How have international equities been affected by the Covid-19 crisis?
International investing has faced a number of headwinds. Number one is that currency weakness has been in our face. Number two, there’s been slower growth, which has led to lower valuations outside of the United States. Number three, value has underperformed growth. In fact, the dispersion in style returns has been near historic levels. As a result, international value has faced a triple headwind, but it’s my belief that all of these things are likely to start to turn into tailwinds in the year ahead.
Can you share some thoughts on the “growth vs. value” dichotomy?
If you compare the relative P/E ratios1 of international large-cap growth and international value, the data2 suggests that growth is more expensive today than it has been during any time over the last 30 years. We saw some moderation in early 2020, but when the pandemic hit, the split reopened. Some of this is tied to the tech sector because outside of the US you have a much weaker tech sector.
Why has the premium for growth stocks risen to such an extreme?
There are several things that are driving up prices, despite lack of underlying intrinsic value. We know there’s lots of manias happening in the world right now: SPACs,3 Bitcoin,4 etc. Although you can never predict the exact moment of adjustment, I believe the huge differences in price/value spreads have become unsustainable. The good news is, as value investors, this creates opportunity.
How does volatility create opportunity for value investors?
I say it time and time again – volatility is our friend. Why? Because movements in share price often hugely exaggerate the underlying movement of the intrinsic value of a business. Investors should remember that value is a function of the stream of cash that a company is capable of producing along with its existing balance sheet and profitability. Ultimately, what makes a company valuable is its cashflow stream, but Mr. Market doesn’t really care about that in the short term. Mr. Market is happy to trade out earthquakes, political uncertainty, Brexit, elections and pandemics. Covid-19 created severe damage in certain sectors of the real economy, but many were isolated. It was hard to say that several of the downward prices that resulted were justified.
What’s an example of a sector that seemed to experience unjustified price declines in the pandemic?
Automobiles is an example. The draconian scenario that was expected in automobile sales never really happened, despite the fact that parts of the global economy were shut down and remain so. But economics is very interesting – you can close one part of the economy, as we’ve seen, while other parts strengthen. Restaurants, travel and tourism were shut down, but consumer discretionary spending on recreation – cars, motorcycles, motorboats – boomed. The point is that value investors can take advantage of volatility. In an environment of fear, we believe we can measure value. In cases where we mark down the value of a business, it can be less than consensus as the average markdown can be overly aggressive.
How do you think about further federal spending related to the pandemic and inflation risk?
When I think about our investment strategy today and about what’s starting to happen in the macro economy, I believe it’s really starting to activate our playbook. What do I mean by this? Well, interest rates have been lower for longer than we expected and people thought inflation was never coming back. This may be starting to unravel – that’s not so unexpected when you have the kinds of fiscal policies we’ve seen as a result of Covid-19. Monetary and fiscal authorities reacted to the crisis to prevent a dire outcome, but we’re beyond the worst of the economic crisis now. I do believe there will be more inflation. However, I think the environment that appears to be forming – higher growth, higher inflation, higher interest rates – is going to be conducive to our value investing strategy.
How might you be preparing for a higher growth, interest rates and inflation scenario?
The notion is not to look in the rearview mirror but to look in the windshield a quarter-mile off, keep the portfolio forward-looking. We’ll aim to stay invested in businesses we believe will have the highest potential return over the next two to five years based on where earnings and cash flow streams are going compared to price. You have to look at the price you’re paying for what you’re getting. Secondly, we don’t fall in love with sectors. Instead, we look for opportunities to uncover strong value proposition. In Europe, we believe an uptick in inflation expectations and long-term interest rates will be a catalyst for realizing value.
What opportunities are you seeing in emerging markets?
It’s driven by our measurement of intrinsic value – nothing more, nothing less. A company’s zip code doesn’t always equate to where it does business. When there’s distress in price, but not in underlying intrinsic value, then we’re going to be really interested. When there’s price euphoria with no corresponding euphoric response in terms of value creation, we’re going to be less interested.
How does the Covid-19 crisis equate to past economic crises you’ve experienced?
I was given my first sum of money to invest in early 1987, and boom – the fall of 1987 brought the stock market crash. I’m pretty used to this. The Latin American Crisis, Asian Contagion, the Global Financial Crisis, the Japanese earthquake, the European Debt Crisis, Covid-19 – this stuff comes and goes. You get over one hump and there’s going to be another. What we try to do as value investors is take advantage of the ups and downs and stay true to our philosophy and process.