Investors Are Finding Value Overseas
After a runup in U.S. markets, people are going abroad.
Editor's note: This article first appeared in the Q3 2021 issue of Morningstar magazine. Click here to subscribe.
Fund investors in the U.S. are turning to foreign markets, with flows into international equity funds rivaling those into domestic in recent months. For insight into opportunities abroad, we brought together three Morningstar Medalist fund managers with different areas of expertise.
Pradipta Chakrabortty of Harding Loevner invests in well-managed companies with strong competitive advantages, growth, and balance sheets at Harding Loevner Emerging MarketsHLEMX, Frontier Emerging Markets HLFMX, and Chinese Equity HLMCX. Elizabeth Desmond, founding partner at Mondrian Investment Partners, invests in developed markets at Mondrian International Value Equity MPIEX with a valuation-driven strategy using a dividend discount model with a long-term time horizon. Finally, Fidelity veteran Jed Weiss has a broad international mandate, targeting high-quality companies with defendable competitive advantages and strong pricing power in industries with high barriers to entry at Fidelity International Growth (FIGFX) and International Small Cap Opportunities (FSCOX).
Our discussion took place on May 27 and reflects performance and valuation info as of that date. It has been edited for length and clarity.
Andrew Daniels: We often hear that non-U.S. stocks are more attractively valued than U.S. stocks. What are the differences among markets that explain this view?
Pradipta Chakrabortty: First, the aggregate valuation measure on the broad index level is not an apples-to-apples comparison. There are different sector mixes in the U.S. versus the EAFE, or the emerging markets benchmarks. The U.S. has higher weights in the tech industry; FAANGs contribute to a large part of this. And if you disaggregate tech, U.S. has much more software and cloud-based services, versus more-cyclical hardware and semiconductors that have a large weight in the emerging markets. That largely explains the difference in valuation. That said, in emerging markets, consumer discretionary stands out as cheaper compared to the U.S. Banks, especially Latin American banks and ex-Chinese Asian banks, are also relatively attractive.
Jed Weiss: Anecdotally, I don’t think there’s much valuation discrepancy among big multinationals, irrespective of where they’re based. Having said that, I do think there are some significant pockets of inefficiency within the international markets that are a lot harder to find in the U.S. In Japan, small- and mid-cap stocks have run in the last five years, but this is following a 25-year bear market. It’s still a land of opportunity. You can still find companies that have never lost money that are trading at negative enterprise values. There are a lot of stocks there that I think would trade at a different multiple if listed on another exchange. You can make a similar argument about Taiwan.
There are also a number of growth-related trends that are at more nascent stages internationally than in the U.S. One example: stocks benefiting from the transition from on-premises to the cloud. We all know the Adobe ADBE story. They demonstrated that the total addressable market after transitioning to the cloud can be a lot higher than it was in an on-premises world. In Europe and Japan, the same economics should play out over the coming year, but the market has been slower to understand this.
Elizabeth Desmond: The U.S. market’s up something like 13% annualized over the past 10 years—that’s a very high return. Japan is up by half that. And the U.K. is up only a quarter of that. So, you’d expect to see that the U.S. market’s profits have grown much faster. But, if you look at real annualized EPS growth, it has been similar to Japan and the U.K. over that time period. There’s clearly been multiple expansion in the U.S.
In fact, Japan has seen some of the fastest earnings and dividend growth over the last 10 years globally. There are also companies with fantastic balance sheets Within this market we’ve been able to identify some very good opportunities with attractive valuations.
Coming back to Europe, as I am based here in the U.K., I have to be mindful about potential home-country bias. With the challenges that the U.K. has experienced with Brexit, returns have been relatively low over the last 10 years, particularly in dollar terms, because sterling has been so weak. The underlying economics aren’t brilliant; I’m not arguing that Brexit’s been a boon for the U.K. economy. However, these challenges are well known and have opened a lot of possibilities.
Returning to Normal
Daniels: Countries are at different stages of dealing with the pandemic. How does that factor into your analysis?
Chakrabortty: Last year, we saw very strong performance in the north Asian countries: China, Korea, Taiwan. They have managed the pandemic well. Those markets have seen a short-term recovery not just in their earnings and their outlook, but also in terms of share prices. That is reflected in the relative valuation, which is a little higher compared to other parts of the emerging-markets world—like Brazil, for example, which went through a pretty severe second wave in the first quarter of this year.
Differences in the way these countries have handled the pandemic have created valuation opportunities. As long-term investors, our job is to look through short-term impacts and look at the long-term implications for earnings and valuations. For example, Brazilian banks are not discounting the significant improvements that are likely ahead. Their stock prices are still beaten down, even though they managed their asset quality pretty well through the first wave and during the second wave. India is still going through the throes of severe COVID. As a long-term investor, it creates opportunities from a valuation point of view for high-quality growth stocks.
Weiss: Stepping back, I want to acknowledge that this is a horrible humanitarian disaster. A fully vaccinated global population can’t come soon enough. But I’m optimistic that in the fullness of time, the world will return to normal.
Since we had great vaccine data last fall, the U.S. and European markets have done a pretty good job of looking through the near-term earnings disruption. If you’re a European gym operator, your business is still horrible and many of your gyms are still closed. But your earnings power on the other side of this is probably not so different from your earnings power going into this—and your stock price, by and large, is right back where it was before the crisis.
Where I’ve found the biggest opportunities is in companies where the competitive landscape has shifted significantly as a result of the crisis. Maybe a company bought out its number-one competitor, or some of its competitors were overlevered. Often that’s happening in the industries that were brutally hit—travel, aerospace, commercial catering. What’s tricky is you don’t see the product of that until business normalizes. When there is no business, it’s not yet obvious that there has been a major market-share shift.
In places like India or Brazil, the on-the-ground situation has been so bad for the last couple months that there are businesses where the market is not fully discounting an eventual return to normalcy. You can make the same argument in Japan: The market has not fully looked through the crisis, maybe because the current reality is so grim.
Desmond: In the developed world, there has been a lot of publicity about the pace of vaccine rollout in developed countries and the progress toward returning to normalcy. While it may have important human consequences, from a long-term investing perspective, the difference between, say, a month and two months in terms of getting vaccination spread throughout a population is relatively insignificant. However, after the immediate crisis, there will be risks embedded in the system, such as additional indebtedness for governments or companies in certain areas. Managing that risk and making sure that risk is properly valued is going to be an issue over the next few years.
Markets have responded very strongly to the great news of the vaccine rollout. Valuations, in many cases, have become stretched, particularly in the U.S. market. We may have some fantastic economic news, but the challenge for investors is being in the right valuation and component of the market to profit.
Daniels: Investors are increasingly uneasy about inflation globally. Do you share that concern?
Desmond: We do all of our analysis in inflation-adjusted real terms, as inflation is ultimately the great destroyer of long-term wealth. Our models are not saying that there is any immediate fear of a massive resurgence in inflation. There’s clearly disruption, because of supply lines, reduced inventory, and changing purchasing patterns. Everybody’s doing a construction project now. Six months ago, everybody was buying leisurewear. Most businesses aren’t structured to deal with these abnormal patterns, so it’s not surprising that you’re seeing short-term inflation.
Some inflation would probably be a positive sign in global economies. I would argue that central banks have the tools and the perspective to address inflation when they want to. It looks to me as if the market has been more concerned that central banks would not address inflation, rather than fundamentally afraid that inflation would get out of control. This is an interesting tension between investors looking forward into the future and central bankers who are desperate to get economies recovering.
Weiss: Prices are going up especially for anything remotely related to housing. Just go try and buy a pool right now, or a kitchen—and good luck to you. That’s not shocking, given there was significant underinvestment and there were supply disruptions related to COVID. I think the jury’s still out as to whether this is a temporary inflationary shock within specific areas or whether this is durable inflation. But I am comforted by the fact that the types of businesses I look for tend to have durable competitive moats with pricing power at every point in the cycle.
Chakrabortty: Looking at emerging markets in general, I don’t see inflation as a concern yet; it is probably something to think about next year. The demand side is still weak across most of these countries. But in general, I think the central banks have enough arrows in their quiver to tackle the issue when it arises at a core inflation level.
China Is Unique
Daniels: China’s been an ever-growing part of the MSCI ACWI ex-US Index, rising from about 5% to 11% in the last five years. Can an international equity manager afford to ignore China anymore?
Weiss: I don’t know that any investor was able to ever ignore China, in the sense that it’s always been an important consumption end market, a supplier, and a competitor. But investment opportunities have grown over time, and now A-shares are increasingly accessible to investors.
Another significant shift is that 10 or 15 years ago, there were a lot of me-too type of companies in China—the “Facebook of China” or the “Amazon of China.” Now China is arguably ahead of the curve in areas such as payments, delivery, mobile messaging, short-form video, and electric vehicles. The U.S. and Europe and Japan are playing catch-up. You go to a supermarket in Beijing, and you can pay with your face. That’s still not an option available to me here in Boston. The short-form video business model was innovated by a Chinese company and then adapted for the overseas market in the form of TikTok.
Desmond: I focus primarily on developed equity markets, but you still need to know what is happening in China as a marketplace and as a competitor. We’re looking for companies that are accessing business in China while staying aware of the risks posed by competitors that are based in China.
Chakrabortty: We’ve been investing in Chinese equities for more than 20 years now, but with the opening up of the A-share market—the Shanghai and Shenzhen Stock Connect program—we’ve increased our coverage of Chinese stocks. China has grown into a giant among emerging markets: It’s close to 38% of the emerging-market index. We are constantly seeing more client interest there, and we launched a dedicated Chinese equities fund last year.
Chakrabortty: It’s not difficult to figure out Alibaba’s competitive advantage. They’re market leaders in e-commerce, with several other rapidly growing online businesses, like cloud services. The scale and the network effects of these businesses translate into significant cost advantages; rivals have much higher customer acquisition costs. They also have partnerships with [grocery retailers] Freshippo and Sun Art, so they are combining the strength and the muscle they have online with these capabilities offline.
This is a high-quality company delivering about 25% cash flow return on investments year on year. It is also one of the most durable growth companies in the online space. They’re investing in the next legs of growth, such as in lower-tier markets with Taobao Deals and community grocery shopping, competing against Meituan (3690):HK, which is backed by Tencent. It ticks all our criteria and is at attractive valuations perhaps because of the regulatory issues at the end of last year.
Tencent is another high-quality company with a strong competitive advantage within Internet community platforms — instant messaging, gaming, and community-based businesses — and is expected to deliver very steady net income growth of 20%-plus, with a strong balance sheet.
Weiss: I have to restrict my comments to my thought process as of our most recent public portfolio on March 31. Pradipta did a good job of summarizing why both companies are dominant within their areas of focus. And they both looked cheap versus global peers as of March 31, especially because there’ve made loss-making investments that will either, presumably, prove successful or be discontinued in the medium term.
There are also challenges. There are competitors like Pinduoduo (PDD) and JD.com (JD) going after Alibaba’s e-commerce business, and ByteDance going after some of Tencent’s advertising businesses. And there’s the regulatory crackdown. Time will tell whether either one of those challenges will prove permanently disruptive to the strength of these franchises in the long term.
Daniels: Pradipta, you invest in frontier markets. Are any countries poised to be the next China?
Chakrabortty: China has been unique. Its transformation from a heavy-industry- and infrastructure-led economy to a skilled-labor-based, Internet-driven economy investing very heavily into R&D has been remarkable. In fact, Chinese investment into R&D is now comparable to the U.S. and way above European investments.
You’re unlikely to see this happening at this scale in any other market as quickly as it has happened in China. But as industries evolve, we do see trends rhyming across different markets. The frontier market that is closest is Vietnam, which is also transforming very rapidly. It’s among the largest producers of smartphones globally. It’s not just cheap labor. Vietnam is replicating the Chinese model of an end-to-end supply chain that’s efficient and low-cost and that works. Vietnam is a very attractive frontier market.
Daniels: For all three of you, what geographical or technological market do you see as having the most promise 20 years from now?
Chakrabortty: We find the entire industrial automation and the robotics space very interesting. China is the world’s factory, with close to 30% of the global share of manufacturing output. Low-cost labor was one of those big drivers of that, and the second big driver was the establishment of a supply chain with excellent logistical efficiency that was unmatched across any other country.
However, in the last five years, wages have been rising in China. Compared to markets like Vietnam, Cambodia, and other Southeast Asian countries, China’s labor cost advantage is decreasing, so we’re seeing increasing emphasis on industrial automation. Because of their investment in R&D and education, you have a massive number of engineers and other technical staff that are available at a fraction of the cost in markets like the U.S. and Europe. That massive pool, along with the end-to-end supply chain in the background, is fueling the beginning of the automation and robotics business there.
Outside of China, we find businesses like the software services businesses very attractive. COVID has given a boost to digital transformation across different verticals. Consumer-facing businesses want to improve their consumer interface. Banks are getting into digital banking. Entertainment companies like Disney (DIS) are improving customer experiences on their apps through more personalization. We own stocks like Tata Consultancy Services (TCS), an Indian company, as well as a Belarusian company called EPAM Systems (EPAM). We’re seeing a very strong order pipeline for these businesses. We’re perhaps in the beginning of a multiyear digital transformation.
Desmond: As an alternative to software and emerging markets, I would like to highlight an investment idea that may appear less exciting at first glance. The energy transition will be an important element for the global economy over the next 30 years. If we are going to meet many of the climate goals that we’re targeting, we need significantly greater use of electricity. Many southern European utilities have transitioned — not completely but significantly — away from thermal generation. They’re leaders in renewable generation in their home markets and increasingly big players in renewable generation in North America and South America, as well.
These companies have secular growth supporting them. Significant investment will need to be made, and they are generally in regulatory environments where they will be supported for making that investment. They stand to underpin much of the secular climate adjustment that needs to happen. We believe these are relatively steady, attractively valued investment opportunities.
Japan’s an industrial country that has been consistently reinvesting in its technology, and is a leader in many areas of electrification, particularly electric vehicles. Its companies are big producers of components for electronic goods. They are involved in digitization and energy efficiency as well. So, while we’re used to hearing the demographic story or the debt story on Japan, there is a competing narrative that’s potentially very attractive.
Weiss: To pick up Liz’s point on southern European utilities: Alternative energy is going to be a major growth theme over the next 20 years. There are different ways to invest along that theme, including consolidated equipment plays in wind, electric vehicles, and solar.
Machine learning is another important theme. It’s going to affect all of our lives, and it crosses a lot of sector bounds. The semiconductor industry is a big beneficiary there. And within semiconductors, extreme ultraviolet lithography and follow-on technologies like high-NA are basically the gatekeeper technology to continued progress in Moore’s law. That’s probably more of a 10- to 15-year theme, maybe not 20-plus, but it’s still a long-term opportunity.
From a geographic perspective: India. It has 1.4 billion people. Although there’ve been fits and starts, the general trajectory of economic performance has been positive in recent years. More broadly, on a 20-year view, there’s a large pool of consumers that will increasingly be entering the middle class and can unleash a consumption boom in India. That’s definitely a country to watch.
Daniels: How important is climate change—as well as other ESG issues—when you’re assessing risk?
Weiss: It’s both a risk and an opportunity. I’m actively looking for ideas consistent with my investment process that are going to be long-term beneficiaries from the general trend towards alternative energy. On the flip side, if you’re a legacy producer of products that may be on the opposing side of the move towards climate awareness, you’ve got to be careful. Take property and casualty insurers: If you look at actuary analysis over the last 50 years, there are certain risks that are happening with more regularity than they did before, so you have to incorporate that in your company-specific analysis. And what are the implications if the electric vehicle transition occurs more rapidly than we think for companies that are making products that are only sold into ICE [internal combustion engines] vehicles? They may still be OK investments, depending on valuation, but you have to be aware.
I’m fortunate that Fidelity has dedicated research teams focused on stewardship and ESG factors that are material to a company’s success. What’s good for society and good for the environment is often good for business—and for stock prices, too.
Chakrabortty: Even before the recent focus on climate change, ESG has been an integral part of our process in terms of identifying risks and pockets to avoid from a long-term point of view. There are also opportunities. China is targeting net carbon neutrality by 2060. It is the world’s largest consumer of energy, and it’s among the largest contributors to carbon emissions, so this has big implications for green technology, not just in China but globally as well. Today, 72% of power generation in China is coal-based, and that is transforming into wind and solar. Solar in China is now largely at cost parity with coal, so the economic case for generating power from coal is disappearing.
Desmond: ESG is part of the long-term evaluation of risk. All of us have spent a lot of time looking at governance of companies to ensure that as long-term investors, we’re going to benefit from the returns that a company earns over time. Governance will always remain a very important factor. If a company is engaged in socially disruptive activities, that’s unlikely to be a sustainable long-term business model, so you need to think about that as an investor, as well. This presents opportunities as well as risks, and we factor these issues into our long-term investment thesis.
Ultimately, at Mondrian we’re driven by valuation, and we’re going to invest in companies that we think are fundamentally undervalued and have the opportunity to offer attractive returns. To achieve this over the long term, we need to understand the companies we invest in and the sustainability of their business model.
Daniels: Thank you all for your insights.
Andrew Daniels is an associate director, U.S. equity strategies at Morningstar Research Services LLC.
Andrew Daniels does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.