While U.S. large-cap stocks enjoyed a robust decade, international equities languished. How will the international equities perform going forward?
In Morningstar's International Equities panel moderated by Kevin McDevitt, Rupal Bhansali of Ariel Investments, Rezo Kanovich of Artisan Partners, and Rob Lovelace of Capital Group discussed a valuation gap between international equities and S&P500, and where they find opportunities amidst COVID and other disruptions.
A lost decade may be a relative term, however, in the last 10 years, the S&P 500 Index nearly tripled the return of the MSCI index. As a result of such performance, S&P tends to trade at a higher multiple than MSCI Equity or MSCI EAFE. This valuation gap has created opportunities for international equities. Some international equities might have higher returns than the U.S. ones.
Valuation and what returns might look like for the next 10 years:
Rob Lovelace, Capital Group:
The valuation gap between the U.S. and international equities has gotten slightly higher but not by too much. Price-to-Earnings (PE) multiples for the U.S. are in the 20s, while the PE multiples for Europe are in the high teens. Investors need to take into account that the constituents in the markets are quite different. In the U.S., for example, we are heavily weighted toward technology, healthcare, and consumer discretionary sectors, while outside of the U.S. – we are heavily weighted toward financials, energy, and commodities’ sectors. In general, the U.S. is heavily weighted toward high multiple businesses.
If you take a look at a particular sector such as consumer discretionary and stocks such as Tesla or Amazon, you note that these are high multiple companies that have been generating the most earnings growth and cash flow. And although they do have high multiples, you want to own these companies. Many fast-growing companies are domiciled in the U.S.
Rupal Bhansali, Ariel Investments:
- Since the world is awash with debt, instead of looking at the PE multiple, she urges to look at the Enterprise to debt value. She notes that the S&P 500 has already exceeded the 1999 valuation levels and that “this is a bubble territory”.
- Shareholders should pay for the Cash Flow. And while the international companies are growing at a slower pace than U.S. ones, their dividend yields are more compelling in the income starved world.
- She is overweight international equities in her international fund. She is advising caution: for years, the interest levels were declining, the higher debt levels can still be managed with manageable debt service ratios. She also foresees defaults… the Fed is very clear in their direction – they will only buy debt of solvent companies. When debt gets downgraded, equity investors suffer significantly. For equity investors, debt is a double-edged sword and we are on the other end of the tip.
Rezo Kanovich, Artisan Partners:
The last decade brought an extraordinary growth of small companies, and many of these companies merged into large companies. Also, an emergence of entire industries (bio-processing, for example) has occurred. Information technology allowed for smaller companies to disrupt the big ones. It is important to understand that there are big structural changes happening in the world. We focus on small and mid-part of the market. We think that this dynamic is similar within the U.S. and outside of the U.S. Some small companies can be more successful than larger companies. They can dominate some large companies’ markets as in asset-intensive industries, for example. They dominate particular niches, benefit from agility and ability to disrupt legacy industry structures. This happened in the Japan software market. The major theme of interest right now is global value supply chains – this industry is being completely disrupted. We look for the opportunities with an aim of identifying when small companies emerge into large companies.
Rise of China and how you find your opportunities:
Rupal Bhansali, Ariel Investments:
Instead of thinking of markets, think of sectors and stocks, growth and value. China is no exception. I am a top-down investor and it is a stock pickers market. International markets are full of these opportunities.
Rezo Kanovich, Artisan Partners:
China has many highly innovative companies such as BeiGene (biotech company focused on developing molecularly targeted immuno-oncology drugs for the treatment of cancer). We also like semiconductor space, electrical space, among others. What worked for us is to identify companies like Nice Systems (an Israel-based company, specializing in telephone voice recording, data security, and surveillance) that will grow into large companies.
Dislocation created through COVID:
Rezo Kanovich, Artisan Partners:
Ingenuity of management teams and entrepreneurial spirit in companies such as Kinaxis (software company) is remarkable.
Rob Lovelace, Capital Group:
Does domicile matter more now? We’ve been in a global shift for a few years now. The supply chain for wholesale was harder to configure for the retail segment. There is also a digital trend happening, which works against borders. So multinational companies as they work to re-wire their supply lines – some factors may come down to domicile, but not for all.
Where do you find companies with good earnings stream and a good downside protection?
Rupal Bhansali, Ariel Investments:
Anywhere in the world and especially in sectors that are direct benefactors of COVID disruption: utilities, telecommunication, and healthcare sectors (Glaxo, Roche, etc.)
Rezo Kanovich, Artisan Partners:
Healthcare, biotech, water companies, smart buildings, companies such as Belimo (development, production, and sales of field devices for controlling heating, ventilation, and air conditioning systems), Finnish company Vaisala (global leader in weather, environmental, and industrial measurements).
Rob Lovelace, Capital Group:
Biotech, software companies, company mentioned above BeiGene, Fintech, or financially related areas, and in countries such as Brazil.
What is the diversification power of international stocks?
Rupal Bhansali, Ariel Investments:
Currencies are a great diversifier.
Rob Lovelace, Capital Group:
Buy the best stock, the best company, give yourself flexibility to diversify, have an economic exposure through revenue as opposed to looking at the domicile status of the company.