Perspective

Six charts that make the case for international equities and value


Looking at the case for international as opposed to US equities, we should emphasise that it doesn’t have to be “either/or”. There’s an argument to be made for owning both. It’s also true that perfect foresight rarely exists so deciding when to time any transition between the two is likely to be harder than diversifying by owning both from the outset.

What we can say is that US equities have outperformed for a long time. At present, we are nine years into a run of US equities outperforming international (i.e. non-US) shares, whereas the average performance cycle is only 7.2 years. This suggests that the cycle may be closer to turning.

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International equities offer diversification

International shares can help diversify your investments in a number of ways:

  1. Exposure to a broader regional and geopolitical sphere.
  2. Exposure via Asia and other emerging markets to faster growing populations, faster growing middle classes and corresponding rates of consumption, and (in some instances) higher levels of GDP growth.
  3. Valuations which are significantly lower than the US, even when adjusted for comparably lower growth rates.
  4. Exposure to other currencies (particularly given the US dollar seems to have reached a plateau and may weaken from here).
  5. Less concentrated markets, and greater opportunities for active investors.

Picking up point 5, the narrow breadth of the US market has been a feature of the past few years. This has been mainly due to the phenomenal success of the US tech giants.

The chart below shows how the top five US stocks alone now make up almost one quarter of the S&P 500 index. By contrast, the top five international stocks account for just 7% of the international benchmark (MSCI World ex US).

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This reflects a period of extraordinary growth for those tech giants. Aside from Microsoft, most of them were barely a twinkle in their founders’ eyes at the turn of the 21st century. There’s no denying that, so far, there has been no good time to bet against their success continuing. But this does raise the question how much further this trend can go on.

As we’ve already said, it’s impossible to predict an optimal time to diversify portfolios. However, this level of concentration in US markets suggests to us that now is probably not the worst time to do so at least.

US outperformance reflects preference for growth over value

The rise of US mega-cap tech has been part of a change in style performance in international markets too, not just in the US. Our analysis (see chart below) shows that over the long run, as measured from the 1990s to Q2 2020, cheap high quality stocks performed well, returning 6.7% on average, and expensive low quality stocks did not, returning -8.6%.

This is the relationship between valuation, quality and returns that one would intuitively expect. However, there have been growing signs in recent years of this relationship breaking down as investors sought higher growth regardless of quality, as the 2017-19 and Q1 sections of the chart show.

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That breakdown has become quite extreme. For example, looking just at Q2 this year, expensive low quality stocks significantly outperformed expensive high quality stocks. Cheap stocks have been left behind.

A lot of this is driven by the performance of companies with high growth potential but no profits. In general, we don’t think this pattern of investors paying more for lower quality can be sustained in the long run.

Expensive stocks are generally expected to grow faster, but this leads to the question, what is already in the price? The right hand side of the chart below shows that expensive stocks - be they low, moderate or high quality - now price in returns well in excess of their likely growth. The blue bar is our view of what is implied ("actual" or priced in); the green bar is what we believe is merited ("warranted" or reasonable).

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The historically poor performance of cheap (value) stocks means this part of the market now implies significantly lower returns, as displayed on the left hand side of the table.

In other words, expectations of value are very low - perhaps too low - giving it a much lower hurdle to clear in order to surprise on the upside.

Value stocks trade well below their long-run average

The poor returns from value stocks over the past decade have led to a very substantial valuation gap to the overall market. The chart below shows that international value trades at a significant discount to the international benchmark currently.

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The chart also highlights that value is now priced at a similar discount as in late 1999/early 2000 during the height of the dotcom boom. This isn’t to argue that value is necessarily poised for a multi-year rally as in the early 2000s, but the pattern is worth noting.

Value investing works better in international markets

Investors could choose to diversify into value stocks but keep their exposure within the US. However, our final charts – below – indicate that value investing has historically worked better in international markets than in the US.

These final charts show the rolling returns of value versus growth for both the MSCI USA on the left hand side and for International (MSCI ACWI ex US) on the right hand side. They show that international value has historically underperformed its benchmark less. As a consequence, it has offered a lower cumulative drawdown than value on a global basis.

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Of course, past performance doesn’t always translate into future performance, but there are two ways to think about this.

Firstly, if you were explicitly looking to invest in value today, then ex-US equities could be an interesting space to add that exposure. Secondly, if you were explicitly looking to add international exposure to diversify away from the rich valuations of the US market and declining US dollar, then the value style in international equities could be considered.  

Could now be the time to diversify?

We would re-iterate that we’re not looking to predict the future, but we can remember some lessons from the past. It may not seem like it right now but international equities have regularly outperformed the US for significant periods of time. They also offer diversification.

But there are several reasons why we think now is probably not a bad time to gain exposure to non-US equities. Recent US outperformance has been led by US mega-cap tech stocks. The success of these companies is well heralded and well deserved; however, they are richly valued and expectations are high, leaving them vulnerable to disappointment.

Meanwhile, international equities, and the value style in particular, are offering record discounts to their benchmarks and appear to be in a zone that could be considered mispriced. A significant opportunity may be available if one can identify cheap stocks with quality characteristics, such as good business fundamentals and good financial strength.

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

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James Brennan

James Brennan

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