SBH Investment Summit: International Equities

[Dan McCormack] Hello everyone and welcome to our investment summit. My name is Dan McCormack, and I’m a member of our consultant and client relationship team. In this session, we’re going to focus on non-U.S. equity markets. To do that, I have two experts with me today. Scott Decatur is the Lead Portfolio Manager for our Quantitative International strategies and John Fenley, who is the Lead Portfolio Manager for our Fundamental International strategies. Let’s begin with the big picture. It’s been a very volatile market year to date for both U.S. and non-U.S. equities. Looking ahead, many are expecting a global recession in 2023. I’ll ask you both, starting with John first, what are your thoughts on the macro environment and how are you positioning your portfolio?

[John Fenley] Thanks, Dan. Yeah, we believe that 2023 will see slowing global growth. In fact, some regions, the UK, Europe for instance, may already be in a recession. We’ve positioned the portfolio with that slowing macro backdrop in mind. We’re focusing on holdings of companies that have either done relatively well in the past in that type of environment, or those that will benefit from strengthening marketing positions vis a vis other competitors in that environment.

[Scott Decatur] Yeah, outguessing the market on macro forecast is always hard, and a recession may or may not come, and if it does, it can be mild or stronger. But even the absence of recession, we think profit margins are still likely to fall, especially in the U.S. which are well above normal. But regardless of the recession possibilities and margin compressions, most of the markets around the world are still offering compelling opportunities in which reasonably price companies internationally are at historically large discounts to the market, and prices that are really attractive in absolute terms. So, and we’re seeing this even in higher quality stocks, so we see that as attractive.

[McCormack] Sticking with the macro backdrop, do you think that central banks are doing a good job this year? A strong dollar has been wreaking havoc overseas, although easing a bit recently. Scott, what do you think?

[Decatur] Central banks do have some responsibility contributing to the inflation trouble with those previously low rates but for the most part, acting pretty prudently right now for the respective economies. The Fed is being the most aggressive as, as we’ve seen which has driven some extreme dollar strength. But the Fed’s actions have been appropriate given the high inflation and the less economic weakness than we’ve seen in other markets. But we think over the course of the coming year, the interest rates between countries will converge, as will currencies.

[Fenley] The central bank responses in my opinion, going to the start of the pandemic, has been a mixed bag. In hindsight, the massive easing during the pandemic was an overreaction, and central bankers have been trying to reign that in ever since. Now there are similar factors like inflation that most are dealing with, but there are also country-specific factors that have been driving performance. For example, the U.K. has been a disaster. The, the prime minister hand-off in September was mismanaged and the pound suffered dearly because of that. Now, fortunately, the newest leadership in place has instilled more confidence in the markets, and the pound has recovered a bit, but it’s an example of how it’s been a mixed bag across the globe.

[McCormack] As you mentioned, some of the issues that occurred in the U.K. pension market, and the near miss there, are either of you concerned with possible liquidity events that could affect a bond market first, and maybe equity sometime after that? Scott, what are your thoughts there?

[Decatur] Many parties are attuned to the kind of risks that you’re talking about and to try to prevent them, this of course, doesn’t pull them out. We’re not changing our portfolios. These are events are not really forecastable, but our approach of investing in cheaper companies that we assess to be strong and healthy are often the place to be in equities when turmoil of this kind of this kind strikes, as we’ve seen this already year.

[Fenley] I agree with Scott, it’s very difficult to forecast, but in that environment, it’s going to be hard to find many winners and you know, sticking with companies that are less interest rate sensitive and investing in companies with no debt should help offset some of that risk, and we’re currently doing both.

[McCormack] Would you expect the volatility that we’ve seen in currencies to continue into next year? I’ll start with you, John. Should investors hedge or not?

[Fenley] That’s a really good question. With so many highly impactful geopolitical issues still in play and exacerbated now, by the massive QT around the world, I think currencies are likely to continue experiencing volatility. We think investors however should keep their currency exposure but do so in a diversified manner.

[Decatur] We agree that we expect currencies to continue to be volatile. At this point the U.S. dollar is pretty expensive, so hedging the dollar from this point could end badly. But even in normal times we think that unhedged foreign currency for U.S. dollar investors is actually a good diversification to help protect those kind of investors against the current purchasing power reductions that you’d have in the event of dollar weakness. Which again, we’ve seen already in the past month or so, we’ve seen dramatic weakening of the dollar.

[McCormack] In previously recorded sessions, we’ve talked about a compelling opportunity set in oversea markets relative to U.S. public equity markets. Do you still see a large valuation gap, and when would you expect that to play out?

[Decatur] –Yes, that gap that we’ve spoken about between U.S. markets and international markets is still there, and it’s quite large. As for a timeframe, we’ve seen a little bit already, but it’s really hard to know the exact timing. It could be in the coming months, or it could take many years. But we are confident in the fact that there is a multi-year advantage for international markets over U.S., just based on the advantageous starting location.

[Fenley] I would agree with what Scott said. I don’t have too much more to add. In general, we see a compelling valuation argument still in international equities.

[McCormack] There’s been a multiple contraction this year that has affected stock prices negatively. Now investors are concerned with earnings announcements. John, how do you view future earnings for your portfolio companies?

[Fenley] Those are very good points, multiple contractions in fact explains the majority of our performance this year. So we would agree that earnings will become increasingly important as companies maneuver still around inflationary pressures and as we enter into next year facing slower growth. We’re sticking with the companies that offer us the best visibility into future earnings. For instance, companies that could have high recurring revenue, or those that supply into their customers’ non-discretionary budgets. Those types of companies to us are still highly favorable.

[Decatur] There’s been a lot of multiple contractions, but that multiple risk is not over. Although the risks on earnings reducing will likely be moving to the fore  in the  coming quarters. We’ve seen the companies that we invest in typically have lower expectations for next year’s earnings. That’s in contrast to other segments of the market that have higher expectations, which may be more vulnerable. So we like that about the kind of companies we look at. We also assess the trajectory of earnings of our companies to see that they are holding up better than their peers. We also know that starting -lower evaluations should offer some protection in the case of reduced disappointments by the market overall. Again, in terms of absolute multiples, our portfolios are starting at around six times earnings. Those are low expectations, which we think will help in a sort of rougher earnings environment.

[McCormack] Some investors have noticed or believed that there’s been a regime change that has been going on between growth companies, towards value companies. Would you say growth companies could be in trouble for a while here relative to value companies, or Scott, do you just need to be more selective right now when looking at growth companies?

[Decatur] I think it’s a little bit of both. Growth has had a big headwind to deal with, and will continue to do so stemming from the excesses of the recent years, but, certainly we think there’s some individual growth stocks that will do well and I’m sure that John is looking at those stocks in particular.

[Fenley] Yeah, we are Scott, thanks. We believe investors have to be more selective at this point. And in periods of a broad economic recovery, the tide lifts most ships, but if we’re heading into a global recession, growth is going to be harder to come by. That’s sad if you’re investing in companies that have been sold down because of slowing growth concerns, but actually perform well operationally in a challenging macro environment. You should be rewarded with positive share reaction.

[McCormack] John, tell us what areas of the market are more attractive today? And on the flip side, what are most concerning to you?

[Fenley] Thanks, we believe that quality has been underappreciated and is attractive today. The market sell-off has been largely indiscriminate, for us particularly in the IT, Consumer Discretionary, and Industrial sectors. But moving forward, companies that continue to generate substantial free cash flow, and high returns should outperform in a global economic slowdown. Now on the flip side, companies with unproven track records of managing through difficult macro backdrops are risky to us. So, we’re staying away from those. We’re sticking with the companies that have demonstrated success in managing their businesses through challenging economic times.

[Decatur] Where we see the market opportunities today look to be more aligned than ever with our long-term focus, which is attractively priced companies, strong profitability, and improving trajectories in their earnings. These are all things that we focus on and look well-positioned right now. Conversely, you see more expensive growth stocks that are at historically high valuations versus the market. Those appear much more vulnerable at extreme levels. But we expect the trend that we’ve seen over the past year or so to continue in the coming years, which is better performance by those reasonably priced stocks, again given where the current positioning is.

[McCormack] Thank you, Scott and John for those valuable insights. And thank you everyone for joining us today. If you have any questions, please feel free to reach out to any of your contacts at Segall Bryant & Hamill, and have a great day.