During this quarter, we took the market weakness due to the coronavirus as an opportunity to build positions in some cyclical stocks with strong balance sheets and share prices that have overcorrected and hence provided attractive downside support. We think they will survive through the downturn and emerge as attractive sources of outperformance once the coronavirus outbreak passes and market and business conditions return to normal.

We believe that as the oil price stabilizes, some heavily sold-off EM currencies should recoup their losses. The oil price may be poised to climb out of its trough. Hence, we turned less underweight to the energy sector during the quarter. In conjunction with our belief in the recovery of cyclicals and based on our bottom-up investment process, we added new consumer discretionary names and turned less underweight to the sector. Elsewhere, we reduced our overweight allocation in financials, our largest sector position. From a country perspective, China remains our largest position in absolute terms.

We Turned Less Underweight Consumer Discretionary and Energy

As we sought to increase cyclical bets in the portfolio, within the energy sector we initiated positions in Petrobras and Lukoil, which as previously discussed were contributors to relative outperformance during the quarter. With the oil price breaking cash costs at current levels, we think that it will soon hit its trough. Should the oil price recover, these companies will benefit not just from the oil price rebound but also from the foreign exchange impact. Lukoil has a net cash balance sheet and generates a 5%-6% free cash flow yield. We also initiated a position in Tenaris, an Argentina-based leading producer of seamless and welded pipes for the oil and gas industry. The company has a solid balance sheet and its focus on efficiency should lead to future gains in market share.

While we invested in these energy names, we eliminated Saudi Aramco, which we viewed as a U.S. dollar cash proxy. Proceeds of the sale were used to build more positions in cyclicals.

In the consumer discretionary space, we reduced our underweight allocation by establishing a position in Mr Price Group, a South African retailer known for its focus on value, which we believe underpins its long-term growth prospects. We are positive about the company's distinct business model, good capital allocation, and strong management execution. The company's strong cash position and improved free cash flow generation provides a lot of room to return cash to shareholders over time. To fund this acquisition, we closed our position in South Africa's Nedbank, a well-managed lender but one lacking in positive internal catalysts.

We started a position in Galaxy Entertainment, one of Macau's casino operators that has a stronger balance sheet compared to its rivals and which may benefit from pent-up demand once the coronavirus outbreak subsides.

We also invested in Tongcheng-Elong Holdings, a Chinese online travel agency which counts Tencent and Trip.com as its strategic shareholders. We think that the company will recover faster than the overall travel industry in China due to its domestic and lower-tier city focus as the country returns to normal following the coronavirus outbreak. In the medium term, it will likely continue to benefit from users in lower-tier cities learning to book tickets online during COVID-19. Moreover, the company's management has a good history of execution.

Financials Overweight Reduced; Exposure to CEE Banks Trimmed due to Regulatory Concerns

In financials, we exited Bank Polski, the largest universal bank in Poland, and South Africa's Nedbank and Absa Group, resulting in a reduced overweight allocation to the sector. Financials emerged as the largest sector position in absolute and relative terms. We have reduced exposure to some CEE financials, which have healthy balance sheets but have suffered due to concerns about the coronavirus outbreak and falling long-term yields. There are also concerns about regulatory risks with dividend payouts being put on hold.

We exited Absa, a financial services company, as despite the high yield, it remains a value trap. We eliminated the position as it has reached the three-year incubation period that we allow for fundamental changes to materialize but the stock has yet to re-rate.

In Asia, despite closing positions within the financial sector, we also initiated new ones such as India's Shriram Transport, a nonbank financial company that will likely benefit when India's economic cycle turns along with an improvement in the commercial vehicle cycle.

In the insurance sector, we started investments in Poland's Powszechny Zaklad, which has a strong balance sheet, and a smaller position in South Africa's Sanlam. We owned Sanlam in the past but sold it when it became expensive to own. We liked the insurer for is high-quality management team and strong position in the domestic market. It has become attractive after the recent selloff and remains a good franchise and a market share gainer with an attractive yield.

We Turned Overweight in China

In China, we closed our underweight position and turned overweight during the quarter. We established new positions in Baidu, the country's dominant search engine, China Mobile and the abovementioned Tongcheng-Elong. Baidu has underperformed the Chinese internet space due to poor execution by management. However, the company, which has net cash on its balance sheet, is cutting costs and restructuring. Moreover, Baidu is selling non-core assets and we think that any stock buyback it undertakes will be a positive surprise to the market. We also added China Mobile to the portfolio, the dominant mobile service provider in a three-player market in China, due to its stable dividend and historically low valuation. With the addition of Baidu and China Mobile to the portfolio, we reduced our underweight in communication services during the quarter.

We exited Fosun International, one of the largest privately-owned conglomerates in China and a stock that we had owned for more than three years. We think the management has lost direction as restructuring stopped after its initial attempt to unlock asset value through potential deals. Despite a strong balance sheet, it has become a value trap.

Brazil Allocation Increased; Overweight in Mexico Reduced

In Latin America, we became more overweight in Brazil with our new position in the abovementioned Petrobras. We also took the opportunity to add to our existing holdings in Banco BTG Pactual, Bradesco and BRF, laggards during the quarter as previously discussed.

In Mexico, we exited Promotora y Operadora de Infraestructura (PINFRA), which owns and operates concessions for infrastructure projects, and Alpek, a polyester chemical company. We eliminated PINFRA as it disappointed us on dividend and capital allocation despite its net cash position. Mexico's sensitivity to the U.S. economy may also negatively affect the company. We closed our position in Alpek due to the oil price weakness and the U.S. economic slowdown, which weighed on the stock. These trades decreased our overweight in Mexico.

We Pared Our Overweight in Russia But Raised Positions in Attractive Dividend-Yielding Names Outside of Energy

Elsewhere in EM, we reduced our overweight to Russia, as we trimmed our position in energy company Gazprom, locking in some of last year's hefty gains. However, we increased our exposure to stable domestic companies which are non-oil related names that have a strong dividend yield, such as Moscow Exchange and Mobile Telesystems (MTS). MTS is one of the top three telecommunication companies in Russia, where sector competition is stable and improving. We like that it is one of the few domestic companies that yields high dividends and is not driven by oil and commodity prices. Moscow Exchange is a trading platform that may benefit from a recovering economy and capital markets. It may also gain from a lower rate environment as investors chase dividend-yielding stocks. We also increased our position in Sberbank, Russia's dominant bank and one of the best-managed large companies in the country, taking advantage of its attractive level. The bank's returns on equity are very attractive relative to other EM banks and especially so compared to developed market peers. As earlier discussed, we initiated a position in Lukoil during the quarter.