Perspective

What makes the case for international equities and value?


The narrow breadth of the US market has been a feature of the past few years. This has been mainly due to the phenomenal success of the US tech giants. There’s no denying that, so far, there has been no good time to bet against their success continuing. But this does raise the question how much further this trend can go on.

US outperformance reflects preference for growth over value

The rise of US mega-cap tech has been part of a change in style performance in international markets too, not just in the US. Our analysis shows that over the long run, as measured from the 1990s to Q2 2020, cheap high-quality stocks performed well, returning 6.7% on average, and expensive low quality stocks did not, returning -8.6%.

This is the relationship between valuation, quality and returns that one would intuitively expect. However, there have been growing signs in recent years of this relationship breaking down as investors sought higher growth regardless of quality.

That breakdown has become quite extreme. For example, looking just at Q2 2020, expensive low-quality stocks significantly outperformed expensive high-quality stocks. Cheap stocks have been left behind.

In general, we don’t think this pattern of investors paying more for lower quality can be sustained in the long run.

Value investing works better in international markets

Investors could choose to diversify into value stocks but keep their exposure within the US. However, value investing has historically worked better in international markets than in the US.

Of course, past performance doesn’t always translate into future performance, but there are two ways to think about this. Firstly, if you were explicitly looking to invest in value today, then ex-US equities could be an interesting space to add that exposure. Secondly, if you were explicitly looking to add international exposure to diversify away from the rich valuations of the US market and declining US dollar, then the value style in international equities could be considered.

Could now be the time to diversify?

We would re-iterate that we’re not looking to predict the future, but we can remember some lessons from the past. It may not seem like it right now, but international equities have regularly outperformed the US for significant periods of time. They also offer diversification.

There are several reasons why we think now is probably not a bad time to gain exposure to non-US equities. Recent US outperformance has been led by US mega-cap tech stocks. The success of these companies is well heralded and well deserved; however, they are richly valued and expectations are high, leaving them vulnerable to disappointment.

Meanwhile, international equities, and the value style in particular, are offering record discounts to their benchmarks and appear to be in a zone that could be considered mispriced. A significant opportunity may be available if one can identify cheap stocks with quality characteristics, such as good business fundamentals and good financial strength.

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