Investing in International Equities: What’s the Point?

09.18.2019 - Erick Rawlings

Over the past ten years, the US equity market has outperformed international equities by 9% annualized1.  On top of that, per the chart below, the diversification benefit of investing abroad for US investors has seemingly diminished since the late ‘90s as the correlation rose alongside the corresponding growth of the asset class’s adoption. 

Rolling 2yr Correlation between S&P 500 and MSCI AC World ex-USA

Source: FactSet, S&P, and MSCI data as of 1/1/1988 - 7/31/2020.
Does the underperformance of international equities mean that the asset class is due for a rebound? Or, conversely, given the tepid performance and diminished correlations benefit, should investors forget about investing abroad? 

The Research team believes the answer to both is, no.

Regarding a rebound, we argue that, at an index level, the inferior returns since the financial crisis have largely been earned and that a rebound will likely occur only when there is meaningful and synchronous global growth.   

During the ’02-’06 period of heightened global growth and synchronization—thanks to China’s admittance to the World Trade Organization and the emergence of the European Union as functioning bloc—international equities generated terrific annualized earnings and cash flow growth particularly vs the S&P 500: 

Source: FactSet, MSCI, and S&P data as of 1/1/02 - 12/31/06.                   

But post-Global Financial Crisis, with global growth tepid and uncoupled, China slowing down, and the European Union fractious, the earnings power of international equities has fizzled.  As a result, the MSCI ACWI ex-US has meaningfully underperformed the S&P 500, and deservedly so based on the resultant earnings per share (EPS) and free cash flow growth. 

Source FactSet, MSCI, and S&P data as of 12/1/09 - 12/31/18.

While China remains, we believe, the marginal driver of global GDP, it is no longer in a place to provide that same level of contribution it did in the mid-‘00s as its growth has leveled off (law of large numbers) and the composition of that growth has shifted toward services/internal demand vs the prior resource-intensive fixed asset investment.  As such, at this juncture we struggle to foresee a sustained rebound in earnings per share growth for the EAFE index.

So then, to our second question—should we give up entirely on international equities? Again, our answer is no. But investing internationally should not be done naively at the index level.  Rather, we believe investing abroad should be done at a fundamental level where the emphasis is on finding managers whose process leads to companies that grow per share earnings at a comparative level as that available in the US, that have quality-like attributes, that derive their earnings growth from unique, durable sources of demand, and that trade at reasonable valuations.

We believe that over the long-term, the quality attributes, the uniquely sourced earnings power, and the attractive valuation entry point will serve to provide compelling compounding opportunities that are at least competitive with US returns.

This fundamental approach underpins our preference in international markets for active managers who tend to run concentrated portfolios with high active share versus the MSCI AC World ex-US Index.

To highlight that point, and purely for illustrative and comparison purposes only, in the table below we share some summary statistics of the top-10 holdings of managers we favor in international markets.

Source: FactSet, MSCI, and S&P data as of 6/30/19.
The above does not tell the whole story, and it is not meant to.  But we do think the table highlights our point not to dismiss international equities in aggregate as there are companies beyond our borders that offer the potential for competitive returns for shareholders as seen by the summary sales growth, return on equity, and free cash flow growth figures of the managers.

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.


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