MASTERCLASS: International Equities - October 2021

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  • 01 hr 03 mins 15 secs
Some investors thought 2020 would be the most difficult year to navigate but 2021 is rivaling those complexities given global supply chain issues, the large pockets of valuation distortions, and the state of the global economy as it recovers from the pandemic.
Two experts share different approaches to finding growth and value opportunities across international markets.

  • Joe Gubler, CFA® - Quantitative Portfolio Manager - Causeway Capital Management
  • Michael Testorf, CFA® - Managing Director, Portfolio Manager - ClearBridge Investments

Jenna Dagenhart: Welcome to Asset TVs International Equities masterclass. Joining us now to share different approaches to investing globally, we have Michael Testorf, managing director and portfolio manager at ClearBridge Investments and Joe Gubler, quantitative portfolio manager at Causeway Capital Management. It's great to have you both with us. And Michael, kicking us off, how would you describe the state of the global economy and what's the case for international equities given the current environment?

Michael Testorf: So, I mean, last year when I gave you outlook here, it was actually much easier for me because, at that time, we were early believer in the mRNA vaccines and the potential success. Now, we have vaccinated a good part of the developed world. And if you look at Israel, UK, and US, we're in the forefront, but by now, this picture has totally changed. I mean, we have now a lot of other countries even ahead of the United States. So, if you look at Singapore with 78, or Germany, 65, and even late adopters like Japan is around 58% on the first dose. But in order to get ahead of this pandemic, we have to catch up on the emerging market world and make the vaccines available and affordable for these countries. And India probably is a positive standout with 36%, but we have to continue working. And that is very important for the overall outlook for the overall equity markets worldwide.

Michael Testorf: So there are definitely worries coming up here in quarter four, and one is of course still the COVID because of the Northern Hemisphere and breakthrough cases. But I think it's encouraging that many countries are now finally going to the point where they say, "I can live with a virus as long as hospitalizations are low." And I see that adopted by more and more countries. But the other worry clearly is the inflation, right? That is particular painful. And there are several reasons for the sharp price inflation. Number one, of course, is the sharp recovery. So, it's a big V-shape recovery and the supply chains were not ready, not prepared for it. And I think it will weigh into their quarter three earnings, but it should ease the more we go into 2022.

Michael Testorf: The other part is energy prices. And there were skyrocketing and here in the US, we haven't really noticed it as much, but if you go into Europe and Asia, we have skyrocketing prices. And I think they will stay high for some time due to the economies which are coming back on stream needing more fossil fuels, and therefore we need some time in order to have a supply response. To give you an idea, China, I mean, they just started talking about buying LNG at any price to be ready for the winter. So, there could be even a little bit further of a spike in fossil fuels and that might weigh a little bit on the equity market, so... And thirdly is the labor market. So here we probably stay with elevated levels for a little bit of time because many countries have quite some tight labor markets and some of them have introduced or increased minimum wages, which cause this kind of spike.

Michael Testorf: So from that side, inflation will be elevated for a little bit and will ease further in 2022, but it will also mean that central banks have to react on that because inflation and strong GDP growths will force the hands of the central banks that will slow down easy money policy or increase interest rates. And some markets have actually adopted that already. So, if you look into Norway, and Czech Republic, and the BOE likely to follow. The Fed, we hear it in every single day, is talking about tapering, and the ECB likely will reduce the asset purchases in 2022. But don't be fooled. The balance sheet of the major central banks is not shrinking. It's still increasing, but by a smaller amount. And higher interest rates and tapering of financial and fiscal support will cause volatility and potentially slighter equity markets in the short term, in particular, when we go into the earning season.

Michael Testorf: But from my perspective, as long as interest rates are not moving up sharply, equity should look actually okay to good. Inflation, what it does in the equity market, it delays a... With a little bit of delay, higher revenues will come, there will be [inaudible 00:05:01], and if you have some pricing power, it will end up also in net earnings, which then will be almost like a wash, and you will have a kind of inflation protection. So, let us also think about what are the other parts, right? Other consumers still in good shape and the US consumer being the most important in the world as it is the largest consumer market. So, we had savings ratio in the United States accumulating a lot in 2021, and we have spent good amount of that in quarter two, and we are still higher than we were in 2019, but not as abundant savings as we used to have.

Michael Testorf: And I think Europe and Japan look a little bit better there because they came laid out of the tight COVID restrictions and will probably spend a little bit more. Service sector is particular interesting from that perspective. So, if I look at the other potential stress factors in the market, and I don't see that much on the default side, I don't see that much on credit spreads, and that would lead us where we are in the recovery. And we have passed already step number one, which normally is share prices go up a lot, earnings initially recover slowly, multiples expanding, and then we go into step number two of the recovery, and I think we just finished that one where earnings multiples are not expanding anymore or might come down actually a little bit, but earnings are growing at a very fast pace.

Michael Testorf: And we go into phase number three now, and that is a more of a critical, or mid cycle, or late cycle where the question is, will the multiples hold when earnings increases are only modest, right? And if we look at earnings increases now, I mean, we had a phenomenal 2021 where we had like 45% earnings scores. It's really mind boggling. But when you look into 2022, consensus earnings are somewhere around 8%. US is smack at 8%, UK, because recovered earlier, a little bit slower in 2022, Euro zone opening up a little bit later in 9.5% for next year, and Japan at 8%, which is a very good level for Japan and the emerging markets are just at par. But I think that does not necessarily compensate for the risk or volatility which we have at earnings.

Jenna Dagenhart: Yeah. And it's so funny, Michael, going back to your first point. I think a lot of people said, "Oh, well, 2021 will be easier to figure out than 2020," but here we are, Joe.

Joe Gubler: Yeah, exactly. One thing I wanted to jump in on is this point that Michael made about supply chains, because I think this is a big deal in the sense that the trend for dozens of years before the pandemic was for global supply chains to become tighter and have less slack and be more globally integrated. And we've seen now some pain and some difficulties from what happens to the supply chains in the face of a disruption like this. And so, we've seen companies having difficulties getting the materials they need, and then there's knock-on effects to that, right? If I'm a car manufacturer and I can't get the chips I need to make the cars, then I'm at a slow down as well, or if shipping capacity is constrained, that has side effects.

Joe Gubler: In the news this week, we've had some concern about US retailers and the effects on their supply chains. Are they going to be able to get the product they need to sell in their stores? And so, this is something that I don't think investors had to deal with on this level for quite some time and I think it will ultimately sort itself out, but the other thing for investors to keep an eye on is, what are the long-term effects? Do supply chains ever go to being quite as globally integrated and with as little slack in them as they had before the pandemic, or do people hold back a little bit having been burned a little bit by the recent experience?

Michael Testorf: Yeah, Joe, I mean, I do agree with that too. I mean, supply chains will probably change globally, and very critical, important pieces of the supply chain might be on short again, and you will see them, whatever, in the US, Europe, and Japan without any doubt, because I think we all learned out of this lesson, also particularly, on the pharmaceutical industry, we cannot be all dependent on Indian vaccine manufacturing. So, it's a very good point.

Jenna Dagenhart: Yeah. A lot of different moving pieces between supply chain issues and still the pandemic. Joe, how is the pandemic in its many phases, as Michael outlined, impacted your investment opportunities and your approach to building portfolios?

Joe Gubler: Well, I think, one thing that you do crave as an investor at times is an event that can produce a difference between winners and losers, and certainly the pandemic did that. There were huge amounts of dispersion between the stocks that were doing well or doing poorly at different phases of the pandemic. In the early phase, I often joke that any company that could help you get online, or buy food, or alcohol, or play video games, or do video conferences with your colleagues, or anybody who made chips that help companies provide those services, those were the big winners. Upfront, of course, we know where the big losers were, travel, leisure, restaurants, things like that, anything having to do with in-person activity.

Joe Gubler: But I think what sometimes happens with the market is that it over interprets themes, it gets carried away. And so, by the time we got to November, and we had effective vaccines coming out, people may remember this, but in November we had probably one of the biggest momentum reversals we've seen in recent memory. And so, I'm a quant guy, so I'm going to talk about nerdy stuff like momentum reversals. But the point was, that was a tremendous reversal of stocks that had momentum in November and in the period just after that. And that's potentially because the market had over interpreted that early pandemic theme. And then, I think the market went on to compound that error by assuming that having vaccines meant we were all clear.

Joe Gubler: And so it got ahead of itself in some ways with that. There were going to be variance as we've experienced. There was potentially going to be some challenges in the process of getting \ to the high levels of vaccination that we need. And so, now we've seen some of that enthusiasm for the stocks that took off after November, tapering over time. And I think the good news again, is that, as investors, this gives us a lot of separation between winners and losers, it gives us a lot of potential mispricing’s that we can take advantage of. But we also have to resist the tendency to over-interpret themes the way that the market often does. From a risk perspective, I think that's a big part of the equation too and it's something that we take very seriously is how we risk manage our portfolios.

Joe Gubler: One of the things that we do that's unique is that... I'm a quantitative investor. I share an office with a lot of fundamental investors. And one of the things that we can provide quantitatively is risk management, risk modeling, understanding of systematic risk as we build portfolios. And normally we do that with risk models that have been developed over time to be, on average, correct across a lot of different types of market cycles. But you have to be flexible. You have to also be able to resort to risk models that are, at some points in time, shorter term, or more sensitive to the risk factors that really matter in the market at that point in time.

Joe Gubler: And I think COVID is a really good example of that. In 2019, you would not have had any COVID or pandemic risk factor in your risk model and hopefully in 2024, you won't have one either. But in 2020 and 2021, those are the risks that really matter. So, you need a risk modeling process that understands how to measure those risks and how to understand how much that risk is building up in a portfolio.

Jenna Dagenhart: Michael, turning to you, how are you taking a broad and diversified approach to finding growth opportunities?

Michael Testorf: Yeah, so indeed, I mean, we're bottom-up investors, we're growth investors. But perhaps in order to put that into perspective, I just want to introduce you, very quickly, so the way, how we are thinking about our strategy. So, the overreaching goal of our strategy is to deliver above market return with market level volatility. So, ensure it's a good risk adjusted return. And we're investing clearly in quality growth companies, which are trading at the discount to the intrinsic value. This is in a very nice sentence, but just to put a little bit more word around it, the discount, which we are talking about, is the one between market expectational consensus and our analysis. And there we see some mispricing and they are very often coming from two things. One is the duration of growth and the other one is the magnitude of growth.

Michael Testorf: And in order to capture as many opportunities and still delivering somewhat around market volatility, we came up with approach of our three buckets, and I just explained them very quickly. The first one is probably the one where everybody says, "Okay, this is a typical growth investor." We call it emerging growth, and we put up to 20% of our money in there. These are the companies which are growing extremely fast, they have larger addressable markets, and there are, very often, these kind of disruptors in their respective sectors, not very cashflow positive but what the market does here, they underestimate these companies, the magnitude of growth. And then we have our second bucket, which is for us, the breadth and butter business for growth investors. And we call it the secular growth bucket. We put 40 to 60% in there, and these names and companies have very long duration often in our portfolio.

Michael Testorf: And these are the one which are still not growing. They're crazy as they're emerging growth bucket, but they're still growing nicely above GDP. They do have very strong cash flows, they have good management, and they are normally delivering superior returns and compounding the profits year by year, by year, normally relatively lower volatility companies. And the last bucket, which helps us actually to gap a little bit the shifts between value and growth, which we call structural growth, are companies which are just GDP growers, very often out of favor, but we see somewhere that earnings are growing, and we see also trigger to unleash this kind of value. And we put 20 to 40% in these bucket which is [good 00:16:20] for our structural growth. So that's, in a nutshell, how we look at our approach and how we define growth.

Jenna Dagenhart: And Joe, concentrated equity portfolios have also become increasingly popular with investors. What are some of the challenges that you face with a concentrated portfolio and what sets your approach apart from other concentrated offerings?

Joe Gubler: Well, I think the big challenge with a concentrated equity portfolio is essentially that, one of the great tools of risk management that we have, as investors, which is diversification, spreading our risks out over a larger number of positions, we're making a conscious decision to not use that particular level of risk control because we have investors, clients who are interested in the absolute best ideas that we can put into this portfolio. They want that concentration, partly because they're worried about what happens when they start putting one portfolio together with portfolio from other managers. Do they end up having positions that cancel each other out or do they end up being too watered down? So, they want this concentration.

Joe Gubler: And I guess, the analogy I would use is like, if we're making a high-performance automobile, we want power, right? The first thing somebody's going to ask you about when you buy a sports car is "How fast does it go to zero to 60? What's its top speed? How many horsepower?" Those are the power elements of it, and I think that's analogous to the concentration of saying, "I'm going to take my very best small collection of ideas and put them into this portfolio." But you'd be crazy to build a car that didn't have the other features that users expect in terms of the suspension, the steering, the safety features, the things that make it possible for you to use that power safely and effectively.

Joe Gubler: And so, what we have to do when we build a concentrated portfolio, what we do, that I think sets our approach apart is, we tap into our extensive experience and skills with risk modeling, we use our proprietary risk models to basically say, "Look, we need to make sure that, given that we're concentrating this portfolio, if we want to have a good chance of having consistent returns, we need to scour the risk landscape for any other kinds of systematic risks or risks that might creep into that portfolio and try to make sure those are not overly expressed in that particular portfolio."

Joe Gubler: And so, when we build a portfolio, it's a combination of taking the expected returns that are coming from our fundamental research, the risk information that's coming from our proprietary risk models, and coming up with, what is the best portfolio you could build with those two considerations? As Michael said, we're interested in risk adjusted returns even in the case of the concentrated portfolio and we want to deliver the best risk adjusted return that we can. Consistent with that idea, we're going to build a portfolio of, in our case, 25 to 35 positions.

Jenna Dagenhart: Now, Joe, with less than 30 holdings in an ACWI benchmark, do you have tracking error constraints? What's the concentrated strategies to active share?

Joe Gubler: Yeah. And I don't think there are any magic answers to that as far as what's the exact right level of concentration or number of stocks. Like I said, we aim to have 25 to 35 stocks in the Causeway Concentrated equity portfolio. We feel that that's an appropriate number where we can get high conviction alpha opportunities into the portfolio, but we still have some ability to make sure that we can play different kinds of systematic risks off against each other in the portfolio, that we can have some level of diversification still in that portfolio. And again, I think one of the reasons that a lot of investors are interested in this, is that they'll occasionally look at their overall collection.

Joe Gubler: If they look across all their managers and all the funds that they hold, and they put that together as one big portfolio, there's a lot of positions in there and there's a lot of risk that what one manager is doing for you is being canceled out by another manager. And so, there are cases where people are saying, "Let me look at a core exposure to a given asset class, and then let me get a concentrated satellite to that, or, just in general, let me trim down the number of names that my managers hold." So, there is demand from that perspective. And again, I think people like the idea that you're just saying, "Look, these are my highest conviction ideas that I'm putting into this portfolio. Here's 25 to 35 names that I can stand behind."

Jenna Dagenhart: Michael, any disruptive forces that you've identified in international markets?

Michael Testorf: Joe, perhaps adding on to your analogy with the cost, right? I mean, I do agree. I mean, you want to have your best ideas in the portfolio. That's what we are also looking for, but we are not as concentrated as you guys. We are somewhere around 50- and 70-year holdings in our ClearBridge international growth strategy. But for us, we want to put our best and most racy ideas into the portfolio, but we want to also think about market risks and whatever. And for us, it was 50 to 70. It's not that we get the car which is taken out of the curve. So, for us, 50 to 70 names is our electronic stability system in your car analogy, so...

Jenna Dagenhart: Well done. Well, Michael, any disruptive forces that you've identified at international markets?

Michael Testorf: Yeah. So disruptive forces, I think it's not only international markets to be very honest. I mean, disruption honestly, it's global in nature and it has to do something with technology and digitalization. And that happens in so many sectors to a different degree. And I had always one rule in my life when it comes to disruption. You want to be investing with the disruptors or the ones which are using this disruptive technology and avoid the disrupted industries. So why is that? And disruption, at the very beginning, is very often misunderstood and underestimated. And in our digital world, which we are living in, the computers are getting faster, the data is available left and right, and the cycles of new invention and disruptions are just increasing. And so, you will be consistently on the lookout for the next big thing.

Michael Testorf: And adoption is also getting easier nowadays, because most of that is software driven. And it's easier to configure today with any kind of APIs where you add it to your existing system in the company. And if you look at the disrupted industries, what is their biggest mistake? They're often very slow to react. And most often, they do not want to kill their cash cow. And there might be other reasons, perhaps lobbying of politicians, or labor laws, or whatever. But the disruptors, on the other side, they're fast and without any mercy, so... And the last one is, what makes it so powerful, is the emergence of venture and private equity. They give them long term capital and a lot of fire power. Have a mind. I mean, this segment, alternative capitals growing by 10% per year.

Michael Testorf: So for the disrupted guys, it's either adopt or die, right? I mean, I'm a little bit extreme here in the explanation. But if you look at how far these kind of disruptions can go... I mean, we know about the electric vehicle, right? Everybody knows the Tesla story. But it's going consistently higher every year. And if you go to China today, we're talking about 10% of all new cars being bought are electric already. This is way ahead of any other major economy. I mean, Norway might be the exception because of all the incentives and so on. So, the incumbents have to think about it. "What do I do?" Merge, sell or die, right? I mean, that's what it is and VW, GM and these ones have definitely adopted.

Michael Testorf: And the next level, in addition to the EV and for the car industry, will be autonomous driving. I mean, it is a little bit quiet about it currently, but there are consistently improvements, and improving AI, faster computer speeds, will change, at one point, the behavior, how we use a car, and that will mean that we end up probably more with right sharing of fleet usage. And that means less cars, which will be more heavily used. And then potentially trucks, at one point, will run throughout our country without drivers, and think about the implications, how much labor will be displaced.

Michael Testorf: And the next one would be then the energy sector, right? I mean, if we go the route I'm talking about, an adoption curve of electric vehicle, and in conjunction with renewable industry, that will replace fossil fuel. And perhaps it goes actually faster than we think. And when you pair that one with battery storage, you will have even a more disruptive power and that will set a lot of geopolitical questions for the energy dependent countries like Russia or the Middle East. So, another industry, which is really at my heart, it's the banking industry, which was very difficult to disrupt because of all the regulatory hurdles and capital requirements, which are very high. But the FinTech companies, which are the diverse disruptors, that try to attack one little piece of the banking business, which is the fee business, which is capital light, and with the use of technology, it can be very profitable. So, what I'm talking about is the payment industry, which is consistently going more into the hands of the specialist players.

Michael Testorf: So we have a company there, which is called Adyen. We have it since the IPO, so we have it for years, and it's one of our emerging bucket examples. And these kind of companies disrupting the banks, which are still the major leader of the payment business, but it's a question of years. And what Adyen does and their competitors, they have developed a platform with superior technology, which offers the merchant and the client a better shopping experience. The speed of checkout is much faster, the decline of your credit card is definitely lower, and the last thing you want, when you go shopping, I mean, a declined credit card, right? I mean, that's what it is.

Michael Testorf: And then these kind of platforms are collecting data. And this data is incredibly useful later on for advertisement or targeted advertisement to you via the merchant. I mean, the pandemic has basically just accelerated the process of online shopping, as we know, and then electronic payment. And in international markets, opposite to the US, we have a very low penetration of payments, and that's where the unbelievable nice growth of payment company comes. And Adyen has delivered a flawless combination of now, online and offline shopping. And there are many more sectors. I can go on and perhaps I mentioned a few of them perhaps, like big pharma, for example, nobody talks about that yet.

Michael Testorf: But there are a lot of small biotech companies which have incredible science. And when you look at the emergence of CROs and CDMOs, which basically is an outsourcing function in making drug development and manufacturing easier, cheaper, faster, and less risky. I mean, we know it now from Moderna and Pfizer-BioNTech, these new technology, mRNA, nobody... I mean, it's already around for some time, but they have now developed platforms. And if they can offer more vaccines, and perhaps the platform goes into different usages, like cancer or autoimmune diseases, which are huge blockbusters for the major pharma companies.

Michael Testorf: So this is very powerful. And the second part which I said about is adopting disruption. So, if I look at AI, right? we have a company which is called Teleperformance, which is basically a call center with add on functions. And they're using AI and train their chat bots. And now, 80% of all calls can be solved through AI. And the number just goes up. Telemedicine will be the next one, also AI data use, and you have probably your first online doctor visit during COVID. Now, at the end of the day, it was not that bad, right? I mean. So, we are just at the beginning.

Michael Testorf: And if I talk about eCommerce, I mean, you know these and we have one company, which is called Ocado, which helps you to save a few hours of your week in grocery shopping. They're partnering up and given the technology, how to be prepared for online grocery shopping and delivery. So, there are a lot of disruptions in real estate and whatever. I mean, I could go on for ages, and there will be one which I'm very much interested, is in the agriculture, where technology, potentially, will provide us with more affordable and less polluting food, and that would make us also less vulnerable to natural catastrophes. So, it's a little bit of a science fiction movie here, but all of that stuff is happening, I mean, and we have to be aware of these.

Jenna Dagenhart: I mean, it's unbelievable. It feels like we're living in the future sometimes with all these technologies that you mentioned. And you're also invested in the renewable space and that's [something 00:30:37] that you touched on. Michael, how should global investors be thinking about clean energy?

Michael Testorf: I mean, in everybody's considerations and all countries in the world, almost all countries in the world, have talked about carbon neutrality. So, we have the Paris accord, we have Europe with a Fit for 55. They give you all numbers what they want to reach by a certain timeframe, but there is no real exact science or numbers behind it, how you want to get there. And one critical part of that would be the renewable energy. And for me, it's crystal clear that all the renewed pipelines, which we have currently, right? Are not enough in order to get there. And I give you a little bit of an idea how much that should be actually. And we want to go there replacing this dirty coal, and in order to get to this CO2 reduction.

Michael Testorf: So we would need almost four times of renewable, if it's solar wind, offshore wind, or whatever it is, to get the intermittent milestone, meaning 2030s or 10 years. And this number would be 20 times. If you want to go where we want to be in roughly 2050. And what is so powerful and that is also one of these... I just talked about disruptive forces. This is another one. And if you look at what happened over the last 10 years, I mean, 2010, we had prices for renewable energy, which coming from onshore wind or solar around 110 to 120 euro per megawatt hour. And the government had to support it with tax dollars. Today, it's very different. So, we are today around 25 to 40 euros per megawatt hour. This is roughly one third, where we have been 10 years ago. And more importantly, renewables do not need subsidies anymore.

Michael Testorf: And actually, today electricity prices... and Europe is a little bit on the high side, US definitely lower, China also a little bit lower, but Europe is so high because of the high gas prices currently, somewhere around 60 to 100 euros per megawatt. So, we're talking about at least half what it is currently. So, it means renewables become more attractive almost by the day. And I wouldn't be surprised. Europe has it already. They have a CO2 scheme that other regions will start introducing CO2 admission penalties and whatever the regime will be. It will increase the price of electricity. So out of my perspective, it will only go one way. It has to go fast, and we have a company here which is called EDP. It's located in Portugal and it's a company which is in developing onshore and offshore wind as well as solar and little bit of hydrogen.

Michael Testorf: And the second business is their network business, which is roughly, to make it round numbers, one third of it. So EDP, interesting also for US investor is active here in the United States. It's one of the best developers globally, and one of the most efficient network operators which is out there. So, what they do... I mean, the business model is very interesting because A, they are developing these pipelines and you have to think about it a little bit like a house builder, right? Which you have here in the US. They have the land, they build it, and at one point... and they're at the stage because they're so incredibly good and there's so much long-term capital looking for investments. They're able to sell it with a very good profit, and then they take this money and build another one and continues and continues.

Michael Testorf: At one point, there will be more of, "I'll hold onto this kind of renewable energy, and I will use that as a kind of energy generation." But there is not that much of this kind of energy, of this kind of renewable build out pipeline in corporate and the price. And then there will be one or two more triggers, which could come at a later point in time, where you have this site, which might be incredibly good in terms of sun or wind, and you have the chance potentially to retool it, which make put a bigger turbine [inaudible 00:35:09], which might have double the output and you will have then doubled the revenues. Or you have a point where the equipment lasts even longer than the depreciation times, in this case 25 years, and you get basically electricity without any kind of depreciation. And if you look at the Green Deal in Europe, it's around 10 trillion euros or whatever, almost $12 trillion. And 2.4 trillion goes into renewables and 1.8 trillion in transmission. And that's exactly the wheelhouse of EDP.

Jenna Dagenhart: And Joe, I want to go back to something that you mentioned earlier. Even though you are on the quant side, you said you are also connected to the fundamental side and some of those people. So how does Causeway combine fundamental research with quantitative risk tools to construct the portfolio? I mean, why is this convergence of fundamental and quant in the same portfolio so unusual?

Joe Gubler: Well, I think it's becoming more common over time, because I think more and more organizations have understood some of the benefits of it, but I will say, we've been doing it since the '90s. We've been doing it since 1995, '96. We've been building our own proprietary risk models for 20 plus years. So rather than buying a risk model from a third party like Barra, we produce it ourselves so that we understand everything about it, we can control everything about it, add the risk factors that we think are important. But to get at the heart of your question, how do we work together? The idea is that when I talk about this concentrated equity portfolio, or our international and global value portfolios, the expected returns, the research process to understand what a company is worth, where we expect it to go in terms of price in the future and therefore which are the attractive opportunities, that's entirely determined by my fundamental colleagues, doing what you'd expect a fundamental investor to do, build a model, understand the business backwards and forwards, understand the management team, understand the competitive landscape.

Joe Gubler: But that gets you to an expected return. And as we know in investing, it's about more than just the expected return. We also care how much return are we getting per unit of risk that we put into a portfolio. And so, that's where the quantitative side comes in. We work with our fundamental colleagues on portfolio construction and weighing and measuring exactly how much return are we getting per unit of risk for each of these stocks using the outputs of our proprietary risk model. And then also helping them to monitor what are the systematic risks that might be coming up in the portfolio, and were those intended systematic risks? Are those risk that I have to take in order to pursue these investment opportunities? Or is it the case that over a number of positions, exposure to this risk factor started to creep up but it wasn't really anything intended or desired on the part of the portfolio managers, and they have a chance to then assess?

Joe Gubler: They've seen every risk that the portfolio is taking on, and then they can make an assessment of, how much return do we think we're going to get? Do we think we're going to get compensated properly to take these risks? I think the most effective way to do that is to incorporate the risk inputs into the portfolio construction process, right? If you produce a portfolio, and then you run it through a third-party risk model, and it tells you something you don't like, then you've got to expend turnover to go fix that problem.

Joe Gubler: If you incorporate risk at the stage of portfolio construction, ideally there are very few surprises, exactly which risks are going in, you've already guaranteed that you feel you're going to get compensated properly to take those risks. And for purely quantitative processes, that's a very common arrangement. The alphas, the expected returns, come from the quantitative side, the risk information comes from the quantitative side. There's a portfolio extraction process that weights and measures those things carefully. I think what we've cracked at Causeway is, how do you put fundamental expected returns together with that integrated portfolio construction and risk management? And again, it's something we've been doing for 20 years. I think you're going to see others start to do more of it, but there's a learning curve there in terms of how to do this effectively. And I think we've learned a lot of important lessons over time about how to incorporate those pieces of information.

Jenna Dagenhart: Now, with less than 30 holdings and an ACWI benchmark, do you have tracking error constraints, Joe? I mean, what's the concentrated strategies active share?

Joe Gubler: So the active share is quite high. It's about 95%, which is not surprising for a portfolio that's concentrated like that and where we're putting our best ideas forward. We don't have any explicit tracking error or risk constraints. What we rely on is that fusion of return and risk information. And the way the process works is that certainly a risky stock could be added to the portfolio, but if it concentrates existing risks that are in the portfolio, if it's risky in and of itself, the hurdle for that stock to enter the portfolio becomes higher, right? The expected return it has to deliver, becomes increasingly high. And so, if we were to concentrate the portfolio too much in one sector or too much in one country, the risk process would start to pick up that concentration and it would effectively increase the hurdle that the next stock in that country or sector has to clear in terms of expected return in order to find a place in the portfolio. So, it's self-regulating in that sense.

Jenna Dagenhart: Michael, what are some industries or innovations that are best provided by non-US companies?

Michael Testorf: Well, we have quite some, to be honest. And for me, there are certain similarities with these kind of companies. So, number one is these companies or sectors, they have certain specialization in one field through science, technology, or whatever the uniqueness is. And number two is, as they do not have large home market that's opposite to the United States, they have to fight extra hard to get into the next markets. And by focusing internationally, you get even a bigger potential market than just the US. And if I give you a few examples, so we have one company called LVMH, very well known. It's in the luxury industry. This is now a global leader in luxury. And what is the uniqueness there?

Michael Testorf: And this is the deep-rooted heritage of the brand and a great management, which has built luxury empire. It's not only anymore like handbags and whatever, and champagne, it's going from all facets of luxury to travel and [accessory-wise 00:42:26] and so on. And the management has really understood to build this platform, acquire smaller brands and take them global. And that makes the additional add on profitability of LVMH. And in spirits, it's a very similar thing. So, companies like Diageo, which we also hold. And the US, we know, has good whiskeys and good bourbons now, no doubt about it. But outside of the US, there are many other spirits, right? We have very big Vodka brands, okay? The scotch is there too, gin, tequilas. And like LVMH, Diageo has built a platform where they acquire other brands, put it on the platform, market them global and that is their success level.

Michael Testorf: And even small areas like flavor and fragrances and... we own a company, it's called Givaudan, that came originally out of a big pharma company. There were nobody in this big pharma company, but they specialized, and through their deep routed knowhow, they were able to become world market leader in there. If you look at skincare, L’Oréal, Shiseido. If you look at semiconductor hardware, right? And foundries, it's clear, it's TSMC, it's ASML and [lithography 00:43:43]. They're the undisputed leaders in their fields.

Michael Testorf: And just one word on waiting of our semiconductor exposure, we were clearly overweight in semiconductors, which helped us, but we are getting a little bit more careful. On semiconductors, of course, we could see that there is a little bit of an over-ordering right now because of the shortage, and then the semiconductor business, in particular on the foundries and on the providers like ASML, they have very little visibility and feel this cycle a little bit later, and I think that the cycle could turn over or roll over beginning '23, and you want to be early.

Michael Testorf: But there are many other [inaudible 00:44:30], like wind energy, which we talked in renewables. Vestas, Siemens Gamesa, two leading suppliers, Atlas Copco, fantastic company in compressor technique in Sweden, very small country, but they've made it global. [Airframe 00:44:43] Manufacturers, it's a duopoly, Airbus and Boeing. We think that Airbus has a little bit of an advantage right now, but I could go on with many more examples, but the pattern is very similar, right? So, as I said, they have to be special in something, they have to be special, and go abroad, and focus internationally.

Jenna Dagenhart: Now, Joe, where are you seeing the largest pockets of valuation distortions in terms of regions, countries, or sectors?

Joe Gubler: Yeah, boy, it has changed quickly over time. During the pandemic we saw a lot of distortions open up. One of the things that I thought was interesting during the pandemic was that we saw banks and other financial shares become pretty cheap throughout the course of the pandemic. And I think there was, to some extent, an instinctive sense on the part of investors that, well, the last crisis was about banks and financials. And so, somehow this crisis is going to be about them as well. And not to say that a slowing economy doesn't present challenges for banks, that they're going to have to surmount, but I think there was an underestimation of how well capitalized banks were, going into this crisis, after a lot of the corrections and the regulation that had been put in place after the GFC.

Joe Gubler: And so, one of the things that we saw is that, by the end of 2020, a lot of banks had gotten really cheap, that has come off. There's still some cheap banks available, and overall, the sector is still somewhat cheap. But a lot of the names that we were holding in financials performed at the end of last year and early this year, and now where we're seeing opportunity more is in materials names and in healthcare names. Healthcare, I think in part, because of concerns about what might happen with pricing in the US. As various legislation moves through Congress, there's a real overhang that's been there and that's masked some of the great potential and the innovation that you're seeing coming through some of these names in terms of their pipelines. We've got Roche, we've got Santa Fe, we've got Takeda, and there there's...

Joe Gubler: Roche in particular had some really good developments on Alzheimer's. But again, because of concerns about US pricing and legislation, I think it's been hard for a lot of these pharma names to launch and move forward. But we have a lot of conviction that they'd be able to do that moving forward from here.

Michael Testorf: Joe, I mean, we are also in banks, invested and our main banking exposure is actually in Europe. And it's normally not the most sexy sector for growth investors. You probably agree on that part, but as you know, we had to... or as I explained earlier, we have this bucket where we can put these names in, in order to get a little bit more risk diversification, and where we see earnings increasing and there's a trigger. So, we have identified the European banks. And when you look at them, what made us actually increasing our weight in European banks over the course of 2021, is that Europe was actually the one where the regulator was the toughest out of all of them.

Michael Testorf: So if you look at Australia, was okay. I mean, it was a happy banking market to start with and Canada as well, but the Europeans punished them because they were still thinking about the aftermath of the great financial crisis, right? So, the result of that, as you just pointed out, I mean, these banks were totally over-capitalized and over-provisioned, and now we come to the trigger. So, I think the trigger that makes you probably, in your portfolio, happy too, is the release of capital, which we most likely see now in October and December. And banks will start with the share by banks and dividends finally, which we've waited quite some time for, right? And the second part would be the provisioning, right? I mean, we have good provision releases for the last two quarters. And I think provision releases will continue for not only two more or quarters, it would be probably four, or six, or whatever but at a much slower speed.

Michael Testorf: So if you put these two things together, actually EPS will look good in particular because you reduce the equity, ROE will go higher, and then you pair that with pre-provision growths of roughly 3 to 5%. It's not a hell lot for growth investors, but there is some underlying growth in the loan business and it's coming from consumer mainly, and mortgages, because some people actually look for bigger homes after being scarred from the work, from home, and kids around you and so and so. They want to have an extra room, and so they need another little extra mortgage, but... So where could that go? And if I should put there some numbers on it and banks were, in general, trading somewhere around 80% of overall index value, at least in Europe.

Michael Testorf: We are currently at 60. If you put the earnings growth on top of it and the dividends, and we are talking dividends, in some cases could be as high in the short term of... as high as 10%. Unbelievable. So, I think this would be one of our holdings, which will not stay very long in the portfolio. Once the triggers are done, we will exit that, but that's normally what we do with our structural bucket.

Joe Gubler: Yeah. And I agree with you that Europe is where the most attractive opportunities are in banks right now. I feel great. I feel like we're unifying the world because growth and value guys are agreeing on certain things here. I think it's funny-

Jenna Dagenhart: This doesn't happen every day.

Joe Gubler: Yeah. Asset TV, bringing people together. I think sometimes people get the wrong idea. Obviously, nobody wants to overpay for any stock. So, we all care about what we pay for a stock. And as value investors, we like growth too. If we see a company that can unleash some growth, we're happy to get that as well. I think, to some extent, it has more to do with which side of the ledger you're skeptical about, right? Value investors might be somewhat more pessimistic people. If they hear a long-term growth story that's many years out, they're skeptical about that. And I think, sometimes growth investors are skeptical about business models that look like they might be under pressure, or broken, or facing a lot of secular pressure. And there's skepticism about whether that can really be turned around. So, I think it's interesting. We both like growth, we both like to pay the right price for something, but we're skeptical about different things.

Michael Testorf: That's so true. Yes, absolutely.

Jenna Dagenhart: Yeah. And pivoting from Europe to China here, I'm sure our viewers would love to get your thoughts on China. Joe, starting with you, China's recently exhibited a sharp increase in the aggressiveness of its regulatory regime. As a global investor, how do you navigate that?

Joe Gubler: Well, I think you have to take it very seriously. There are definitely some headlines coming out of China from a regulatory perspective that have been troubling, but as always in investing, we want to be really careful not to overreact or over-interpret a particular theme. And so, for now, the assumption I think, needs to remain in place that the Chinese leadership will ultimately avoid doing anything that is destructive to growth or destructive to economic prosperity in China. But I think it's important for us to understand they have a little bit of a different emphasis now than they may have had 10 years ago. And I think growth was put above all else earlier in China's economic history. And now there are concerns about common prosperity, and social welfare, and individuals in China dealing with challenges, with the cost of education, and the cost of housing, and the cost of healthcare.

Joe Gubler: And then throw on top of that, this idea that there have been some very large companies that have grown up, that have an incredible amount of power within a particular market. I think there's a desire to, from an antitrust perspective, push back on that to a certain degree. You saw that when Alibaba and the Ant Financial IPO was moving forward and that got shut down. And if you think about that behind the scenes, to some extent, there's a disintermediation of Chinese banks, of state-owned bank enterprises, which can be a lever to exert power and influence within China. So, part of it may also play into the power dynamics of, let's be careful about letting any of these entities get too large and too powerful within China.

Joe Gubler: Now, one area where we're fortunate, is that we actually have a Shanghai based research subsidiary of Causeway. And we had that in place just before the pandemic hit. It's been very hard actually for those people to move back and forth between LA and China. For the time being, that's getting better. But it's been fortunate to have that in place because we can get research reconnaissance, ideas from people on the ground about where regulation might be heading, what the objectives might be. And, of course, no one has a crystal ball. It's very difficult to figure out exactly where Chinese regulation might be heading. But one of our themes is to try to understand what it is that the Chinese government wants to accomplish over the next 10 years and be very careful about entering into positions that, in any way, have too much potential to run contrary to those objectives. So that's a risk factor that you want to be careful about. And I think having those conversations with our Shanghai based colleagues is helpful in understanding that better.

Michael Testorf: Yeah, Joe, I mean, our point on China is also a little bit more capital, I have to say. We have reduced our exposure in 2021. And it's actually interesting when you said that the Ant Financial was, for you, one of the trigger points that was for me as well, because I cover financials and all the FinTech space as well. And I saw also the disintermediation and come to my disruption again.

Joe Gubler: Yeah.

Michael Testorf: And financials and how much advantage they have because of the database. So, I mean, that was for me, also one of this moments where I got very careful. Overall, I mean, China is an El Dorado for growth investors, because there you have the growth, which you don't find in some of the developed markets. But that comes with the risk of macro government interference, corporate governance problem, and so on. But it started already when we were really honest. I mean, it started already 2018 where they were just cracking down on financial leverage, and financial situation was pretty tight actually, over the years. And they were cracking down on the wealth management products, and then the Ant Financial thing, and then we had the Tencent gaming situation, education, and all the censoring, and that definitely [inaudible 00:56:20] a lot of international investors, which are in these companies.

Michael Testorf: I mean, the locals are more on the cyclical stuff and whatever, and they felt it a little bit earlier. But there's one thing which worries me a little bit over the next one or two quarters. It's not the whatever Lehman moment, but Evergrande is actually a pretty big problem in China. And if you look at the real estate sector itself, it's so important to the Chinese economy because it makes 25% of GDP.

Michael Testorf: And secondly, it is the store of value for a lot of richer Chinese. They buy apartment one after the other, and if the developers have problems, what do they have to do? They have to sell their [inaudible 00:57:02], they have to sell their finished apartments, or repairing their balance sheet that will have an impact on real estate and that will have an impact on wealth effect, and that will have that an impact on overall consumption in China. So, I mean, if I had to put numbers on it, again, it would be somewhere between 1 and 4% of GDP growth impact, most likely on the low side, 1 to 2, but it will be felt, and I think it will be repaired somehow by the Chinese government.

Michael Testorf: There will be plenty of liquidity flying into the economy, which is overall a positive also for other sectors, but solving of Evergrande will be taking time and it will be complex. So, I'm a little bit careful for the next one or two quarters, but Chinese equities are cheap without any doubt. And basically, as you said, Joe, we need a little bit of a trigger where we see some indications from the Chinese government what will happen next. But there's one thing which I have, which really made me thinking about China overall. With all these intervention, which President Xi did, what will happen actually with this spirit?

Michael Testorf: I mean, the kind of entrepreneurship, is this spirit now suppressed or not, or will it come back? And that is the one which made China so incredibly successful. One was cheap labor, but that's a long time ago. Now, we are talking about entrepreneurship and will that last? And you're right. I mean, there is a tradeoff between profitability of companies and the social good for the population now. And that has to be shown in the next quarter, so the next year.

Jenna Dagenhart: Yeah, in addition to inflation, which Michael mentioned at the beginning of the program, interest rates are going to be a key thing that investors are watching moving forward. Joe, what role do low interest rates play in the challenges that value is placed? And what are the prospects for a change in that regime of persistently low interest rates? How can investors effectively navigate the challenges of rising interest rates?

Joe Gubler: Yeah, I mean, clearly, really since the global financial crisis, we've been in an era of unprecedented monetary intervention and the pandemic really accelerated that. But at some point, there's going to need to be an exit from that. One of my biggest concerns is that if central banks are too cautious about ultimately finding a way out of that, that you just end up in economic malaise for a long period of time. So, I mean, they're going to be careful. No one wants to be blamed for being the central banker who moved too early, but we were talking about inflation. Inflation may potentially start to force the hand over time. And it's hard to say, some of the inflation that we're seeing, as we talked about... We've had supply chain disruptions; we've had labor disruptions. Do those get fixed and does that take some of that pressure off? Or are we really moving into a regime where inflation's going to be more important over time?

Joe Gubler: It's very difficult to predict when interest rates might start to move up anything more than a head fake. We've seen a little bit of that recently, but we've seen a lot of periods of time, over the last several years where there's been a movement and then we retrace that. What I will say is that it has had a profound impact on valuations. I did an interesting exercise this morning. I've been struck by the number of stocks you can find in, say, the ACWI index just anecdotally, that have price to sales ratios above 10. And if you want to get a little bit more background on why that's potentially problematic, there's a really famous rant from the early 2000s, maybe late '90s where Scott McNealy, one of the founders of Sun Microsystems, was talking about his company being purchased at 10 times sales, at the height of the TMT bubble.

Joe Gubler: And he goes on and makes a lot of interesting observations about what it means from evaluation perspective to sell at 10 times sales. That's a very steep hurdle to clear and I've been across so many names where that's true. And so, I did a little search this morning. I found that there are hundreds of names in the ACWI index that have this characteristic, where they trade for more than 10 times sales, which is pretty wild. Now some of that is true disruptors, the types of things that Michael's talking about, where these are such disruptive companies. If you to look at like a snowflake, it's off the charts, it's 100 times price to sales, but that's a true disruptor snowflake. As somebody who's in the quantitative space, dealing with lots of data, there is a lot going on there that's disruptive and has potential going forward.

Joe Gubler: So you may see names that are getting those kinds of multiples because of that true disruption potential. On the other side of the ledger, I saw Carnival Cruise Lines in there, and that's because there's a company that essentially has had no revenue over recent time periods, or very little revenue because of the pandemic, but investors are saying, "Okay, this is temporary, this will be corrected." But when you continue that search, you start coming across names like a Twitter or a Netflix that traded 10 times sales. And to me, whatever you might say about those names, they're not in that early disruptor phase anymore. Netflix is not a disruptor, Twitter's not really a disruptor. They're fairly mature companies that so far haven't really managed to earn incredibly high margins. And to me, that makes me think that a lot of names in that middle category have seen this escalation in their price to sales ratio more because of persistent low interest rates than because of anything special about what the company is doing.

Joe Gubler: I mean, if you're Netflix and you're sitting at a table with Disney and Amazon, and you're not sure who's for lunch, you're probably the one who's for lunch. Those are some serious competitors that you're dealing with there. So, what we tend to see when interest rates start to move up is we see some of these types of names get hit pretty hard by the threat of rates moving up. I think again, there are going to be legitimate world changing disruptors who deserve those multiples and they're going to be fine, but if you're not very careful as an investor about having exposure to things like that, it's going to be quite painful when rates move back up. And to the extent that your equity portfolio is supposed to be diversified to your bond portfolio, which is also going to get hurt when rates move up. That's a pretty dangerous place to be.

Michael Testorf: Yeah. That's a good point, Joe. I mean, look, we are also valuation conscious growth investors and higher rates will lead to higher discount factors ultimately. I mean, that's what it is. And if volatility comes on top of it, then you have to discount your future cash flows with a higher number, right? I mean, fortunately we have always taken already higher numbers in our models than actually you would get with a CAPA model. But yeah, that can be very powerful, and if you miss in the growth world with earnings, then you get penalized. I mean, there's no doubt about it. So, you have to be extra assured, or particular assure to do that. I mean, multiples probably have to come down a little bit.

Michael Testorf: That's what I try to explain with this step number three in where we are in the recovery. So, this is where a little bit of a worry comes and where the little bit of a wobble comes, but I think longer terms, some of the ones which are delivering good free cash flows and have good management, these are the ones which are in our second bucket, secular bucket. These ones actually should do fairly well. There might be some derating, but if its smart management coupled with good free cash flows, you could put it into growths, you can give it to shareholders, but it's at the discretion of management. And if they're good, they'll do the right thing.

Jenna Dagenhart: Well, Michael or Joe, I could talk to you both all day, but we better leave it there. We are out of time.

Joe Gubler: All right.

Michael Testorf: Good.

Joe Gubler: Thank you.

Michael Testorf: Thank you so much, Jenna.

Jenna Dagenhart: And thank you for watching this International Equities masterclass. I was joined by Michael Testorf, managing director, portfolio manager at ClearBridge Investments, and Joe Gubler, quantitative portfolio manager at Causeway Capital Management. And I'm Jenna Dagenhart with Asset TV.


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