Bargains, Balance Sheets, Bonds and Beta: The International Saga Offers Opportunities
International Markets Review & Outlook 3Q 2012
In general, the third quarter continued a strong market year. Much of that was driven
by the US Federal Reserve Board's announcement of its third quantitative easing
(QE3) program and the European Central Bank's open-ended bond-buying Outright
Monetary Transactions (OMT) program. Both programs have excited the markets about
the potential for improving long-term fundamentals. At the same time, short-term
economic fundamentals and corporate earnings have actually been weakening, and
there hasn't been real improvement in bottom-up fundamentals. So it's a somewhat
more challenging environment for "quality growth" investors like ourselves, given the
markets are being driven more by shorter-term factors. High beta, or higher risk, stocks
have historically done well in this type of environment.
Earnings, quality and valuation — our view of global markets
Our quality growth investment framework closely analyzes three key characteristics —
earnings/quality/valuation (EQV). Here's a snapshot of each of these characteristics as of the
- Earnings: Negative earnings revisions persist around the globe, and the rate has actually
picked up somewhat recently because of additional weakness coming out of Europe, China
and elsewhere in Asia.
- Quality: Return on equity and invested capital remain high, balance sheets tend to be strong
and dividends are increasing around the world.
- Valuation: Valuations remain relatively low, although a little higher than last quarter.
However, it is more challenging for us to find bargains because many quality stocks remain
valued more highly.
Let's take a look at how regions fared on a macro level during the third quarter.
Bad news from Europe was easy to find. Here's a sampling:
- Eurozone unemployment was 11.4% at the end of August versus 8.1% in the US.1
- The September Purchasing Managers Index (PMI) was 46.1 in Europe,1 indicating
contraction even in stronger-performing economies such as Switzerland, Sweden, Norway
and the UK. (A reading of 50 or higher generally indicates that the industry is expanding.)
- European auto registrations — a fairly good proxy for sales — were down 11% in September.1
- Greece has experienced six straight years of economic decline.2
So why should investors look to Europe, where there's virtually no growth? There are several positives for Europe. One compelling plus is valuations. Consider these facts:
- The forward P/E is 10.8 for the MSCI Europe Index versus 12.8 for the S&P 500 Index.2
- Dividend yields are 4.1% for Europe versus 2.3% for the S&P 500 Index.3
- The Schiller PE (using 10-year average earnings) is 12.3x for Europe versus 21.9x for the
S&P 500 Index; that's a 44% discount, which is historically very high, and well above the
37% discount seen during the first quarter of 2012.2
Investors should consider this historic undervaluation of Europe relative to the US. As we've
reiterated many times, economic growth is not correlated with market performance ―
valuation is a much more important factor for long-term returns.
Skeptics may point out that earnings multiples are less relevant because margins are historically
high. But the MSCI Europe Index price-to-sales ratio is roughly at the 12-year average, and the
price-to-book ratio is actually slightly below the 12-year average.3
More good news out of Europe is that the immediate risk of a country leaving the eurozone
appears to have receded. According to In-trade, the chance of a country exiting the eurozone
by the end 2012 is only 12%. The projected chance for the end of 2013 is 49.5%.
Government bond yields are also sharply down. As of Oct. 17, 2012, the 10-year bond yield
for Ireland was 4.6%, for Italy 4.8%, for Spain 5.5% and for Portugal 7.7%.2 Those yields are
sharply down from where they were a few months ago — Portugal was 12% in May, Spain was
7.5% in July, Italy was over 6% for several months earlier this year and Ireland was more than
7% in May.2
Another positive development has been the realization by European companies that they need
to broaden their funding sources. Historically, the market for corporate bonds in Europe has
been underdeveloped as companies have tended to rely more heavily on bank lending. However,
this now appears to be shifting as issuance of high-yield bonds in Europe is increasingly shiftly.
Another interesting trend is the rise in merger and acquisition activity. Private equity has
about $200 billion of dry powder (investable assets) raised in 2007 and 2008 that must be
given back if not used the next year. The average multiples private equity has paid are up to
10.6 times earnings before interest, taxes, depreciation and amortization (EBITDA), higher
than current levels of many quality companies.4
So the European outlook for investors is not all gloomy. In fact, investors should consider toning
down the bad news and looking at the many bright spots — the valuation picture appears very
attractive, bond yields are down significantly, the risk of countries exiting the euro appears to
have receded, and merger and acquisition opportunities appear to be on the rise.
The Japanese economy continues to face significant headwinds with weak export markets,
and the yen stabilized at near-record highs. This is putting significant pressure on exportoriented
Much of the growth in the Japanese market this year refl ects the temporary benefit stemming
from resumption of production after the disruptions following the earthquake and tsunami in
2011. In our opinion, this boost won't repeat beyond this year.
The Japanese government is beginning to recognize the long-term problem their heavy
debt loads may cause. As a result, it has passed legislation increasing the sales tax by five
percentage points between now and 2015. As Japan tries to address the government's budget
deficit, the increased tax burden may have a significant negative effect over the long term on
their domestic economy as it continues struggling to generate appreciable consumption growth.
With the underperformance of the Japanese market this year, valuations have finally fallen to
levels on par with those in the rest of Asia. In previous comparisons of opportunities in Japan
versus those in the rest of Asia, none of the E (earnings), Q (quality) and V (valuation) profiles
stacked up well. Now it's just the E and Q characteristics that don't stack up well. For example,
Japanese companies still have slower long-term growth prospects, and they generate a return
on equity that's less than half that of the rest of the region — not a compelling picture for
Asia Pacific ex-Japan
Governments in the Asia Pacific ex-Japan region appear to be in a wait-and-see mode
evidenced by little additional monetary or fiscal policy stimulus during the third quarter. This
was in sharp contrast to the monetary and fiscal stimulus we saw in the region in late 2011
and in the first half of 2012.
Weaker exports continue to negatively affect the region, leading to a 4% reduction in earnings
growth expectations during the third quarter.5 There continues to be a clear distinction between
countries that have robust domestic demand and those that are more export dependent.
The economies of North Asian countries — Taiwan and South Korea — have been weighed down
by weaker export markets, causing their stock markets to underperform.
Southeast Asia has been a different story with robust domestic demand making these economies
more resilient. Thailand is benefiting from fl ood reconstruction and rising rural incomes. The
Philippines is experiencing strong growth in business process outsourcing, and Indonesia has
benefited from strong investment, particularly in residential construction.
Investors have been shifting money to these more resilient regional economies, and consequently
the Southeast Asian markets have performed exceptionally well. However, with the strong
performance, their valuations have become less compelling. These less compelling valuations
prompted us to trim some of our outperformers in Southeast Asia and redeploy funds into
Chinese companies with more attractive valuations. Many of these companies have been on our
"wish list" for some time. They are outstanding businesses we've wanted to own for years, but
they've been much too expensive until recently, when their valuations reached levels at which it
made sense for us to buy.
Emerging markets continue to produce disappointing economic data, including more downward
revisions to gross domestic product during the third quarter. This weakness is resulting from
both the fl at global economy and weakening domestic demand.
We've seen a significant divergence between BRIC (Brazil, Russia, India and China) and non-BRIC
economies in terms of economic growth. The BRIC economies have experienced much more
significant slowdowns than non-BRIC economies.
To combat weak economies, some central banks have been more willing to respond to the
weakening growth by loosening monetary policies, while others are constrained by infl ation
pressures and domestic structural issues.
India, for example, continues to be challenged by elevated infl ation and current account deficits,
so overall policy support has been quite selective and modest.
In China, the government-in-transition hasn't been aggressive in its policy measures to boost
the economy given concerns over rebounding property prices. The new government should be
complete by year end, and we expect that rebalancing the economy is likely to remain one of
the main policy themes going forward.
Like China and India, Brazil's economy is also experiencing significant slowing in growth. Growth
has been much weaker than expected because of slowdowns in investment and industrial output.
The Brazilian economy faces headwinds from both cyclical and structural issues. Encouragingly,
the government has recently announced a series of measures to address structural issues,
including reducing payroll tax, lowering interest rates on consumer loans and reducing utility
costs. The government's adoption of these measures should help Brazil deal with the issues
affecting the economy.
On a more positive note, the 12-month forward price/earnings multiple for emerging markets
is 10x, which is 20% lower than the long-term average and at a 17% discount relative to the
developed markets.6 This means valuations have come down significantly in the large BRIC
markets, including Brazil and China.
These attractive valuations, relative to historical averages and to non-BRIC emerging markets,
provided us an opportunity to add to our exposure in Brazil and China — markets in which
we've been underweighted for some time.
Implications for investors
In our opinion, investors should evaluate international markets through a longer-term lens that
filters the current gloomy headlines, and may help identify the bright spots in the big picture —
Europe's valuations in particular are compelling, despite the drumbeat of economic doom. For
long-term investors, international markets offer many attractively valued, high-quality companies.
Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, relative lack of
information, relatively low market liquidity, and the potential lack of strict financial and accounting controls and standards.
Investing in developing countries can add additional risk, such as high rates of infl ation or sharply devalued currencies against the
US dollar. Transaction costs are often higher, and there may be delays in settlement procedures.
Political and economic conditions and changes in regulatory, tax or economic policy in Japan or China could significantly affect
the market in that country and surrounding or related countries.
Sovereign debt securities are subject to the additional risk that — under some political, diplomatic, social or economic
circumstances — some developing countries that issue lower quality debt securities may be unable or unwilling to make principal
or interest payments as they come due.
Securities issued by foreign companies and governments located in developing countries may be affected more negatively by
infl ation, devaluation of their currencies, higher transaction costs, delays in settlement, adverse political developments, the
introduction of capital controls, withholding taxes, nationalization of private assets, expropriation, social unrest, war or lack of
timely information than those in developed countries.
Small capitalization companies often have less predictable earnings, more limited product lines, markets, distribution channels
or financial resources and the management of such companies may be dependent upon one or a few key people. The market
movements of equity securities of small capitalization companies may be more abrupt and volatile than the market movements
of equity securities of larger, more established companies or the stock market in general and are generally less liquid than equity
securities of larger companies.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise; conversely, bond prices generally rise as
interest rates fall. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics,