Reasons for Optimism in Non-U.S. Equities

With market sentiment firmly shifted to pessimism, the current environment presents an opportunity for U.S. investors to consider diversifying their portfolios with international equities. Despite doom-and-gloom headlines, we believe that non-U.S. equities are poised to benefit, and that investors can weather disruption by diversifying with international stocks over the long run.

From our vantage point as manager of the Virtus Vontobel Foreign Opportunities Fund, there are several reasons for international investors to be optimistic.

1. Valuation and consensus have no margin of safety built in for increased macro risks

Although the U.S. economy is likely to weaken, it should endure an economic downturn better than many other countries. As a result, the U.S. dollar – at its highest level in decades – is expected to remain strong. International companies generating sales in dollars should benefit. In our view, the Virtus Vontobel Foreign Opportunities Fund is positioned to take advantage of this trend, with greater than 34% aggregate U.S. revenue exposure (as of 8/31/22).

2: Multinationals Can Be Resilient to Rising Inflation

Higher energy prices in Europe will undoubtedly have a negative impact on economic growth across the region. However, there are many high-quality, globally dominant franchises listed in Europe that benefit from diverse geographic exposure, deriving revenues from around the world. Further, many non-U.S. companies with high gross margins and pricing power can withstand rising costs and a weaker economy and are thus well positioned to combat inflation.

Consider these examples from the portfolio:

• French-based cosmetics and hair care company L'Oreal has high gross margins of 74%. If production costs increased by 10%, it would only need to raise prices by 2.6% to earn the same gross profit.
• Inflation is a tailwind for Dutch payments company Adyen’s top-line growth since it charges a percent of each transaction.
• French luxury goods company Hermes appeals to wealthy consumers who can afford high-end brands whatever the market conditions and are unlikely to balk at price increases.

3: Non-U.S. Equities are Trading at Historic Discounts

The U.S. equity market has become relatively expensive, with the S&P 500^® Index trading at more than 17.5 times forward P/E (as of 8/31/22). Headlines around China lockdowns, Europe’s gas shortages, and foreign currency declines have led to historic discounts in both developed and emerging equity markets. While timing is uncertain, we believe that discount should reverse as these issues resolve.

In the meantime, we are taking advantage of current discounts to pick up high-quality non-U.S. companies at compelling valuations – for example:

• Spirax-Sarco is a British manufacturer of steam management systems and peristaltic pumps. Its end-demand should be positively supported in the future by energy efficiency, a desire to reduce carbon-dioxide emissions, and industrial outsourcing. We added it to the portfolio at a discount of more than 30% since the beginning of 2022.
• Budweiser Brewing Co. APAC (Hong Kong) is the leading premium and super premium brewer in China, which represents 75% of the firm’s EBITDA. We believe its stock is undervalued due to COVID’s lingering effects on restaurants and bars. Taking a longer view, we believe the company should grow revenue in the high single-digits and EBITDA should grow in the low to mid-teens.

International Opportunities Abound for Active, Bottom-Up Investors

We believe international equities are not a substitute for U.S. equities, but a complement, offering investors access to great businesses that are not available (or of the same quality) in the U.S. Our international strategy seeks to invest in high-return growth businesses around the world with strong profitability and durable franchises, trading at attractive valuations. The strategy seeks superior alpha capture with lower risk over a full market cycle, aiming to lower overall portfolio volatility and offer a hedge against potential U.S. market weakness. As we see it, the best investment ideas may be conceived in down markets, only to be realized during more buoyant times.