Q&A with Brandes: Why Look for Opportunities Overseas?
Matthew Johnson is the Director, Private Client Sales, at Brandes Investment Partners, L.P. His responsibilities include sales management, product distribution and business development, as well as developing the strategy and planning and executing the firm’s field sales efforts. He joined Brandes in 1993.
Jeffrey Germain, CFA, is a Director, Investments Group, at Brandes Investment Partners, L.P. His responsibilities include serving as an analyst on the basic materials research team and as a member of the International Large-Cap Investment Committee. His experience began in 2001 when he joined Brandes Investment Partners.
I spoke with Matthew and Jeffrey on June 20, 2019
Let’s start with some background on Brandes and your overall view of the international markets.
Matthew Johnson: Brandes is a Graham & Dodd value manager. We were founded in 1974 in San Diego, California. As a firm, Brandes has been investing in international markets for about a half-century or so.
With the S&P 500 tripling over the last decade and significantly outperforming markets around the world, investors seem to have lost interest in international investing. Given this sentiment, we think it’s important to revisit the concept of diversification. The case for making an allocation to international markets today is particularly strong given the valuation discount in international markets we are seeing versus the U.S.1
With respect to diversification, are you trying to make the case that U.S. equity investors are not properly diversified regionally?
Jeffrey Germain: I think it’s important to first set the stage with where the U.S. based investor is allocated regionally. We should then explore the issues of whether such an allocation is prudent from a diversification standpoint and if it leaves room to grow the international allocation.
At the end of 2018, the equity allocation for a typical U.S. investor was 70% in the U.S. and only 30% in international markets.2 If you consider this allocation in the context of where most of the world’s gross domestic product (GDP) is being generated, it does not seem properly balanced. International markets actually represent 85% of global GDP, with the U.S. comprising the remaining 15%.3 The international equity markets also offer a fuller opportunity set as a significantly higher percentage of large-cap companies are domiciled in markets outside the U.S.4
So yes, more GDP is generated outside the U.S. and the opportunity set is larger, but, are the companies domiciled outside of the U.S. ones I want to invest in? Are these companies I would recognize? We believe the answer to both questions is yes. The international marketplace is home to many businesses with powerful brands that are well known. As an example, just under half of the 2018 Top 100 Most Valuable Brands are represented by non-U.S. companies. Also, of the brands that represented the 2018 Top 20 Risers, more than half are from non-U.S. companies.5
To sum it up, in our view and at a high level, a 70% allocation to U.S. equities does not appropriately consider the economic realities of today’s world and likely reflects a home country bias.
What has kept investors so heavily invested in the U.S.?
Jeffrey Germain: Well, there have been many factors at work here, but a key reason has been strong U.S. equity performance. In other words, part of the attraction and increasing allocation to the U.S. market has been the result of the U.S. market’s strong absolute and relative performance for an extended period of time. In fact, as of June 30, 2019 the U.S. market outperformed international equities for a record 139 months on a cumulative basis.6 So in part, the high U.S. equity allocation reflects a positive feedback loop: investors have increasingly allocated to the part of the market that has performed well. The key question is, will U.S. outperformance continue or will international equities eventually have their day in the sun? In our view, there are several factors that support a compelling positive outlook for international markets.
First, when reviewing the historical performance of the U.S. and international equity markets, it’s clear the relative performance pattern has been cyclical. In fact, since the 1970s, there have been a number of periods when international equities outperformed the U.S. over a long period.7 For us, it’s hard to believe that such cyclicality is no longer present. Second, and most importantly, we believe valuations favor international equities over the U.S.
What about investor concerns? The U.S. has been a safer place perception-wise than international markets, which have been dealing with a lot of macro and political issues.
Matthew Johnson: This notion of investor concerns never seems to go away, despite the fact that international markets keep on churning along. It’s been that way for a long time. What we have found from decades of investing is that when there is investment uncertainty, it’s a good time to hunt for opportunities.
Jeffrey Germain: Yes, there has been a lot for the market to digest and be fixated on with respect to international equities. Still a lot of uncertainty with Brexit, the European economic outlook has deteriorated and the ongoing trade war is on everyone’s mind. These issues are real and it’s important to study and account for them when considering an allocation to international markets. However, after carefully examining and accounting for these issues, our view is that the market is placing too much emphasis on them and this anxiety has led to unjustifiably low valuations for non-U.S. markets.
The market’s tendency to overemphasize broad risk factors and misprice equities in the process is not new. In fact, there are a lot of historical examples of dramatic macro-driven market sell-offs that were overdone and resulted in a very attractive opportunity set for bottom-up, fundamental investors. For example, performance following the 1994 Mexican Tequila Crisis, the 2002 Brazilian Real Crisis and the 2014 Russian Financial Crisis were all very strong.8 That’s not to say that there was no risks or issues present during these episodes. It just highlights that some of the best investment opportunities have emerged when the market’s focus on long-term company specific fundamentals morphed into a panic about the broader market contention.
Let’s focus in on one of those geopolitical risks. How is the uncertainly around Brexit impacting the attractiveness of the U.K. equity market?
Matthew Johnson: Part of the issue here is reality versus perception. The U.K. market has at times traded at a premium to the broader European markets. In today’s environment, given Brexit uncertainty, the U.K. market is trading at a discount across a variety of valuation measures.9
Jeffrey Germain: What’s interesting is that this discount isn’t just for U.K. domiciled businesses – those that have a lot of exposure to the U.K. economy – as its spread to businesses with significant global exposure. These global businesses, or companies with <50% of their revenue generated in the U.K., actually comprise the majority of the MSCI United Kingdom Index.10 So in our view, the uncertainty surrounding how Brexit plays out is creating opportunities in the U.K. market. A sizable portion of these opportunities are in companies that don’t have the majority of their business tied to the U.K. economy.
Looking at the current concerns, is it good enough to have a portfolio that is heavily-weighted to the U.S. because U.S. companies have international exposure?
Jeffrey Germain: The answer is no. First, the U.S. ranks as one of the more insular countries when comparing the level of corporate revenue generated in foreign markets verses other regions around the world. For instance, in France and based on the MSCI France Index, about 80% of corporate revenue is sourced from foreign markets. For the U.S., based on the MSCI USA Index, the share of corporate revenue sourced internationally is just under 40%.11
Second, even if investors are content with the international exposure they are getting from the MSCI USA Index, they are actually paying a lot more for it given the premium valuation U.S. companies trade at compared to those in international markets. Sticking with France, the MSCI France Index traded at a forward price-to-earnings (P/E) multiple of 13.9x, while the MSCI USA Index traded at 17.2x as of March 31, 2019.12
Based on these data points, it’s not clear that U.S. investors are getting a lot of well-diversified international exposure inside their U.S. equity allocation. And the exposure they are getting is coming at a high price.
Why is now the best time to invest internationally?
Jeffrey Germain: From January 1970 until November 2007, the annualized returns since inception for the U.S. and international markets were about even, at 11.4% for the S&P 500 and 11.8% for the MSCI EAFE Index.13 So, the material outperformance by the U.S. has only been present over the last decade or so. The key question is: Will this decade-long significant U.S. outperformance continue in the future?
Our view is that the relative price movements for U.S. and international equities over the last decade or so have not fully been supported by fundamentals and this has opened a strong value proposition in favor of international markets. More specifically, across a number of different valuation metrics, international markets are trading at higher than historical discounts to the U.S. market. For instance, the price-to cash-earnings discount for international markets of 34% vs. the U.S. market is well above the average discount of 25% over the last 20 years.14
International equities also stack up very well against the U.S. when considering current dividend and earnings yields. For instance, the dividend yield for non-U.S. developed (3.1%) and emerging markets equities (2.3%) is higher than U.S. equities (1.9%). Also, there are more companies with an earnings yield above 8% in the international markets than there are in the U.S. Another way to frame this earnings yield statistic is this: there are more international companies trading at a less than 12.5x P/E than in the U.S.15
Has there been a secular change in market composition? Tech companies dominate the U.S. but they’re not as strong internationally. Is that what is keeping this discount at a permanently low level?
Jeffrey Germain: It’s a good question to consider and address. It’s certainly part of the reason for the discount, but it’s not the entire story. By comparing valuations amongst companies within the same sector, you can better appreciate that it’s not just one U.S. sector driving the valuation discrepancy. For example, by examining the largest U.S. and non-U.S. companies in the MSCI ACWI Index by market-cap, it’s clear that many U.S. companies are trading at notable premiums to their international peers across a number of different sectors. This is happening even though the U.S. constituents offered inferior dividend yields.16
Should U.S. investors wait for a catalyst before increasing their allocation to international markets?
Matthew Johnson: Timing is difficult and it can be costly if you do it incorrectly.
Jeffrey Germain: Investors do sometimes try to find a specific catalyst and time their allocation decisions. While some catalysts can be identified, timing the market and knowing when a catalyst will appear is difficult. As Matt mentions, if an investor gets that timing wrong, future returns can be negatively impacted. Consider a hypothetical $10,000 investment in the MSCI EAFE Index starting on January 30, 1970 and ending on March 31, 2019. If you held that investment throughout this period, would be worth just over $784,000. However, if you tried to time the market and missed the best six months of returns, your original $10,000 would be worth just over $350,000. An even more dramatic reduction would result from missing the best 12 months of returns. The value of the original investment would then be worth only a little more than $184,000.17
You’ve made a compelling case to consider international markets. Now they look especially good for the reasons you’ve discussed. But perhaps you can drill down further. What types of companies look attractive today in international markets?
Matthew Johnson: Certainly we’re big believers in value and it seems to be a particularly good time to be looking for value stocks in the international markets.
Jeffrey Germain: As we have said, international equities look particularly attractive to us based on their absolute and relative valuation attributes. The other dynamic we’ve witnessed over the last 10 years is a split between the value and glamour segments of the international equity market. While value stocks are trading below their 20-year average price-to-book, growth stocks are trading above their long-term average. We believe this valuation differential bodes well for value stocks.18
But maybe the market has changed and it’s a permanent difference? Within the glamour area of the market, you’ve got disruptors like the tech companies. Is it possible history won’t behave in the same way again?
Jeffrey Germain: That’s an important point to consider. The argument that, in total, disruptive technology is dramatically impairing the fundamentals of “value” companies does not seem to hold up to us. When looking at the long-term expected EPS (earnings per share) growth of value and growth stocks, we find that the differential has actually been fairly constant over the past 15 years.19 The ramification of this observation is that the current wide valuation discrepancy between value and glamour is not adequately supported by differing growth fundamentals of each cohort’s constituents.
Matthew Johnson: There will always be a valid basis for seeking investment opportunities in potentially undervalued companies in the United States chosen with a sound value focus. However, a home country bias that precludes considering good companies outside the U.S. may not serve investors well. Intelligently diversifying by capturing the potential for returns from appealing opportunities in international markets makes sense. Directing some investor resources to international markets may be a prudent long-term strategy and a reason for resisting the allure of keeping all of an investor’s money close to home.
Dividend Yield: Dividends per share divided by price per share.
Earnings Yield: Earnings per share for the most recent 12-month period divided by the current market price per share.
Price/Book: Price per share divided by book value per share.
Price/Cash Flow: Price per share divided by cash flow per share.
Price/Earnings: Price per share divided by earnings per share.
Forward Price/Earnings: Price per share divided by earnings per share expected over the next 12 months.
Yield: Annual income from the investment (dividend, interest, etc.) divided by the current market price of the investment.
The S&P 500 Index with gross dividends measures equity performance of 500 of the top companies in leading industries of the U.S. economy.
The MSCI ACWI with net dividends captures large and mid cap representation of developed and emerging markets.
The MSCI ACWI Value Index captures large and mid cap securities exhibiting overall value style characteristics across 23 Developed Markets countries and 26 Emerging Markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
The MSCI ACWI Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across 23 Developed Markets countries and 26 Emerging Markets countries. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
The MSCI Brazil Index is designed to measure the performance of the large and mid cap segments of the Brazilian market.
The MSCI Europe Index with net dividends captures large and mid cap representation of developed market countries in Europe.
The MSCI France Index is designed to measure the performance of the large and mid cap segments of the French market.
The MSCI Mexico Index is designed to measure the performance of the large and mid cap segments of the Mexican market.
The MSCI United Kingdom Index is designed to measure the performance of the large and mid cap segments of the UK market.
The MSCI USA Index measure the performance of the large and mid cap segments of the U.S. equity market.
The MSCI EAFE (Europe, Australasia, Far East) Index with net dividends measures equity market performance of developed markets in Europe, Australasia, and the Far East.
The MSCI EAFE Growth Index with gross dividends captures large and mid cap securities across developed market countries, excluding the United States and Canada, exhibiting growth style characteristics, defined using long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.
The MSCI EAFE Value Index with net dividends captures large and mid cap securities across developed market countries, excluding the United States and Canada, exhibiting value style characteristics, defined using book value to price, 12-month forward earnings to price, and dividend yield.
The MSCI Russia Index is designed to measure the performance of the large and mid cap segments of the Russian market.
The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries excluding the United States. With 1,012 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
Diversification does not assure a profit of protect against loss in a declining market.
The declaration and payment of shareholder dividends are solely at the discretion of the issuer and are subject to change at any time.
Past performance is not a guarantee of future results. One cannot invest directly in an index. Rolling periods represent a series of overlapping, smaller time periods within a single, longer-time period. For example, over a 20-year period, there is one 20-year period, eleven 10-year rolling periods, sixteen 5-year rolling periods, and so forth.
This material is intended for informational purposes only. The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Market conditions may impact performance. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes, differences in financial reporting standards and less stringent regulation of securities markets which may result in greater share price volatility.
The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice.
Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.
1 MSCI via FactSet, MSCI World Ex USA Index discount to MSCI USA Index, 03/31/99 to 03/31/19 based on price-to-cash earnings discount.
2 Assets based on Morningstar U.S. open end & ETF and Separate Account & CIT universes for U.S. and International Equity at 12/31/18.
3 IMF Factbook, S&P Capital IQ at 12/31/18.
4 S&P Capital IQ companies greater than $5 billion in market cap: 69% are outside the United States at 12/31/18.
5 Kantar and WPP, 2018 Brandz Top 100 Global Brands.
6 MSCI via FactSet. MSCI EAFE vs. S&P 500, Relative outperformance measured monthly, February 1, 1971 to June 30, 2019. MSCI EAFE Index inception is March 31, 1986. Performance shown prior to inception is the result of back-testing by the index provider. There may be frequent material differences between back-tested performance and actual results.
7 MSCI via FactSet. MSCI EAFE VS S&P 500, Relative outperformance measured monthly, February 1, 1970 to March 31, 2019.
8 Brandes, MSCI via FactSet. Based on MSCI Mexico, MSCI Brazil and MSCI Russia Index subsequent 3-year cumulative performance.
9 MSCI via FactSet. MSCI United Kingdom Index traded at a discount to the MSCI Europe Index on a Price/Earnings (P/E), Forward P/E, Price/Cash Flow, and Price/Book basis at 3/31/19.
10 Brandes, MSCI via FactSet. MSCI UK Index constituents with less than 50% of revenue from the UK account for 84% of the index at 3/31/19.
11 Brandes, MSCI via FactSet at 3/31/19.
12 Brandes, MSCI via FactSet at 3/31/19.
13 Brandes, S&P, MSCI via FactSet. MSCI EAFE Index inception is March 31, 1986. Performance shown prior to inception is the result of back-testing by the index provider. There may be frequent material differences between back-tested performance and actual results.
14 MSCI via FactSet. MSCI World Ex USA discount to MSCI USA, 3/31/99 to 3/31/19.
15 Brandes, MSCI via FactSet. Non-U.S. Developed represented by MSCI EAFE; Emerging Markets represented by MSCI Emerging Markets; U.S. represented by S&P 500 as of 3/31/19.
16 Brandes, MSCI via FactSet. Using MSCI ACWI constituents, we chose the largest U.S. company and non-U.S. company by market cap for each industry, discounts based on P/E at 03/31/19.
17 Brandes, MSCI via FactSet. Cumulative returns. MSCI EAFE Index inception is March 31, 1986. Performance prior to inception is the result of back-testing by the index provider. There may be frequent material differences between back-tested performance and actual results. This hypothetical example is for illustrative purposes only. It does not represent the performance of any specific investment.
18 MSCI via FactSet, Value stocks represented by MSCI EAFE Value Index. Growth stocks represented by MSCI EAFE Growth Index. As of 6/30/19, the price-to-book ratio for value stocks was 1.1x, compared to 20-yr average of 1.4x. The price-to-book ratio for growth stocks was 3.1x, compared to 20-yr average of 2.9x.
19 MSCI via Factset and Bernstein. MSCI AC World Value vs. MSCI AC World Growth as of May 31, 2019.