Investing in International Equities: What's the Point?
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.
*Source: MSCI and Morningstar
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 at Athena Capital 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:
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.
The chart below reinforces the point in the above tables by showing a longer history of the EPS growth of the S&P 500, the MSCI Emerging Markets Index, and the MSCI EAFE. Just look at that tremendous EPS growth for the EAFE and EM indices from the ’02 lows! But then also note the generally flat growth since 2010. All of which leads us to conclude that an investment at the index level is primarily a bet on the level and the synchronization of global growth.
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.
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.
**Source: MSCI and Morningstar. We use S&P 500 and MSCI World to represent U.S. and Global equities, respectively. "Average Mutual Fund" = is the Morningstar Large Domestic category for the U.S. and Morningstar Large World Stock category for Global.
1 Per Morningstar: annualized ten-year return through Aug. 31, 2019: MSCI AC World Index ex-US: 4.5% vs S&P 500: 13.5%