Underweighting Asia was the primary driver of returns from regional allocation in 2021, when China, Hong Kong, Japan and South Korea all underperformed global equity benchmarks. We have consistently held an underweight position in China, where many companies have weak corporate governance practices and are vulnerable to rapidly changing regulation. Underweighting China contributed most to relative returns in 2021, when the introduction of consumer protection regulations and other rules drove down Chinese market returns.
Figure 1: Relative Valuation of International Equities to U.S. Equities Hit a 20-Year Low
While up for the year, international equity returns lagged far behind US equity returns again in 2021: The MSCI ACWI ex US Index’s 7.8% return was less than one third of the S&P 500’s 27% return. As a result, the price-to-earnings valuation of international equities fell even further below the U.S. market P/E. The valuation discount of non-US to US equities is now 34%, larger than at any time in the last 20 years (Figure 1). We believe this valuation disparity presents investors with an attractive long-term opportunity. Several catalysts, including rising interest rates, may help international equities outperform US equities from here.
The New Year began with uncertainty and volatility. Investors are grappling with many issues, including
The Omicron variant has caused additional supply chain challenges and higher inflation readings. Any perceived or actual changes to interest rate policy in response to higher inflation are likely to have a significant impact on equity markets. As it relates to China, we maintain our underweight positioning there as it is challenging to find Chinese companies that meet all of our investment criteria. We believe the changing regulatory landscape poses a risk and corporate governance standards in China are generally poor. In addition, the Chinese government is looking to shift their economic model to reduce the magnitude of economic growth, and make their growth more environmentally sustainable and more evenly distributed across society. Given the size of the Chinese economy and its impact on the global economy, we think this deceleration could have a significant impact on various countries and sectors, and specific companies.
While the issues noted above may influence markets in the near term, we believe that predicting specific short term economic variables and inflection points is a challenging exercise. As such, we take a sustainable growth approach and remain focused on investing in competitively advantaged companies that are likely to deliver consistently high earnings growth because they benefit from long-term secular trends, not cyclical reversals. Some of the trends we are investing behind are driven by technological shifts and changes in consumer behavior. We are focused on the growth of ecommerce as an important long term secular trend, as well as increasing adoption of digital payments. This approach has served us well over time and the past year was no exception.
Why Sustainable Growth
Our research shows that investing in a select group of economically resilient companies that can sustain five consecutive years of above-average earnings growth has historically delivered strong and consistent excess returns, while preserving capital during equity market selloffs.
Our research centers on identifying secular trends and the companies best positioned to benefit from them. We construct portfolios from the bottom up, reflecting where we find the most attractive opportunities. This research focus has led to the portfolios’ current overweights in the Healthcare, Technology, and Communication Services sectors. Some of the trends benefitting our holdings in these sectors are shown in Figure 2.
Figure 2: Secular Trends Drive Overweights in These Sectors
Strong long-term earnings growth backed by secular trends is just one of eight components of a sustainable business model that we believe influences long-term investment outcomes. When selecting stocks, we conduct quantitative and qualitative assessments of each of these eight components, or factors. Among these are sound corporate governance, responsible management of environmental and social exposures, balance sheet strength, and a diversified business where concentration risk is limited. (Figure 3)
Our investment approach has historically produced concentrated and differentiated portfolios, with compelling profile, high active share, low volatility, and low downside capture. (Figure 4)
Figure 3: Investment Selection Criteria
Figure 4: Attributes of Sustainable Growth Investing | Fundamental International Equity all Country Representative Account1 vs. The MSCI ACWI Ex-US Index
Environmental, Social and Governance (ESG) investing has become more popular recently. These issues have played a critical role in our investment selection process for many years as we believe that ESG factors are an excellent indicator of longer-term risks and opportunities. As a result of the natural alignment between our investment approach and ESG factors, our portfolios had less (better) ESG risk than the index at year end. (Figure 5)
Figure 5: Sustainable Growth Approach Delivers Low Relative ESG Risk
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