Sector Watch: Cautious optimism for global equities

As of Aug. 15, the MSCI EAFE index was up by 4.5% for the year to date. The MSCI Europe index was up by 4.6% for the same period and the MSCI Far East index by 3.3%; the MSCI Emerging and Frontier Markets index was down 3 basis points. In comparison, the MSCI North America index was up by 13.8%.

At the macro level, trade tensions between the U.S. and its major trading partners, particularly China, have become a major risk to global growth, which is already slowing, according to the International Monetary Fund (IMF). The IMF’s July 2019 World Economic Outlook Update states that global growth is projected to slow to 3.3% this year from 3.6% in 2018 before returning to 3.6% in 2020.

Tension between the U.S. and China – the latter is now the world’s second-largest economy, based on purchasing power parity – go beyond trade and extend to concerns over China’s domination of next-generation technology, U.S. military “freedom-of-navigation” posturing in the South China Sea and the U.S.’s apparent support for the separation of Taiwan, which China claims as its territory.

In Europe, the U.K. is scheduled to withdraw from the European Union (EU) on Oct. 31, but does not yet have an approved agreement about the terms that will replace the 45 years of open trade that came with being an EU member. Boris Johnson, the U.K.’s new prime minister, insists that the withdrawal’s (a.k.a. Brexit) terms be renegotiated.

To stem the downside risk to global growth, central banks appear set to lower interest rates to provide stimulus for growth. The U.S. Federal Reserve cut rates by 0.25% in July, and the European Central Bank and the Bank of Japan are considering similar moves.

John Hock, chief investment officer with Altrinsic Global Advisors LLC in Connecticut, says there are risks in international equities markets, but, “generally speaking, there is much greater value and superior risk-adjusted opportunities in these markets following the multi-year period in which U.S. equities have meaningfully outperformed, [which was] led by a narrow group of highly priced growth stocks.”

Hock, who is subadvisor to the $138-million CI International Value Fund, contends that while “the risk factors affecting international equities are the same as those affecting U.S. and Canadian equities, some additional risks are more acute in international markets, including those from Brexit and Italy’s fragile economic condition.” He adds that companies’ profit margins have become vulnerable to “rising labour costs, increased regulation, competition, disruption and stagnating economic conditions.”

Nonetheless, international equities are attractive because they “trade at lower valuations than those in the U.S. and possess greater scope to increase profitability,” Hock says. As of July, according to MSCI data, the regional price/book ratio for stocks listed in the S&P 500 composite index is 3.3 times book, while those in the MSCI World index are 2.4 times; the MSCI Europe index, 1.9 times; the MSCI Emerging Markets index, 1.7 times; and the Nikkei 225 index (in Japan), 1.2 times.

However, with improved performance comes greater volatility, says Hock: “Investors should brace for gyrations much greater than experienced in the post-[global economic crisis] world as markets grapple with policy normalization and interest rate fluctuations off a low base.”

Hock, a value-style portfolio manager, says his emphasis is on company fundamentals, risk management and a desire to capitalize on dislocations or mispricings. He pays keen attention to a company’s balance sheet and capital structure, as well as to macro risks. This approach, he says, “results in a portfolio that is typically quite different from those of broad market indices.”

The CI fund holds 63 investments, with “a risk profile well below that of broad market indices,” according to Hock. Indeed, 62% of assets under management are in companies based in Europe, 20% in Japan and 14% in other countries, including emerging markets (EMs).

Financials (35%), health care (15%), consumer staples (12%) and telecommunications (11%) represent the largest sector weightings. Exposure to financials comprises primarily “capital-light and cash flow-driven non-bank financials, with meaningful exposure to non-life insurance and insurance brokerage companies.” The CI fund’s investments in banks had been primarily in Japan, but subsequent to years of material underperformance there, Hock recently began investing in Western banks.

In the health-care sector, the CI fund invests in undervalued, established medical device and pharmaceutical companies, as well as in unique specialty pharmaceuticals, facilities and other health-care enterprises. Exposure in consumer staples is to well-capitalized Europe-based multinational franchises, while telecommunications exposure is largely to companies that own premier network, technology or content assets.

One of the CI fund’s major holdings is Switzerland-based Zurich Insurance Group, one of the world’s largest insurance companies, which operates in more than 210 countries.

“Zurich trades at a large discount to its peers, which we see as a very attractive valuation, given our belief that [the firm] can produce higher returns with lower volatility,” Hock says.

Another holding is Japanese technology company Nintendo Co. Ltd., which holds the top share in the global markets

“Asia is looking great, as many Asian political uncertainties have been resolved” for games played on either consoles or mobile devices. This cash-rich company is poised to achieve higher earnings margins, driven by growth in digital downloads and product monetization, which provides significant potential to grow Nintendo’s operating profit.

Hock hasn’t made any recent material changes to the portfolio: “As long-term investors, [our] portfolio characteristics tend to evolve gradually, with the exception during major market dislocations or episodes when short-term market fear presents long-term opportunity.” However, he began accumulating shares in well-capitalized Western banks following significant share price weakness at the “expense of European banks, which have weak capital positions, poor liquidity profiles and low profitability levels.”

Jeff Feng, head of emerging markets equities with Invesco Hong Kong Ltd., says international equities – which “are trading at a 51% discount to U.S. equities from a price-to-book perspective and are at their cheapest level in over 40 years” – are attractive investments.

“Valuations of Western Europe and Japanese stocks are quite stretched,” Feng says, “even with interest rates at extremely low levels.” Growth, he adds, is mostly priced in. However, at a macro level, Feng says, “Asia is looking great, as many Asian political uncertainties have been resolved.”

For example, Joko Widodo was recently re-elected as president of Indonesia; Narendra Modi, as prime minister of India; and Prayut Chan-o-cha as Thailand’s prime minister.

Feng also foresees “plenty of room for easing in the region, [as] witnessed by recent interest rate cuts by the central banks of Indonesia and Korea.”

The only dark cloud for Asia now, Feng says, is the trade war between China and the U.S. The related uncertainties have depressed stock prices in China, Korea and Taiwan.

“[These] short-term headwinds will eventually pass, but it’s nearly impossible to guess when,” Feng says. So, he focuses on identifying businesses that can survive and prosper during storms.

Feng, a growth-style portfolio manager with a long-term focus, manages the $499-million Invesco International Companies Fund, which invests in businesses that he believes “will have similar or better demand for their products and services in five years [vs what] they do today.” He seeks businesses with proven management and “decent and sustained returns on capital, [as] measured by true cash,” that are trading at the “right” price.

The Invesco fund’s investment objective is to deliver a highly active portfolio that can generate significant returns over a market cycle.

The Invesco fund’s portfolio consists of 30 to 45 stocks. “It is concentrated by business ideas that are weighted based on the team’s conviction of their expected risk- adjusted return,” Feng says. “Country and sector allocations are byproducts of stock selection. Risk is mitigated by diversifying the fund’s holdings into businesses located in various regions of the globe.”

Using a strictly bottom-up approach to stock selection, the Invesco fund invests in any market capitalization and any region, but avoids constraints that can limit alpha generation. As a result, Feng says, “the fund is benchmark-agnostic.”

The Invesco fund’s largest country exposure is to the U.K. (19%), followed by China (16%), Japan (15%), Belgium (6%), Luxembourg and South Korea (5% each), and South Africa and Chile (4% each). Investments in other countries, including EMs, account for about 20% of the portfolio.

Feng says EMs are attractive compared with developed markets; the Invesco fund “has its highest exposure to emerging markets in the past 10 years.” Among EMs, he prefers Asia: “We believe it is different from Latin America, Eastern Europe and Africa.”

One of the Invesco fund’s largest holdings is Anheuser-Busch InBev SA/NV, a Belgium-based brewing company with significant presence in EMs. The company has dominant positions in Brazil and the U.S., two of the world’s largest beer markets, and is the market leader in Mexico, Korea, China and South Africa.

Another holding is Softbank Group Corp., a Japan-based technology conglomerate with significant ownership interests in high-quality businesses such as Alibaba Group Holding Ltd. and Uber Technologies Inc., both of which are well positioned in today’s digital economy. The Invesco fund also has significant minority interests in several rapidly growing private companies that are likely to emerge with dominant economies’ digital platforms, and are trading “at a massive discount to net asset value,” Feng says.

Over the past few months, the Invesco fund added to its holdings in Softbank Group, Kweichow Moutai Co. Ltd. and Anheuser-Bush, which “experienced an indiscriminate sell-off during the fourth quarter of 2018,” falling by an average of 22%.