0
6.1
1.6
7.7
11.3
9.8
2.8
2.1
0.0
1.2
0.6
2.1
6.2
2.7
0.5
2.4
1.3
6.1

S&P
500
4.6
20.3
22.6
6.3
31.8
18.7
5.3
16.6
31.7
3.1
30.5
7.6
10.1
1.3
37.6
23.0
33.4
28.6
21.0
9.1
11.9
22.1
28.7
10.9
4.9
15.8
5.5
37.0
26.5
15.1
2.1
16.0
32.4
13.7

Bonds
AAA/AA
2.0
42.5
6.3
16.9
30.1
19.8
0.2
10.7
16.2
6.8
19.9
9.4
13.2
5.7
27.2
1.4
13.0
10.8
7.4
12.9
10.6
16.3
5.3
7.9
5.9
3.2
2.6
8.8
3.0
12.4
18.0
10.7
7.1
17.3

5.5

3.7

1.2

4.3

9.0

2.6

11.4

10.1

International Active Update

Second Quarter 2015

REGIONAL COMMENTARY
In the first six months of 2015, the Nikkei has outperformed the S&P 500 by roughly 14% in U.S. dollar
terms as two macro themes are presently captivating investors collective attention. First, we are witnessing
a material rotation of risk assets out of Japanese Government Bonds (JGBs) into equities by, among
others, the Japanese Government Pension Investment Fund (GPIF). At the same time, Japanese corporate
management teams are increasing their commitment to shareholder returns. The convergence of these
events is not a coincidence, in our view; Japanese pension funds are forced buyers of equities, which raised
the bar for expected return. A positive cycle has been set in motion, but the question remains one of
sustainability.
The Bank of Japans domination of the bond market in 2013 and 2014 has driven the price of JGBs to
unprecedented levels. The asset allocation decision to rotate out of bonds was formalized on October 31,
2014, when GPIF announced its intention to raise the equity target from 12% to 25% and reduce JGBs from
60% to 35%, with trading set to commence on January 1, 2015.
From 1986 to August 2012, the cumulative returns of JGBs outperformed the Nikkei 225 by more than
200%. The magnitude of this equity underperformance highlights the perils of asset overvaluation and the
malaise of low return on equity (ROE) in Japan. One may ask, given the historic relative performance of
the Japanese stock market vs. the bond market, why move to equities? According to the GPIF, it forecast 10
years of rising bond rates against the backdrop of needing 1.7% real return to meet its pension obligations.
It is turning to the equity market in search of smart beta stocks that offer bond-like characteristics of
stable and above-average ROE with high liquidity. However, in September of 2014, of the roughly 3,600
listed Japanese companies, only 700 had a market cap greater than $750 million with fewer than 350
companies producing 8% ROE or higher. Compare that to the U.S., which at that time had 3 times the
GDP, but more than 10 times the number of companies that met those criteria. Clearly, the Japanese market
needs to make some changes to insure that Japanese management will be good custodians of the capital that
is being increasingly sent their way.
GPIFs forced buying of equities has created a governance response in Japan. Professor Kunio Ito, an
influential professor of finance from Hitotsubashi University, issued a comprehensive report commissioned
by the Ministry of Trade and Industry that called for a capital efficiency revolution in Japan. The report
read like a value managers manifesto. For the first time, there was official endorsement of the importance
of generating an ROE higher than the cost of capital. Professor Itos framework for putting the primacy on
generating shareholder value came shortly after the announcement of the creation of the JPX 400, an index
of 400 companies in Japan with ROE higher than 8%. GPIF and other auxiliary government pension funds
explicitly use the new index for passive investing of the money intended to be allocated to equities.
When the JPX 400 started trading on January 6, 2015, several companies suffered the shock of not being
included and took action in the form of buybacks and dividends. Shortly thereafter, the Financial Services
Agency (FSA) released the Japanese Stewardship Code, largely modeled on that of the U.K., which
encourages company board members to engage with institutional shareholders to make sure shareholder
interests are properly protected. The largest proxy advisory firm seized upon the governance momentum to
issue new proxy voting guidelines that included an automatic vote against a corporate board that produces
lower than 5% ROE for five consecutive years. There are finally real consequences of poor performance
for Japanese management teams.
The obvious question: Is the Japanese market outperformance due to aggressive buying from the GPIF or
a genuine uptick in expectations for shareholder value return in Japan? We believe the answer is both. We
estimate that there is roughly $80 billion of demand for equities from the domestic pension funds, with
daily Topix turnover of $200 billion, which would be about 2% of market volume for 230 trading days.
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Copyright 2015 by GMO LLC. All rights reserved.

International Active Update

Second Quarter 2015

As 45% of daily volume is high frequency trading, the domestic pension funds represent upwards of 5% of
the real directional flow on a daily basis, which can have a positive impact on market action. However, the
real impact of GPIF will not be clear until the end of the calendar year when pension buying is anticipated
to stop. In addition, companies have responded to the call for higher returns to shareholders. According
to J.P. Morgan, 12-month rolling share buybacks are now running at just under 1% of Topix market cap;
almost a tripling off the post-Lehman Shock lows. Total dividends paid is about triple buybacks, implying
roughly 2.4% yield. Taken together, Japan Inc. is returning over 3% by being better managers of capital.
Is this a shareholder revolution? It is still too early to tell, but the signs are positive. We remain enthusiastic
about value stocks in the Japanese market, mainly banks and telecom names. For banks, we believe that
the discount to the market is still too large given that their earnings should benefit from a rise in the yield
curve and their capacity to deliver higher dividends and buybacks will increase as they exit the cross
shareholdings. The telecom companies we hold are committed to delivering upwards of 10% compounded
EPS growth. The robust nature of telecom cash flows allows these names to overcome earnings shortfalls
with material buybacks to reach their respective EPS and ROE targets. After decades of malaise, there is
an atmosphere of heightened commitment to delivering shareholder return. After all, the management of
Japan Inc. is now working for GPIF, and in a way, its own retirement. Strong incentives indeed.
COUNTRY ALLOCATION AND MARKET UPDATE
Country and currency allocation was 0.1% behind the benchmark. Our weight in Europe is lower than
that of the benchmark, but we have an overweight position in the eurozone. In January we hedged the
account such that the exposure of the portfolio to the euro was closer to that of the benchmark, and the
hedge against the euro was negative in the quarter. This was mostly offset by an underweight position in
the underperforming Australian market, which added to returns.1
The Pacific was the best performing region in the quarter. The only stock market in Asia that has been
able to keep pace with Japan this year has been China, both up about 18%, although most of the Middle
Kingdom's move came in the second quarter whereas most of Japans performance came in the first. This
contrasts sharply with the rest of Asia where markets are down in U.S. dollar terms over the quarter, the
worst being Indonesia. The common theme across Asia ex-Japan has been a gathering economic slowdown
that we attribute to an ebbing of dollar liquidity, which is slowing money supply growth the reversal of
the process that propelled the boom in the region since the early part of this century. It is curious that the
same process is, we believe, working in China, but in the second quarter its stock market has shot higher
at the same time its economy has predictably struggled in line with the rest of the region. We suspect
that it is a combination of assumed exchange rate stability combined with panicky monetary easing that
seems designed to lift asset prices, an attractive combination for speculators. Indonesia's predicament is a
template for what we fear could happen elsewhere, even China at some point. This is that capital outflows
and exchange rate weakness are met with weak economic growth, tying the hands of policy makers who
have been backed into a corner after a decade of accommodating an unsustainable boom. A rising cost of
capital across the region would not be good for equity markets.
Europe did reasonably well in the quarter, but the strong run in European stocks came to a halt at the
end of the quarter when Greece defaulted on a 1.3 billion payment to the IMF, triggering a sharp selloff in eurozone equity markets. Further volatility resulted from the Tsipras Government's launching a
referendum on the proposals outlined by the EU, ECB, and IMF for reducing the country's debt burden.

1 Data is that of a representative account from within the Composite.

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Copyright 2015 by GMO LLC. All rights reserved.

International Active Update

Second Quarter 2015

Though the Greek population voted down the proposals by a wide margin (probably surprising the Tsiparas
Government as much as anyone), at the time of writing the main political parties in Greece seem to have
capitulated to an even harsher set of packages amid fears of an imminent exit from the eurozone. We
remain of the view that several sectors in the eurozone such as construction offer reasonable valuations
on depressed margins and sales and that a Grexit scenario can at worst delay recovery in some of these
highly depressed sectors. It should be noted that the leading economic indicators in the eurozone have
recently been extremely robust, though it remains to be seen if the Greece-induced volatility will derail this.
Outside of the eurozone the U.K. economy remains on a robust recovery trajectory.
During the second quarter, the U.S. market turned lower against the backdrop of a strengthening dollar,
geopolitical volatility (including the potential for a Grexit from the eurozone), as well as the volatility in
the Chinese stock market. Domestically, the market continues to suffer from declining earnings estimates
(mainly due to energy companies), and valuation levels, which continue to be elevated. However, an
improving job market and the prospect of increased consumer spending given the decline in fuel prices
have continued to give support to the market. Record cash balances and strong cash flow generation are
fuelling share repurchases and M&A activity, and will likely limit some of the downside risk posed by
elevated valuation levels.
STOCK SELECTION
Stock selection beat the benchmark by 2.9% in the second quarter. Holdings in Europe, Japan, and Australia
outperformed. On the negative side, stock selection in emerging markets hurt returns, particularly holdings
in Korea.2
Stock selection in Europe outperformed in the second quarter. Holdings Peugeot in France, house builders
in the U.K., and Vodafone were all large contributors to returns. Our holding in Peugeot enjoyed a strong
quarter, helped by the French car makers field trip to China, where the company operates a joint venture
with Dongfeng and Changan. CEO Carlos Taveres revealed that volumes and pricing in Europe remained
robust and that the company was ahead of schedule on its Back in the Race recovery plan. In tandem
with some ambitious targets on Chinese sales, this triggered material earnings upgrades from some
sell-side analysts. U.K. house builders and home improvement companies, particularly Taylor Wimpey,
Howden Joinery, and Berkley Group, received a boost from the Conservative election victory (the party
was perceived to have a far more favorable attitude toward the sector than the Labour Party, which accused
the sector of hoarding land). At the same time, the building companies continued to reap the benefit of
a remarkably benign land market with smaller private builders remaining starved of capital and unable
to bid up prices. Market participants re-rated U.K.-based Vodafone, as M&A speculations resurfaced.
Cable giant Liberty Globals main shareholder sees an obvious fit between the two companies European
operations. Vodafones telecom business in the U.K., Germany, and the Netherlands would be immediately
complementary to Libertys cable services, allowing a joint company to offer bundled telecom and television
packages in those countries. Such a move would take advantage of massive synergies and enable a clearer
valuation of Vodafone assets; currently the value of businesses in India, Turkey, and Africa is not being
reflected in Vodafones share price.
In Japan, our holdings in banks outperformed the market in the second quarter. A main driver of this
trend is the increasing market expectation that banks will exit the crossholdings with their corporate
customers. The practice of holding the other companys shares traditionally cemented the relationship

2 Data is that of a representative account from within the Composite.

4
Copyright 2015 by GMO LLC. All rights reserved.

International Active Update

Second Quarter 2015

when a company decided from which bank to borrow in an economy that is severely overbanked. It
has always been unclear whether the crossholdings genuinely helped banks make loans, but it is clear that
the practice left bank balance sheets exposed to moves in the stock market. Exiting these crossholdings
is positive as it allows investors to focus on a banks credit risk and no longer worry about the embedded
equity market risk. Insulating the banks balance sheet from equity market moves also increases its capacity
for higher levels of dividend payouts and share buybacks. Holdings in NTT DoCoMo (NTT), Japans largest
integrated fixed line/mobile operator, outperformed in the quarter due to two factors. First, the company
released a mid-term plan that included financial targets that were focused on delivering higher ROE and
EPS growth. The EPS forecast included a commitment to achieving 350 of earnings per share in 2018, or
roughly 13% compounded annual return. The company made it clear that should organic earnings trend
below this forecast, management will buy back shares. The second positive factor is NTT has started a new
wholesale service for fiber optic cable to the home (FTTH). The new scheme encourages the three cellular
service providers to bundle NTTs fiber with their wireless service. The benefit to NTT is that they aim to
dramatically reduce marketing expenditure to get incremental subscribers. Cost savings are material, which
gives further credibility to the goal of achieving the EPS target.
Asciano, the Australian port and rail company that we have written about many times in the past, received
a buyout offer from Brookfield Infrastructure Partners of Canada. The stock traded up sharply as a result.
Korean car company Hyundai Motors has been a value trap for over a year. The latest blow to the stock was
poor sales numbers due to their aging model line-up. We believe the stock is now discounting a halving of
margins and remains very inexpensive. Any positive moves on the corporate governance front, or a weaker
won, should be positive for the share price.
CURRENCY AND HEDGING
For the most part currencies rallied against the U.S. dollar in the quarter. The euro climbed 3.6% despite
rumblings about Greece, and the U.K. pound gained 5.9%. The Japanese yen was one of the few currencies
that fell, declining 2.1% while the Australian dollar gained 0.6%.
As mentioned above, in January we hedged the account such that, despite more exposure to eurozone
markets than the benchmark, the exposure of the portfolio to the euro was roughly in line with that of the
benchmark. As of June 30, 4.1% of the account was hedged. The hedge against the euro was negative in
the quarter.

5
Copyright 2015 by GMO LLC. All rights reserved.

International Active Update

Second Quarter 2015

Sector Weights and Performance June 30, 2015

MSCIEAFE
SectorPerformance
SecondQuarter
2015

Sector

SectorWeight
June30,2015
GMOInt'lActive
MSCIEAFE

2.9%

8.5%

14.0%

9.0%

0.8%

5.0%

5.2%

5.2%

Energy

2.4%

2.6%

4.5%

9.0%

Financials

0.1%

6.6%

33.1%

37.1%

Healthcare

4.8%

7.9%

7.4%

7.5%

Industrials

1.4%

6.2%

8.3%

9.6%

InformationTechnology

2.6%

6.0%

8.3%

2.0%

Materials

4.3%

2.4%

1.0%

8.3%

TelecommunicationServices

3.8%

7.1%

13.0%

5.8%

Utilities

0.4%

3.3%

5.2%

6.6%

ConsumerDiscretionary
ConsumerStaples

GMO Parameter Profile June 30, 2015

Priceto
Book

Priceto
Earnings

Priceto
CashFlow

(weightedmedian)

(weightedmedian)

Yield

Total
Yield

FreeCash
FlowYield

GMO

1.4

16.2

8.3

3.0%

3.4%

4.7%

MSCIEAFE

1.8

19.1

12.2

3.0%

2.9%

4.4%

23%

15%

31%

17%

6%

Region/Country

GMOPremium/(Discount)
toMSCIEAFE

Free cash flow yield is calculated using the cash flow from operations less capex, divided by the market cap of the company for all companies
except for financials. The net income divided by the market cap is used in the case of financials. Companies that do not have a reported
number are excluded from the calculation.
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 2014.

6
Copyright 2015 by GMO LLC. All rights reserved.

International Active Update

Second Quarter 2015

MSCI EAFE Country and Currency Returns

2015Q2

June30,2015

Country
Ireland
HongKong

MSCIEAFE
Weight
0.4%

GMO
Int'lActive
Weight
0.0%

3.3%

1.9%

MSCIEAFE
Returnin
LocalCurrency
4.6%
5.6%

MSCIEAFE
Currency
Return
3.6%

MSCIEAFE
Return
in$US
8.5%

0.0%

5.6%

Norway

0.6%

0.0%

0.9%

2.3%

3.3%

Austria

0.2%

0.0%

0.5%

3.6%

3.2%

Japan

22.9%

20.9%

5.2%

2.1%

3.1%

UnitedKingdom

20.3%

19.8%

2.8%

5.9%

3.0%

Netherlands

2.8%

1.1%

0.9%

3.6%

2.8%

Italy

2.4%

6.3%

1.2%

3.6%

2.5%

Denmark

1.7%

0.0%

1.5%

3.6%

2.4%

Portugal

0.2%

0.5%

1.7%

3.6%

2.0%

Belgium

1.3%

1.4%

2.6%

3.6%

1.0%

Switzerland

9.2%

7.2%

2.8%

3.7%

1.0%

1.8%

2.4%

0.6%

France

9.7%

13.3%

3.3%

3.6%

0.3%

Singapore

1.4%

0.0%

2.0%

1.9%

0.2%

MSCIEAFE

Israel

0.6%

0.9%

6.6%

5.3%

1.5%

Spain

3.5%

3.6%

5.6%

3.6%

2.0%

Sweden

2.9%

1.5%

6.6%

3.8%

3.0%

Finland

0.8%

0.8%

7.4%

3.6%

3.9%

Germany

8.9%

6.4%

9.0%

3.6%

5.6%

Australia

6.9%

3.1%

6.8%

0.6%

6.2%

NewZealand

0.1%

0.0%

3.6%

9.9%

13.1%

EmergingMarkets
Cash

0.0%
0.0%

6.4%
4.8%

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 Form ADV 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. The attribution information above 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 2014.
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 form and 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 from making) 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).

7
Copyright 2015 by GMO LLC. All rights reserved.

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