Investment Ideas for Cost-Conscious Investors
While US equity returns have outpaced non-US returns over the past decade, it may be a prudent time for investors to consider foreign stocks as valuations in the US continue their ascent. Because US stocks have mostly outperformed, earnings multiples have been driven higher than the rest of the world, making future return hurdles far more challenging for US stocks.
Broadly speaking, global equity returns have been healthy since the depths of the global financial crisis, having been driven by global economic and earnings growth. Dividends have also played a role in investors’ total return, but a decent portion of the returns has been due to valuation expansion. Today, investors are generally paying more for a dollar of earnings than they were 10 years ago.
If we decompose the global market into the US versus the rest of the world, we see that the US market trades at about 22 times earnings while non-US markets trade around 14 times earnings (Exhibit 1). That's a hefty premium for US equities. Certainly not all US-domiciled businesses are overvalued, but the non-US opportunity set is a great place for equity investors to find value today.
Exhibit 1 – Global Valuations
Source: FactSet, as of 31 Dec 2021. Price-to-Earnings (FY1) represents the weighted harmonic average. Price-to-Book represents the median.
While we are seeing interesting opportunities broadly across countries and industries in non-US markets, two areas that look especially attractive to us are China and the video game industry. Regulatory pressures in China have created extremely wide discounts for Chinese internet companies in particular. Tencent is our favorite in this area right now because its dominance in social media and gaming. The company has a fast-growing cloud business, and the management team has a long-term perspective on how they run the business, which aligns well with our ownership mindset and long-term approach. Also, Tencent has investments in over 800 companies around the world, which provide a sizable source of enterprise value. In our view, this enterprise value is being overlooked by the market right now. When we consider the public equity investments alone, they account for 25% of Tencent's current market capitalization. If we strip out this value, we’re still left a core business that's growing revenue in the high teens and trading in the low twenties as a multiple of next year's earnings expectations. Additionally, the underlying business has substantial operating leverage potential. Using our intrinsic value lens, based on discounted cash flows, Tencent looks extremely undervalued. And Tencent's private market investments could be an additional source of value that we're not even accounting for in our valuation of the company.
The video game industry is an interesting space right now. The industry is in a bit of a slump due to pandemic-related lockdowns–revenue growth in 2021 has been lower than expected as demand was pulled forward in 2020 due to the pandemic. Also, studio productivity was negatively impacted by the sudden shift to remote working, which delayed release dates for several games. While these factors are short term and solvable in our view, they've created some attractive buying opportunities throughout the gaming industry. One example is video game maker Nintendo. It boasts a strong portfolio of franchise games, and its new SwitchTM console has also become very popular. Nintendo faced a steep decline in sales after its Wii platform faded, which is a risk as we consider the future of the SwitchTM console. But we have reason to believe the SwitchTM has several good years ahead due to the flexibility of its system and the rising popularity of games today.
Nintendo has an incredibly strong balance sheet, a good financial model and a management team that thinks long term. Nintendo's net cash balance equates to roughly 25% of the firm's current market capitalization. Once we strip out that cash, we're looking at a company that is trading at roughly 12 to 13 times current earnings, and it's a business that has generated strong free cash flow over many years. Again, as we apply our intrinsic value lens, Nintendo is a company that we are confident will be around for a long time and has high estimated expected returns. We also believe Nintendo has a lot of opportunity to increase the monetization of its overall franchise portfolio over time.
One final area in which we are seeing a lot of attractive valuations is the UK–and this has basically been the case since Brexit. But the long-term value is being driven by more than just price discounts in the market. For example, we own a UK asset management firm called Ashmore, which is a highly respected manager of emerging markets debt portfolios, and most of its strategies have solid track records. Emerging markets have been cheap for a while and with the possibility of the US Federal Reserve raising interest rates, this creates even more uncertainty for emerging markets investors. While this uncertainty can have a negative impact on Ashmore's business if investors become less willing to allocate to emerging markets fixed income as an asset class, Ashmore’s stock has sold off quite a bit recently and is currently trading well below our estimate of intrinsic value. Like Nintendo, Ashmore has a substantial net cash balance and a business model that generates high cash flow.
While pandemic-related and inflationary uncertainties persist for equity markets and businesses around the world, we believe there are some truly compelling discounts out there in foreign markets for long-term oriented investors.
As of 31 Dec 2021, Diamond Hill owned shares of Tencent Holdings Ltd., Nintendo Co. Ltd. and Ashmore Group plc.
The views expressed are those of the author as of January 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.