MASTERCLASS: Liability Driven Investing - October 2019
October 7, 2019
Remy Blaire: Welcome to Asset TV, Monetary policy and geopolitics affect broader market sentiment and, of course, market direction. When it comes to investing outside the US borders, it's important to understand fundamentals, and know that money managers can take a top-down or bottom-up approach to investing. Joining us today to discuss international investing is Pawel Wroblewski, Director and Portfolio Manager at ClearBridge Investments, and Kevin Ross, Senior Vice President and Portfolio Manager at Advisory Research Investment Management. This is Asset TV's International Investing Masterclass. Gentlemen, great to have you here. Thanks for joining me today.
Kevin Ross: It's a pleasure to be here.
Pawel W.: As well. Thank you.
Remy Blaire: Well, the first quarter of 2019 has been a better start to the year, compared to last year. For 2018, we saw a decline across most asset classes across the globe. We're seeing a market improvement this year. This topic for today's discussion is international investing, so I want to learn more about your individual approaches. Pawel tell me a little bit about your approach.
Pawel W.: Yeah, sure. I represent our international growth strategy at ClearBridge. We are in a high conviction, all market cap strategy. We invest in quality growth companies that in our review are mispriced, either because their growth is mispriced, or derivative growth, or the magnitive growth is mispriced. We identify the candidates for our investments through a very systematic process that combines some quant tools, and fundamental analysis.
Remy Blaire: Kevin, what about yourself?
Kevin Ross: Thank you. I'm from a Chicago-based investment management firm called Advisory Research. I manage two international equity strategies. One is focused on developed markets. The international small cap value fund. Then, one is an emerging market mid-cap strategy. Each portfolio has between 60 and 80 positions. We target owning quality businesses that are trading at a reasonable price.
Remy Blaire: When we have a discussion about international investing, we'll have to look at the macro picture, so I think a really good place to start would be central banks. When we start with the US, we know where the Fed stands, at least for now in terms of their rate outlook. I know that you individually focus on different regions, around the globe. Pawel, I want to start out with you. If you could tell me about your position regarding China, and why you think that stimulus measures are so important for that country. We did get a bunch of economic data. GDP retail sales, industrial production, which were better than expected. Tell me about your position.
Pawel W.: Sure. Let's talk about stimulus measures in China. Of course, China has its own policy cycles. Not long ago, China was still tightening, because of their, the leveraging campaign. They wanted to control shadow lending. But the policy has really turned significantly at the beginning of 2018. Partially because of the trade war, and the significant slowdown in the Chinese economy. Since then, China has implemented a large number of stimulus measures. Someone counted, I think, more than 75 different stimulus measures already introduced in China. Both on the monetary side, and fiscal side. It's a very substantial stimulus program, as a package. We've seen rate cuts. We have seen reductions in the reserve requirement ratio for the banks to stimulate lending. Corporate's received significant tax cuts. The consumer gets VAT reduction. It's a very substantial program. In its totality, I think it counts to way more than 10% of GDP. It's a very substantial stimulus program that is working itself through for the system.
Pawel W.: Of course, there's a delay between stimulus measures and kind of the economic impact, and now, yes, as you said, we are seeing positive data coming out of China. If you look at March data for credit creation and retail sales and so on, they were pretty good. This stimulus will definitely help boost growth in China. But more importantly, it will also have positive implications outside of China. China's a huge importer. The second largest import in the world, and if you are a company in Japan or Korea or Europe that e-sports to China, you'll see a very strong benefit from that stimulus as well.
Remy Blaire: Now that you've laid the groundwork for how the stimulus measures are affecting the economy, can you tell me about how this affects equities?
Pawel W.: Of course, in China, we have seen, also, a very significant increase in consumer confidence. We have seen valuations going up in the local market. From an international perspective, companies that are ... Exposed to China are seeing better and better [inaudible 00:04:40] and also better valuations, of course.
Kevin Ross: One thing I could just add, as it relates to China, that's interesting for foreign investors is starting last year, MSER started including on-shore domestic equities within the global benchmark. We now have access to those domestic markets, which year to date, driven by a lot of the stimulus measures mentioned, are up over 20%, year to date. Hong Kong has performed very nicely, so far this year. I think one thing that we're thinking about is now that you've seen the better expected data points for the first quarter, and March, particularly, you had the PMI go back into expansionary territory, the question is does the central bank and the government shift to more of a neutral policy stance? You're starting to see some rhetoric coming out this week, related to that. Markets, I think we can gradually grind higher for the rest of the year. But I think that the bulk of the returns have been made so far, year to date.
Remy Blaire: Kevin, since you set the stage, can you tell me a little bit about some of the risks that you're seeing, in terms of international small caps?
Kevin Ross: Yeah. I think that the couple of risks that we're monitoring, of course, is inflation. It remains very low globally, right now, but you're starting to see commodity prices increase. Crude oil prices increase. I think another, we're always closely monitoring political risk. We haven't talked about Brexit yet, but that is of course relevant in the context of non-US investing. Our base case is that we will not have a hard Brexit, but certainly, that is something that we're closely monitoring. We should have some resolution later this year, particularly in October. Other risks that we are monitoring is, of course, US-China trade tensions that we had, and there seems to be resolution, on that front, and good dialog between both countries. But should things get further delayed out into the year, the business and the consumer confidence improvements that we've seen could start to deteriorate or gradually decrease.
Remy Blaire: I think you highlighted some macro points that apply to all economies, whether we're talking about the UK, Europe, China, or Japan, or the US. Pawel, I want to ask you about the ECB, now that we've covered China. We had a more [inaudible 00:06:53] ECB at the latest meeting, and we had some commentary out from Dragi as well. But what do you expect, in terms of stimulus?
Pawel W.: Okay, let's talk about the ECB policies. Over the years, of course, ECB was very supportive for the European economy and the European markets. Really, the ECB has to be credited for really helping Europe recover from the financial crisis. But I think if you take a step back, I think it's a fair observation that the ECB was a bit maybe late, or at least later than the Fed in implementing some of the stimulus measures. The QE program in Europe was way later than in the US. We all remember the Bumblebee speech by Mr. Dragi was I think in 2012.
Pawel W.: When he promised to do whatever it takes to save the Euro. Then, the QE only started in 2015, I believe, so really a little bit late for [inaudible 00:07:42] political reasons, et cetera, et cetera. I think because of that, we see that the economic cycle in Europe, the recovery in Europe, is a little bit behind, really, behind the US. Right? The cycle is not yet as extended, if you look at the level of domestic earnings, capital spending, and so on and so forth. I think the ECB will remain very cautious, and very patient. The ECB will continue to provide [inaudible 00:08:05] liquidity, to kind of nurture the continued recovery in Europe. My understanding is that the rates will stay low, at least until the end of this year, and that the ECB will be in no rush to reduce the size of its balance sheet.
Kevin Ross: Yeah, I would just add one point to that. If you look at the data points coming out of the manufacturing sector in Germany, for instance, the last couple of months, and particularly starting in the second half of last year, when you had a change in the emissions standards, it's been very sluggish. PMI is below 50, and GDP growth is expected to be below one and a half percent, this year. I would agree. I think the ECB will remain very accommodative, in terms of their monetary policy stance.
Remy Blaire: When it comes to the ECB, we know that there are a lot of risks, as well as opportunities. We're all interconnected here, so when it comes to currency as well as political risks, I think we have to watch what happens, and I believe that currencies are a little bit more predictable, sometimes. But Kevin, I know you focus on that, so can you highlight some of those risks?
Kevin Ross: Our portfolios are unhedged. Naturally, we take on currency risks in our underlying positions. I think what's positive this year, relative to what we've seen over the last previous 18 months, is when the Federal Reserve was naturally hiking interest rates, that was very supportive of an upward trend of the US dollar. For non-US investors, last year, the currency detracted about 600 basis points. We think in an environment this year, with the Fed not raising rates, and/or potentially now, some market strategists are expecting a cut, sometime later this year, depending on how the data points flow in, we think that the dollar will be flat to maybe even slightly down, against a broad basket of currencies. We don't see as much upward currency lift for the dollar, and we think that's positive for international investors.
Remy Blaire: Sticking to the FX market, and segueing into the Japanese Yen, that currency is one that people have traditionally focused on when there is a risk. But I know that you want to talk about Japan, and that nation is entering into an extended golden week. 10 days, to be exact. The markets will also be closed. There is some upside, but there also is some rusk. What's your outlook, for that country?
Kevin Ross: There's a couple of, I think, positive developments in Japan. We've alluded to a few of those, so far. One is better data points coming out of China. Many of the Japanese companies in the materials and industrials sector will benefit from better economic activity, and resolution of the US-China trade war. I think other places in Japan that we're finding value, and we find compelling, are in the health care sector, for instance. Just given structural demand drivers, and favorable demographics for many of those companies. Another point that you talked about, the Golden Week holiday, and just in general travel demand in Japan.
Kevin Ross: There continues to be structural growth in inbound tourists coming into Japan from throughout the Asia-Pacific region. China, specifically. It's growing at 15%. Annualized over the last couple of the years, we would expect that to continue. There’re many companies that benefit from those drivers. Another area that we find compelling, and you talked a little, a lot of corporates in Japan, they talk about labor shortages. The unemployment rate there is below two percent. We found a lot of very interesting temporary staffing businesses, and companies that can help resolve that labor shortage that many corporates face.
Remy Blaire: Moving, before we move away from Japan, we can't have this discussion without talking about the Bank of Japan. Now, their meeting just concluded, and their rates were unchanged. They don't expect any change in stimulus until 2020, the middle of 2020. But given that they're concerned about slow growth, and they're away from their inflation target, what do you expect to see, going forward, from the BOJ?
Kevin Ross: I would expect the monetary policy to be similar, as we talked about, with the ECB to be, remain accommodative. One other thing we haven't talked about is Japan has a plan to raise the consumption tax in October of the year by 200 basis points. I think that will, in the short term, be a drag on growth, looking out into next year. Then, you'll see some normalization. There is the potential for that to be delayed if the economy continues to decelerate. That's a risk that we're potentially monitoring. Another data point next year, Japan will host the Tokyo Olympics, which we think will be a nice driver for the consumption-oriented companies.
Remy Blaire: We've highlighted some of the Central Bank, so far. I want to talk about investing philosophy, as well as strategy for both of you. Now, the gains that we saw in the first quarter of this year in the US as well as abroad, we're seeing some of those as simulative economic policies come into effect, leading to some of that rebound. But Pawel, when it comes to growth stocks, can you tell us about the various stages in terms of growth, including emerging secular as well as structural?
Pawel W.: Okay, great. Thank you so much. You're touching upon one of the hallmarks of our strategy, which is diversification across the different buckets of growth. Really, our goal here is to create a portfolio that can participate in different market regimes. Different market environments. We do recognize that growth comes in different shapes and forms. Growth stocks can have higher growth rates, different risk profiles ... The company can be in very different stages of growth, obviously, and they are perceived differently by investors, right? You can have aggressive growth companies that tend to do well in the same momentum markets, you can have more secular growers that do well, let's say more volatile markets, and so on and so on. There's a whole spectrum of growth. Our philosophy is to really build a portfolio that's diversified not only by market cap, sectors, and currency dogs, but also by these different type of growth companies.
Pawel W.: This way, we think we can capture different market cycles. Of course, we have a very strong focus on valuation, so we would tilt the portfolio to those areas of the market where we see more attractive valuations. That's just our approach to controlling risk, controlling valuations, being able to be more flexible to perform over different market cycles. We don't have a very narrow portfolio. It only works when, let's say, large companies go in, or something like that.
Remy Blaire: Kevin, what about yourself?
Kevin Ross: As I said, we focus on buying quality businesses. We are also similarly focused on valuations. We like growth as an upside catalyst. We're just very sensitive to paying a very reasonable valuation for that growth potential.
Remy Blaire: Pawel, tossing it back to you, regarding your approach, how important is it to promote consistency when it comes to your approach?
Pawel W.: We follow a very robust investment process. Think it's very important to recognize in our industry and in investing you have biases. You might like something; you don't like something. You make behavioral mistakes. The idea of a repeatable and systematic process is to avoid bias, these behavioral mistakes, really focus on attractive ideas maybe that the market is missing, market is not talking about. We have structure. A very systematic process from idea generation to our self-discipline. We have a valuation approach to growth. We're really trying to find differentiating investment [inaudible 00:15:16] for our investments. That's how we hope to perform in different market environments.
Remy Blaire: Kevin, when it comes to the international small caps, why do you think investors should have this as part of their portfolio asset allocation? How should the everyday investor approach this?
Kevin Ross: I think it's interesting. Most US investors recognize that there's a small cap premium. Whereby small caps will outperform large caps, just given different liquidity profiles, different growth potential for smaller cap businesses to grow and compound value, over time. That exists in the international markets, as well. The magnitude is even greater than what you see in the US. We've studied this over the past 20 years. The small cap premium is about 400 basis points of excess returns. Owning small cap over large cap in the ETHA benchmarks. That is at a similar risk level, as measured by standard deviation. Consequently, the sharp ratio, or sortino ratios, or your risk adjusted returns for owning small caps is going to be very strong, in the international equity markets.
Kevin Ross: In terms of how investors should get exposure to this asset class, I think it's very challenging to own these markets passively, just given the 21 different countries that we're dealing with, the different liquidity and trading challenges associated with that. We think this is a space that active managers can significantly add value, given informational advantages that can be garnered from many of our markets. We think partnering with an active management firm, finding a strategy, or a fund that has a long-term track record, and a portfolio management team that has experience navigating in these markets makes sense.
Remy Blaire: Do you have a vehicle, or do you have an appropriate vehicle for this type of strategy?
Kevin Ross: Yeah. We manage mutual funds, SMAs, limited partnerships to navigate this particular asset class. I think there is an ETF that exists, but it has significant tracking error, and the fees are above average, relative to what you would expect. Which is why I think active management can significantly add value.
Remy Blaire: I know that you favor investing in the smaller companies versus the large ones. Can you tell me how much more responsive the management teams are?
Kevin Ross: Yeah. I think what's interesting and compelling about small cap is that the management access that you get is inversely related to the size of the company. Our weighted average market cap is between two and three billion. But we go all the way as low as 300 million. Maybe up to about five billion. We get access to the C suite of management teams. We're talking to CEOs, CFOs. They're very responsive ... last year, for instance, we met with 500 different management teams. We think given [inaudible 00:18:09], too, given less cell side coverage for many of these businesses, and that's going to decrease over time, we think those managers that can navigate these markets, and get the information that they need in order to uncover the inefficiencies, they can add value.
Remy Blaire: Kevin, you have highlighted some of the benefits or opportunities, but how can investors manage the risk that's associated with this?
Kevin Ross: Well, I think, like anything, investing diversification is key. We, our portfolios generally have 70 to 80 positions, on average. We want to be broadly diversified amongst the 21 different countries that we have exposure to, in our benchmark. I think it's also important, when you think about risk, to make sure you're not taking on any unintended bets, in the sense that you want to limit your country and sector bets, and really allow the bottoms-up, company-specific drivers to be what drives your return. We have some parameters around our country and sector allocations in order to achieve those goals.
Remy Blaire: Pawel, moving back to you, speaking of some of the macro numbers that we saw from the EU, the region is still home to many high-quality growth companies. What's your definition of quality growth?
Pawel W.: That's a good question. You're right. We're not relying, really, on the macroeconomic growth to find growth companies, per se. I think GDP in Europe will probably be somewhere around between let's say one and two percent, maybe, next year ... The economic fundamentals are improving. But it's not going to be a fast-growing region like say China, right? We are really trying to target companies that can create their own growth. Companies that are in control of their own destiny, either through superior business models, or some innovative products and services. Also, they can grow through geographical expansion, or MNA, so there are different ways companies can grow through their organic growth, right? Believe me, there's no shortage of talented entrepreneurs, talented managers in Europe. We see quality companies across all sectors.
Pawel W.: Sometimes, I'm amazed to see fantastic, multi-national companies that really grew from a small country, Denmark, Sweden, because the hall markets were too tiny, and over decades, they had to expand globally, and they're really best in class at what they do. Quality in Europe is really outstanding, in many sectors. What we like specifically, now, we really like a lot of companies in many different sectors.
Pawel W.: We're a growth fund, so of course, we are tilted towards technology. But we also like many other sectors. In technology, we have a few software companies in Europe, a number of semi-conductor companies which really dominate their respective niches. In a more broad industrial space, we like business services, we like specialty chemicals, and maybe on the more consumer side, we like e-commerce. Some very kind of focused e-commerce players. We also like luxury goods. Europe has some fantastic luxury good brands, of course, which are still growing globally. There's a lot of like in Europe. A lot of quality companies there.
Remy Blaire: Kevin, what about yourself? Based on your investing approach, which companies are you finding opportunities in?
Kevin Ross: One thing that I think is interesting is if you look at the UK, given this Brexit overhang that it's suffering from right now, many of the valuations I think are below what they would be for companies that have a global footprint. We own a couple of I think interesting businesses that are listed in the UK, domiciled in the UK, but predominantly, their production and sales footprint is global, and outside of the UK. The valuations are compressed, as a result of that. Two examples. One is a company that makes gas masks and respirators.
Kevin Ross: They are the leading global player. They have leading market share. They primarily sell to the US Department of Defense and the UK military. They have a multi-year backlog, and the best technology of any of their competitors. Another one that we own is a leading manufacturer of threads for things like apparel and footwear, and they also have a fast-growing, high-performance materials business, including into the auto sector. That's a company that they have some production in the UK, but primarily, their footprint is globally. The multiples of these stocks are trading at a discount to their historical levels, and also relative to peers elsewhere, and we think because of the Brexit overhang, consequently, as we get more resolution on that front, looking out into later this year, we think that there's some re-rating potential for those names.
Remy Blaire: Kevin, you already alluded to this, and also highlighted some of the advantages of considering advantages outside of the US, but why do y think it's important to do that for wholistic small cap strategy?
Kevin Ross: Well, I think there's a couple of reasons. Number one, there's a strong diversification argument for owning non-US investments, and the correlation coefficience right now for developed markets, X US is about zero point seven, so you're getting a nice diversification benefit both from the equity market, but also from the currency that I had mentioned earlier. If you look at many of the non-US currencies on a long-term purchasing power parity basis, they are trading at discounts relative to their fair value. You should have an uplift from the currencies, over time. Our view is that on long-term basis, currency returns are generally neutral, but since we've had such under performance from a currency standpoint over the last few years, that should mean revert, over the long term. Also, I think given the current valuation levels, most of the international markets, broadly speaking, are trading at discounts relative to their historical valuation levels, which is different than what you would see in the US context.
Remy Blaire: I think both of you have already highlighted risks through Brexit, and there are a lot of concerns about how this will play out. We're already seeing some of those effects take place, but regarding Brexit and the Bank of England, they are looking for a new successor right now. But going forward, how do you see Brexit [inaudible 00:24:14] affecting either one of your strategies?
Kevin Ross: I think certainly some of that risk is reflected in the current valuation levels. Our base case is that we do not expect to see a hard Brexit. I think that the EU and the UK will come to some resolution. I think it's something that when we do our bottoms-up analysis, we really need to think hardly, think hard about what is the end market exposure, particularly when you're talking about companies importing goods from outside of the UK. Because I really think the risk is more on the currency side than anything. We want to be sensitive to that dynamic. We've maintained an underway position in the UK for a couple of years now.
Kevin Ross: We've reduced that a little bit, because valuations certainly haven't gone up as much as you've seen in Europe and other markets. One other interesting thing that I've noticed in the UK context is that because the markets have been kind of sluggish, the last two years, we've seen a lot of takeover activity from strategic and private equity buyers. Given this Brexit overhang has compressed a lot of the valuations, there's a lot of strategic buyers, private equity players out there, who are looking. There's a lot of capital on the sidelines, of course, looking to take advantage of that.
Remy Blaire: Pawel, do you have any comments regarding Brexit?
Pawel W.: I think what the Brexit uncertainty has created is it has slowed down investments into UK, just very broadly across many industries. Automotive industry, just many companies have kind of slowed down, not knowing what the situation would be. There's an economic impact on the UK ... We analyze, of course, risks for every individual company we own. We don't have ... [inaudible 00:25:57] to domestic UK economy. Businesses that we have are very global. They're not really exposed to just one country. From the portfolio perspective, we do not see a significant impact.
Remy Blaire: Continuing this discussion on global risk, Pawel, what are the biggest risks that you're looking at, in terms of international equities as well as economies through the rest of this year?
Pawel W.: Risk? Okay. Risk is very important for us. We think about risk all the time. We have a very systematic way of analyzing risk. We do this on a number of levels. On a portfolio level, we really want to make sure we are not taking an excess risk compared to our local markets or local benchmarks. We look at every company's risk in terms of their competitors, regulator risks, individual industry cycles, et cetera, et cetera. That's on a portfolio level. If you're asking me about more systemic risk, which could affect the level of markets, here, I think there's always two big things I focus on. One is excess financial leverage. That's what typically can create big systemic problems, as we know. Then, everybody has to learn about some exotic financial terms, [inaudible 00:27:01], et cetera, et cetera.
Pawel W.: Politics, obviously. Populist politicians, especially in countries [inaudible 00:27:08] excess leverage, and in need of structural reforms, which are not happening. In terms of excess financial leverage, right now, we are not seeing a lot of stress. We are monitoring some let's say parts of the financial system, such as leverage loans, leverage [inaudible 00:27:22]. Private equity seems to have a lot of leverage. We are watching some of these financial markets, but there doesn't seem to be any sort of short-term stress in them. Anyway, we have to live with those risks. We have to manage for those risks, so we follow our process, focus on valuations, focus on quality, and we hope to perform also in down and volatile markets.
Remy Blaire: Now, I think you mentioned a key word there, which was politics, and we continue to monitor politics in this country as well as overseas. When it comes to trade war discussions between the US and China, we need to keep an eye on that because of the ramifications. But Kevin, how are you seeing trade wars potentially impact small caps? What have you seen so far?
Kevin Ross: I think one benefit of small cap investing is that many of the companies are focusing on their domestic demand in their home economies. I think the risk from escalation of trade wars is a little bit less in the context of small caps, as compared to multinationals who have global supply chains, and trying to figure out do we need to move plants from China over to Mexico? Or, if there was certainly risks of NAFTA last year, so even changing from Mexico to somewhere else in Latin America. I think in the case of small caps, that's mitigated, to some extent. However, when you're talking about US-China, that is impactful from just a general economic standpoint. We are hopeful this year that sometime over the summer, which is certainly what we've been hearing, that there will be resolution on the US-China trade war.
Remy Blaire: Within the small cap space, are there any sectors that you're looking at where you see a move higher, heading into the rest of this year?
Kevin Ross: One sector that we've been positive on for a couple of years now for a couple of reasons is paper and packaging. On the demand side, you have structural growth coming from e-commerce. It seems like every week; I've got a recycling bin full of packages from all the e-commerce orders that my family goes through every week. You could apply that pretty much globally. You're seeing demand accelerate. On the supply side, supply is pretty much curtailed. We don't see new supply coming online for three or four years, given that it can take four to five years to build new plants.
Kevin Ross: Companies are seeing strong pricing, margin expansion, and that's allowing them to generate significant amounts of free cash flow, and dividend that back to shareholders. One additional driver is you're seeing industry consolidation. We saw some takeover activity last year. One of our portfolio companies, for instance, received a takeover bid, and they felt that the price was not as high as it needed to be. They ended up actually declining that. Even today, we still see the valuation levels remaining very attractive. We owned three paper and packaging companies. One listed in Ireland. One in Australia. Then, one more in Finland. I would say ... What I've just described is fairly consistent, across all the different geographies.
Remy Blaire: Well, it's very interesting that you mentioned the boxes that you are seeing for all the packaged goods that are arriving at our doors. I do Internet shopping. I think that highlights a trend, in terms of retail and technology and disruption. Pawel, I want to ask about your take, in terms of disruptors. What are you seeing right now, in terms of eclectic vehicles, and that's a big theme, when we talk about disruption? Can you give us your take on that?
Pawel W.: Yeah, sure. Electric cars and disruption more broadly, we like to partner with disruptive technologies, or companies or products that do benefit from disruptive technologies. The way we think about it, we like technologies that have very steep learning curves, that do have these exponential improvements, that get cheaper every year and better every year, like semi-conductors are a good example, right? But you have also sensors, solar panels, all sorts of different technologies that every year are getting better and faster and cheaper. Electric cars, yes, we like electric cars, because they benefit from almost exponential improvements in the rechargeable [inaudible 00:31:29] battery.
Pawel W.: That's a product that basically every year gets better, in terms of dollars per kilowatt. I think the improvements we've seen in rechargeable batteries is something of the tune of 15, 20% every year. They're getting better and cheaper every year, because of scale economies in these big battery plants, because of technological improvements, and it looks like it will continue for many years to come. Electric cars will get better and cheaper, and if you think about why an electric car could potentially be disruptive is because of lower costs of ownership. Electric cars, when you buy one, let's assume the same price than an internal combustion car, it's cheaper to own. These cares have very few moving parts. The engine has thousands of moving parts. Electric car has very few moving parts. Maintenance costs are lower.
Pawel W.: They typically last longer. They don't break as fast, so the depreciation costs are lower. The electric motor is extremely energy efficient. That's very important. Every time you charge an electric car, you will save money, relative to fueling an internal combustion car. Lower cost of ownership, and if you think about it, if I can buy it at the same price, it starts to make economic sense. In the past, of course, electric cars were expensive. But with lower and lower battery costs, that dynamic is becoming to play out, and be very interesting. We like to partner with these types of products, these types of technologies. Not necessarily with fluid electrical company, but potentially for the supply chain to the battery pack or to the electric motor. That supply chain is very developed in Asia. We see some interesting companies also in Europe that supply electric motors and machines to make electric motors. There's a whole supply chain that we like and would love to investigate further.
Remy Blaire: Well, could you also shed light on how your participating in the evolution of electronic vehicles, and also other ESG trends you're watching?
Pawel W.: Right now, the way we are participating in the growth in electric cars would be through specialty chemicals. The battery has the anode and the cathode, and we actually like the cathode part of it. This is where the secret source is to make the battery more efficient, more energy efficient. This is where the cost reductions are happening because of better chemistry. We like companies that have the secret sauce for the cathode. Specialty chemicals is one way to play the trend. We also like some engineering companies in Germany that help assemble the entire power train. It's a very dynamic space. There's a lot of growth, and there will be a lot of new players coming in. It's still not clear who the winners will be, but it's one of the very interesting industries we are watching.
Remy Blaire: Kevin, what about yourself? Is there anything you're watching in the space? Do you focus on any ETFs that are based on smaller companies that is applicable to the space right now?
Kevin Ross: Yeah. A couple thoughts. On the EVs, we have high respect and regard for the South Korean battery manufacturers. They have been growing their top lines about 30% over the last couple of years. That's expected to accelerate to about 50%. They're very close to break-even. I think within the next 12 to 18 months, you'll start to see them turn profitable. Some of them, the valuations do not in our view ascribe the full value for the EV businesses that they have. That's a part of the supply chain that we've been spending quite a bit of time. You also mentioned ESG. I think one thing that I didn't talk about earlier, in the context of Japan, is Japan is going through a revolution, in terms of improvements in its ESG, particularly on the G side. The governance sides. There's been some laws and reforms tied to the stewardship code, and the corporate governance code, which we think can unlock a lot of value in many of these particularly small caps but in general the overall equity market will benefit. Really, it's focusing on a couple of key areas. One is reducing cross shareholdings.
Kevin Ross: Many of the Japanese corporates would own small equity positions in a number of their suppliers, or sister-affiliated companies, which is not the most capital efficient way of managing your balance sheet. Another area is pushing them to improve their dividend payout ratios. Japan, historically, has a below global average dividend payout ratio, with many companies that were overcapitalized, and this is resulting from over a decade of low inflation in their markets. Then, the third point is really pushing them to improve their ROEs and have set ROE targets. All of those three areas - improving ROE, improving dividend payout ratio, reducing cross shareholding - we think that should allow the market in general to re-rate over the long term. I was just in Japan at the end of March, a meeting of about 25 different companies. This particular topic came up in almost all of my meetings. It's something that is happening on the ground today. It's a gradual process, but we're very enthusiastic about the development.
Remy Blaire: Gentlemen, before we move on, I do want to get a summary, in terms of your individual approaches. Now, it seems as though diversification is very, very important for both of your strategies. This was a discussion on international investing, so in a nutshell, if you had to summarize what your strategy is to an advisor as well as a retail investor, what would you say, Pawel?
Pawel W.: Well, the goal of our strategy is not only to deliver good performance relative to the benchmark, but we also are very careful about risks, and volatility. Our goal is to deliver that performance. We're actually not taking more risk in the market. If you look at the historical patterns or returns of our strategy, we have very good capture on the way up, and very good downside protection in down markets which we think is very, very important ... When markets are down, we'll protect the capital of the strategy.
Remy Blaire: Kevin, what about yourself?
Kevin Ross: Yeah, I think we have many similarities. We try to own quality businesses trading at attractive valuation levels. We want to have a multi-year holding period. We have very cost and attack sufficient strategies, given that we have low turnover. We want to protect capital on the downside. Generally, our downside captures are in the 80%$ range. Then, we want to participate in upside markets like we've seen this year to date, and in 2017. We think that we can add a lot of alpha, being in the small cap part of the market, where the markets are naturally inefficient, and those inefficiencies are going to remain in place, and in our view, with [inaudible 00:38:06], too, and other regulations should increase, over time.
Remy Blaire: We're all familiar with what's happening, in terms of the federal reserve, the Central Bank here in the US. I think going forward, it will be important to continue to listen to what the Fed's speakers say. But in an ideal scenario, for both of you, starting with you, Pawel, what would the ideal scenario for international investing look like? What would the macro picture look like, and what would the fundamentals be?
Pawel W.: I think you have seen, historically, those long periods, multi-year periods where international markets outperform the US. Then, they underperform the US, and it's driven by different economic cycles. Of course, currencies are very important. Now, we are coming out of a very long period since basically 2008 when international markets are actually underperforming. Underperforming the US. That's driven by a number of things. European, as I mentioned before, delays with the QE programs. Currencies are playing a major role. But I think the US dollar is pretty expensive, if you look at various indicators. If that would turn, I think the returns from international markets will significantly improve, in dollar terms.
Remy Blaire: Kevin, you?
Kevin Ross: Yeah, I think we're kind of in the sweet spot right now, where the Fed is on pause, but the US economy is still growing. The global economy, the gross seems to have stabilized, following the weak period that we saw in the second half of last year. If you look at the IMF stats, they're expecting things to go up to three-point six percent. Global GDP growth next year from three-point three percent. Today, if we don't have any additional rate hikes, from the Fed over that period of time, and as was mentioned, we think that the dollar is also overvalued. That sets up for a very interesting proposition, we think, for international equities, where you have stronger global growth. You have no hikes from the Federal Reserve, and potentially a weak dollar. We think the markets look quite favorable today.
Remy Blaire: When it comes to any type of investing vehicle, or even a sector, we know there are a lot of common myths and misconceptions. I think with international investing, it's such a broad topic. If you could highlight any misconceptions that you see out there, whether on the advisor side or from the retail investor, and you want to clear that up, what would that be?
Kevin Ross: Well, I think the big misconception, and this is just natural given that the US has outperformed over the last 10 ... Years, is investors should look and focus on the diversification benefits that international investing can offer them. I think it's important to look at what is the global equity market contribution from the international markets? The US only accounts for about a third to 40% of global GDP, and global equity market cap. Most US investors, most US advisors, have probably more than 80% of their equity allocations to the US. There continues to be a pretty significant home bias. I would argue let's not look at what the last 10 years of returns have been, but let's look out over the next 10 years, given currency dynamics that we've discussed, given valuation levels, which look much more attractive in the non-US economies, given the economic recovery, which we think has been lagging in the US. We think that sets up for a long-term return stream that should look quite favorable, on a relative basis.
Remy Blaire: Pawel, what do you think?
Pawel W.: I totally agree. I think we have this recency bias that everybody's looking, "Oh, US has outperformed, so I don't need to allocate so much for international markets." However, international markets do offer some fantastic growth companies. Through active management, especially, you can participate in the growth. You can also participate in the growth of emerging markets, which obviously have higher growth rates than in the US.
Remy Blaire: There's a reason why these misconceptions exist. What kind of education do you think really needs to take place?
Kevin Ross: Well, I think investors, it's important to partner with active managers that can educate them. They need to understand what they're owning. I think that's also why it's challenging to own an ETF in this space, because there's a lot of different risks that you're taking on, from political, regulatory, and currency. If you don't know what you own, it's likely that in a period like last year, you're going to be selling, which is not a good time to be getting out of these markets that we've seen year to date. Working with an active manager, and someone that has deep experience in these markets we think could be valuable from the education standpoint, as well.
Pawel W.: Yes. I think there are also more opportunities ... In international markets for active managers than in the US. These are big markets. There's less information, less liquidity. Coverage is not as good. Companies, sometimes, don't report as well as in the US. There’re more opportunities for active managers to kind of play for those market inefficiencies than in the US, I think.
Remy Blaire: When it comes to the US, we're living in the US right now, so we know what the perspective is here. But I understand both of you travel overseas, and you have conversations about investing in the US as well as overseas. What are you hearing from people when you travel regarding the US markets?
Kevin Ross: I think people are, I'm personally, and I think the folks that I talk to were surprised that the down draft that we had in the fourth quarter of last year, and similarly, people are surprised with the sharp snap back that we've seen year to date. I think we, our team has been seeing decelerating economic data points going back to last summer. Globally, but then also in the US. The volatility I would say has been the biggest surprise over the last nine months.
Remy Blaire: Sure. Pawel, what are you hearing in your conversations?
Pawel W.: I agree. There was a bit of surprise about the volatility. But I think generally speaking, there's a little bit of complacency about the US markets. They have done so well, and the run was also pretty narrow in terms of [inaudible 00:44:17] and tech. I think valuations there are becoming pretty extreme, relative to international markets. That's clearly something on people's radar screen.
Remy Blaire: We just returned from the long holiday Easter weekend here in the US. The equity markets hit all-time intraday or closing highs, in terms of the NASDAQ S&P 500. But on the heels of the latest earnings, we saw a pullback again. When we look at those financial headlines, we hear about how this bull run is continuing, but there's a lot of risks involved that aren't mentioned in the headlines. For international as well as domestic investors, what are your key takeaways? What do you think the viewing audience should keep in mind as we head into the rest of this year?
Kevin Ross: Well, I think the old adage, "Selling may go away" is something that I'm thinking about in the context of the US, because we're close to that point. Given the sharp gains that we've had year to date, does that come to fruition for the summer or the rest of the year? I think it's certainly in the US context I would be excited about the year to date gains. But just thinking about what the upside opportunity is and looking for a basis. We always think about the upside in the context of the downside, as well. What are the downside risks, relative to your upside? From my perspective, that doesn't look very favorable today in the US context.
Remy Blaire: That expression, "Selling may go away," for viewers who are not familiar with that, could you explain what it means?
Kevin Ross: Yeah. Generally, markets, seasonally, I would say, have a strong run, first couple months of the year, and then generally the summer lull. Traders are away from their desks. You kind of see a little bit of a pullback, and then seasonally, a sharp rally into the end of the year. That's something that we're thinking about for this year.
Remy Blaire: Pawel, what about yourself? What are you seeing?
Pawel W.: Well, I'm, again, going back to the complacency comment before, this year has been one of the strongest in history, in terms of performance in the first few months of the year. I think investors have assumed that the Fed will stay accommodative. That rates are not going to go higher. Maybe, the Fed will even become to cut rates. I'm not convinced that that's the way necessarily the policy will go. I think we will be cautious about that complacency about the monetary policy going forward in the US.
Remy Blaire: Gentlemen, before I let you go, because you both have a different approach, so what do you think of each other's strategies?
Pawel W.: [crosstalk 00:46:54].
Kevin Ross: I think, no, I certainly, getting back to what I said earlier, and I think you would agree, that international markets are a great space to be an active manager. The inefficiencies that exist in these markets are so high, and only going to increase, going forward. I think both strategies can be successful. I think if you're an allocator, certainly, look for experienced managers, and make sure that they have philosophies that they can talk about, explain, that are consistent with over time, applying those. I think there's place for both strategies, and other firms with similar styles.
Remy Blaire: Pawel, what do you-
Pawel W.: I agree, what you just said. International is a great place to be right now. Valuations are more attractive. The cycle is less extended. Stay with quality. Stay with managers that have good track record, and a good process.
Remy Blaire: Before I let you go, could you tell me a little bit about the philosophies that you have high regard for?
Kevin Ross: Well, I think we believe in quality, and we believe in value. We also believe in small cap. We think all of those market inefficiencies and anomalies, if you will, can drive alpha in the international equity markets.
Remy Blaire: Last but not least, Pawel, what is your take?
Pawel W.: I do believe in fundamental investing, and I believe in understanding the sector you're investing in. The companies you invest in and trying to spend time to the differentiated point of view from the market. That's the only way that you can constantly deliver performance. It's really a combination of a good process and fundamental analysis.
Remy Blaire: For the final question, before we wrap up this segment, we're heading into the rest of Q two. People will be paying attention to fundamentals, and what's happening from the central banks. But we also have to keep an eye on what's happening in Washington, DC. Of course, international politics. The debt ceiling. The partial government shutdown was the longest in history, but in terms of economic growth, we're seeing those effects subside as we get the economic data out from the government. How do you see those risks affecting the international markets, as well?
Kevin Ross: I think the data points coming out of the US still suggest fairly moderate to slightly strong GDP growth. We haven't seen a material slowdown. That's certainly not our base case from the investment committee that I sit on with the other US-oriented colleagues. I think soon, we'll start looking out into the election next year. I think that's another risk that we haven't talked about so far in the US context, is there's going to be elections, and politics drive a lot of volatility. I would expect that to be the case probably later in the fall this year as well.
Remy Blaire: If you could just highlight a little bit some of those election risks, and how you're preparing for that.
Kevin Ross: Well, it's not just election risks in the US. You had elections in Indonesia earlier this year. You right now have elections in India, for instance. Our view, I mean, given that we're not political experts, is we tend to take a more conservative approach in advance of the elections. We don't want to be ramping up our allocations, per se. But it's something that we try to understand what's going on the ground, what is everyone expecting, in terms of base case? Then, what are the risks for things changing relative to that base case that could disrupt the capital markets? You have reforms going on in Brazil. There's a lot of political dynamics happening on a global basis that we're monitoring.
Remy Blaire: Pawel, what is your take?
Pawel W.: Of course, we are watching the macroeconomic fundamentals in a number of countries, looking at their positions in terms of external debt, in terms of their dollar reserves, inflation, et cetera, et cetera. We kind of create a heat map. Which country maybe has more risk. Which has less risk. There are a lot of countries, there are a lot of emerging market countries where the market economic situation is not perfect and could create some sort of volatility and even systematic risks going forward. Also, I am a little bit concerned about some, well, some Southern European countries which still need some fundamental reforms. Especially of their labor markets, and those reforms are not happening as fast as I wish. That could be a source of future volatility, if growth generally slows down. These are the risks we are constantly watching on the macroeconomic level.
Remy Blaire: Well, gentlemen, we could have an entire discussion on the US election coming up in 2020, but we will close today's discussion. Thank you so much for insights on international investing today.
Kevin Ross: Thank you so much for having me.
Pawel W.: [crosstalk 00:51:33]. Thank you.
Kevin Ross: Thank you.
Remy Blaire: Thank you for watching the International Investing Masterclass. I was joined by Pawel Wroblewski, Director and Portfolio Manager at ClearBridge Investments and Kevin Ross, Senior Vice President and Portfolio Manager at Advisory Research Investment Management. From our studios in New York, I' Remy Belaire for Asset TV.