Fundamental International Equity – 1Q23 Review and Outlook

Quarterly Review

After a challenging 2022, which saw international equity markets fall -16% as the war in Ukraine exacerbated inflation concerns and led to more aggressive central bank policy, 2023 began with a relief rally. Turmoil in the global banking industry led investors to believe that central banks will have to slow their pace of interest rate hikes or even change course and lower rates later this year. The reversal in market direction is a welcome change, but we would note that both last year’s and this quarter’s market movements have been driven almost entirely by changes in P/E multiples, while earnings estimates have been largely unchanged. There is typically a time lag between changes in financial conditions and changes in business fundamentals, but we have been surprised by the lack of change in earnings estimates even as the probability of an economic recession has increased. We expect earnings estimates to come under greater pressure later this year, but we believe that our portfolio, comprised of what we believe are economically resilient growth companies benefitting from long term secular trends, is likely to see more modest revisions to earnings estimates amidst a broader slowdown in global economic activity.

Our international equity strategy modestly outperformed the ACWI ex US Index on a gross and net basis primarily due to favorable regional and sector positioning, as we held overweight positions in Europe and in the Technology sector, both of which outperformed in the quarter. Since our investment approach targets economically defensive companies with healthy balance sheets, we also benefitted from underweight exposures to the Real Estate and Financials sectors, both of which underperformed in the quarter. In contrast, performance was negatively impacted by adverse stock selection in Japan and within the Industrials sector.
 

Market Observations and Outlook

While international equities rallied in the quarter, they are still trading at only 12.7x next twelve months’ earnings estimates, 8% below their 10-year average of 13.7x. Moreover, international equities underperformed US equities in the quarter, and their discount to US equites, which are currently trading at 18.4x next twelve months’ earnings estimates, widened to 31% versus a 10-year average of 21%. We believe these valuation disparities present investors with an attractive opportunity to increase their allocations to international equities, though we acknowledge that ongoing geopolitical tensions may limit upside potential.

Price over the NTM PE against the MSCI ACWIxUS

We increased our Materials exposure by establishing a new position in an innovative UK-based specialty chemicals company that provides unique ingredients to cosmetics, homecare, and life sciences companies. According to our research, the company is poised to deliver high single digit operating profit growth for the next several years in large part due to changing consumer preferences and changing regulatory requirements, both of which favor increased usage of natural ingredients over petrochemical based inputs. In addition, we maintain that the company stands to benefit from increased utilization of novel excipients which allow the active pharmaceutical ingredients in biologic therapies to more effectively reach their intended target. We raised our exposure to the Industrials sector by increasing our positions in several Japanese business services companies which underperformed the broader international equity universe in the month of February. Note that our Industrials exposure is heavily weighted towards asset light business services companies. 

Conversely, we reduced our Healthcare exposure by trimming positions in two Irish healthcare companies which provide clinical trial management and sterilization services to life science and medical technology companies. The stocks of both companies delivered strong returns in January after comments from management assured investors that business momentum remains strong, despite the recent slowdown in biotech venture capital funding. We reduced our Communication Services exposure by trimming our position in a leading Chinese internet company whose shares rallied following the government’s decision to eliminate zero-COVID policies which had been in place for much of last year.  The shares also benefitted from investor perception that a period of increased regulatory scrutiny on the Chinese technology sector may be nearing its conclusion.    

We maintain a strong conviction in owning high quality companies poised to deliver superior earnings growth backed by powerful long term secular trends. Among the more compelling trends we observe are the increased outsourcing of Healthcare research and manufacturing activities, and the rising penetration of digital payments, driven by regulation, consumer convenience, and e-commerce. In addition, we think that the companies in our portfolio are well positioned to withstand a challenging macroeconomic environment thanks to strong business models, healthy balance sheets and highly capable management teams.