Key Takeaways
- Through their domestic equity bias many US investors are missing out on opportunities to own great international businesses and failing to make the most of the potential portfolio diversification benefits foreign markets historically have offered.
- Though relative performance in recent years has favored the US, equity market leadership has been more balanced over the long term.
- The disparate quality of international companies highlights both the benefits of selectivity in the non-US equity space and the value that can be added by managers able to identify companies that are underpriced relative to their perceived intrinsic value.
- At First Eagle, selectivity is at the heart of what we do, and the flexibility of our mandate allows us to exercise this selectivity free from any benchmark-related limitations and to build truly differentiated portfolios.
At First Eagle, we’ve long held that the United States does not have a monopoly on good companies. While we think most market participants would agree with this sentiment, asset allocation data suggest US investors in general continue to be significantly underexposed to international equities relative to their share of the global opportunity set. This bias both de-prives investors of the opportunity to own high-quality non-US businesses and limits their ability to capture the potential risk/return benefits global equity diversification1 historically has provided.
Dynamics that emerged in the aftermath of the financial crisis—including significant US outperformance and rising cross-market correlations—appear to have reinforced this domestic predisposition, casting doubt on the strategic value of global diversification. Closer examination, however, reveals a far more nuanced global investment environment; while in-ternational equity markets continue to represent a broad and diverse opportunity set populated by a range of high-quality businesses, their breadth and diversity demands a selective in-vestment approach. We believe flexible, benchmark-agnostic active managers with a proven track record of successful stock picking may be well positioned to construct international portfolios that offer differentiation from the primary indexes as well as the potential for enhanced risk-adjusted returns.
International Markets Represent a Fertile Environment
Just as it does not have a monopoly on quality companies, the US does not have a stranglehold on the global investment opportunity set—far from it, in fact. US-based companies accounted for 42% of global public equity market capitalization as of year-end 2018 compared to 58% for non-US companies,2 and 79% of public companies with market caps between $1 billion and $10 billion worldwide are domiciled outside the US.3 Because of their “home -country bias,” however, many US investors are missing out on opportunities to own great international businesses. Domestic-heavy investors also are failing to make the most of the portfolio diversification benefits— including potentially better risk-adjusted returns over the long term—that may be gained through exposure to foreign markets subject to varying economic fundamen-tals, interest rate regimes, political conditions, risk factors and other endogenous performance drivers.
Notably, the increasingly close relationship between the performance of US and non-US stock markets over the past 20 years, as shown in Exhibit 1, suggests invest-ment strategies that closely track an international equity benchmark like the MSCI EAFE Index—including many passive and index funds—may provide only marginal risk/return benefits as a complement to a US equity portfolio. Rather than disquali-fying non-US equities as a diversifying asset class, however, we think the index’s limi-tations spotlight the importance of an active, flexible approach to international equity portfolios.
Long-Term Relative Performance Paints a Balanced Picture
US investors’ bias toward domestic holdings likely has been reinforced by the relative performance of domestic and international stocks in recent years. Since bottoming in the aftermath of the global financial crisis, US equity markets have posted outstanding returns; the S&P 500 was up 294% over the 10-year period ended June 30, 2019, for example, while the tech-heavy Nasdaq gained an even more impressive 389%. Interna-tional stocks, as represented by the MSCI EAFE, have also rebounded but returned a more pedestrian 94%.4
While the response of various global central banks to the financial crisis—aggressive and swift by the US Federal Reserve, less so by the European Central Bank—appears to have had outsized influence on the behavior of risk assets in the years that followed, a longer-term view reveals that the relative performance of domestic and international stocks historically has been cyclical. Exhibit 2 plots the relative performance of the S&P 500 and MSCI EAFE over rolling 10-year periods beginning in 1970. During this 50-year span—comprising 469 discrete measurement periods—US stocks outper-formed only 51% of the time. Should this pattern persist, the recent run of US domi-nance will end at some point as international equities reclaim the lead.
A Diverse Opportunity Set Demands Selectivity
The performance of stocks in the 10 years since the financial crisis has resulted in a US equity market that, on the surface, appears quite fully valued relative to international indexes. For example, the S&P 500 traded at trailing price-to-earnings ratio of 20.2 as of June 30, 2019, compared to 15.6 for the MSCI EAFE Index.5 Other valuation metrics—including price-to-book and enterprise value to EBIT—paint a similar picture of “cheaper” international markets. Drawing a conclusion about relative valu-ations from these index-level metrics is unwise, however, and those who point to the MSCI EAFE’s lagging multiples as evidence of the broad appeal of international stocks fail to account for some valid reasons the index as a whole trades at a lower multiple than the S&P 500. One is simply that the MSCI EAFE has a higher concentration of what we consider to be low-quality stocks that may appear statistically cheap but fail to incorporate a “margin of safety”6 along other dimensions.
Take European banks, for example. A number of the Continent’s largest and most systemically important financial institutions are trading at meaningfully depressed levels relative to their book values and historical trading ranges. It’s hard to see these banks as undervalued, however, as most are struggling to generate profits in the face of ultra-low interest rates, competitive pressures within their home markets, high regula-tory and legal expenses, and talent drain from their more lucrative lines of business. Perhaps not coincidentally, financials represent the largest share of MSCI EAFE, as shown in Exhibit 3; the S&P 500, in contrast, is dominated by the high-flying infor-mation technology sector.
In Pursuit of Quality
Our research has shown that high-quality international companies have tended to be valued comparably to their US counterparts. Consumer goods companies Procter Gamble (US) and Nestlé (Switzerland), for example, trade roughly in line with one another on a price-to-earnings basis, as do cosmetics giants Estée Lauder (US) and L’Oréal (France). Whether or not these stocks represent a compelling investment opportunity depends on their price at a specific point in time, but we believe these high-quality businesses generating stable cash flows likely deserve their premium valuations.
While US investors likely are quite familiar with the abovementioned international giants and their products, there are a range of companies overseas that offer similarly attractive business models. These companies have maintained stable market shares and profit margins over time, with strong cash flows and healthy balance sheets, while also demonstrating strong qualitative characteristics—like corporate governance and share-holder alignment—that are more difficult to measure but just as important to their investment cases. In some instances, these firms have high levels of insider ownership, often held by descendants or close associates of the company’s founder, which may make them more resistant to conflicts of interest between management and share-holders. With more “skin in the game”—financial and in many cases emotional— management of these companies tend to be focused less on quarter-to-quarter metrics and more on the creation of value for shareholders over time, an approach well aligned with our style of long-term investment.
Take, for example, Hong Kong-headquartered holding company Jardine Matheson (LSE:JAR, Financial), which was founded in 1832 as a trading partnership between two Scotsmen in Asia. The company has diversified considerably since then, and while Jardine Mathe- son’s organizational complexity can be a bit daunting, peeling back the layers reveals what we consider to be a collection of excellent business franchises predominantly across Greater China and Southeast Asia, including ultra-high-end real estate, a global luxury hotel chain, consumer retail outlets, and automobile and machinery distri- bution. The company’s management team—many of whom are descendants of the founding Keswick family, which collectively owns more than $1 billion of company stock7—has proved to be a good steward of capital over the long term.
Another example of an old family-owned business is Laurent-Perrier (XPAR:LPE, Financial), a Champagne maison founded in 1812 and controlled by the De Nonancourt family, which has been running the company for three generations and currently owns 61% of it.8 With its supply structurally limited by French law that defines the geographic area in which it can be produced, Champagne is a scarce asset, and the vast majority of both the wine and the grapes needed to produce it are in the hands of large maisons like Laurent-Perrier. While its Champagne brands—most notably Laurent-Perrier but also Salon, De Castellane and Delamotte—are very valuable, Laurent-Perrier also controls certain impossible-to-replicate assets in the form of its vineyards and other prime real estate and its large inventory of aging bottles.
Turning to more modern times we have Hiscox (LSE:HSX, Financial), an international commercial insurer focused primarily on risks that most other insurers are unable or unwilling to under-write, such as fine art, wedding cars, kidnap and ransom coverage, and racehorses.
Notably, our research shows that Hiscox typically maintains the largest market share within these specialty lines, which over time has allowed the company to develop a highly detailed understanding of their performance. Though no longer led by a Hiscox—either founding partner Ralph Hiscox or his son Robert stood atop the company’s org chart from 1946 to 2013— Substantial insider ownership suggests the interests of company management and directors should continue to dovetail with those of shareholders.
Japan’s Keyence (TSE:6861, Financial) is another company at which the founder’s ethos remains keenly felt even as day-to-day leadership has passed on to others. Launched in 1974 by Takemitsu Takizaki—who serves as honorary chairman of the board of directors and, along with his family, remains a significant shareholder—Keyence is a global market leader in the sensors that serve as the “eyes and ears” of automated factories and warehouses to help ensure their efficient operation. Keyence’s main competitive advantage lies in its broad product portfolio combined with a large in-house salesforce that allows it to develop entrenched relationships with its customers and respond nimbly to their needs. Keyence has capitalized on this attractive value proposition.
A Potentially Attractive Strategic Allocation for the Selective
Though non-US equities have long been considered a reliable source of portfolio diversification for domestic investors, significant outperformance by US indexes over the past 10 years combined with increased correlation among global markets have led some to question the value of international equity exposure. While it’s true that post-crisis market dynamics have made meaningful diversification more difficult for US investors, they also have highlighted the potential benefits of an active, benchmark-agnostic approach to international equities. Investment managers untethered from the constraints of an index can be selective in leveraging the broad and diverse non-US opportunity set to construct portfolios that not only provide investors with truly differ-entiated sources of risk and return, but that also seek to generate alpha. For long-term investors, participating in international market advances while consistently mitigating the downside may help avoid the permanent impairment of capital and thus increase return potential over time.
At First Eagle, selectivity is at the heart of what we do, and the flexibility of our equity mandates allows us to exercise this selectivity free from any benchmark-related limita-tions. We build portfolios from the bottom up, stock by stock, investing in businesses across countries and sectors that meet our criteria—or avoiding entire countries or sectors if they lack securities that pass muster. We look for companies that demonstrate scarcity in their market position and, as a result, persistence in earnings power, placing a premium on strong balance sheets and what we believe to be conservative manage-ments. Our long-term, patient approach enables us to wait for such a stock to be available at a price that includes a meaningful “margin of safety” and to then hold that stock as long as we believe its intrinsic value exceeds its market price.
The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any security. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.
