Harvesting Alpha in Non-U.S. Markets

[Daniel McCormack] Welcome everyone to our podcast regarding current opportunities and risks in non-U.S. equity markets. With me is Scott Decatur, Lead PM and Director for our Quantitative International Strategies, and John Fenley, Lead PM and Director for our Fundamental International Strategies. It’s great to have you both here with me again for another informative podcast. A lot has changed since the last time we met earlier in the year, with many big topics on investors minds including geopolitical and economic concerns such as the war in Ukraine, China’s fluid COVID lockdown status, and rising inflation and risks of recession on a global basis. Let me start with you, Scott. Do you believe that non-U.S. markets still offer more value today relative to the U.S. equity market?

[Scott Decatur] Thanks, Dan, yes we do think that they offer great value. As you just recapped, a lot has happened in the first half of ’22 in equity markets, both U.S. and non-U.S. have fallen by roughly similar amounts, plus or minus a few percentage points. And this has left the already wide valuation advantage that non-U.S. markets had over the U.S. in pretty similar levels as before. That is, some of the best opportunities to buy U.S. markets that we’ve seen throughout history.

[Dan] Thanks, Scott. John, what is your perspective on the opportunity international markets in today’s environment?

[John Fenley] Yeah, thanks Dan. Because of the massive sell-off in equities across the globe valuations are becoming more attractive on select companies. Although macro economic headwinds remain virtually everywhere, not all companies will be adversely effected from an operational standpoint, despite many of those also experiencing declining share prices. We feel that it is as important as ever to stay focused on companies with enduring free cashflow and earning streams. Just as we recognize the importance of diversification in our portfolio holdings, particularly during periods of heightened risk and uncertainty, we feel that it is crucial that investors continue to diversify their investments as well. We would argue that exposure to high quality, international equities is a prudent diversification strategy in today’s environment.

[Dan] So, given this opportunity that you both described, tell us, Scott, from a portfolio management perspective how are you navigating the current market environment and mitigating risks?

[Scott] There’s surely a lot of uncertainty out there right now. Geopolitics, interest rates, economies. Two key ways that we look to protect against the various risks are diversification and buying lower priced assets. On diversification, which we do across countries, sectors, and stocks, this helped to insulate a portfolio from getting upended in this kind of market by one stock or by a group of stocks. As for buying lower priced assets, when risks seemed distant it was fashionable to own whatever was hot and had momentum which included the U.S. as a whole and growthier stocks both at home and abroad. But now that investors are being reminded that we don’t live in a risk free world, we’re seeing the value of oriented strategies starting to dominate again in all markets, as they’re less exposed to over valued assets. And in many cases, especially overseas, our measures show that these stocks are trading at very attractive prices. This combination of diversification and price discipline to be really powerful. Great example is that despite all the turmoil in some of the emerging markets this year, our well diversified E.N. value strategy is actually ahead of the S&P 500 throughout the first half of this year. And we think investors should be doing the same things we are to protect against these risks. Diversify, and in particular, shift more to high quality, safer price value assets.

[Dan] Thanks, Scott. John, as a Fundamental Manager, how are you investing in today’s market environment and mitigating the risks?

[John] Right, so far the multiple contraction due to rising rates and the bleak economic outlook coupled with the declining U.S. dollar explain the vast majority of our disappointing performance. That said, the operating performance of our portfolio holdings continues to be strong. This is due to our strict adherence to quality businesses which leads us to companies with strong free cashflow generation, high returns, and robust balance sheets.

[Dan] What about the fact that growth companies have been takin’ it on the chin this year? Do you think investors now have a higher hurdle for growth companies relative to the past three to five years?

[John] Yeah, we believe that there has been a shift in investor sentiment away from a high level of interest in quality growth businesses to a significant degree of skepticism and scrutiny of these companies, which has resulted in indiscriminate selling. This has presented a very attractive environment for us as few stocks have been completely spared, especially taken in context with the last two years. It’s our view that many investors are realizing that they don’t really know what they own, make negligent assumptions regarding company fundamentals, and were over emphasizing the short term. We remain optimistic that our portfolio quality businesses are strongly positioned and attractively priced. The high quality of our portfolio companies, their continued strong execution, and their niche operations gives us confidence in these businesses going forward, regardless of the macro environment. Quality for us includes investing in companies with strong balance sheets, mostly with net cash positions and that are capital light, which should help mitigate inflationary and interest rate pressures.

[Dan] Scott, given those observations from John, do you think this environment will favor value and quality for the foreseeable future?

[Scott] Yeah, in fact, we think the swing back towards value is just in its earliest stages. In all the markets in which we invest, those cheaper high quality stocks that we favor are historically attractive valuations compared to the market. And conversely, those most expensive stocks, despite recent under performance, are still near historically high premiums to the rest of the market. Given the extreme current market valuations combined with the catalyst of rate rises at the end of free money, we expect the coming three to five plus years to deliver very strong tailwind for value approaches. And within the value space, we see the best opportunities within higher quality value stocks.

[Dan] We’ve talked about the attractiveness of international markets versus the U.S., but is now the right time to invest? Scott, why don’t you go first?

[Scott] Yes, we believe now is a great time to invest. Non-U.S. markets have been way ahead of the U.S. in terms of pricing and the risks that we are now seeing materialize. As I said earlier, this margin of safety and the price at which you buy stocks is one of the most powerful risk mitigation tools. In many of our strategies you’re paying close to one third the price for a dollar of earnings as compared to the S&P 500, and these high quality value oriented non-U.S. portfolios are not only very well positioned relative to U.S. markets, but they’re also really cheap in an absolute sense at roughly six to seven times earnings providing what we see as a great entry point.

[John] Right, and we also believe that it’s the right time to invest with active managers. For example, we continue to trim or sell outright holdings that have zero or minimal upside intrinsic value or those where underlying operations are deteriorated and with cash generated from several recent buyouts we have been opportunistically adding to existing holdings as valuations have become more attractive. That private equity and industrial buyers are interested in our holdings is evidenced by the recent takeovers is reassuring as those buyers tend to be long term focused as well and speaks to the over sold condition of our quality holdings.

[Dan] I’d like to thank you both. We’ve certainly touched on some compelling opportunities and it’s great to hear how your teams are navigating the complexity in today’s markets. I invite all our listeners to contact your SBH representative to dive deeper into this topic with our investment professionals. Thanks for listening and please look for our next podcast in the coming months. Thank you.