The Broad View
International investing has been disappointing in recent years. Despite a forceful rally at the end of 2019, international equities have trailed the blazing gains of their U.S. counterparts over the past decade. An array of factors has contributed to this disparity, including a downshift in global growth, the drawn-out U.S.-China trade brawl, the potency of the U.S. dollar and Britain’s labyrinthine split from the European Union.
Nevertheless, appearances definitely can be deceiving, and the index-based returns that most investors follow tell only part of the international investing story. Indeed, a look under the surface reveals a number of favorable dynamics that are easy to gloss over in the aggregate but point to a breadth of investment opportunities around the world.
Consider one of the more eye-opening facts of the past 10 years. At a time when U.S. indexes were outrunning their foreign equivalents, an average of three-quarters of the top-returning stocks each year were headquartered outside the U.S. To put it another way: Even as investors were entranced by U.S. technology giants such as Apple and Google, the vast majority of top stocks were based overseas. More than half the time, non-U.S. businesses accounted for more than 80% of the top returners. Only once did non-U.S. companies make up fewer than half of the best stocks.
This illustrates a simple truth: A corporate address doesn’t matter the way it did decades ago. International investing was once premised on the theory that homegrown roots gave foreign businesses unique access to their domestic markets, partly because they were there physically. That no longer holds in a globally integrated world of interlocking supply chains and globe-spanning corporations.
Whether they’re domiciled in the U.S., Europe, Asia or elsewhere, multinationals typically generate revenue throughout the developed and emerging worlds. The best-run companies have the operational heft and strategic wherewithal to home in on promising opportunities regardless of locale. In many cases, the location of a company’s headquarters is significant only in terms of regulation and taxation, not for earnings prospects or long-run growth potential.
“A lot of the U.S. companies I hold are growing outside of the U.S.,” says Noriko Chen, a Capital Group equity portfolio manager. “A number of the European companies I hold are growing in the U.S. and in emerging markets. The same is true for Asia. It’s really very company-specific.”
International companies boast other attractive features today. In part because U.S. equities have done so well, foreign enterprises tend to sport comparatively favorable valuations and above-average dividends. Of course, any number of conflicting economic, financial and political factors affect specific markets and companies, making it impossible to predict the near-term outlook of non-U.S. markets.
Nonetheless, international equities hold great promise and remain a fundamental component of well-diversified portfolios. Part of that is numerical. There are simply many more companies based outside the U.S., providing a vast pond in which to fish. Beyond that, indexes don’t necessarily represent the best growth opportunities, especially outside the U.S. In-depth research is often a better way to uncover potential winners.
“Some of the world’s best-run and fastest-growing companies are based outside the U.S.,” says Gerald Du Manoir, a global equity portfolio manager for Capital Group Private Client Services. “To have a well-rounded and robust portfolio of stocks, investing in international markets is a must.”
The imbalance between domestic and international indexes results in part from investors’ broad embrace of American companies, which have benefited from steady U.S. economic growth, and in part from the indexes’ structural differences — specifically, their exposure to tech.
It’s no surprise that domestic tech companies have been market Goliaths in recent years, with Facebook, Apple, Amazon, Netflix and Google parent Alphabet even garnering their own acronym, FAANG. Along with Microsoft, these stocks have collectively generated half of the return of the S&P 500 over the past decade. Apple shares alone bounded by more than 800% in the 10-year period ended in 2019. That bravura showing has naturally overshadowed much of the rest of the market. After all, why venture abroad when you’re doing so well at home?
“There’s a halo effect when a market does well, and people require some convincing to look elsewhere,” observes Steve Watson, a Hong Kong–based global equity portfolio manager at Capital Group Private Client Services.
More than that, there are important fundamental differences among equity indexes. International benchmarks have a higher concentration of value stocks in “old economy” sectors such as materials and financials, with less exposure to digital behemoths. By comparison, technology, health care and consumer tech dominate the S&P 500. This accounts for much of the decadelong disparity between U.S. and non-U.S. stocks.
Tech’s marquee results have obscured the fact that promising businesses and sizable parts of key industries are found outside the U.S. For example, Switzerland’s Novartis and Britain’s AstraZeneca are dominant in pharmaceuticals. Denmark-based Novo Nordisk is the world’s largest producer of insulin, the hormone used to manage diabetes.
The same is true in luxury goods. The industry is centered in France, Italy and Switzerland. And though France’s Kering may lack brand-name recognition, consumers know its nameplates, including Gucci and Balenciaga. Ditto for LVMH, the Paris-based home of Louis Vuitton, Sephora and Fendi.
“LVMH and Kering both have sophisticated management and massive resources,” says Julie Wang Chou, a Capital Group equity analyst. “And they both feature several billion-dollar-plus brands. That’s really important for luxury brands. Once you get to a billion dollars in size, it’s a virtuous cycle. You have enough resources to expand faster, you attract better talent, you get better real estate.”
Another promising industry in Europe: renewable energy. The Continent’s strict regulations have forced companies to develop economically viable technology, Chen says. Some examples are Italy-based Enel and Spain-based Iberdrola, the latter having business in its home country as well as in the UK, Brazil, Mexico and the U.S. Green energy “is cleaner, it has generated good returns and there are compelling growth prospects,” she says.
And it’s not as though other countries don’t have some formidable tech companies. It’s just that many of them lack broad name recognition because they aren’t consumer-facing. ASML Holdings, for example, is the world’s largest supplier of photolithography equipment — complex devices used to manufacture microprocessors. The company, whose share price nearly doubled in 2019, is based in the Netherlands.
The story is similar outside Europe. Japan is home to many cutting-edge robotics companies, such as Fanuc and Murata. Some of the world’s most successful technology names hail from Asia, including Alibaba, Samsung, Taiwan Semiconductor and Tencent.
International businesses have other appealing traits. When it comes to dividends, for example, more than 80% of the publicly listed businesses with yields above 3% are found outside the U.S. Though a high yield doesn’t automatically mark a stock as defensive in nature, steady income can help a portfolio weather a downturn.
Equally important, the non-U.S. market is effectively on sale right now. Investors’ preference for U.S. businesses has made overseas stock prices comparatively attractive, both historically and in relation to their American peers. For example, Samsung’s forward price-earnings ratio is lower than Apple’s. Ditto for Swiss food giant Nestlé compared with U.S.-based Hershey.
In some ways, global investing used to be a simple exercise: Divvy a stock portfolio into two buckets — U.S. and non-U.S. — to achieve instant diversification. That’s no longer the case because correlations between U.S. and international markets have more than doubled in the past 25 years. Correlation gauges the tendency of two assets to move in the same direction. In portfolio construction, lower correlation is generally better because it can help reduce risk. When one asset is zigging — say, declining — the other might be zagging because the economic and market forces propelling those moves differ from one place to the other.
Nowadays, U.S. and international markets are increasingly rising and falling together. Why? Globalization is partially responsible. Without discounting the impact of escalating trade tensions in recent years, companies and countries are more integrated than ever. As companies have become more global, the lines between U.S. and non-U.S. indexes have started to blur, and correlations have risen.
Similarly, as the world has become ever more interconnected, revenue sources have displaced company location as most important to an enterprise’s growth prospects. A company’s products are often made with parts manufactured in several countries and sold to customers throughout the world.
Multinationals may be less exposed to regional issues when they’re earning income from many parts of the world.
For example, the 10 largest companies in Europe generate less than a third of their revenue in their home regions. Although political strife or an economic slowdown could still hinder European stocks, it would affect individual businesses differently.
“Nestlé does something like 3% or less of its business in Switzerland,” Watson notes. “Is it Swiss? Well, it’s Swiss by domicile. Is it Swiss by profit generation? Well, no. The bulk of its growth is coming from the developing world, where growth has been relatively strong.”
Finally, company fundamentals are more important than ever. As the developing world has become more established, the best-run companies are rising to the top. Research has shown that emerging market businesses were once at the mercy of their location and industry, with factors such as strong management and disciplined growth accounting, on average, for less than 40% of their returns in the early 1990s. Now some 64% of emerging market returns can be explained by corporate fundamentals, similar to the proportion for companies in the U.S.
Sector- and country-specific issues will still influence profits, but the best companies are often led by strong management teams able to overcome external factors. This is where bottom-up research becomes essential — and can be the difference between investing in a company that succumbs to macro headwinds or one that becomes the next big growth story.
“When you step back and look at the world picture, I think we have a reasonably encouraging picture for global investing,” Watson says. “We build our portfolios company-by-company from the bottom up. And as we do, I see many attractive businesses outside the U.S.”
The above article originally appeared in the Winter 2020 issue of Quarterly Insights magazine.