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
During the quarter, we increased our exposure to the Materials and Industrials sectors, and lowered our exposure to the Healthcare and Communication Services sectors.
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.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios within the composite are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
MSCI ALL COUNTRY WORLD ex-US INDEX - The MSCI ACWI ex US Index is a market-capitalization-weighted index maintained by Morgan Stanley Capital International (“MSCI”) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI ACWI ex US index includes both developed and emerging markets.
MSCI emerging markets Index – The MSCI Emerging Markets (EM) Index was launched in 1988 including 10 countries with a weight of about 0.9% in the MSCI ACWI Index. Currently, it captures 24 countries across the globe and has a weight of 12% in the MSCI ACWI Index. Constructed according to the MSCI Global Investable Market Indexes (GIMI) Methodology, the MSCI EM Index is designed to dynamically reflect the evolution of the emerging markets opportunity set and to help investors meet global and regional asset allocation needs.
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