International value managers expect obstacles to persist for their asset class, which has long struggled to keep up with U.S. and growth-oriented equities for the last decade. But they are also acutely aware that no cycle persists forever.

By using their bottom-up investing lens they’ve identified select foreign value stocks that they think are well positioned to weather the macroeconomic turbulence picking up around the globe. Value stocks, which trade at a discount relative to their fundamentals, have underperformed growth stocks in this prolonged environment of very low interest rates because investors have been willing to pay a premium for future earnings growth.

Value saw a bit of a recovery in late August and September as U.S. 10-year Treasury yields rose above 3%, says Harry Hartford, president and head of fundamental research at Los Angeles-based Causeway Capital Management and a manager of the Causeway International Value Fund.

Although value’s underperformance trajectory “has been arrested,” Hartford says, another challenge is mounting: Investors are quickly and severely punishing value and growth stocks when companies fail to meet expectations. “It’s a phenomenon that we’re seeing not just in the U.S. but across the board,” he says.

For example, he notes that the share prices of Germany-based lighting manufacturer Osram Licht AG and France-based automotive supplier Valeo SA dropped dramatically this year after macroeconomic and business-specific concerns prompted the companies to cut sales and earnings forecasts.

Hartford expects more disappointments ahead as companies grapple with labor shortages, higher unit labor costs and production disruptions. “Underneath the [S&P 500 and MSCI EAFE] indices are what might best be described as a rolling bear market,” he says. “There are various pockets of indices both here in the United States and overseas that are experiencing significant underperformance,” he says, “and a fair amount of turmoil.”

Looking past that turmoil to consistent long-term, risk-adjusted returns is the goal of the fully invested Causeway International Value Fund (it always holds less than 3% of its assets in cash). “The amount of capital that we allocate to an individual security, for the most part, reflects the degree to which we think that security is mispriced,” says Hartford.

The fund’s largest position (as of September 30) is Germany-based Volkswagen AG. Auto makers in general have experienced poor performance in 2018, he says, and the stock has never recovered fully from the company’s “dieselgate” scandal (in which the auto maker was accused of violating its cars’ emission controls during testing). Hartford thinks the investment community is waiting for Volkswagen to demonstrate that new management is capable of invigorating the brand and generating profitability and margins similar to those of other auto makers—and he believes it is.

Banks are the single biggest exposure of the Causeway International Value Fund (12% as of September 30). Its lion’s share is in European banks, which “have become quite compelling from a valuation perspective,” Hartford says, as they continue to underperform because of low interest rates in Europe and concerns about Brexit, Italy’s budget and European countries’ high levels of indebtedness. “There’s a little bit of a political football going on between the Italian administration and the EU in Brussels,” he says. Financial companies are the largest sector (about 20%) of the STOXX Europe 600 index, he notes.

Bank positions in the Causeway fund include UniCredit S.p.A. (based in Italy), BNP Paribas (France) and Barclays (U.K.). Hartford also highlights several telecommunication services holdings that he says are inexpensive, offer dividend yields of 3.5% to 6.5% and have limited competition in their markets. They are China Mobile Ltd. (Hong Kong), KDDI Corp. (Japan) and SK Telecom Co. (South Korea).

A Value Shortage

A decade of falling interest rates and quantitative easing in the U.S., Europe and Japan has helped propel stock prices to very elevated levels from a valuation standpoint, says Charles de Vaulx, chief investment officer of International Value Advisers LLC in New York and portfolio manager of the IVA International Fund and IVA Worldwide Fund. Both funds reopened to new investors in September for the first time in seven years.

Although stock prices have fallen quite a bit, “we’re still struggling to find enough bargains to be fully invested,” says de Vaulx. Even the largest foreign stocks deserve to be a lot cheaper than U.S. stocks, he says, because their companies and industries don’t have the vigor of the tech sector giants propelling the U.S. market.

De Vaulx thinks stocks and bonds can be hurt by a rise in interest rates (in the U.S. and globally) that’s likely to exceed what the markets anticipate. The catalyst will be inflationary pressures (especially wages) that “will surprise on the way up,” he says. He expects other businesses to follow Amazon, which recently hiked its minimum hourly wage to $15 for U.S. employees. Stock buybacks, which have been a huge support for the market, he says, may disappear if interest rates continue to rise.

Growing political uncertainty around the globe also concerns de Vaulx. It’s unclear what reforms Brazil’s new president will be allowed to implement (particularly regarding pensions) and how his actions will ultimately impact Brazil’s stock market, de Vaulx says. Italy’s new populist government is creating much uncertainty, political trends are worrisome in China and Russia, and “Argentina is a mess,” he adds, saying only time will tell what will happen in the U.S. before the next presidential election.

The IVA International Fund lowered its cash allocation (which peaked at 35% a year and a half ago) by buying shares in Mexican companies after the peso took a beating following President Trump’s election, says de Vaulx. But the long-only fund remains defensive, he says, with about 18% in cash and 6.6% (its largest position) in gold bullion.

“It’s a useful tool to have something like gold which can zig when the rest of the portfolio zags,” he says, noting that gold is often inversely correlated to stocks and bonds.

The second largest position in the fund as of September 30 is France-based Bureau Veritas SA, a global leader in testing, inspection and certification for many industries, including ships and nuclear plants. It’s a slightly cyclical business, he says, but the company generates a lot of cash.

Another top-10 position in the IVA International Fund is Kangwon Land, Korea’s only casino operator. The company is partially owned by South Korea’s government (which largely restricts gambling), it has a lot of net cash and a dividend yield of 3.4%, and it’s priced very cheaply, says de Vaulx.  

The IVA International Fund has been adding shares of Allied Irish Banks. It’s basically trading at its tangible book value, it’s a player in an oligopolistic market, it’s well capitalized and, assuming interest rates eventually rise in Europe, it has the potential to grow its earnings as it reduces its nonperforming loans, he says.

Other positions in the fund, global companies that de Vaulx finds reasonably cheap with attractive dividends, include Japan-based Miraca Holdings, which operates in the health-care sector, and Holland-based Royal Boskalis Westminster NV, a leading dredging contractor that provides a variety of maritime services.

Addressing Question Marks

In general, the landscape for international value is “a somewhat precarious environment,” says Matt McLennan, head of global value at First Eagle Investment Management in New York. “There are some potential headwinds the markets may need to digest” over the next 12 to 18 months.

The U.S. will lack fiscal stimulus, he says, and the combination of this, the rise in interest rates and the rise in oil prices could result in a normalization or slowdown in U.S. growth. What happens in the largest economy impacts the rest of the world, he says.

China is becoming a “trickier landscape,” he says. Its stock market tumbled this year amid the country’s shift to more modest monetary growth (an attempt to rein in shadow banking or unregulated lending), its elimination of presidential term limits, its weak exchange rate and President Trump’s exacerbating talk of tariffs, he says.

Europe’s economic growth has decelerated this year and there are “potential fissures,” he says, in Europe’s structure. Besides Brexit, he notes that Italy’s budget crisis will test the European Union and that the spreads between Italian and German sovereign bonds are wider than they’ve been in five years (signifying weakness in Italian bonds).

Prudent investors must look at all these “question marks,” says McLennan.

The First Eagle Overseas Fund, one of the portfolios he manages, had over 72% allocated to equities as of September 30. The balance was in cash (14%), gold-related investments (11.5%) and sovereign bonds (around 2%). The fund is hedging currency a bit because the yen and the euro aren’t as cheap as they have been at times over the last decade, he says.

McLennan is generally open to investing anywhere. “We don’t believe that any one region in the world has a monopoly on good businesses,” he says. “It’s just a matter of finding the right business at the right price.” But he’s avoiding China because many of its larger companies have dramatically grown their balance-sheet debt over the last decade.

One of the largest positions in the First Eagle Overseas Fund, France-based Danone SA, is a world leader in yogurt and bottled water. Its price-earnings ratio is in the teens, while many food companies in slower growth categories trade at 20 times earnings, he says. Danone’s 3% dividend yield is reasonable, he says, and can grow as the business grows organically.

Emerging markets have struggled in recent years. However, Centerstone Investors’ chief investment officer Abhay Deshpande believes it is a huge mistake to lump the entire universe into a single basket.

The downturn in many emerging markets provides an attractive entry point to buy quality companies, in his view. Between March and June, Indocement, a leading Indonesian cement manufacturer, saw its stock drop nearly 45%. “Virtually nothing had changed; the business is doing fine,” Deshpande says. A competitor is being auctioned in Indonesia and the “prices being discussed would indicate [Indocement] is very cheap.”

Another company that Centerstone favors in the developed world is ICA Sweden, a grocery store chain operating on a franchise model. It trades at 15 times earnings and has a market share of between 40% and 50%, Deshpande says. In contrast, Walmart’s market share of grocery sales in America is about 25%.

Merlin Entertainments, the world’s second-largest theme park operator, also is in Centerstone’s portfolio. At present, it is building a theme park in Japan and another in upstate New York, depressing margins. In early October, the stock was down 25% from its peak. That suits Deshpande just fine. “I’d rather they continue to build more theme parks,” he says.

More Globe-Trotting For Value

Bill Kornitzer, co-manager of the Buffalo International Fund, which invests in growth and value stocks and is part of a family of funds advised by Kornitzer Capital Management in Mission, Kan., says it’s a good time to consider the relatively cheaper valuations in international stocks and the accommodative credit cycle in global markets. But he warns against flocking to low price-earnings ratios without considering the risks.

“If we’re 80% through the economic cycle—which is probably as good a guess as anybody will give you out there—then this isn’t the time that you buy those [discounted] heavily cyclical industries,” he says. “The reality is these multiples and these earnings can crater by two-thirds from where we are right now.”

Among his value-oriented positions are Brenntag AG and Fresenius SE & Co., both based in Germany. Brenntag, a global leader in chemical distribution, is consolidating the very fragmented distribution market, it’s relatively cheap, and the companies it buys will be more attractively valued if a recession begins, he says. Fresenius, a leader in dialysis products and services, is relatively immune from the overall economic cycle, he says.

Low turnover is a common theme among the quintet of managers interviewed here. For example, when Kornitzer initially invests in a security, he expects to hold it for five-plus years. Many people want to move their money around and “dance across the water on the tips of the alligators’ snouts,” he says, “but we really take a very measured approach here and think about the long term.”