All the pieces are in place and the table is set. Mainstream thinking holds that value stocks have been set up as winners over the next five to 10 years while non-U.S. markets will enjoy valuation advantages in the same period, as both have underperformed for 15 years until 2022.
That’s the expectation, anyway. Yet so far in this decade, many economic predictions are failing to materialize. Last year, there was supposed to be a recession in Europe. Now in 2023, the recession is expected to arrive on domestic shores. It may but it hasn’t yet.
What is likely is that global growth should be driven by the usual suspects. Both China and India are expected to enjoy GDP growth of just over 5% in 2023, according to David Rolley, vice president and co-head of the global fixed-income team at Loomis Sayles, speaking at a press luncheon in mid-April.
Those two nations should account for more than 50% of all global growth this year. That sounds impressive, but much of it will be powered by China’s reopening, not productivity.
Deglobalization has been rearranging international supply chains. Market structures are rapidly shifting away from the era when cheap Russian gas fueled Europe’s growth engine, something that was happening even before the Cold War ended, according to Hassan Malik, a global macro strategist at Loomis Sayles who also spoke at the luncheon. Malik said it’s not clear if the current dynamics are sustainable, as emerging markets appear to be struggling with supply chain issues. Many developing nations were harder hit by the pandemic than mature markets, but their recovery could be a surprise factor in the next few years. And a number of former Soviet satellite states in Central Asia could enjoy more economic power as they emerge from under Russia’s thumb in the decade ahead.
Still, emerging markets now look particularly cheap, with many posting earnings growth in the mid-teens and their stocks selling for around 10 times earnings, Malik said. On top of that, nations with younger populations than the United States, Europe and Japan don’t have to grapple with the same acute labor shortages afflicting developed markets.
There’s little doubt that emerging markets boast compelling investment fundamentals. These attributes are likely to become even more obvious as developed countries face secular challenges of debt and demographics in the next decade. Some of the world’s smartest value investors, including GMO’s co-founder Jeremy Grantham and Rob Arnott of Research Affiliates, have been banging the drum for developing markets for the last decade.
A Heyday For Value?
Giant investment complexes like Vanguard Group, meanwhile, say value stocks will outperform in the next five years, after growth stocks saw their outperformance reverse beginning in 2022.
But the conventional wisdom that quality growth stocks are difficult to find outside the U.S. is a misconception.
Just ask Jeff Mueller, co-manager of the Polen Global Growth, who teaches a class in “Compounders” in the value investing program at Columbia University Business School. Polen is viewed as a growth shop, but Mueller takes some of his cues from Berkshire Hathaway’s Warren Buffett, another alumnus of that B-school.
Polen looks for investments with five specific guardrails. These criteria include companies with a 20% return on equity, strong balance sheets (often with more cash than debt), stable to improving margins, abundant levels of free cash flow and strong organic growth. Only about 300 global companies meet all five requirements. Polen then strips out names it considers to be cyclical, leaving 150 stocks evenly divided between the U.S. and the rest of the world.
One of Mueller’s current holdings is London-headquartered Aon, a sprawling global insurance brokerage. The company is actually a beneficiary of inflation—since it can pass on any increase in prices to its clients. But its moat doesn’t stop there. It enjoys such a strong relationship with businesses that when insurance companies receive a claim they consider questionable on a policy sold through Aon they are likely to pay it rather than incur the giant brokerage’s disapproval.
“That’s power,” Mueller says.
Another international company Polen holds is ICON, a Dublin-based concern billing itself as the world’s largest clinical research organization. Many pharmaceutical and biotech companies rely on its services to outsource drug trials.
Investors looking to take advantage of growth industries often end up moving into the technology or bioscience spaces. But the concept of digitalization is broadening out to other industries as well, according to Tom Coutts, a partner at Scotland-based Baillie Gifford, which co-manages a sleeve of the giant Vanguard International Growth Fund. Consumer behavior has become increasingly digital since the pandemic and the work-from-home boom “brought forward” demand for tech-related services and products, he says.
While cautioning that he’s not a macroeconomic forecaster, Coutts doesn’t believe the world will return to the low interest rates and quantitative easing that propelled growth stocks to sky-high levels in 2021. So companies need to be able to navigate their way through a variety of changes in the external environment in this strange post-pandemic world. Coutts doesn’t believe there will be a lost decade in tech stocks, though he urges investors to “be aware of the price” they pay for them.
As consumers engage with more digital services, Coutts expects to find more opportunity in the commercial semiconductor business. One of his favorite stocks is the Netherlands-based ASML, which will allow “the miniaturization of semiconductors to continue.”
Both Coutts and Mueller like a select swath of consumer stocks. Not surprisingly, they favor companies with pricing power that need to capitalize on technology and social media.
The beauty business is a prime example. Both managers cite Paris-based L’Oréal as a winner. Mueller also likes Estée Lauder. Though the company, which is popular in China, was hamstrung early in the pandemic by its reliance on a single distribution center in Shanghai, it now has four distribution centers across the nation.
Many of Mueller’s and Coutts’s favorite consumer stocks target the world’s growing affluent population. Mueller likes LVMH’s fashion and leather goods business, saying it should be able to generate double-digit sales gains for the next five years.
Coutts likes Gucci and Ferrari. In South America, he also sees a lot of running room for Mercado Libre (the “Amazon of Argentina,”) which benefits from being in a region whose retail infrastructure is much less extensive than those in the developed world. As an Argentinian company, Mercado Libre also has more experience dealing with inflation than most retailers in other nations.
One industry where the two managers disagree is the payment processing business, however. Coutts likes Adyen, a young Dutch company bearing some similarities to Stripe. He says he wouldn’t be surprised if Adyen was a serious rival to Visa and Mastercard in 2033 in the so-called “war on cash.”
Mueller has looked at the Dutch company, though, and says only that he wishes them lots of luck challenging the Visa-Mastercard duopoly. That duo has “seen their moat attacked by a host of dominant players,” he says. Yet behemoths like Apple Pay, crypto currencies and buy-now-pay-later services like Affirm haven’t dented their businesses.
With personal consumption expenditures growing 4% or 5% annually (and plastic each year capturing 4% to 5% of the payments from cash), credit card executives enjoy almost a double-digit growth rate “before they get out of bed,” Mueller says. Furthermore, Visa and Mastercard “are completing transactions in microseconds” and providing their business clients with data analytics. Their services business also sells fraud detection and cybersecurity systems that are increasingly valuable.
It’s understandable that advisors looking to protect portfolio drawdowns and generate income would look to foreign markets—heavy with banks, energy and industrial businesses—to produce conservative outcomes for clients. Coutts himself says U.S. investors in foreign value stocks should be fine if their time horizon isn’t that long.
But that doesn’t mean one can’t find growth abroad.
Evan Simonoff is Editor-in-Chief of Financial Advisor magazine.