About 1583, Galileo discovered that each swing of a pendulum takes the same length of time, which led to the creation of the first accurate clocks. And, like the factors that influence the movement of a pendulum — angle, pivot point, and force of gravity — many factors influence market movements.
Since emerging from the 2008-09 financial crisis, U.S. equities have dominated — and after such a prolonged period of U.S. outperformance, investors are starting to question the value of investing overseas. However much individual markets run up, like a pendulum, they will inevitably swing (or even crash) back. We cannot time when or how long it will take for this to happen, but by actively allocating to international equities, one can achieve greater diversification within a portfolio and gain exposure to a unique opportunity set of strong businesses while trading at a historically large discount to the U.S. market.
FIGURE 1: SWINGS IN U.S. VS. INTERNATIONAL EQUITY RETURNS Cumulative Total Return 12/31/2000-3/31/2020
Source: FactSet, Growth of $10,000. Past performance is not indicative of future returns.
The U.S. is just one piece of the opportunity
Although the U.S. stock market is the largest in the world with a value of roughly $30.4 trillion, it only amounts to about 44% of the value of global equity markets.2 Further, while the U.S. is a large, diversified, and dynamic economy, it accounts for just roughly 15% of global GDP and 4% of the world’s population. Despite its better stock market performance, U.S. economic growth has not kept up with emerging markets. Over the last decade, emerging markets were the fastest-growing economies with aggregate GDP growth of 5% versus 2% for the U.S., which means that the U.S.’s share of the global economy is declining. Investing in international companies lets you directly access this faster growth.
Exchange rates can be an important component of returns, or a significant detractor. In a complex macro environment, exposure to international equities can be a good hedge against the risk of dollar depreciation. While the U.S. dollar has appreciated relative to the main currencies in the last decade, as with shifts in market leadership, this has not always been the case. A period of dollar strength in the 1990s was followed by a considerably weaker greenback from 2001 to 2008. The currency has been on a decade-or-so long recovery ever since. Investing internationally can provide more resiliency when currencies swing.
FIGURE 2: 30 YEARS OF USD CYCLICALITY U.S. Dollar Index vs. A Basket of Major World Currencies, as of 4/30/2020
Source: FactSet. The U.S. Dollar Index tracks the strength of the dollar against a basket of major currencies which include the euro, Japanese yen, pound sterling, Canadian dollar, Swedish krona, and Swiss franc.
2. Unique Set of Businesses
Distinct investment opportunities
The U.S. is home to a number of the world’s top companies – Alphabet, Apple, Microsoft, to name a few. However, in some industries, international companies are dominant. Take the consumer staples sector, for example. Europe is home to many of the most well-known global consumer staples businesses in the world. Companies like Unilever, Nestle, and Anheuser Busch InBev have larger exposure to faster-growing emerging markets than their U.S.-listed peers. In emerging markets, we also find high-performing, consumer-oriented companies such as Walmex, the largest retailer in Mexico and Central America. We believe Walmex provides investors with exposure to the best of both worlds – a higher growth opportunity and good management and corporate governance (Wal-Mart is Walmex’s largest shareholder with a 71% stake).
Walmex’s growth opportunity comes from market consolidation (small “mom and pop” retailers account for 60% of the market in Mexico) by offering customers lower prices and better service. In addition, Walmex benefits from increasing income per capita among Mexican households. In the last twenty years, Walmex has been compounding profit growth by 12% in USD terms, two times faster than Walmart’s. Over the same period, Walmex’s stock outperformed its parent company by 230% on an accumulated basis.
It comes as no surprise that U.S.-based consumer staples companies have underperformed both consumer staples companies in both the MSCI EAFE and MSCI Emerging Markets Indexes over the last 20 years.
FIGURE 3: INTERNATIONAL CONSUMER STAPLES COMPANIES HAVE OUTPERFORMED U.S. CONSUMER STAPLES COMPANIES Cumulative total return 12/31/2000-3/31/2020
Source: Bloomberg. Note: MSCI Emerging Markets Consumer Staples Index inception: January 2001.
FIGURE 4: WAL-MART DE MEXICO VS. WALMART INC. (in USD) Stock total return 12/31/1999-3/31/2020
In addition to consumer staples companies, some of the best performing stocks in the consumer discretionary and industrials sectors are also located outside of the U.S. So if you enjoy a fine champagne or appreciate a fashionable purse or stylish watch, you are probably a customer of one of the global luxury companies based in Europe, such as LVMH, Hermes, and Richemont. And every time you board an airplane, it is most likely powered by an engine manufactured by a European company, such as Safran, Rolls-Royce, or MTU Aero Engines. We see engines as the most profitable and predictable segment of the aerospace industry. Unfortunately, for a U.S.-dedicated investor, there is no direct way to get exposure to this space. You can only access this end market through one of the two large U.S. conglomerates, GE or United Technologies, which also expose you to a swath of other less attractive businesses.
Banking is another industry moving at a very different speed in international markets. For example, HDFC Bank in India ranks as one of the top global banks in terms of earnings growth and profitability. In the last decade, HDFC Bank’s earnings compounded at 23% per year (in USD) compared to a quite respectable 9% for U.S. bank Wells Fargo. While developed market banks continue to struggle for loan growth in general, HDFC Bank has averaged loan growth above 20% for many years as India’s middle class swells and millions move into formal banking for the first time.
Investing only in the U.S. excludes these opportunities. Why invest with one hand tied behind your back?
FIGURE 5: HDFC BANK BEATS INDIAN AND U.S. BANKS FOR LOAN GROWTH
Source: Company data (2013-2018), FactSet. Top 4 U.S. banks are: JPMorgan Chase, Wells Fargo, Citibank, Bank of America. Past performance is not indicative of future results. The securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Greater opportunities for active management outside the U.S.
The gap in performance of the overall universe is wider in international markets than in the U.S. In our view, that means that international markets are less homogenous in terms of quality. Thus, there is likely more opportunity to capture alpha with active stock picking in international markets than in the U.S.
FIGURE 6: WIDER DIFFERENCE IN RETURNS FOR INTERNATIONAL VS. U.S. STOCKS as of 12/31/2019
Source: FactSet. Top 3 quartiles vs. total performance average spread over the past 10 years. Spread represents the arithmetic difference between the top and bottom quartile performers.
“The upshot is that investors without international diversification may be at greater risk of future underperformance.”
3. Attractive Valuations
The U.S. market has become relatively expensive, with the MSCI USA Index trading at an average of over 20x forward P/E. As a result, international benchmarks are trading at the largest discount to U.S. indices of any point in the last 20 years. The risk that the discount to the U.S. will continue to widen is lower. The upshot is that investors without international diversification may be at greater risk of future underperformance.
FIGURE 7: VALUATION AND GAP BETWEEN MSCI U.S. AND EX-U.S. WIDEST IN 20 YEARS Forward P/E, as of 4/30/2020
Valuation spreads between the U.S. and the rest of the world could reverse going forward. Looking back over the past decade, it isn’t surprising that the U.S. outperformed international markets as the earnings of the S&P 500® companies grew faster than international ones driven by its higher weight in certain growing sectors – healthcare and information technology. The U.S. was also helped by better capitalized banks.
Interestingly, if you adjust for the difference in the markets’ sector weightings, the historical earnings growth gap declines meaningfully as shown by Europe’s significant improvement as shown in Figure 8 (Annualized EPS Growth 2006–2019).
Going forward, EPS growth is forecast to be much higher, even across markets (Figure 8). The valuation and performance could therefore normalize between the U.S. and the rest of the world.
“Some of the best performing stocks in the consumer staples, consumer discretionary, and industrials sectors are located outside of the U.S.”
FIGURE 8: THE GAP BETWEEN U.S. AND INTERNATIONAL EPS GROWTH IS EXPECTED TO NARROW IN COMING YEARS Forward P/E
Source: FactSet, Standard and Poor’s, I/B/E/S, Goldman Sachs Global Investment Research.
As Galileo witnessed over four centuries ago, when the pendulum swings one way, it is followed by a swing in a different direction. Even though international markets have underperformed the U.S. in the last decade, we know they will swing back. At Vontobel, we have a deep history of managing a concentrated International strategy, where we aim to invest in consistently growing businesses that can provide meaningful returns with less risk than the market.
By seeking to invest in high quality growth businesses outside of the U.S., an investor can gain exposure to greater opportunities in market or industry segments at relatively compelling valuations, with the diversification of macro risks. We believe that a diversified portfolio invested in both domestic and international equities is the most sensible approach for long-term investors.
1 October 31, 2003 – October 31, 2011.
2 As of year-end 2018. Source: The World Bank
Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates, or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.
The S&P 500®Index is a free-float market-capitalization weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The MSCI EAFE® Index (net) is a free-float-adjusted market-capitalization weighted index that measures developed foreign market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index (net) is a free float-adjusted market capitalization weighted index designed to measure equity market performance in the global emerging markets. The MSCI AC World ex USA Index (net) is a free float-adjusted market capitalization-weighted index that measures equity performance of developed and emerging markets, excluding the U.S. The MSCI USA Index (net) is a free float-adjusted market-capitalization weighted index that measures the performance of the large and mid-cap segments of the U.S. equity market. MSCI indexes are calculated on a total return basis with net dividends reinvested. All indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and they are not available for direct investment.
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