Our international equity strategy meaningfully outperformed the ACWI ex US Index in the third quarter. Favorable style positioning, currency allocation, country allocation and good stock selection all contributed to our outperformance. Our style positioning benefitted from our overweight exposure to small and mid-cap companies, which are more likely to achieve strong earnings growth. Our currency allocation benefitted from our underweight exposure to several Asian currencies which weakened in the quarter, most notably the Australian Dollar and the Korean Won. Our underweight to China, which reflects concerns about poor corporate governance and an uncertain regulatory environment, was a key factor in our positive contribution from country allocation as the Chinese market declined by -22% in the period. Stock selection benefitted primarily from the strong performance of several holdings in Europe.
Year to date through September 30, the ACWI ex US Index has fallen more than -26% as investors have worried about the impact that the Russian invasion of Ukraine, the slowdown of the Chinese property market, and rising interest rates will have on global economic growth and corporate profits. As a result, international equities are now trading at 11.6x next twelve months’ earnings estimates, more than one full standard deviation below their 10-year average of 13.7x. (see Figure 2).
Figure 1: 3Q22 Index Returns
Figure 2: MSCI ACWIxUS - NTM PE
In addition, their discount to US equities, which are currently trading at 15.4x next twelve months’ earnings estimates, has widened to 25% from a 10-year average of 21%. While we acknowledge that the near term economic growth outlook remains challenging, we believe that current valuations present investors with an attractive opportunity to increase their allocations to international equities. Moreover, we foresee catalysts which could help international equities move higher, including
We are less optimistic on the chances of a resolution to the war in Ukraine, but we believe that any de-escalation of the conflict would be beneficial for inflation expectations, and have positive implications for global interest rate policy, economic growth, and asset prices.
During the quarter, we increased our exposure to the Materials and Technology sectors and lowered our exposure to the Healthcare and Financials sectors.
The increase in our exposure to the Materials sector was driven by adding to our existing positions in two high quality European companies, one a leading industrial gas player helping companies reduce the carbon footprint of their manufacturing activities, and the other a leading provider of cultures and enzymes to food manufacturers worldwide. Our higher weight in the Technology sector was driven by increasing our exposure to a leading provider of digital payment solutions, and by initiating a new position in a German company which develops software for architectural, construction and engineering firms. Companies in the construction industry have been among the slowest adopters of technology and still rely on manual processes and spreadsheets to run their operations, but regulations aimed at improving building quality and reducing waste are benefitting software adoption.
Our lower exposure to the Healthcare and Financials sectors was driven by exiting the stocks of three companies where our views of management changed for the worse. We sold the stock of a Brazilian health insurance provider after it was acquired by a company with weaker corporate governance and an inferior management team to its own. We also exited our position in a Japanese provider of medical data after several acquisitions which seemed outside of the company’s core competency. Within the Financials sector, we exited our position in an Asian focused life insurance company after it named a candidate from outside the firm to be its new CEO. While we typically view a change in CEO as a potential risk to management execution, it does not usually lead us to exit a position entirely. That said, this company recently lost 11 of the 14 directors on its board, the head of the Asia region, and 4 country heads as well. Given the high turnover at the senior level and a management vacuum until the new CEO joins the firm next year, we chose to sell the name outright.
Figure 3: Biggest Sector Weight Changes | 3Q22
Our concentrated and differentiated portfolio typically consists of 40-50 names and has an active share exceeding 90%. These characteristics are a natural result of our investment approach, which focuses on identifying well managed and competitively advantaged companies likely to experience above-average earnings growth backed by long term secular trends. Although we are currently in a very challenging period for equities, we continue to believe in this process and believe it will generate superior returns, regardless of our environment.