International Stocks: Sorting Through the Noise

How have international equity markets performed over the past decade and what is your outlook going forward?

The world has faced a lot of challenges over the past 10 years, but for equity investors, many of those challenges have simply amounted to noise. As investors in international markets, we spend a lot of time looking at individual hotspots, whether they be countries, regions, politics, etc. But the three biggest factors impacting equity returns globally in recent years have been low inflation, low interest rates and slow global economic growth.

Over the past 10 years we’ve seen solid returns, remarkable given how low inflation has been. The developed world has returned roughly 10% annualized over the past decade, with particular strength in the U.S. and Japan, which experienced returns in the low teens. India, China and Australia also saw high single-digit returns, and the rest of the world markets returned between five to seven percent, broadly speaking. Aside from some disappointments here and there, international markets have done pretty well.

Driving these returns have been earnings growth, dividend yield and changes in market valuation multiples. In 2011, international markets had a dividend yield of about 2.5%. And over the next 10 years, earnings increased annually a little over 4%. So roughly 6.5% of the return was driven by fundamentals, whereas the balance multiple expansion—a fairly sizeable percent. Part of that has been a function of lower bond yields—low inflation and low risk-free rates allowing valuation multiples to stretch.

Today, dividend yield is around 1.7% and valuation multiples are around 20X forward earnings, which assumes a strong earnings recovery in 2021. We think it’s hard to see valuation multiples expanding significantly beyond where we’re at today over the next 10 years. But we do expect earnings growth in the range of 4%-5%, so we expect roughly 6%-7% total return for global equities over the next 10 years.

One question I ask myself as a portfolio manager is: What is my required rate of return for a business that I'm considering adding to the portfolio? If I’m considering a business with an expected return below 6%, that's not very attractive over the next 10 years. At the same time, we don't need to take excessive risks to generate a 15% return from a portfolio holding, because I know my implied required rate of return is 6%-7%.

How do you approach investing in international markets?

For us, it's a bottom-up process looking at individual businesses. The most important aspect for us is estimating intrinsic value—central to everything we do. Intrinsic value is a function of a company's future free cash flow discounted to present value. After we examine a company from the inside, we then look at external factors. For example, what do changing health care policies in China mean for this particular Chinese health care provider? Or what does it mean for this company to operate in the U.K.?

Where do you see international markets today with regards to price to intrinsic value, and where are you finding opportunities?

It’s been an interesting year. In January 2020, discounts to intrinsic value were about as narrow as we’ve seen them. While the economy had been slowing, there didn’t appear to be significant downside risk. We were in late-cycle, slow-growth mode. Then the pandemic hit, and that changed everything. We saw a substantial short-term decline in economic activity and a dramatic drop in corporate earnings. That was compounded by a substantial contraction in equity valuations.

Intrinsic value is based on cash flow generated several years out—not just this year or next. So, our intrinsic value estimates didn't fall nearly as far as short-term corporate earnings or market prices. Therefore the portfolio experienced a sharp turn going from very narrow discounts in January to the widest we’ve seen since the launch of our international strategy in March. Of course, we've had a strong rebound in equity prices, and right now, consensus estimates suggest global earnings will increase 60% in 2021 from 2020 levels. In our view, the market appears to have already priced in this expected earnings recovery.

So, we are now somewhat where we were at the start of 2020—valuation discounts are fairly narrow. We’re not seeing broad opportunities in any particular area of the market right now—it’s really business by business. In the past, you might have been able to say, for example, Brexit created some opportunities in the U.K., or the trade war between the U.S. and China created some interesting opportunities in China. Right now, we can’t point to any specific countries or regions.

However, from an industry level, we do see some pockets of investment opportunity. Pharmaceuticals are somewhat interesting as discounts have widened quite a bit over the past year. Also financials have been reasonably attractive for a while, though the discount has narrowed with the expected economic recovery. On the other side of the coin is technology, one of the least attractive areas in our view. We’ve found a few individual opportunities in tech, but for the most part technology companies, especially those in the software or semiconductor industries, are trading at extremely narrow discounts to intrinsic value, if at all.

During severe market disruptions like the pandemic of 2020 or the 2009 global financial crisis, do you adjust your intrinsic value estimates?

I remember back in 2009, people called the global financial crisis a once-in-a-lifetime event. Now, with the pandemic, we’ve experienced two once-in-a-lifetime events in our investing careers. It’s interesting to consider the behavioral side of big market disruptions. At one point in 2020, our international portfolio dropped 11% in one day. That kind of move could certainly affect your behavior as an investor. For us, it’s important to go back to the fundamentals of the business and evaluate what those fundamentals will look like over the next 12 months. Do we think the business will recover? How quickly will it recover? We incorporate those considerations into our discounted cashflow model and our valuation of intrinsic value, which helps keep us grounded.

There were certain businesses in the portfolio that gave us concern during the pandemic. One example was Copa, a Latin American airline. We spent an extraordinary amount of time trying to understand its access to capital, its balance sheet and its cash flows over time. We owned the stock through the down market in 2020 and into the market recovery. But as part of our ongoing evaluation of the business, we decided that we didn’t need to own this particular business right now—especially given the extended timeline for a recovery in business travel—so we sold our position in the fourth quarter of 2020.

During market disruptions we ask ourselves again: What is the discount relative to my estimated intrinsic value? If it's widened substantially and we still have confidence in the business, then it’s an opportunity to buy more shares of that business.

Where do you see the current state of the global economy? And do you believe a rebound in international markets will be similar to expectations in the U.S.?

In general, I believe the sharper the decline, the sharper the recovery. I think there are certain countries where we'll see a lot more economic growth as lockdowns ease. In some countries that had sharp GDP declines last year, like Mexico and Brazil, I would expect strong rebounds. On the other end of the spectrum, we saw economies like China’s grow in 2020. So, while China should see additional growth, I wouldn’t expect a huge rebound there.

Next year’s consensus estimates are projecting 5.5% global growth. In 2020, we had a 3.5% percent decline in global GDP, which is fascinating because it sounds like a small number, but the market and earnings declines felt fast and dramatic as they were happening. It's really going to come down to productivity growth—how productive we are, how many people are in the labor force—and those are pretty slow-moving numbers. I expect three or four years down the road, we'll fall back in line with normal global growth trend levels.

What do you look for when analyzing a company’s revenue growth and operating margin?

First, we come up with a base case. We look at the company’s history and how revenue growth has evolved over time. We look at the sources of growth—how much is organic versus inorganic. What kind of investments the company has made to generate that growth. We also look at volume and pricing, when possible, and try to understand how much growth has come from the company’s ability to raise prices. But the most important element is how sustainable revenue growth will be going forward. Have there been industry changes or company changes that would cause revenue growth to deviate from its historical path? The longer the operating history of a company and the less change within the company’s industry, the easier it is to make those kinds of forecasts. Ideally, we like to understand how things are going to change relative to the past to get a sense of what intrinsic value might look like compared to what the market expects.

On the operating margin side, there are a couple of ways to look at it. You can look at it from a fixed cost versus variable costs standpoint to understand how much operating leverage the business has and what that business will look like in a downturn. Or we can ask what types of investments the company is making. For a company like Taiwan-Semiconductor, for example, depreciation is a huge part of the cost basis. In other words, it's a highly capital-intensive firm. But understanding this helps us focus on the most important parts of the business. On the other hand, a company like Facebook—even though it is somewhat capital-intensive now—R&D, sales and marketing are huge parts of the investments it makes to sustain a competitive advantage. Another critical point to consider is that operating margin can hide certain things. So, you really want to see what’s driving operating margin and what could cause it to change going forward.

Alphabet, for example, had a business unit that consisted of advertising revenue and cloud services, which were bundled into one reporting segment. Recently, Alphabet split out its cloud services revenue from advertising revenue. In doing so, we learned that the cloud business, which we thought was moderately unprofitable, was highly unprofitable and generated an operating loss of almost $6 billion. That shifted our way of thinking—we now realize that Alphabet’s advertising business is more profitable than we previous thought and, that once the cloud business achieves scale, Alphabet’s corporate operating margin will be higher than we previously modeled.

In the end, growing companies are always making investments. Investors need to understand what part of a company’s cost structure is for growth investments and what part is simply to maintain the existing business going forward.

In international markets, investors need to understand and evaluate the impact of multiple governments, debt levels, and taxes, among other factors. How do you gather information on various markets and economies?

In today’s digital world, there are probably too many sources of information for investors. There are some quick ways to get high-level data—we use Bloomberg, for example. In the U.S., investors have access to FRED®, which provides all kinds of economic data. The OECD provides tons of data on individual countries. But investors can simply search the internet for a lot of information. You can google “telecom regulatory policies in the U.K.,” for example, and get a link directly to the regulator’s website. But the hardest part is figuring out what data actually matters for a particular company. As bottom-up investors, our research process starts at the company level. We read through filings, understand who competitors are, talk to the investor relations team, attend conferences, and speak with people who understand the company better than we do.