By RiverFront Investment Group
Recently, we at RiverFront have been on a crusade of sorts, attempting to convince investors to stick with global diversification after years of US equity outperformance. Not surprisingly, we have encountered a fair amount of skepticism and pushback to our pro-international message. One of the arguments we have recently heard is, “My portfolio is comprised of US companies that do business around the world, so I don’t need to own international stocks.” In this Equity View, we will cover the reasons, in our view, US multi-national companies should not be expected to stand in as sufficient substitutes for international stocks in a diversified portfolio.
Why US Multi-National Companies Should Not Be Expected to Perform Like International Equities:
1) US valuations are currently higher overall than international valuations
Over long periods of time (20+ years), large-cap stocks in the US and large-cap stocks domiciled in other developed markets can be expected to perform similarly, according to our Price Matters® This is evident in the fact that the long-term real total return trend lines for US large-cap and MSCI EAFE are the same at 6.4% (see charts below). However, few investors have the time horizons or the patience to wait 20 or 30 years to experience the long-term averages. For the investors we normally encounter, who have time horizons in the 5 to 10 year range, starting prices are often a better determinant of returns than long-term averages, particularly when those starting prices are significantly above or below their long-term averages. Today, according to our Price Matters® discipline, US equities are trading at roughly fair value (Chart 1), while developed international equities (Chart 2) are trading at valuations that are 36% below their long-term trend line. This significant difference in valuations between US large-caps and EAFE has historically led to dissimilar future returns. Their less expensive valuations also mean international equities to offer superior dividend yields, beating their US counterparts by 50 to 100bps. Past performance is no guarantee of future results.
2) In our view, US earnings growth is likely to be slow
US earnings growth has stalled over the past few years, while earnings for companies outside the US have been rising. Below are of the few key factors we believe are contributing to slowing US earnings growth:
A) Low oil prices: Low oil prices have a greater impact on the US economy than the economies of most European or Asian countries. This is because the energy sector generally makes up a greater proportion of the US economy and its movements can influence other tangential sectors like housing, banking and consumer spending.
B) Strengthening dollar: Dollar strength leads to decreasing competitiveness for US multi-nationals and makes foreign profits less valuable when brought back home. To the extent we anticipate continued dollar strength as our monetary policy diverges from the rest of the world, we believe this will remain a consistent drag on the earnings of US multi-nationals and a consistent boost for the earnings of companies domiciled outside our borders.
C) Less low hanging fruit: US companies have been quick to react to the “new normal” of slower global growth. In the US, we recalibrated our workforces, recapitalized our banks and bought back stock, which boosted the bottoms-up earnings of S&P 500 companies 40% above their pre-financial crisis highs (Factset). Companies in Europe and Japan have been slower to react and have not fully deployed many of the tactics undertaken by their US counterparts, which explains why the earnings of most EAFE companies remain below their pre-crisis levels. We believe this slower earnings growth means that there is more “low hanging fruit” still present for developed international companies to take advantage of, while fewer such opportunities exist in the US.
3) US multi-nationals do not offer local market exposure
Three of the trends we are most excited about in developed international markets are not accessible by investing in US multi-nationals. These three trends are:
A) International Consumer: With both the European Central Bank (ECB) and the Bank of Japan (BOJ) targeting consumers by stimulating employment and/or increasing wages, we anticipate attractive returns for international consumer companies. Many of the companies we anticipate outperforming operate in the services industries, like retail, restaurants and consumer services. Typically, US multi-nationals operate in the goods sectors and are less exposed to services and thus less likely to fully capitalize on strengthening consumer trends.
B) Real Estate: A second trend that we are bullish on is international real estate, particularly in Japan. We believe that the easy monetary policies instituted by the Bank of Japan (negative interest rates and quantitative easing) will lead to rising real estate prices across Japan. This trend can only be played through Japanese real estate management companies and Japanese real estate investment trusts (REITs).
C) Low Volatility: Stocks that look like bonds (i.e., low-risk assets) were among the first beneficiaries of easy monetary policies in the US as investors were forced out of low yielding safe assets. We anticipate the same types of stocks to be among the first to benefit from similar easy money policies overseas. “Bond look-alikes” typically occupy industries like insurance, food & beverage, public utilities and telecommunications that may not necessarily be accessed through US multi-nationals.
Bottom Line: While the theory that US multi-nationals should participate in foreign stock market strength sounds appealing, this has not been borne out in practice. If the theory were accurate, one would have expected European and Japanese multi-nationals to perform similarly to their US counterparts since 2009, but they have not. The theory also did not play out for four straight years (2004-2007) when US large-caps underperformed their foreign counterparts by as much as 10% a year. As obvious as it might sound, we believe that the only way to get true international equity exposure is to buy international equities, warts and all.
This article was written by Chris Konstantinos, Director of International Portfolio Management, Adam Grossman, Chief Global Equity Officer, and Doug Sandler, Chief U.S. Equity Officer, at RiverFront Investment Group, a participant in the ETF Strategist Channel.[related_stories]
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