International Investing Interview

At a recent Advisors Capital Management conference, ACM portfolio managers Randy Coleman and David Ruff gave their thoughts regarding international equity investing and current global outlook. The following provides an edited summary of four questions during the interview:

Question 1: The world can be a complicated place. What do you look for when making an investment in an international company?

Answer: The first thing is jurisdiction. We ask ourselves is it conducive to business? Is there stability in the country’s politics or is civil war possible? Bank of Georgia was a long-term holding in our International Institutional strategy – a bank with impressive profitability, regularly posting return on invested capital over 12%. Yet, Bank of Georgia trades just slightly over book value and has a low 4.5 times price-to-earnings ratio. The stock provided a very attractive return of 13% per year since 2016. Unfortunately, the country’s recent election was manipulated by Russia, and we think a civil war or at least significant instability is more than possible. Thus, we sold the position. We also look at other country fundamentals. Is there out-of-control inflation? Argentina provides a good example here. Is there independence of the Central Bank? Turkey lacks central bank independence and we’ve seen the Turkish lira drop more than 90% over the last 10 years. Obviously, there are no perfect jurisdictions, including the US, but it’s important to avoid the ultra-bad, which can be dangerous for equity investing.

Next, we look at the company, guided by our investment philosophy: invest long term in attractively-valued, conservatively-structured, competitively-advantaged, dynamic companies with growing free cash flow and honest, competent leadership. Investing “long term” means we’re looking to invest in great companies, not stocks with short-term holding periods. For “attractively valued” we project conservative estimates of long-term earnings power for purposes of coming up with an intrinsic value of the company and compare that to the current stock price. We like to see the potential for the shares to double in three years. Thus, valuation plays a major role. For “conservatively structured” we review how the company is financially structured and also review earnings quality. In other words, we want companies to have lower amounts of debt in its capital structure compared to peers and industry, as well as having very high earnings quality, which is primarily measured by the amount of cash in reported earnings. Low quality includes Boeing, where earnings can be theoretical due to capitalizing fixed costs over the projected number of manufactured planes and estimating improving cost efficiencies over the projected selling period for the model of the plane, typically 10 years or more. Obviously, these estimates can be far removed from reality. “Competitively advantaged” pertains to profitability comparisons. We seek companies generating greater profit per dollar of investment compared to peers, something measured by return on invested capital. We highlight this premium profitability on our Fact Sheets. “Free cash” is most important since it represents the true economics of the business. This metric should be the greatest interest to shareholders since it represents the good things a company can do for shareholders like paying a cash dividend or buying back stock, making the remaining shares more valuable. “Dynamic” means the board and management stay paranoid and stay attuned to competitive threats. Holding RELX, a database and analytics provider for legal, finance, and medical industries, serves as an excellent example. The company’s LexisNexis recently incorporated AI into its offering. Clients very much appreciate the feature. Finally, our “honest and competent” leadership focus helps steer us away from companies with accounting irregularities, legal problems, or outright fraud. Examples included a plant visit where the company lacked proper safeguards for employees, potentially opening up the company to future lawsuits. In another instance in an Eastern European country, we witnessed a parking lot filled with high-end cars like Lamborghinis and Ferraris. Noting the size of the company and management compensation, we wondered if management may be skimming profits. Our 12-point corporate governance scoring system, focusing on such things as management incentives, independence of the board, and auditing records, serves us well in avoiding poor governance situations.

Disco Corp provides a positive example of a company visit helping us identify a good investment. A globally dominant provider of semiconductor finishing equipment puts Disco in the packaging and assembly segment. The company provides the tools which take individual tiny semiconductor chips, encapsulate them in a protective package, connects them to external circuitry, and tests them to ensure they meet quality standards. It’s the final crucial step in the manufacturing process of a semiconductor device and it has become increasingly complex as circuits miniaturize and chip designs move to 3D structures.

After meeting with the company in September 2015 and again in March 2016, we initially invested in the company in April 2016. These on-site visits not only gave us insight into the incredible precision of their machines, as well as their customer’s dependency on their products, but we also learned how the company prioritizes capital allocation between R&D, capex, and cash dividends; this information not generally available from earnings calls, financial reports, or data services like Bloomberg.

Question 2: Your largest weighting to a country overall is Japan. What do you like about it?

As just discussed with Disco, we’re finding globally competitive companies in Japan, but more broadly, there are structural changes occurring in Japan that make it a much more attractive jurisdiction for domestic investment as well. Importantly, the country appears to have finally slayed the deflationary dragon, posting positive inflation over the last two years. That’s not just a cyclical improvement, we believe this represents a fundamental game changer for the country. Because of deflation, consumers and businesses postponed purchases as long as possible, waiting for lower prices, and hoarding cash, but we look for this behavior to increasingly change as wages have accelerated along with inflation. Given the tight labor supply condition, wage growth should continue. Importantly, a turn toward reflation should release the country’s excess savings, now at a staggering $9 trillion, or 54% of assets. Indeed, in the last quarterly GDP print, household consumption expenditure grew at an annualized rate of 3.8%. Japan has not seen this kind of annual consumer spending growth on a sustained basis for several decades. While we expect near-term reported GDP to be lumpy due to the external environment, the fundamental change in inflation will shift Japan’s economic growth driver to domestic consumption.

Additionally, corporate Japan, also flush with cash, and faced with rising wages, will more aggressively spend on productivity enhancing equipment as well as labor-saving software. This appears to already be happening as capital investment recently registered 7.4% year-over-year growth.

Finally, the government, effective January 2024, meaningfully contributed to the positive equity investing outlook by tripling the allowed annual contribution for Nippon Individual Savings Accounts (NISA) and made dividends and capital gains permanently exempt from taxes. As it did in the US and Australia, this type of retirement plan legislation change encourages households to increasingly participate in equity markets.

Despite the positive fundamentals, Japanese equities remain extraordinarily cheap, trading at just 1.4 times book value, less than 30% of the S&P 500 level, a gap never before seen. With Japanese companies exhibiting better corporate governance and delivering better profitability we look for this valuation gap to shrink in the coming years. Accordingly, Japan ranks high in our International and Global portfolio allocations.

Question 3: Do you invest in China? How do you avoid the negative consequences from the growing geopolitical conflict between the US and China with prospects for increased trade tariffs as well as the increasing polarization in the world?

Yes, we’ve successfully invested in China and Hong Kong, although you’ve had to be selective, especially over the last few years. We currently have four positions — Anta Sports, Tencent, BYD, and SITC. These names account for around 10% of the portfolio, and all of them provided positive returns since initial investment, which ranged from 2018 to 2021. SITC has been a highlight, benefiting from the geopolitical tension with the US. With direct trade between China and the US under pressure, trade between China and ASEAN accelerates, as China-based manufacturers shifted a portion of their operations out of China to lower labor costs and reduce trade friction with the US. SITC, a China/Southeast Asia regional shipper, benefits from the growing interconnectedness between China and Asia as supply chains adjust. This largely renders the US threat of 60% tariffs on China imports ineffective. Given the dependence of the US on Chinese electronics, electrical goods, communications equipment, machinery, furniture, plastics, and medical goods, etc., as well as China’s dependence on US agricultural exports like soybeans and Boeing’s commercial jets, the two superpowers will need to continue to work together. I might add that China may have been less prepared for tariffs and tariff negotiations in the first Trump presidency, but they’re better prepared now. An example includes the leverage implied by China’s global monopoly on rare earths refining including a key electronic rare earth, gallium. As the US and other parts of the world try to build their own advanced semiconductor supply, they’ll need to work with China to source these key rare earths. Thus, there may be some polarization, but taken too far both economies would suffer tremendously. Both US and China leaders will avoid this scenario.

Question 4: International markets have underperformed domestic. Is that likely to continue?

International equities have underperformed domestic stocks for an extended period now, longer than we expected. Although there have been spurts of foreign outperformance, basically, for more than 13 years, going back to the Arab Spring of 2011, domestic equities outperformed. The S&P has delivered 14% a year, while foreign only 4.5% per annum. Of course, few investments have kept up with the S&P over that time period and even domestic equity managers have failed to keep up. Less than 10% of investment funds have kept pace with the S&P 500 over that time period. We like to point out, however, that foreign has had extended periods of outperformance, as well, with the first decade of this century being a notable example with 700 basis points per year outperformance over the S&P. Nobody perfectly times changes in market leadership, but I can tell you that a necessary ingredient for the rotation centers on valuation. Back in 2000, the S&P 500 traded at 5.6 times price-to-book compared to 3.2 times for the MSCI All Country World ex US Index. Now, there’s greater disparity. The US is back to 5.6 times book while the foreign index is at 1.9 times.

In conclusion, it’s easy to dismiss the international equity asset class after its extended period of underperformance and especially now with the recent pressure the class has been under given US tariff fears. However, it’s not sentiment, but earnings power that determines stock prices in the long term, and you can build a diversified foreign equity portfolio with strong earnings power which is fairly independent of US policy, providing a tremendous diversification benefit when the US again enters a period of flagging performance like it did in the 1980s and the first decade of this century. In addition to international stocks being cheaper, we think the likely strengthening of many undervalued foreign currencies will contribute to returns in the coming cycle. All asset classes go through cycles of underperformance, but it’s important to stay invested to participate when the cycle turns. Thus, don’t give up on foreign equities.

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