MASTERCLASS: Inflation - May 2021
April 20, 2021
Jenna Dagenhart: Welcome to Asset TV's International Equities Master Class. Joining us to discuss where they're finding opportunities, the impact of higher interest rates and different themes and regions to watch, we have Arjun Jayaraman, head of quantitative research and quantitative portfolio manager at Causeway Capital Management, David Souccar, portfolio manager, international equity quality growth strategy at Vontobel Asset Management, and Danton Goei, a portfolio manager at Davis Advisors.
Everyone, thank you for joining us. And Danton, let's start with a question advisors often hear from clients. Why invest overseas when having a home country bias has worked out pretty well over the past few years?
Danton Goei: Great question and certainly these days might be a difficult conversation to have with clients that look back and say, "It's been a decade of out performance of US stocks. Why should I change?" But we know that historically there have been long periods when international stocks have out performed the US stocks. For example, the decade leading up to 2007, international stocks out performed US stocks by over 300 basis points a year for a decade. Then the decade leading up to 1987, that decade, international stocks out performed US ones by over 600 basis points a year for a whole decade. So there have been long periods.
Then today, because of what we're talking about, the out performance over the last decade of US stocks, the valuation differential is quite stark. In fact, if you look at the MSCI ACWI ex US index, the PE multiple differential is over 30% relative to the S&P 500. That is a huge starting point difference. And starting point, of course, matters, valuation matters. Today, in terms of valuation, it is a good time to have that conversation. Then we are finding more and more great companies, great management teams trading at attractive valuations. So we believe it is a great time now, maybe just because of the last decade of US out performance, to look at international ones.
Jenna Dagenhart: David, what advantages does investing overseas offer US investors?
David Souccar: Yeah, I agree with Danton's points. US has been out performing international, but there were clear times international performance have to pick up the right entry point. But if you are an investor who are looking to diversify risks, international is a good option. Particularly now that there is a lot of risk about inflation in the US, and you are running the [inaudible 00:02:47] of risk.
In addition to that, I will also say that there are opportunities in international markets that you do not find equal opportunities in the US market. For example, in the luxury risk space, the Europeans dominate that area. So, if you want to get [inaudible 00:03:03] the best names there, you should invest in Europe. If you want to invest in staples, the best multinationals are in Europe, companies like Nestlé, Unilever.
Now, in Japan, you find some very exciting companies in [inaudible 00:03:18] knowledge. You don't have the cable in the US. So, diversification of risk, exposure to different opportunities are two good reasons why investors should be thinking about international.
Jenna Dagenhart: Arjun, what opportunities do you see in emerging markets? And on the other side of that, what are some of the risks?
Arjun Jayaraman: Yeah, I would completely agree with David and Danton, in the sense that the US has really outperformed over the past decade compared to international markets, and EM certainly fits that bill, in terms of underperforming over the last decade. But what's very interesting about emerging markets, as opposed to developed ex US, is that EM's profile, in terms of exposure to tech and new economy, is similar to that of the US. So, if you are an investor that's looking for growth over the next decade or further, you can look to EM as a real significant source or growth, not just from a new economy perspective, but also from the perspective of higher GDP growth rates.
Developed markets, especially the US, we're talking about very low single digit growth rates versus EM, you have countries like India, Indonesia, even China, mid to high single digit growth rates. So, that's a very powerful growth narrative, coupled with cheap valuations. And when we think about other aspects of EM, you think about monetary and fiscal policy. The developed markets, especially the US, have engaged in a lot of stimulus, monetary, fiscal stimulus, to try to prop up economies and markets. In EM, we don't have that dynamic.
So, if you believe in the phrase that you have to pay the piper at some point, that reversion aspect is not as prevalent in emerging markets compared to the US, that is. So, EM is very compelling in that respect.
Now, certainly we want to look at the risks of EM, as well as the opportunities, and there are certainly risks in EM. I would say the number one risk is currency risk. That being said, today's EM is not the EM of 25 years ago, where you had seen significant currency devaluations. Today's EM, for the most part, the risk from currency is not ginormous, except for a couple of countries I would highlight, countries like Turkey or Brazil. But that still is a risk, currency risk.
Geopolitical risk is there. You think about some of the relations between the West and China, Russia for instance. So, that's certainly a risk. And then one thing to be aware of when you invest in emerging markets, especially a country like China, we in the West think about democratic governments, democratic institutions. China, admittedly, is a communist country.
Now, they've been making a lot of overtures to make their markets friendly to foreign investors, but nevertheless, it is still a communist country, and due process and things like that are not really prevalent there. So, that's just some of the risks that we see in emerging, but certainly, the opportunities are very significant.
Jenna Dagenhart: Thanks for sharing some of those risks. And we'll talk more about geopolitics later in the program. Now that we've addressed some of the benefits of investing internationally, let's talk about the method for doing that. Danton, what's the best way to invest overseas? What's your investment process?
Danton Goei: We would say that, absolutely critical, is selectivity and experience. So, selectivity by country, as we've been talking about. Selectivity by sector. And then, of course, by actual company that you invest. So, in terms of the countries, you want to be very selective in terms of countries that have a stable government, that are supportive of corporations and are focused on economic growth. And in terms of sectors, you want to be focused on the most attractive sectors. Not all sectors, historically, have been, actually, sort of money making areas and above average returns.
So, for example, we are invested in China, and in that country, we're focused specifically on the consumer sector. It's the most attractive part of the economy. So, rather than invest in an entire economy or market across the board, try to choose the right sectors to invest in. And then, finally, the actual companies, in terms of competitive advantages, in terms of the quality of the business model, certainly management teams matter hugely, especially if you're a long term investor, as we are.
And then, finally, valuation. Valuation is absolutely key, especially in this market, when valuations have risen. So, certainly selectivity on those metrics, and then finally experience. If you have a proven model, a proven business approach, we are long term fundamental investors. But if you have a proven business model that, over long periods of time, through different cycles, our firm has been around for over 50 years and it's a proven approach, if you can find and manage it with a proven approach and experience that can provide it on a selective basis, I think that is a winning, long term strategy.
Jenna Dagenhart: David, how do you incorporate EM in a foreign strategy?
David Souccar: Oh, that's a good question. So, at the end of the day, we are bottom up investors. So, what matters for us is what companies are we going to invest, not so much where those companies are located. Macro is impartial to [inaudible 00:09:11] and emerging markets, to a certain extent. So, there's certain countries that we avoid, like Turkey, South Africa. But outside that, we are open to all the countries, in terms of where we need to find great investment opportunities.
I think one of the advantage of emerging markets is that you find business models that, we're quite used to it, but they are not as mature as we find in emerging marketing. For example, staples, or a company that I like a lot, Asian Paints in India. Those are the business models that are simple, we understand. They are successful in developed markets, and you can invest in those names like if you were investing in the United States in the 1950s. Those are companies that have [inaudible 00:10:03] They have a long [inaudible 00:10:04] of growth, and they are simple to understand.
In addition to that, in emerging markets, because of technology, sometimes they leapfrog phases of development in the United States. For instance, the payment space in China and India, and you can benefit from that in terms of companies that have a superior business model and higher growth approaching. So, in a sense, it's about finding business by business, and avoiding countries that we do not feel comfort.
Jenna Dagenhart: Arjun, I know you have a bit of a quant process. Why is EM well suited for a quant process?
Arjun Jayaraman: Well, we think EM is very well suited for a quant process because there are so many drivers of alpha in EM. So, today, a lot of investors in EM are growth investors, and that's a very legitimate way of investing in EM. But historically, at least in the 2000s, value investing was more efficacious in EM, and we're actually seeing value coming back this year. And then we've had references to bottom up versus top down. So, the idea here is there's many diverse drivers of alpha in EM, and the nice thing about a quantitative process is that we can combine those all into one seamless process, and we can be more agnostic.
So, we are more value oriented investors, but we do realize a significant cohort of EM is driven more by growth. So, we want to have exposure to the value side of EM, countries like maybe a Russia or even a Brazil, but we also want to have some of the growth drivers in EM, because if you invest in EM and you do not invest in new economy stocks or tech stocks, you're missing out on a very significant opportunity set.
And then, also, we think about bottom up versus top down, a lot of investors like to call themselves bottom up investors, but if you ignore the top down in emerging markets, you could take on a lot of risk. We've seen some of the risks from currency, for instance, this year, with a rising US dollar. We've seen some currencies like the Turkish lira, the Brazilian real really get hit because these economies are more challenged in terms of fiscal and current account issues. So, we want to combine all these sorts of information into one seamless process.
Lastly, we have a layer of risk management, quantitative risk management on top of the process. You know, EM is a high alpha asset class, but it also is a higher risk asset class, so you want to have a risk process that can extract that alpha without taking on undo amount of risk, and so quant really is a good way to combine all these different sources of alpha and risk.
Jenna Dagenhart: Could you talk to us a little bit more about fundamental in science and alternative data? How do you incorporate them into your process?
Arjun Jayaraman: Sure. Good question. I mean, we are not what I would refer to as black box quants. We don't just build a model, hit go, send to trading. That's not our process at all. Our process is have a quantitative infrastructure, but then rely on our fundamental analysts, and we have a global sector team here at Causeway, who covers companies globally, by sector. Get a sense from them as to what are the shortcomings or blind spots from our quant model.
And you think about some of the issues like regulatory risks in the case of utilities or telecoms. You think of something like non-performing loan issues in the case of banks, especially Chinese banks. So, some of the blind spots for our quant model, we rely on our fundamentalist sector specialist to help us with those blind spots, and that helps complement the quantitative process.
Similarly, on the alternative data front, we realized that there's a lot of new data sources coming out to sort of complement the traditional quantitative factors. One example of this is we recently added smart phone app usage data into our model, just to get a sense of, and it's a big source of data in China, get a sense of which are the apps that are most popular in China, and which are the companies, obviously, that own those apps.
We're also looking at alternative data for elections. What we've seen the last few years, and this is not just a EM phenomena, it's also a developed markets phenomena, that elections have undo influence on markets. We've also seen some of the experts in forecasting elections have not done that well. So, what we've done here at Causeway is we look at social media, specifically Twitter, in countries around the world, to help us try to forecast elections, to help us, both from a risk and alpha perspective, try to navigate some of these elections.
And upcoming now, we have the Mexican legislative elections in June of this year, and so that's an important election because it will either be a confirmation of the current president, AMLO, who's more left leaning, or more market friendly, it won't support his party, it'll support the opposition party, in which case it won't be so left-leaning in terms of the policies in Mexico. So, in other words, elections are very important and we're trying to look at some alternative data sources, like Twitter, to help us forecast those in our process.
Jenna Dagenhart: David, what sort of secular trends are you excited about?
David Souccar: I'm excited about many, many trends. If you open the newspaper, there are a lot of places to get negative. There is the issue with the US-China trade war, there was the pandemic. But I see more opportunities than problems. What happened with how the world came along in solving the pandemic, it's just amazing how they developed the vaccine in such a short period of time, and the cooperation that happened across the countries.
So, you can see the cup half empty, half full. I see good opportunities in the payment system, in biotechnology. Even in mundane industries, like the railroads. There's very interesting technology to allow railroads reduce the maintenance time, to have trains that are not operated by people, drivers, electric trains. So, the obvious things that people talk about, batteries, electric cars, but there's a whole gambit of applications that's happening across all the industries. Companies that sell data services, now they can collect the data and analyze the data in much more detail, and tailor the information specific to each customer, which those customers rely on those data to make decisions, so they're very sticky businesses. There are many things that make me excited about the future. I can't remember a period of time where so many new technologies and ideas came along.
Jenna Dagenhart: Certainly. Danton, what things are you focused on in your global and international portfolios?
Danton Goei: Yes, we do have a number of long term themes, often decade long or even multi-decade long themes that we do look at. We want to fish in areas that are faster growing, that have a big opportunity going forward. As you know, though, at the end of the day, we are fundamental, bottom up investors. We think that, if you look at us relative to the index, for example, we look totally different than the index, and that's on purpose. When you look at the index, if you have 3000 companies, almost, in there. We know that they're not 3000 great or even 3000 good companies in there. So, choosing 30, 40 best of breed compounding machine type of companies and letting them grow over time is really the approach that we take.
And then we want to marry that with some long term themes that we have. So, some of those themes are, both on the consumer side in terms of our consumer habits changing, certainly e-commerce, for example, or entertainment, online video, or video games. Those are big areas where our habits, all of us, with the number of boxes stacking up on our doorstep. Our habits have been changing, and so we have a number of companies in the portfolio that have been huge beneficiaries. We obviously saw that during COVID in 2020, that those businesses were already going fast, but now, even accelerated in 2020. We expect that acceleration and that growth sort of continue going forward.
So, that is certainly a big theme in terms of these changing consumer habits, and certainly the move to online. But married to that are also companies that you probably put more in the value bucket, and we think of them as resilient value or durable value. Where they have proven business models, they've been through lots of cycles. Some of these companies have been around for decades, or even a few of them for over a century.
And so, they're proven business models, yet their valuations, their multiples, are very low. And so, as value investors, that is very attractive to us. Proving attractive, profitable business, trading on low valuations, and specifically, I'm thinking of the financials. That is in an area that the valuations are very low, echoes of the financial crisis that we had a dozen years ago. They're still very low, yet they're safer than ever.
For a lot of these companies, their capital ratios for the banks are double what they went into the financial crisis, originally. And yet their valuations are very low on depressed earnings. The low interest rate we're in now is actually hurting their earnings, and the worries about the recession that we went through is also hurting their earnings.
And so, the multiple is low, but we think that, going forward, should rates rise or, as we expect, the loss is not to be as bad because of all the government support that's been happening in 2020 and 2021, that people will kind of relook at the financials in a different light, in a opening economy, in a growing economy, with lower than expected losses. And then, with the upside of long term potential rates rising, with the low multiples that you're paying on the banks today, they look really, really attractive.
So, I think both these growth stalwarts, we call them, that are taking advantage of changes in our consumer behavior, married with these resilient value companies that are cheap, yet also proven business models, we're finding quite a few really attractive companies out there.
Jenna Dagenhart: Following up on your point about e-commerce and that market penetration, as much as it seems like e-commerce is dominating, and I mean, it is, to a large degree, a lot of the world still doesn't have a smartphone, which I'm sure you're seeing as well, Arjun, and a lot of the world still doesn't shop online.
Danton Goei: Yeah, absolutely. It's true. There's still a lot of growth ahead of us. Worldwide, the penetration of e-commerce as a percentage of retail is around 10-12%. So, that still means that over 80% of retail is not online. And in some countries, we know, for example, China, they're already at 25%. Korea, they're already at 33%. So, some countries are ahead of the curve.
But if you think about the globe overall, that 10-12 is certainly moving up. When we're talking together in five years from now, that number will be much, much higher. So, that is a great tailwind to have for your companies.
Jenna Dagenhart: Arjun, anything you would add , given your research?
Arjun Jayaraman: Yeah, no, I would completely agree with that. China has higher penetration, but if you look at India or parts of [inaudible 00:23:12] Brazil, for instance, penetration is lower there. So, this e-commerce, neo-economy theme, fintech as well, has a lot longer to go. So, as people get smart phones in their hands, on the supply side, as companies evolve their supply chains, especially in India, where the retail market is very segmented, if you look at the Chinese model, there's a lot of room to grow in India, in terms of e-commerce penetration.
Jenna Dagenhart: Turning now to interest rates, Arjun, what are the implications for the EM equity asset class, from the sharp rise in yields we've seen globally, especially here in the US?
Arjun Jayaraman: Yeah, that's a very interesting question because EM has evolved in a pretty significant way over the last 25 years. Historically, EM has benefited from higher rates and steepening yield curves, mainly because those were indicators of improving global growth. But that was kind of the old model, in the sense that, that was a relationship that was borne out in a period of good, secular growth in the global economy.
Unfortunately, today, we are in more of a liquidity driven world, where economies and markets are more dependent on global liquidity from central banks. Unfortunately, in today's world, as rates rise here in the US, especially, and we've seen the very stunning rise, at least in a percentage terms, of the ten year from whatever, 60 basis points at the beginning of the year, now to 170 in a very short period of time, that's going to lead to a reduction in global liquidity.
And so, EM is dependent on that global liquidity, so a net net, it's not as clear as it was historically. There is certainly the positive global growth aspect, which EM should benefit from, but the reduced liquidity globally, and we also see that in the rise in the dollar, will be negative for EM. So, not as clear cut as historically.
Jenna Dagenhart: David, I want to get why our take. Are you concerned about the impact of rates on the market?
David Souccar: Yeah, it depends on why rates increase. We need to separate here. If rates increase because the economy after COVID is recovering, and we're seeing robust recovery, that's a positive. I think that's normal. There's more demand for capital, interest rates will increase, but [inaudible 00:26:10] earnings growth will also accelerate. Maybe it goes a little bit of multiple contraction, but overall, I think that's a constructive scenario.
The scenario that I'm concerned about is the interest rates increase because inflation get out of control. And that's a plausible scenario because, if you see the large increase in the [inaudible 00:26:34] in the United States, and if that's the case, then interest rates will win back companies that are not well protected against inflation. And here, stock can become very important, separating those companies that have a mold, they have pricing power, and they can protect against inflation, even benefit from inflation, versus those companies that have more commoditized products and services. They're going to have their margins squeezed.
Jenna Dagenhart: Arjun, what are the implications of rising yields for value versus growth, an old economy versus new economy?
Arjun Jayaraman: Yeah, so that's, along with rising rates, the value growth differential has certainly been one of the big stories in equity markets this year. So, as a value investor, it's not been easy the last few years, especially the last two years, so 2019 and 2020 were very strong growth years. And 2020 is not surprising with the lockdown, with all the effects of the pandemic, in terms of global slowdown. People gravitated towards new economy growth stocks, online, e-commerce, fintech, all the stuff that was able to continue its business operations through shutdowns really benefited.
But now, we have the flip side. We have the vaccines coming out. We have economies opening. We have tremendous stimulus, both fiscal and monetary, globally, and so we're seeing these value stocks really outperform, thus far, this year. And it's not just a case that growth, with rising rates and growth are long duration assets, and therefore, from a discounting perspective, they're not as attractive. But it's more a bullish case on value.
The old economy, financials, certainly, as yield curves steepened, they will benefit banks, especially, but also, in terms of material stocks and industrial stocks, as economies open and as infrastructure spending happens, those kind of stocks will benefit. So, it's a dramatic shift this year, in the value growth spectrum, and we think that could have more legs in the remaining part of this year.
Jenna Dagenhart: Yeah, Arjun, and we just saw President Biden rolling out a $2 trillion infrastructure plan.
Arjun Jayaraman: Right. These numbers are huge, and they seem to be going up every day.
Jenna Dagenhart: They certainly do, and David, how are you positioning your strategy for the risk of higher rates?
David Souccar: Sure. Two different ways. One is our natural way of investing. We're focusing on quality companies, companies that have pricing power and they should be able to protect against, in some case even benefit from, increasing inflation. The second way is to balance the portfolio between companies that we consider more defensive versus companies that are more growth in nature, so we have a large exposure to companies like staples, that if we've got a situation of inflation and recession, those companies should protect well on the down side.
Jenna Dagenhart: Now, taking a closer look at different regions, Danton, you've been overweight China, which has helped you out perform. Are you still bullish there, despite some of the antitrust concerns and other headlines we're seeing coming out of the region?
Danton Goei: Yes. So, China has been a big focus. And when we think about any country that we want to enter, we think just about, similar to a company that we want to invest in, what's their track record. And certainly, in the case of China, the track record of growth has been extremely strong. In fact, 2020 was the 16th year in a row that China has been the biggest single contributor to global GDP growth. So, an amazing, long term record of growth there.
But certainly, things also to worry about, that you need to focus on, and you mentioned the antitrust concerns there. And we're seeing things that are actually quite reminiscent of what we're seeing in Europe the last five or six years, and certainly the last one or two in the United States as well, is this focus on big tech over there, where technology companies have become such big parts of the economy, big parts of all of our lives, that regulation is just catching up there.
And so, that's what we're seeing, we believe, in China right now, with the focus there. And we've seen the government look at regulation in different sectors, historically, at different times. So, in 2016, it was education and video game companies, and at other times it was online video. So, recently, it's just been big tech overall, and antitrust concerns that have been the focus.
We think that the government and everything they've done so far has been in line with the idea that they want a healthy, growing sector, and so they want to eliminate any bad practices that might have grown up over time. And there have been some bad practices that needed to be cleaned up. Historically, China's been more lax or laissez faire on antitrust than other countries, certainly versus the EU and even versus the US, so there are things that they want to improve on and clean up there.
But everything that we've seen leads us to believe that they still believe that the companies in this space, these big tech leaders that we all know are big parts of the Chinese economic landscape, will continue to be the ones that are going to lead the economy going forward. If China wants to become technologically independent or more independent in the future, it's going to be thanks to companies like an Ali Baba, or a Tencent, that are leaders in innovation and technology.
But we still think that these companies are attractive places, and because of the antitrust concerns, the valuation right now, looks especially compelling, even though we've seen that antitrust, whether it's in Europe or the United States, it's not really impacted the long term earnings power of these type of companies. And certainly, in China, we think the similar thing will happen, where the space will be better regulated, but the companies will still be allowed to sort of grow and innovate over time.
Jenna Dagenhart: To elaborate on that, Danton, can you give us an example of a company that represents the opportunity you see in China?
Danton Goei: Yeah, absolutely. One really interesting, maybe not a household name over there, but is a really sort of leader in their space, in a space that is a growing focus for the government and the economy, is New Oriental Education, the leader in for profit education in China. It's the best known brand in China, started in 1993 by their founder, and still running the company, Michael Yu. So, we like the focus on education. We think that, because China's moving up the value chain, education has become that much more important in China. They can no longer rely on maybe the low cost labor leader anymore, and they have to focus more on the innovation. So, of course, education becomes more important.
And New Oriental's biggest business is the after school tutoring business, where they have over 1500 learning centers across the country, and it's really driven by the fact that, for example, here in the United States, the top 50 universities have a entrance bar of 28%, so 28% of applicants get in, which is a very high bar. But in China, the top 39 universities, the acceptance rate is 2%, one in 50. So, kind of faced with those daunting odds, parents send their children to after school tutoring, preparing for the gaokao, which is the college entrance exam, at an early age.
And actually, today, with about 40% of children attending, that's about half the percentage that you see in South Korea and Japan, with similar education systems. So, the market, overall, is growing very rapidly, and New Oriental, as a leader, is also taking a share. So, today, they only have about three or four percent of the market, even though they have over 2 million students at any given time in their classrooms. They only have three or four percent market.
So, that four percent is going to grow over time, in a growing market. And the other thing that's really interesting is that, because they're growing so fast, their margins are depressed because, of course, when you open a new school, occupancy rate can be relatively low. So, they're growing that very rapidly. We think margins, today, at about 13%, are on their way to 20% over time, which would be like a 50% increase in margins.
So, when you have a company that's growing revenues in the 20-30% range, with operating margins growing 50% over time, that is a really, really attractive business. And then, on top of that, they have really strong competitive advantages, that makes you think that they're going to keep on taking share, they're able to pay the teachers 20% more than on average, they're spending over $100 million a year on online education.
One last fact I'll just give you on this is that, during COVID, during the pandemic, when all the schools were shut, including the after school tutoring schools, you would think that would be disastrous for a company like New Oriental. But in fact, over a two week period, they were able to transfer 100% of their 2 million+ students to online. And so, if you look at their financial statements, you can hardly tell that there was a pandemic at all. So, they were able to adapt really well and put their competitive advantage to work.
And so, today, they're taking share from the smaller players in the space. So, I think that's a really interesting, well run company that has a very bright long term future ahead of it.
Jenna Dagenhart: And David, what are your thoughts on Japan? I know you mentioned Japan earlier. What types of opportunities are you finding there?
David Souccar: Japan is an interesting market because it has over performed the global market for many, many years. The most [inaudible 00:37:07] are in Japan for good reasons. Corporate governance in Japan, on average, is not very strong. Managers are not worried too much about maximized margins, return and [inaudible 00:37:23] shareholders.
But things have changed in Japan, and I think this change has to do, one, which Danton just mentioned, China. There's pressure on Japan to improve productivity because they're lagging China. The second pressure they have is the demographics. As the population age, they need to become more efficient. They need to invest more in information technology, where Japan [inaudible 00:37:47] is lagging behind the developed world.
So, managers, on average, are becoming more focused on shareholders. It's a slow process. Nothing happens fast in Japan. But there are some interesting companies that are ahead of the curve. And that's an area that we've been getting more excited, and added to our portfolios. So, I'll give you an example. Hoya. It's a company that is a global leader in the technology for manufacturing semiconductors. They're basically is a monopoly in what they do. They are exposed to the expansion in UAV. They're also one of the leaders in substrates for high density disks, and they're also the market leader in optical lens in japan. If you pull out your [inaudible 00:38:48] generate lot of cash flow, and different than most companies in Japan, they actually return cash to shareholders.
Jenna Dagenhart: Now, turning to another region, Danton, what's your view of Europe? I like the example you gave in China. Could you also share an example of a European company that you own today?
Danton Goei: Yeah. So, Europe is a place that's sort of near and dear to my heart. I was born in Germany. I grew up in France, even though I might not look like either one of those. But there are some challenges in Europe, certainly. A lot of structural challenges there, which has led to sort of slower growth there. One good statistic, for example, in 1990, Europe was 32% of the global GDP. So, well ahead of the United States, which was at 24-25% at that time. And today, they're at 21%.
So, they've gone from 32 down to 21% of the global GDP mix, as other countries have risen over time. So, it is a slower growth area. You can find good companies there, and we focus more on the multinational companies there, where they can benefit from emerging market growth, from growth in the United States. Or also, we found some really attractive select financials in some of the stronger economies in Europe. Because, of course, in the 27 country EU, there are some that are better than others.
So, one good example there is DMB, the number one bank in Norway. So, Norway is a really interesting economy. It's sort of pretty decent growth there and also has a very, very strong safety net, in part, also, because there's over $200,000 in the Sovereign Wealth Fund for every man, woman and child in Norway. This is the oil and gas earnings that they've put aside and very smartly invested over time. So, it's become a very big fall back safety net should anything happen.
And during COVID, we also saw the government really step up in terms of unemployment support for the population, which is very important if you're the bank. So, DMB is the number one bank in Norway. It's three times as large as the number two player, which also, very interesting, it's very, very technologically advanced and forward. I mean, for example, they serve a country with 5.3 million population with only 50 branches. And a very small percentage, about 5% of transactions, actually happen with cash. So, it is a very technologically forward bank in a technologically forward economy.
It is also a very safe bank, with 18% tier one capital ratio. So, an extremely high capital ratio, and we feel very safe there. They've got a good return on equity, about 12%. And another interesting fact, in today's yield starved world, DMB gave a 5% dividend earlier this year. In October, we expect them to pay out a second 5% dividend, and then early next year, we expect them to pay another 5% dividend. So, you're going to be paid about 15% dividends in less than a year and a half time.
So, when you have that kind of earnings power and that kind of strong return of cash to shareholders, that can be a very attractive proposition. Today, the valuation is also very interesting. So, we think that select European financials in some of the stronger economies, Norway, Denmark, Switzerland, can be very attractive.
Jenna Dagenhart: So, as you've highlighted, there are a lot of different opportunities in different regions, but they all come with their own risks as well. Arjun, what are your concerns in EM from a geopolitical standpoint?
Arjun Jayaraman: Sure. Over the last few years, we've seen geopolitical issues become more impactful on EM. And I think there was a expectation that, when Biden would come in as President of the United States, that we might see a reset of some of that. We really haven't seen that. And so, the two big relationships I'm talking about are the West with China and the West with Russia. So, in the case of the West, with the US leading with China, it's pretty clear over the last few weeks that the US intends to keep up the pressure on China, in terms of some of the human rights issues, the Uyghurs, the Hong Kong issue, some of the threatening rhetoric against Taiwan.
It's pretty clear that the US is not going to relent on some of those issues. And they are impactful. I'm not just talking about not rolling back the tariffs that we put on China, but I'm talking more about supply chain issues, especially semi-conductors, which it's a lifeline for China for a lot of its development on new economy businesses. If companies are not allowed to freely sell semi-conductors, especially cutting edge semi-conductors, to China, that's going to be impactful. So, you need to be aware of the geopolitics.
And I think the good news for investors, in terms of geopolitics, I think there's going to be less uncertainty in the relationship, as opposed to what we saw the last few years, where policy by tweet seemed to be the norm, that's not going to be happening going forward. But it's not necessarily the trajectory is going to improve dramatically.
And then, if we think about the US-Russia relationship, we could also see similar issues impacting that relationship. Not as obviously impactful from a global perspective as the US-China relationship, but it is something for EM investors to keep in mind. We've had multiple sanctions levied since the Crimea annexation from a few years ago, against Russia, and each of those events has led to a selloff in the ruble and the Russian markets in general. And so, most recently, we've had some issues, Russian interference in the US election, the Solar Winds hack, some of the chemical weapons usage against opponents type issues come up. So, you could see some more sanctions risk against Russia.
But we are overweight Russia on our portfolio. We still think the valuation is very cheap in Russia and it's a cyclical market, and it should do well in the reopening narrative. But these are risks to keep in mind as you invest in EM.
Jenna Dagenhart: David, what are your thoughts on current market valuations, and what are some important risks that you think the market may be underestimating?
David Souccar: Yeah, in terms of valuation, if you look at the headline, the market will look overvalued with trading [inaudible 00:46:23] thirty times on a normal line's earnings. If you go one step further and you eliminate more of the speculative stocks, some of them aren't even generating any earnings.
I think there are plenty of opportunities. The valuations, I wouldn't call them cheap, but reasonable, especially when you consider we're in an environment of low rates, so we find plenty of opportunities, if you are willing to do the work and pick the right stock and avoid more of those bubbly companies.
One area that I think people are overly excited, and I think there is excessive valuation is the renewables space. Solar, wind, electric. Yes, they have a strong growth potential, but some of those industries, the return on capital is not high, so when you combine high growth with low return of capital, I think it's a dangerous combination.
In terms of areas I'm concerned, there's two areas of concern. I'm not seeing a lot of discussion in the media. One is what happens as China starts to export less to the world. It's just normal that Chinese consumers are going to consume more of their own work and export less. This has been a major tailwind for the development of factory in terms of margin expansion. I think that's going to change, and that is important [inaudible 00:48:02] inflation.
And the second is all the divestment and the cost in the effort to reduce the CO2 emissions. Either you invest or don't invest. There's going to be [inaudible 00:48:14] in terms of the costs to the economy. I think that those are two issues that are still going to come to the floor, that people are not thinking much about.
Jenna Dagenhart: Thankfully, we are seeing a pretty rapid rollout of vaccines, but we're not on the other side of the coronavirus pandemic yet, especially not on a global scale. Arjun, are there any concerns about the lingering effects of COVID-19 on emerging markets?
Arjun Jayaraman: Yeah, I think, in the US, we're seeing a pretty successful vaccine rollout, and so, it may be natural for US investors to think this is the case in other countries. It's much more difficult when infrastructures are not as strong as they are in the case of other countries, or in the case of, like, an India, for instance, where you've got to get needles in 1.4 billion arms. Some of these numbers are just huge in terms of the rollout, so that is a concern.
We are seeing some resurge in cases in some countries, Brazil and India, and so the vaccine rollout speed is important. And unlike the US, as well as other parts of the West, EM countries are not able to stimulate their economies the way the US can, whether it's Mexico hasn't really done anything. Brazil has done, but the real has certainly taken a hit.
And then, over in Asia, think about a country like India, it's been pretty tough as well. So, there are lingering effects, but the good news is, economies are not shutting down the way they were in 2020. So, at least the economic effects, currently, should be limited. And then there should be the global tailwind of global reopening. And so, with the exception of a couple of economies, I think EM, especially the major economies like China, Korea and Taiwan, will do fine through this.
Jenna Dagenhart: I'm glad you bring up currencies, though, which you mentioned is one of the top risks for EM earlier. How are they responding to the stronger dollar?
Arjun Jayaraman: Yeah, that's the risk, and currency is always one of the principle risks of investing in EM. The good news is the problem currencies have shrunk over time, in terms of their importance in EM. Today, the three big components of EM are China, Taiwan and Korea. The Chinese yuan is doing fine, as is the Taiwan dollar. Korea is getting hit a little bit, but the real problem currencies, like maybe the Turkish lira, the Brazilian real, these are currencies that are suffering, and these economies have had to raise rates.
In the last couple of months, we've seen Turkey, Brazil and Russia having to raise rates, in part to support their currencies, so they won't have import inflation. But of course, raising rates when growth is still slow is not helpful for growth. So, it's kind of a balancing act that they have to do. So, a rising dollar environment is always an environment for EM that exposes the weaker currencies. So, you have to be aware of that.
Jenna Dagenhart: Mm-hmm (affirmative). Danton, what should investors worry about? What keeps you up at night?
Danton Goei: Well, it's been much discussed, but it's worth sort of revisiting and talking about just the general risk of inflation. And certainly, there's been warning signs. It's something they've been worried for a few years now, of course, but it's sort of accelerated the last couple of years. For example, in the United States here, the M2 money supply in 2020 was up 26%, and this year, in 2021, it's expected to be up at least 12%. So, together, over a two year period, up 38%, close to 40% growth in the money supply, when, on average, the money supply has been growing about 5.5% a year, is a big, big, huge leap in increase. So, it's something to worry about.
Now, what do you do in the face of that risk? That's in the face of rising federal deficits, rising national debt levels. We still think that equities is the best place to invest. Companies can adapt to those circumstances, as opposed to, say, fixed income, where you have no ability to adapt. And then, you want to think about the type of companies you're investing in. Do they have pricing power?
So, that's kind of big focus. But maybe even some companies might benefit from inflation, such as the financials. So, really thinking about what class do you want to be in with the equities, as the class that you want to be in. And then, in terms of the companies, making sure that your companies have pricing power is key.
Jenna Dagenhart: Danton, following up on that, financials have already seen some nice gains the past three or four months. So, some investors might argue that some of these expectations about the future benefits have already been baked in devaluations. What are your thoughts? Do you think there's still more room to run there?
Danton Goei: Financials have had a good three or four months, but this is following about a decade of under performance. There is still a long ways to go here. The valuations still remain very low, and there's still a lot of reason to be optimistic about earnings. Of course, we were expecting a better 21 or a better 22 relative to last year. And also, longer term, as we were talking about before, they might benefit where a lot of companies might stumble with rising rates. So, the low valuations are still there. So, when we think there's still a long ways to go, this is still very early innings.
Jenna Dagenhart: David, I know you're more of a growth investor. Why do you have such a large underweight to energy commodities and financials?
David Souccar: Yeah, let me tell you the commodities first. Well, let me step back. For us to invest in a company, we need to believe that this company has a growth potential, but also they need to generate high returns of free cash flow. So, if we take the commodity business, the mining and the energy parts, we have to start in figuring out what is going to be the commodity price, which I think is very hard to do. So, if I can't figure out what's the transfer commodity price, I can't figure out [inaudible 00:55:19] their earnings grow. So, from a risk perspective, I find opportunity in other sectors more attractive. I don't have that level of risk.
On the financial side, I think they're investible, but in my view, they're more a trading opportunity. Sometimes the [inaudible 00:55:37] point's low and you can ride the multiple expansion. But as business, in terms of track records, especially in the developed market, financial haven't the most strength in it. Very high growth, high returns. And from time to time, you have some blow ups.
We just had recently the issues with [inaudible 00:55:59] And others you have pick your bank, your financials, correctly. But they all need to be over black box. And so, again, similarly from our quantitative perspective or from a risk perspective, you find better opportunity in other places.
Jenna Dagenhart: And more and more investors, globally, are turning to ESG to help mitigate risk, and also drive positive change. Arjun, how are you approaching ESG with your investments?
Arjun Jayaraman: Yeah, so in emerging markets, ESG is very important. And of the three, I would highlight the G with corporate governance being the most important. And EM has this Achilles heel, let's be honest about it, which is the SOEs, the state owned enterprises. So, when you're investing in a company where the government owns more than half of that company, you have to ask yourself the question, "Yeah, this company might be very cheap, but is the company working in minority shareholders' interests?
And so, when we look at SOWs, and in general, they're a very cheap part of the value spectrum. A lot of financials, energy, companies in that bucket. We are willing to invest in some of these companies, and what we specifically look for is high dividend yields. So, even as a company with questionable managing practices, a couple [inaudible 00:57:35], if it's paying a strong dividend yield and has a track record of having paid strong dividends, we are more willing to invest in that.
Because cash return to shareholders, to me, is the ultimate form of good corporate government. Whatever you might think they're doing behind the senses and whatever type of working in the national interests, in the case of a Chinese bank, and they were cash shareholders I believe that's a good sign that they're doing things that's positive for minority shareholders.
So, I'd highlight that. The corporate governance is very important to us. And the SOE aspect. And then, in terms of E, which is environment. I think, historically, EM is probably perceived to be an asset class, with these big, dirt energy companies. Highly reliant on fossil fuels.
But today's EM, I think, has a lot more exposure to things like NE-V, New Energy vehicles, solar companies. The companies Dave was talking about, solar and wind companies, in the case of China. And even materials companies. Some of these companies that mine copper or nickel or platinum palladium, these are all very important metals in the production of batteries and things like that. So, EM, and these are very important alpha drivers, so EM certainly has a lot of exposure to the Greener Industries.
And then, lastly, S. And I also thank Ian, has gotten to know on S, specifically through some of the labor practices that we've seen. And also, on this front, I think Ian has made a lot of strides forward. And I'll just give you one example. Think about the apple supply chain. Apple has these huge margins, in its smartphones, and then all the companies that produced the components and mainly in Taiwan, have these tiny little margins. And so you get this notion that they're using very cheap labor because the margins are so compressed.
But one thing we know is that there's been a lot of pressure on companies like Apple to make sure that the labor practices, across their whole supply chain, do not border on things like human slavery and do not engage in labor practices. So, EM has been benefiting from that trend as well. So, ESG is very important. ESG is here to stay. It's a long term trend, and we see that for investors globally. And we are very heartened by the fact that an EM has made a lot of strides forward on the ESG side.
Jenna Dagenhart: It certainly has. And David, how do you incorporate ESG into your mandate, while still adding alpha? How do you address investor concerns that ESG need to track from performance?
David Souccar: Yeah. In our investment style, the [inaudible 01:00:56] never have been a problem because we invest mostly in companies that are not as intensive. As we discussed, we don't invest in energy and mining. So, that part has not been a problem. When we look at field transmission, what research output look. Very good, [inaudible 01:01:14] as a benchmark.
But ESG we have a very strong effort on our side. We have a team dedicated in looking at the ESG issues in our companies. And what it did for us, it became a new tool to measure risk. So, while the impact of our companies are strong, and make us way more aware of the SMG side, of what they're doing. And it let us to also engage with management when we find something that we are not comfortable with. In some case, even allowed to changes. So, as a tool to manage risk and engage with management, ESG became very important for us.
Jenna Dagenhart: Well, everyone, we better leave it there. Thank you so much for joining us.
Danton Goei: Thank you so much for having us.
David Souccar: Thank you so much.
Arjun Jayaraman: Yeah, thanks so much, Jenna. It was a pleasure.
Jenna Dagenhart: And thank you for watching this International Equities Master Class. I was joined by Arjun Jayaraman, Head of Quantitative Research and Quantitative Portfolio Manager at Causeway Capital Management, David Souccar, portfolio manager, international equity quality growth strategy at Vontobel Asset Management, and Danton Goei, portfolio manager at Davis Advisors. And I'm Jenna Dagenhart with Asset TV.