MASTERCLASS: International Investing - August 2018

Is it time for advisors and investors to reevaluate their allocations to international exposure? In this edition of MASTERCLASS, industry experts join to discuss global markets and international investing.

  • James A. Doyle - Portfolio Manager at Causeway Capital Management

  • Robert Bush, IMC, FRM - ETF Strategist at DWS

  • Bill Kennedy - Portfolio Manager at Fidelity Investments

  • Todd Morris - Portfolio Manager & Analyst at Polen Capital

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  • 56 mins 41 secs

PRESENTER: With the continuation of ever increasing bull markets here in the US, advisors and investors have not had to look abroad for yields, dividends and income. And as we round into the second half of 2018, with the return of volatility and with the geopolitical headlines making news daily from across the globe, perhaps now is the time for advisors and investors to reevaluate their allocations to international exposure. I’m joined today by four experts from leading international management firms to discuss international opportunities, and how investors can access them across the globe. Gentlemen, welcome to the International Masterclass. ALL: Thank you. PRESENTER: Absolutely, so let’s started, James, I’m going to start with you. What’s the big picture? JAMES A DOYLE: Well the big picture is that equity markets have had a huge run basically since the global financial crisis in the US and in Europe since the end of the European crisis. You have an environment where equities are relatively expensive, economic growth is I would say OK but not great, and we’re in an environment where monetary policy is starting to tighten. So it’s not a great environment from a top-down perspective in terms of equities. PRESENTER: Excellent. Bill, what’s the big picture? BILL KENNEDY: Yes I agree. I mean if you look at it valuations tend to be high relative to historical trading ranges, particularly in the S&P 500. International markets trade at a discount to the S&P 500. And international markets that discount, it’s the widest it’s been in a long period of time. So then it gets me encouraged that international markets perhaps don’t have the froth that we see in the United States. But interest rates are starting to go up globally, and that’s usually not good for P/E multiples, and it puts the pressure on earnings. So the short term I’m reasonably cautious as well. PRESENTER: Definitely. And, Rob, where are some of the opportunities now? ROBERT BUSH: Well, I think, when you’re thinking about international markets, you always have to start with the default position that strategically it’s right to hold international. You know, it’s something that I think people lose sight of. And actually sometimes we get, I get the sense that people get overly focused on the tactical nature. So they might go into a market, come out of a market, and they might do that wholesale. They’re either fully in or fully out. But actually I think you can make a strong case that it’s always right to be strategically allocated. So you have your kind of skeleton portfolio that contains the global equity market, and those tactical positions can be expressed through over and underweights, but you still have the core position. So that said I think in terms of those tactical positions, you know, we’d agree with Jamie that US at the moment is a little bit on the expensive side. So I think that lends regions like Europe and emerging markets as maybe being particularly attractive right now. Now this year of course we’ve seen a little bit of a wobble, I think in emerging markets particularly, but again strategically the argument is very sound. They’re a great addition to a portfolio, low correlation, and from a tactical perspective I think you’re seeing an improving macro situation in many emerging markets. Earnings are improving, and you’ve got the attractive valuations on that. So we definitely think emerging markets are well worth a look. PRESENTER: Definitely. Todd, give us a sense of what you’re seeing as an overall picture. TODD MORRIS: Sure. So at Polen Capital we have a very long-term horizon in mind when we invest. We’re looking five to ten years out into the future, and although there are reasons for concern at the margin on a short-term basis we still see great opportunities within our portfolio. So we’re investing in information technology, services businesses, healthcare and the like. So we see good opportunities in those corners of the market outside the US. PRESENTER: Definitely. And, Rob, coming back to you, with respect to recent geopolitical uncertainty, threats of so many kinds, what’s the impact of political instability around the world? ROBERT BUSH: Well, I’m afraid to say I think the main impact is probably that it does investors a disservice by putting them off international investing, and I think that’s a very unfortunate result. And a good example of that is Brexit: the situation in 2016 where a couple of things happened. First of all, we tended not to predict that it was going to happen. I use “we” in the broader sense across the street, across commentators. But then even when it did happen I think the reaction was poorly understood, because in fact the UK market that year was very strong. UK stock market in 2016 was up around 20%. I mean that in a year when Brexit happened. So you would have been wrong on two fronts, you know, the event itself and the market reaction. Now, if you looked at the headlines and the perception building up to Brexit, it was very hard to have conversations with anyone, I think, and say you still want to retain your position in the UK, it’s still one of the biggest equity markets in the world, you should always be in the UK – a lot of people were actually just pure scared away. And that’s on geopolitical risk. Now, you know, you lost out if you were scared by those headlines. And you exited your position in the UK, you lost out. So I think it’s a great case study in kind of bringing home the point that if you’d retained a strategic position, and yes you could have underweighted it a little bit, fine, I mean I think that’s a perfectly reasonable thing to have done. It turns out it would have been wrong, but it would have less wrong than exiting entirely. So I think that actually I’m afraid to say geopolitical risk I think is getting a little decoupled from markets, and I think it’s serving a disservice of frightening us away sometimes from investing in markets. I think that we almost have to find a way to cut through some of that noise. PRESENTER: Definitely. Bill, I saw you nodding along. Do you have to something to add? BILL KENNEDY: Yes I agree. I use political uncertainty as an opportunity to buy great companies. I buy companies over a three to five year view. I’ve been quite overweight emerging markets, taking advantage of any weakness we saw. Particularly in Korea, we saw a lot of weakness in the fall due to all the missile threats and all of that. I mean you could buy a lot of really attractive companies out or below book value. You know, if you look at the structural things behind emerging markets, emerging markets are cheaper than developed markets. They have much better demographics than developed markets. Believe it or not, 90% of the people under the age of 30 reside in emerging markets, and those are consumers of tomorrow. They’re buying homes, they’re buying cars, you know, they’re demanding to have roads being built and all of that. And if you look at the significantly lower amounts of consumer debt in emerging markets, and then on top of that you have the valuation support. So, in my mind, there’s a lot of talk about the strong dollar, and the impact that has very short term on emerging markets, a lot of uncertainty on the politics with trade disputes, and all of that, I use that as an opportunity to buy some companies that I see can put out earnings growth way in excess of what you can earn here in the United States over the next three to five years. PRESENTER: Excellent. I guess we’ll stick with Brexit first. James, I know you wanted to talk about Brexit as well. Where are we? How does this play into international investing? JAMES A DOYLE: Well we still don’t know exactly how Brexit is going to play out. I think the policymakers are trying to figure it out. Certainly the capital markets are as well. I would agree with Rob that the market’s reaction post-Brexit was very surprising. The UK market is one of the markets that we find most attractive from a value perspective. When you look at the types of companies that we own – GlaxoSmithKline and AstraZeneca, British Petroleum, Vodafone, Prudential, Aviva – these are companies that can do very well even if you want to bearish about the impact on Brexit on the UK economy, or even on the broader European economy. Prudential has a very strong business across Asia. As Bill was talking about the great demographics you get in Asia, well Pru is very well exposed to that trend. And you get to invest in a company like Pru at the valuation of a beaten down old line UK equity, with the upside exposure of the UK. So, look, analyzing policy is very difficult to do, and that’s frankly why we tend to avoid it. It is much easier, in my opinion, to analyze the valuation of an equity on a medium to long-term timeframe, than to analyze what President Trump’s latest tweets mean, or the back and forth about trade war, or our engagement and disengagement and reengagement with North Korea. That’s very difficult to analyze. Analyzing equities is a lot easier. So, as it stands with Brexit, we do have some concerns about what the impact will be on the domestic economy, we tend to have modest exposures to companies that would be exposed to a weak UK consumer, but in general we’re very enthusiastic about our exposure to the UK equity market. TODD MORRIS: It is interesting to think about, if you zoom out and think about the social underpinnings of what’s happening with these trade policy changes. I’m a history buff, so I like to look at what’s happened and why do we get to this point, how are we here? The GATT – the General Agreement on Trade and Tariffs – went into place 70 years ago, this year, and that basically fostered a collaborate global economic regime of low tariffs and low trade quotas to foster the idea of freer flowing capital and efficiency of movement of goods across markets. And the byproduct of that over 70 years though is that in developed markets the low skill working class has been somewhat left behind because of labor arbitrage. And I think they’ve finally found a voice. And things like the Brexit vote, or in the election of Donald Trump in the US, and that is being represented in terms of economic policy with tariff agendas, and it does represent a change to the global order. But as we’ve already heard it’s changing daily, the news flow is incessant, and it’s very difficult to make a near term position change. But that again reinforces our belief in our way of investing at Polen Capital, which is much more of a long-term mindset: finding great businesses that enjoy competitive advantages, and have the ability to reinvest in their own operations over the long run to drive growth. PRESENTER: Bill, I saw you react to that. Do you want to follow up with that or no? BILL KENNEDY: Yes I agree. I just think you take advantage of political uncertainty. I think we’ve seen the example of Korea. We’ve seen the example of Brexit. I live in the UK, and people were shocked when it happened. And, you know, it’s hard to get, people got emotional, and the markets got very emotional. But when the markets get emotional that’s when you’ve really got to start getting constructive and sharpen your pencils, and look where the valuations are. PRESENTER: Definitely. James, I’m going to come back to you. You submitted this question. What is the rationale for large exposure to UK with Brexit looming, and what is the exposure in defence telecoms yet in banking and energy? JAMES A DOYLE: So, specifically to UK exposure, what we discussed is that you have to differentiate between the market in which the stock trades, and what the underlying economic exposure is. And one additional point that I would make is that for many of these multinationals, a weak sterling, if you want to be bearish about the UK, bearish about Brexit, bearish about the British pound, that is actually going to be beneficial for many of these multinationals, because they tend to over-index their cost base to the pound, but under-index their revenues. And so, yes, when you look at our portfolio, and this is something that we sometimes get from our clients, is how can you be so bullish about the UK when there are these looming difficult to analyze risks. And of course if you understand the underlying economics of the companies that we’re investing in, the risk is actually a bit different. PRESENTER: Absolutely. Let’s switch to another hot topic: trade wars, US trade deficits with China. What are the risks to equities from trade disputes? JAMES A DOYLE: Well I can take a crack at that. I mean I would say, and it will be just a crack! There are two issues I think that are important to understand. One that’s been talked about quite a bit and that’s with a reduction of global trade that means a reduction of global GDP and all that comes with that. In addition, you have a loss of consumer confidence, a loss of corporate confidence. It’s effectively monetary tightening, and in an environment where not all economies need a tightening. And so that’s the macro challenge. But there is another problem that I’m not sure is well understood. I certainly wouldn’t say that I understand all these issues. But when you look at how complicated the global supply chain is, you pick the industry, but autos and technology are two great examples. Products and components and subassemblies go back and forth across borders all the time. A great example I think about is post the Tsunami in Japan several years ago. It devastated the power grid part of Japan, and it took down a lot of manufacturing. There was a small company that specialized in pigments that were used in paints that sold this pigment to auto manufacturers all over the world. And because they could no longer manufacture this pigment, all manufacturers that used this high end paint could no longer manufacture models with that color. And this was exposure that the manufacturers didn’t understand. It was so far down the supply chain, they didn’t realize that they were exposed to a single supplier in such a small part of the value chain, but it means that the entire vehicle cannot be sold. And that’s one of the worries I have with some of these trade restrictions and tariffs, is that there are very subtle impacts on the supply chain that we won’t know until these tariffs get put in place, and we start to see where the shortages are, and where the price increases fall out. PRESENTER: Interesting. Rob, I’m going to bring that question to you. What are the risks to equities from the trade disputes? ROBERT BUSH: Well I think more broadly on the trade disputes I still hold out the hope that eventually it will lead to a GATT world in fact where you do have lower tariffs across the board. Even if that might mean higher tariffs in the short run, you know, I hope that’s the end game. Because probably like most of us, and like any trained economists, you tend to believe that throwing sand in the wheels of the machine is always a bad idea, and that’s effectively what tariffs do. I think that we talked earlier about the headline risk from geopolitical events, I think that maybe there’s a little bit of that happening with the trade wars. And if I give you the example of China, the China A share market, which you’re probably familiar this year is starting to be included in some of the major indices. That market has sold off year to date. And I think a large part of it is probably due to headline risk around trade wars. But we did a piece of work looking at actually the proportion of sales from domestic Chinese companies that goes to the US, and it was very small. It’s around 2% of their sales derived in the US. Now, if you feed that back through what the revenue has been of those top 300 companies or so in China, apply some assumptions around margins, you get a number that’s pretty small frankly in terms of the maximum possible hit that could have to the Chinese bottom line. And it kind of looks like that you have a hard time reconciling what looks like a relative small hit to the bottom line verses what the market has done year to date. So I think that there’s a possibility that we’re getting caught up again in the headlines, and actually I thought some of our panelists has made a very good point. You asked me about investor reaction to geopolitical, I said don’t get blinded by it; they said use it as an opportunity. In other words go one step further. I mean maybe that’s somewhere you could be right now with trade wars. PRESENTER: Definitely. Go Todd. TODD MORRIS: If I could just add to that. Thinking about US versus China, specifically, and with our long-term view in mind, I think there’s good reason to be optimistic about what’s happening in China’s future. So, first off to Bill’s point, the consumer economy in China is underrepresented relative to global averages, so consumer spending in China is under 40% of GDP. I’d look for that to grow over time towards the global average of mid-50s, as compared to the US which is 72%. And in addition to that there are new efforts to open up different trade routes away from the US/China relationship over time, and the one built one road initiative there will represent more than one trillion dollars of investment with trade channels to Africa, other parts of Asia, Europe, that again are pushing China’s growth agenda away from exports to the US. And by the way the next export picture is just a couple of percentage points of GDP. Yes, it would be disruptive if there were the maximum amount of tariffs and a tit for tat situation developed, but in the long run I think China’s pretty well positioned to establish itself as hegemony for this century. PRESENTER: That’s awesome. It’s great to talk to the expert because it’s funny, you guys really, like you said you see the opportunity in it, when you look at the news headlines it does, it feels scary. It’s like oh we should be in fear of this, and it really, it’s so interesting to really talk to people more exposed to it, and look at it in a positive way, instead of just coming down like every typical headline which says yikes! Todd, I’m going to stay with you, Polen Capital, what do you think about trade policy and central bank policy? TODD MORRIS: Right. So at Polen we aim to be fully invested across market cycles. We don’t have a top-down view, we don’t make macro calls. And the way we’re able to do that is really by thinking about the businesses first and foremost. And in order to have a long-term view on a business we really need to gain comfort with the competitive position of that company. So we’re a concentrated manager, and we have, relative to many other firms, you could argue we have more exposure to each individual position. And so by having that comfort in the competitive position, you can stay committed to that investment for the long run. All of which gets me to the point that at the margin some of these changes with tariff policy could certainly impact one of the businesses in our portfolio. And if it were to impact them in terms of impairing the competitive advantages, that is a real source for concern. So we’re watching the news flow, and observing what’s happening, but we still remain committed to the portfolio, and actually feel very confident in the positioning of the portfolio for the long run. JAMES A DOYLE: Yes, I would just add on, even though at Causeway we take a different approach to investing than Todd does at Polen – Todd’s growth oriented; Causeway is value oriented – I think we share the belief that the best way to invest is to understand individual equities. Maybe you’re more growth-oriented; maybe you’re more value-oriented. But as I said earlier analyzing policy is very difficult, and whether that’s trade policy or central bank policy it can be very difficult. And so even in an environment where it looks like, as I started off our conversation talking about the challenge that rising rates will present for overall equities, you don’t want to let that. And this is what Rob alluded to in describing how to allocate across asset classes, you don’t want to lose sight of the fact that you’re investing in individual businesses. That are coming out with new products, that are restructuring their business, that are thoughtfully deploying capital, opportunities to succeed as an equity independent of some of these macro thematic challenges, like central bank policy. One point I would add that maybe ties together a couple of these policy issues, it will be interesting to see if there’s a US central bank response to some of these trade issues. Because, as I said earlier, a reduction in trade, trade tariffs are effectively a tightening, so it’s possible that President Trump and the EU and Canada and China may be doing the Fed’s job for them. I don’t think that’s the way we want monetary policy to be set, but it is an interesting way to think about it. PRESENTER: Interesting. Anybody else want to talk about that? BILL KENNEDY: We are seeing that in China. They’ve already reduced the renminbi requirement ratio. So they’re starting to ease monetary policy a little bit in reaction to some of the equity market weakness they’ve seen recently. JAMES A DOYLE: And interestingly enough that also presents a little bit of a different type of trade war, right, so debasing of the currency. Well, if you’re going to put 25% tariff on, if we devalue by say 12% that cuts the impact of that tariff. PRESENTER: Definitely. Rob, do you want add anything? ROBERT BUSH: Well only that I hope it doesn’t devolve into that sort of tit for tat. We had currency wars back in I think 2010 it was, and we don’t need to see it again. But you’re right that it is, it’s a policy response that China, the obvious place to think of, could have in fact. So I guess we have to hope that that doesn’t happen, which is why I remain hopeful about this being just a short-term story. BILL KENNEDY: I hope it’s short term, because I do think the supply chain alone will force everybody to get together and start to agree on things. PRESENTER: We also have a chart on emerging markets from Bill; if you’d all like to turn around and take a look at that as well. BILL KENNEDY: It’s a very simple chart. It just looks at the P/E ratio of the emerging markets versus the S&P 500. And we’ve had a lot of problems in emerging markets. We’ve had political uncertainty, we’ve had trade uncertainty. We’ve had saber rattling with North Korea. We’ve had a big political change in South Africa. That has now been resolved in the favor of South Africa with Zuma losing power. We’ve had political problems and corruption in Brazil, sanctions in Russia. So we’ve had a lot of problems in emerging markets, and that’s why they’re cheap relative to the S&P 500. And if you look at the discount, it’s the widest it’s been in a long time. But back to my earlier point is when people are getting emotional about things, and there’s a lot of headlines in the news, that’s usually when you can find companies that are banging out 20% earnings growth, 20% plus ROEs over a long period of time, you can find them at pretty cheap prices relative to their developed market alternatives. I just look at the P/Es relative to where they have been in the past, and relative to where they are trading to the S&P 500. And right now things are telling, the numbers are telling me that one should be constructive on emerging markets, given the three-to-five-year, even the ten-year outlook for these economies, are going to continue to grow at a pace that I would imagine given all the dynamics I laid out earlier would be faster than developed markets. PRESENTER: Did you want to react to that, yes? JAMES A DOYLE: Our team actually just got back from a two week trip to China. There were five of us that went to see not only portfolio holdings, but also some new companies, particular A share companies that we hadn’t looked at so closely before. So we saw some of our old friends like China Mobile and Baidu, but we also some of the A share companies that we hadn’t looked at before. And we came away, although there’s definitely a spectrum of quality, both corporate governance and business models, we came away very impressed with some of the companies that had been unknown to us in terms of the strength of their business model; in many cases the high quality management, the competitive returns that these businesses were generating, and of course the growth. PRESENTER: Very interesting. Bill, I was going to bring this question to you. Do investors have to worry, if you’re investing internationally do investors still to worry about the US dollar? BILL KENNEDY: In terms of hedging the currency? PRESENTER: Yes. BILL KENNEDY: Well, if you look at a couple of things. First of all, it’s very difficult to predict the US dollar versus the yen and versus the euro. So in developed markets it’s, and the variability is quite low in the scheme of things. Where you’d want to actually look at it would be in emerging markets. However the cost, people always say it’s great to hedge emerging market currencies, but the cost to hedge is very expensive. PRESENTER: That’s interesting. Rob, I know you’re into hedging currency conversation, but how much are investors missing out if they’re only focused in the US, and they’re not investing internationally? ROBERT BUSH : Well I can answer that. I mean I frame that question is to think if you ballpark global GDP at around $80 trillion, and you think the US is around $20 trillion economy, just to keep the math simple, then obviously the US is around 25% of the global economy. If you think about market cap, the US is around 50%. So call it $60 trillion global market cap again to keep it simple. US call it $30 trillion. So you’ve got a situation where the US is half of the equity market, but only a quarter of the global opportunity. So clearly right off the bat you can see that either it’s an over-equitized culture, which I don’t probably think is right, or that there’s just a large swathe of the economy out there that likely will play catch up, or where there is opportunity. So I think that’s an interesting way to frame it, because it shines a spotlight on the ratio if you like globally GDP. The equity market to GDP ratio globally is 0.75%; in the US it’s 1.5%. So it suggests to me that there is a large swathe of investment opportunities out there. TODD MORRIS: Could I add to that? PRESENTER: Yes please. TODD MORRIS: So again looking forward for the next 10 years I think there’s a great reason to be optimistic about this exactly dynamic playing out. There’s an interesting study by McKinsey’s research institute that’s called the City 600. And it looks at the drivers of growth, and it really makes the point that urban density is the key. And among that, the City 600 study looks at the 600 largest cities by population, 440 of those cities are in emerging markets, and Asia specifically, and those 400 cities are expected to be contributing more than half of the incremental GDP growth for the next 10 years. So you definitely want to be looking in those parts of the world for interesting business. Even if it’s a multinational in Western Europe that sells into those markets, that’s a great way to get exposure as well. So it’s a case in point with our portfolio. We’re underweight emerging markets relative to our index, but on a look through basis about 40% of revenues are coming from emerging markets. PRESENTER: Interesting. Bill, do you want to add to that? BILL KENNEDY: Yes. I think emerging markets are an important point of what you do, and we can debate the cost of hedging but the stuff that, the true emerging markets in my mind, the cost to hedge is very high. Cite the example of Brazil, India and all of that. And I do believe that if you feel as though the currency is going to depreciate that much, chances are highly likely that you’re not going to make a lot of money in the equity markets if you own those currencies. PRESENTER: Got you. JAMES A DOYLE: I would also point out not just emerging markets and growth. But even just in the constraints of developed markets, you can sometimes find cheaper equities ex-US than you can in the US. We have a lot of exposure to European pharma right now. Companies like Novartis, I mentioned AstraZeneca and GlaxoSmithKline, we feel that there’s much more value in large cap pharma in the European listed companies than in their US brethren. PRESENTER: So, Bill, bring it back to your evaluation conversation. Given all of this, we’ve talked about getting back to valuations, how does the impact, this impact performance of securities? BILL KENNEDY: Well, you want to buy stocks when they’re cheap, and when they’re cheap relative. I tend to look at them relative to their global peer group. So if I can find something in Europe to the point just made, that’s cheaper than its global peer group, and has better earnings prospects and all of that, I will certainly look at that. And in general, as I mentioned earlier, international markets, developed as well as emerging are at bigger discounts than historically you’ve seen relative to the S&P 500. So when you’re buying international equities, not only are you diversifying some of the revenue streams you’re earning, but you’re not paying the multiples you’re seeing here in the United States for that to do that. PRESENTER: Got it. Bob, I’m going to come back to you. Even with stronger growth and fewer political risks potentially on the horizon, many investors are still focused, we’re going to focus back on the domestic market versus international market, why has it been so difficult for investors to shed that homeland bias and go international? ROBERT BUSH: Yes, so home country bias is an interesting one, because I think there was probably a time when it was understandable and rational. It was probably just hard to access international markets. We’re clearly not in that world today. So I would say it’s very behavioral now in fact if you are ignoring the international opportunity, because it’s not a question of access. The case in terms of diversification and risk reduction is compelling and strong. I definitely agree with Bill and others comments around the emerging markets being a great uncorrelated asset to add to a portfolio. It can have immediate tangible benefits in terms of risk reduction. So what’s a little I guess surprising is that we’re in a world where it’s not about not knowing the advantage. I think most people now in finance know the advantage. But even knowing the advantage of having an international portfolio, we don’t, at least in the US, take advantage of that, and the numbers bear this out. So it’s almost like to me there’s an analogy. There is this concept called the hot hand in basketball, where it was commonly believed that somebody who scored twice was more likely to score a third time. And it was kind of fascinating to have that disproved by economists. But what was more fascinating was that even after you told somebody it was a fallacy they still continued to believe in it. And I think we’re in the same world with international. Even though we all know that we should be internationally diversified, and we’ve seen the benefits and we can have it explained to us, we still aren’t doing a good job of being internationally allocated. Now, I’m guessing that there’s three stages in moving away from this. The first stage is you’re making a mistake without knowing it. The second stage is you’re making a mistake but you know it. The third stage presumably is you stop making the mistake. So at some point I think we will see the home country, the bias of home, I think it is coming down, but it does remain a puzzle. PRESENTER: Bill, coming back over to you, you’ve kind of alluded to this before, let’s talk about growth and opportunities, G7 versus BRIC, like Brazil and opportunities there, just what are some of the opportunities that you’re seeing there? BILL KENNEDY: Yes, I mean I think clearly, if you look, the big argument for emerging markets is that the populations tend to be quite young. The demographics are very favorable. And these are people under the age of 30 moving into consuming, buying homes, consuming cars, you know, starting to use rudimentary banking services and all of that. That is clearly a long-term structural trend, and particularly you find India, Indonesia, Philippines have phenomenal demographics, very young populations. And then so does a lot of countries in Latin America. And a lot of consumers also have very low levels of indebtedness. Brazil probably not so much, but in places like India, places like Russia, and even in China, the consumer has very low levels of indebtedness, and then on top of that you’ve just had phenomenal GDP growth, and GDP per capita has been growing consistently in India and China. Russia, to answer your BRIC question, Russia and Brazil have been less clear, particularly over the last couple of years, because they’re commodity-based economies, and they tend to move a little bit more with the commodity cycle. But if you look at the structurally good growth companies in India and China, they’re doing very well, benefiting a lot from per capita incomes rising, and low levels of indebtedness, allowing consumers to start to consume. PRESENTER: What role should emerging markets play in international allocation? I think you’ve kind of touched on that, but is there anything else you wanted to add to that, what we talked about? ROBERT BUSH: Yes, so I guess I’d add one or two things. So one is that, so I did a bit of analysis looking at the risk, the volatility of emerging markets over the last 20 years or so, and I was very surprised to find that in around, around three quarters of the time it was lower than the US. So that’s the volatility of the EM basket versus the volatility of the US. Now that’s a very surprising statistic to me, I was surprised when I saw that. And I think what’s happening is that we are, we’ve talked a lot on this panel about behavioral mistakes and kind of irrational things that we all think. I think that maybe we’re conflating individual emerging market risks with the risk of an emerging market basket. And if you think about the emerging market basket, it’s a very disparate group of economies with very low correlations. So I think what’s happening is they’re offsetting. So actually if you have that fairly comprehensive emerging market portfolio in your asset allocation, I think you benefit from the diversification even within EM, and that brings down the risk. So I thought that was interesting. And then we talked a little bit about the low correlation and the role that can play. That’s obviously the other part of it. But those are I would say fairly compelling strategic reasons for always having EM in the portfolio. PRESENTER: Anybody else want to touch on? BILL KENNEDY: I think we kind of agree. I mean within EM there’ll be very expensive currencies to hedge, right, because some of the, and much more volatile, and then there’s a big anchor in China. You mentioned Hong Kong as a big part of the basket. But Hong Kong is tied to the US dollar so it’s going to inherently be lowly volatile. But you’re right. I mean on average you have a lot of emerging markets. Some of them export commodities, some of them import commodities, so a lot of that kind of circular trade within that kind of smooth, some of the fluctuations that inevitably would create some volatility within EM. ROBERT BUSH: Yes. PRESENTER: We’re going to look at Rob’s chart he brought from DFW, if you would all like to turn and look, if they’re going to flip it up here. There we go. ROBERT BUSH: What we’ve got here is the returns to the EFA basket, so Europe, Australasia, Far East. So developed international markets, and it’s been broken down in a couple of different ways. One is if you hedged and the other is if you didn’t hedge. So you’ve got two sets of stock returns. And then you’ve got the currency in orange there. So that currency, any time that’s above the line that means the EFA currencies have appreciated against the dollar. So you’ve won if you’ve been unhedged if you like. But what I find interesting about this chart – we go back to 1983 here – is really a couple of points. The first is that it’s clear just at a glance the role that currency can play in the portfolio. The orange bars are the currency effect. And it’s important for investors to remember if you buy an international asset and you don’t hedge, that’s fine, but you’re long the currency, be aware of that. It’s a risk that you need to think about. As long as you’ve thought about it, and you’re happy with it, that’s great. If you haven’t thought about it, or you didn’t know you had it, that’s not so great. So you have to think about the implication and the repercussion of being long the currency. So you have to have a return forecast, a risk assumption, a view on how that currency is going to be correlated with your portfolio: is it decreasing risk, increasing risk, what was the cost to hedge it? So those are the four main components. But what we’re showing here, and I think this is the other interesting point, is that roughly half the time if you count these bars, as I have done many times, currency either helps or hurts roughly half the time. So it looks a little like a coin toss in the portfolio from a return perspective. If you look at the equity returns, it’s positive two thirds of the time. So actually the reason I like this chart is because it confirms an intuition that we all have, which is that it’s right to be long equities, they have a positive risk premium. They pay you over the long run. That hopefully compounds. And this chart shows it: two thirds of the time equity market’s been up. But that may not be true of the currency market, where here again I’m showing 50% of the time it’s up, 50% down. That starts to look a little bit more like noise in the portfolio, so just be a little bit aware of that I would say as you invest internationally if you tend not to hedge. PRESENTER: Interesting, Jamie, coming to you, do you actively currency hedge? JAMES A DOYLE: We typically don’t. There have been a handful of times when we have been very confident in the underlying equity that we own, but we’ve had some concerns with the currency. So think about the Asian financial crisis for instance. We had a significant exposure in Hong Kong. We did have some concern about the integrity of the currency, and so we hedge a little bit. But as a rule we don’t. And I think Rob’s analysis hits it on the head: you don’t really generate value by hedging. PRESENTER: Interesting. TODD MORRIS: Same answer. I mean we’re large cap investors. So the vast majority of our portfolio is invested in multinational companies that do business all over the world. Some of them hedge internally. They’re certainly generating revenue in having offsetting expenses in numerous currencies all over the world, so we do not view there being a value-add to having a hedging program on top of that. ROBERT BUSH: So, just to be clear, I would agree on the returns side, but I think the point I’m making is that on the risk side there’s often the opportunity to reduce the volatility of the portfolio. So I would certainly agree to the point on the return side, but the concern I would have is that if you’re leaving the currency in, and you do believe it’s zero return, oftentimes it is in fact making the risk of the portfolio higher. That’s the main strategic rationale, case that I lay out for hedging. So I would almost say certainly developed markets, if you are indifferent on the return front, at least take a look at the vol reduction potential by removing the currency risk. JAMES A DOYLE: But I do think you need to understand the economics, the underlying economics of the equity that you’re hedging. If you for instance were shareholders of Siemens, so Siemens is long dollar and short euro. If you were to take a look at your 2½% weight in Siemens and say this is 2½% euro exposure, what you’re actually doing is doubling down on your exposure. ROBERT BUSH: So we do hear that argument a lot, and we do disagree with it actually, because we argue that a Siemens stock, whether you hedge it or not, will always do what it’s going to do. But your exposure to it if you don’t hedge will remain long the currency. So we actually argue that the extent to which a company does or doesn’t hedge is already built into the stock price. And that may or may not reduce the volatility of the stock, or make it more attractive to shareholders. But it’s the future of the stock, whereas the currency effect is separate. JAMES A DOYLE: So you don’t think that if the euro is volatile that you see volatility in Siemens. ROBERT BUSH: You might well, but that volatility is going to be there regardless of whether or not you hedge. So we argue that it’s kind of built into the stock price already, and the hedging decision as a US investor we argue is quite separate. PRESENTER: I feel like you’re in the middle of that, do you have anything to add? BILL KENNEDY: Well, I ran a Japanese fund and I lived in Japan for a long time, many years ago, and the currency was a big driver of the underlying shares, the yen weak and the exporters did not do very well, they underperformed. And if the yen was, I’m sorry if the yen was strong the exporters underperformed. If the yen was weak they did very well, because they had big translation gains and then their earnings go up substantially when the yen is weak. And you’re more than compensated for that, because there’s operating leverage in the model, so that is the yen weakens by 1% a lot of auto manufacturers will see more than a 1%, like 2 or 3% improvement in their operating profits. And if you assume the multiples are the same, you can actually make money by owning a currency that’s weak but owning the exporters. PRESENTER: OK. Interesting, anybody else want to touch on that? ROBERT BUSH: Only that I’m not disputing that at all, totally agree with that. I think that the individual stock will have that impact. It’s well known particularly in the case of Japan. But again just making the case that the currency that you have separate from that decision is also something you need to consider. So I’m divorcing these two things I guess where my coanalysts are putting them more together. BILL KENNEDY: I think his point was it sometimes can be part of a thesis. If the currency does depreciate, there can be a benefit to the company in the earnings line. ROBERT BUSH: Right, but I think you’ll have that benefit regardless of whether or not you hedge. PRESENTER: Interesting. Todd, I’m going to bring you into this conversation. What is the philosophy, how does your philosophy apply to international markets? TODD MORRIS: Sure. So we’re applying the exact same philosophy that’s brought the US strategy success over 30 years in the international strategy that I run. So it centers on high quality growth investing. We’re looking for compounding businesses, and we’re investing for a five-to-ten-year horizon. So think of this as a low turnover tax efficient strategy, but it’s really driven by that competitive advantage I talked about earlier. Now, we happen to think that our time horizon is a source of our own competitive advantage, because it allows us to look through noise or volatility that can visit markets on a shorter run basis. But another aspect of our approach is that we view concentration as a risk mitigant. So that’s not necessarily a common view on Wall Street, but we feel that our portfolios, our US portfolio has 20 holdings, the international portfolio has 25, and could have as many as 35 at any point in time, but we feel like those are a unique source of risk management, because of our bias towards quality. So, by having a bias towards quality companies in a concentrated manner, the question we like to ask is what is the marginal benefit by adding by your next best idea? Because it’s by definition lower quality and could be dilutive to the quality and the earnings potential of the portfolio. PRESENTER: Interesting. Jamie, what are some of the challenges for value investors in this market? JAMES A DOYLE: Well certainly the last couple of years have been tough for value investors. That’s certainly been the case in the US. I think it’s been more powerful in the US, but it’s true for us in the international markets as well. If you take a look at the long-term performance of international markets, value is a very powerful driver, and dividend is part of that. Also part of it is buying cheap and selling at normalized valuations. And that combination does generate long-term performance. However, there are periods where it does underperform and it can be very frustrating. It’s frustrating for us as managers. It can be frustrating for us as clients. It can be questions as simple as why don’t you own Alphabet, why don’t you own Tencent? These are businesses that are going to take over the world. And my answer is we’d love to. We just have to wait for a price that’s compatible with our approach to the long-term value of the equity. So, it’s a core part of how we invest at Causeway, over the long term it has certainly worked, but it brings with it a degree of uncomfort sometimes with our clients and with ourselves as well. I would point out that we are in a period where relative valuation of value as a factor versus growth as a factor, no, that’s a little confusing a concept. But you can take a look at the expensiveness of factors. You can look at it on a P/E basis; you can look at it on a price to book basis. And just as Bill was saying that the relative value of international versus US is close to an all-time high, I don’t know if that’s what you were. BILL KENNEDY: The gap is alike yes. JAMES A DOYLE: The same is true of value versus growth. So the discount that you get by being a value investor right now is close to what it was going back to the TMT bubble, so international value really seems coiled for a lot of outperformance. You have normalisation of value for the international markets, and you have normalisation of the value for value as an investment approach. PRESENTER: So I’m going to bring that same question to you: challenges for value investors in this market. BILL KENNEDY: Yes I agree. I’m a growth investor, but I find growth expensive. And I’ve cut way back on my tech weightings. I used to be way overweight tech. I’m pretty close in a lot of areas of the market to the index right now, which is uncharacteristic for me. And the reason being is that I’m not finding a lot of valuation anomalies. And I like growth, and I want to buy growth that’s durable. You’re finding with the exception of some places in emerging markets where cost to capital’s very high, you’re finding growth is expensive, and the fund is much more defensively position, because I can’t find the growth that is cheap or undiscovered relative to some of the opportunities in value land. JAMES A DOYLE: I’ve got some stocks you can buy! PRESENTER: Did you want to add something, yes? TODD MORRIS: Sure, if I could add to that. So as a firm at Polen we’ve always looked for growth and compounding investments. And as a result of our desire to find competitively advantaged growth businesses we’ve paid a premium since 1989. We’ve always paid a premium, and yet despite paying a premium, because of our view towards long-term compounding, we find that when you do pay a premium for a truly great business, it often exceeds Wall Street’s expectations, and can deliver great returns to investors, which is why our US strategy has had so much success paying a consistent premium. It’s almost like to reframe the Ben Graham quote about a 50 cent dollar, which is value investing, and we’re looking for a dollar’s worth of earnings for about a dollar today, with a belief that there’s a good business behind it, and it’s going to compound and double to $2. And if we can see the business has a good runway ahead of it maybe it’ll go to $4 beyond that. So that’s sort of our way of thinking about valuation to day. PRESENTER: Interesting. Rob, I’m going to have you bring us into your portfolio construction. Smart beta approaches, do they work abroad as well as they do in the US? ROBERT BUSH: Well we think they do. If you think about what’s at the heart of most smart beta, I’d tend to agree with the camp that believes it’s based in behavioral economics and fallacies that we all make as investors. And I’ve got no reason to believe that we’re any more susceptible to those in the US than we are, than anyone else would be anywhere else. So that’s the first point. I think your intuition would tell you it ought to work internationally. And I think the data backs up that it does. We run a number of funds that take factor tilts in the US and internationally, and the empirical evidence is that they do tend to work internationally. And the nice I think feature of it is that not only have you tended to see uncorrelated factor returns in the US, so it’s broadly true I think that the excess return to value for example or size or momentum are relatively uncorrelated in the US, I think they’re also relatively correlated internationally. And a good example of this is last year, if you look at what happened with the, if you’re an investor that has a size bias, so tending to prefer smaller companies because over the long run they’ve tend to outperform, that was a tough year last year in the US, where you had a large cap rally effectively. So that hurt in the US, and it hurt in emerging markets. You had a large cap rally there as well. But it helped you in developed international. So you’ve got a factor there right off the bat that you believe helps over the long run in all markets. But in fact if you were diversified in that factor across markets, holding it in international developed would have helped you in a year when it hurt you in the US and emerging markets. So there’s not only this idea that they work in the long run, but there’s this idea that they’re relatively uncorrelated intramarket and intermarket, which is quite nice. PRESENTER: Interesting. Todd, what’s your theory behind international diversification? TODD MORRIS: Sure, so to talk about diversification I would head back to the track record of, or the philosophy we’ve used for 30 years at Polen Capital, and the view that concentration limits risk if you’re investing in high quality companies. Now, to flesh that out further, we are a concentrated growth manager. So most outside observers would tell you well that must be a volatile strategy. And our experience over 30 years has been quite the opposite. So our growth strategy has roughly kept up in rising markets, and then significantly outperformed in down markets. So the risk statistics and the volatility measures show that quality investing in growth companies can work very well across market cycles. Another point on that I’d make is there’s a study that we love as a firm called the Evans and Archer study from the late 1950s. And it basically makes the point that once you get beyond 15 equities in a portfolio, the marginal benefit from each incremental company added to the portfolio in terms of risk mitigation is basically de minimis. So we feel like we’re adequately diversified at 25 holdings in the international strategy. PRESENTER: Bill, same question to you, what’s the theory behind international diversification? BILL KENNEDY: I think, if you look at just from an earnings perspective, there’s different earnings drivers outside the United States than there are in the United States. And a lot of countries outside of the United States are on different interest rate cycles. They’re on different points in their demographic development. Japan’s aging, but Indonesia is really young. India’s really young. United States is kind of in the middle. So as investors we like to just have some diversification in terms of earnings streams, in terms of economic cycles, and what have you. And then the other thing for international investing the diversification benefits you get, there’s tons of brand names that we go into the store every single day and we buy that are not US brand names. And we’re going in our own personal capacity. We’re buying Japanese cars; we’re buying German cars; we’re buying phones that are made in China; we’re buying Korean TVs; we’re buying Korean phones. And these are brands that are recognized all over the world that we are consuming because they’re best in class. A lot of these equities can be considered best in class as well, and we should follow, with our investment portfolios follow how we’re consuming things day to day. PRESENTER: And staying with you, Bill, active versus passive in global markets. BILL KENNEDY: I find there’s a debate going on, particularly in developed markets, active versus passive, but I travel a lot. And I find really interesting companies in India, and I can buy a lot of them and make it a big weight in my portfolio. I would not be able to do that with a passive strategy. Stock picking in international equities, international equities are less efficient, particularly in emerging markets. I go to companies in India; they don’t have investor relations departments. They kind of talk to you and they say well listen why are you here? You want to lend us money or you want to buy our stock? Oh yes, we do have shares that are traded. But you tend to find that these are undiscovered companies that are underresearched. PRESENTER: Rob, same question you: passive, active, global markets. ROBERT BUSH: I think there’s a place for both. I would agree with Bill that I think you can identify asset classes or areas where you might think that good active management has an edge. But don’t lose sight of the fact that for every active manager there has to be a bad one, so always ask yourself who the mug is, who’s the loser round the table. And I don’t think that, I often hear the comment that markets are easy to beat, which I dislike very much because I don’t think that’s true. I think that even a market where you may think you have a higher chance as an active manager, it’s still a tough proposition. You know, it’s still you’re going to find, if you do identify that active manager, they’re going to be smart, well educated, hardworking, well paid. So that doesn’t sound like easy to me, that sounds like quite hard. And I do think that we shouldn’t lose sight of the fact that market cap approaches, I like to compare them to the New England Patriots, they’re a very good start, they’re not unbeatable, but they’re a very good starting point. And I think you should approach them the way you’d approach playing the Patriots, which is that we can beat them, but we have to be on our best game. PRESENTER: I like that. That’s a good analogy. Jamie, what’s your theory behind international diversification? JAMES A DOYLE: I think the panel has said it pretty well. I would agree that the international markets are more inefficient. That’s greater opportunity for active managers, not only in industry allocations but stock weights as well, but in particularly country weights. You can take a look at performance of countries like Japan over a very long term, and they’ve been very poor. Countries like Australia. Australia might be one. Certainly the last several decades Australia has been the best performing developed market. The US has been a very strong performer for a long time. So, as an active manager, you don’t have to have the benchmark weight in Japan. If you want to be underweight Japan because corporate governance is poor, capital discipline is bad, the valuations are expensive, the business models are bad, the demographics aren’t good, I can go and on. You don’t need to have that 22% weight that MSCI EFA says you need to have. And that’s an additional opportunity to add value. PRESENTER: Do you want to add anything? TODD MORRIS: Sure, this kind of pivots back to our way of thinking at Polen Capital. But, you know, the US index has over 1,800 companies in it, and an index in my opinion is a collection of businesses meaning it’s an average. So the vast majority of those companies are average companies. Some portion of those companies are below average companies, and a small portion are above average companies. So we like to think that our entire approach aims at finding the best companies we can invest in for the next five or ten years, just out of that portion of the universe. So we think active absolutely has a place in international markets. PRESENTER: Excellent. This has been a fascinating conversation to say the least. We’re coming to an end, I want to get your final remarks here, and I’m going to start you off with this question: why should investors be considering more international exposure? I’ll start with you Todd. TODD MORRIS: Sure. So up until the end of 2016 it was a lagging part of the world to be invested in, and its time is coming I believe. So for some of the reasons we’ve talked about today with urban density and rising middle classes outside of the United States, I think there’s a great reason to have some allocation to international markets. ROBERT BUSH: As we discussed, there’s a huge opportunity set out there. It’s underutilized and I think maybe the most compelling point for me is that it’s going to have a different correlation to the US. It’s going to be below one. That means it’s going to add value to your portfolio, potentially reduce risk. PRESENTER: Excellent. Bill? BILL KENNEDY: You get all those benefits, and you get them at a cheap price relative to the S&P 500. PRESENTER: Excellent, short and sweet. JAMES A DOYLE: International is cheap, value is cheap. PRESENTER: The takeaway from this is really turn it into an opportunity, don’t look at it as a scary headline, but look for the opportunities. That’s really what I took away from this. Outlook, what is the outlook, just as a final point to everybody, anybody want to add what is the outlook for international? ROBERT BUSH: Well, strategically, it’s always positive. I think you always want to have that international portion, and to the point I made at the top of the conversation tactically maneuver that for sure, but I mean for me strategically it’s always a positive outlook. PRESENTER: Absolutely, all right, excellent. Well guys thank you so much for being here today. This was fantastic. ALL: Thank you. PRESENTER: Yes, absolutely, and thank you for tuning in. I’m Sarah McCooder, this is, and this was the International Masterclass.