Commentary: International equities – managing market swings with timeless tactics

About 1583, Galileo Galilei discovered that each swing of a pendulum takes the same length of time, which led to the creation of the first accurate clocks. And, like the factors that influence the movement of a pendulum — angle, pivot point and force of gravity — many factors influence market movements.

Since emerging from the 2008-09 financial crisis, U.S. equities have dominated — and after such a prolonged period of U.S. outperformance, investors are starting to question the value of investing overseas. However, individual markets run up, and, like a pendulum, they swing (or even crash) back. We cannot time when or how long it will take for this to happen, but by actively allocating to international equities one can benefit from greater diversification and exposure to a unique opportunity set of strong businesses, while trading at a historically large discount to the U.S. market.

Although the U.S. stock market is the largest in the world, its economic growth has not kept up with emerging markets. Over the last decade, emerging markets were the fastest-growing economies with aggregate GDP growth of 5% vs. 2% for the U.S. Investing in international companies lets you directly access this faster growth, whether you invest in emerging market companies directly or in those that have EM exposure.

While U.S. companies dominate many industries, in others, international companies are dominant. For example, in the consumer staples sector, Europe is home to many of the most well-known global businesses in the world. Companies like Unilever, Nestle and Anheuser-Busch InBev not only dominate their home markets, but also have larger exposure to faster-growing emerging markets than their U.S.-listed peers.

Within emerging markets, high-performing, consumer-oriented companies such as Walmex, the largest retailer in Mexico and Central America, provide investors with exposure to a higher growth opportunity, as well as good management and corporate governance. Walmex's growth comes from market consolidation and increasing income per capita in Mexican households. Its stock has outperformed shares of its parent company, Walmart, by 230% during the past 20 years.

Some of the best-performing stocks in the consumer discretionary and industrials sectors are also located outside of the U.S. If you enjoy a fine champagne, fashionable purse or stylish watch, you are probably a customer of one of the global luxury companies based in Europe, such as LVMH, Hermes and Richemont. And every time you board an airplane, it is most likely powered by an engine manufactured by a European company, such as Safran, Rolls-Royce or MTU Aero Engines.

Banking is another industry moving at a very different speed in international markets. For example, HDFC Bank in India ranks as one of the top global banks in terms of earnings growth and profitability. In the last decade, HDFC Bank's earnings compounded at 23% a year (in U.S. dollars) compared to a quite respectable 9% for U.S. bank Wells Fargo. While developed market banks continue to struggle for loan growth in general, HDFC Bank has averaged loan growth above 20% for many years as India's middle class swells and millions move into formal banking for the first time.

Not only can investors find better performing companies in international markets, but the gap in performance of the overall universe is wider in international markets than in the U.S., meaning that international markets are less homogenous in terms of quality. This creates more opportunity to capture alpha with active stock picking in international markets.

The U.S. market has become relatively expensive and international benchmarks are trading at the largest discount to U.S. indexes of any point in the last 20 years. The risk that the discount to the U.S. will continue to widen is lower. Investors without international diversification may be at greater risk of future underperformance.

Valuation spreads between the U.S. and the rest of the world could reverse going forward. Looking back over the past decade, it isn't surprising that the U.S. outperformed international markets as the earnings of S&P 500 companies grew faster than international ones, driven by a higher weight in certain growing sectors — health care and information technology. The U.S. was also helped by better capitalized banks.

Interestingly, if you adjust for the difference in the markets' sector weightings, the historical earnings per share growth gap declines meaningfully as shown by Europe's significant improvement in the chart below.

Going forward, EPS growth is forecast to be much higher, even across markets. The valuation and performance could therefore normalize between the U.S. and the rest of the world.

As Galileo witnessed over four centuries ago, when the lamp swings one way, it is followed by a swing in a different direction. Even though international markets have underperformed the U.S. in the last decade, the pendulum will swing back.

By seeking to invest in high-quality growth businesses outside of the U.S., an investor can gain exposure to greater opportunities in market or industry segments at relatively compelling valuations, with the diversification of macro risks. A diversified portfolio invested in both domestic and international equities is the most sensible approach for long-term investors.

David Souccar and Donny Kranson are portfolio managers and Ben Falcone is a client portfolio manager at Vontobel Asset Management's quality growth boutique, based in New York. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.