MASTERCLASS: Fixed Income - February 2021
February 10, 2021
Jenna Dagenhart: Hello and welcome to Asset TV's International Investing Masterclass. We'll explore the state of the global economy and different approaches to international investing and where to look for opportunities today after what's been a very volatile year. Joining us now are three portfolio managers, Eric Braz of MFS Investment Management, Steve Nguyen of Causeway Capital Management, and Danton Goei of Davis Advisors. Everyone, thank you for joining us and Steve, starting with you, why go international and why now?
Steve Nguyen: If you look at rolling three-year returns dating back to the 1970s, there have been four or five distinct periods where international equities did outperform US equities, in some cases quite dramatically and for a period of several years. Recently, the US has had an amazing run of out-performance versus international equities, pretty much since 2010. The duration of this out-performance in terms of US versus international is about three times longer than the run of US out-performance in the early '90s, nearly twice as long as the out-performance during the run-up to the TMT bubble in the late '90s, and on a valuation basis, the US is becoming increasingly stretched versus international markets with the US versus international relative PE multiple now at the very high end of the range dating back to 1970. It's true that the US has traded at a premium for most of the time since 2000, but this premium has now reached about 50%, a level which was last only seen after the TMT bubble and after the global financial crisis. Clearly, international has underperformed, but what would change the tide? Why invest now?
Steve Nguyen: I think one thing about the makeup of the US market versus the international market now is that tech has become a dominating component of US equity indices. Information technology is about a third of the MSCI USA Index today while it's less than 10% of the world ex-US Index. While we certainly wouldn't want to bet against some of the top US tech companies, what certainly is clear especially recently is that we're entering into a period of increasing regulation for some of the top technology companies, and we do think that is one of the reasons for why the tremendous growth that these companies have enjoyed for the past decade is likely to slow at least on relative basis going forward. On the other side of things, we do expect a strong recovery to eventually take place once we've put COVID behind us. We're seeing that some regions like Asia and Europe have been able to begin to reopen their economies in advance of the US, so a faster recovery out of COVID could also be a catalyst for international stocks to retrace some of the recent under-performance.
Jenna Dagenhart: Certainly, and I know we'll touch on COVID during this panel as well. Now Danton, when it comes to investing outside of the US, it seems like advisor interest is increasing. This might be driven by weakening US dollar or evaluations of non-US stocks. Why do you think now is a good time for investors to look outside of the US for opportunities?
Danton Goei: Well thanks, Jenna. I think if you just take a step back and you think about the opportunity, it really is huge internationally, right? If you think about the fact that 96% of the world's population lives outside the US, the fact that 76% of the world's GDP is outside the US or even that 83% of the world's listed stocks are outside the US. You're really fighting with one arm tied behind your back if you are only focusing on a single geography and ignoring that. That's really where the opportunity is. The other thing is, is that the growth is there as well, right? If you think about the last 11 years, since 2009, the global middle-class has grown by about 800 million to 3.8 billion today, but over the next five years, another 800 million are forecast to join the middle class.
Danton Goei: Then the next five years after that, from 2025 to 2030, another 800 million. Over the next decade, you can expect around 1.6 billion consumers joining this global middle-class, being consumers for all of these international companies and driving growth there. The opportunity is there, the growth is there, and like we discussed earlier, the valuations are really attractive today. If you look at the international indices versus the US one, right now, there's a 22% discount in terms of PE multiple for the international index versus the US. Then if you look beyond that at some certain indexes for example the MSCI China Index is at 28% discount, or even the Hang Seng Index in Hong Kong, that's at a 46% discount to the US S&P 500. You can find markets where there is a big, big discount as well. The opportunity growth, and then today, the valuation makes it likely that over the next decade international stocks and markets might outperform US ones.
Jenna Dagenhart: Eric, building on the global versus domestic debate, what are some of the benefits of looking internationally right now?
Eric Braz: For starters, thanks Jenna for having me. It's great to be here. For frame of reference, I co-manage a global small mid-cap core strategy, which is basically go anywhere buy anything strategy with our loan restriction being market cap. Basically, what we're trying to do is identify the best ideas globally, and so when we think about the benefits of international global investing versus domestic, we really think there's two things that are attractive and allow us to generate alpha out-performance. The first one is the opportunity set. The benchmark we're measured against is over 7,000 names, and so we only need to identify or pick than 1.5% of the names in our index to create a unique hundred named portfolio. We think that's a very doable undertaking. Then the second thing is really the research coverage. When I think about large cap versus small mid-cap where we play, or even domestic versus international, I think what you find is that there's less coverage in small mid-cap than there is in large cap. There's less coverage internationally than there is domestically. Also, that international coverage from our perspective is less robust, so at the end of the day, we have a broader opportunity set that is less well known or less research, which creates more opportunity to differentiate and identify new ideas.
Jenna Dagenhart: Now, spending a little time here on different investment opportunities, Steve, where are some of the areas where you're finding value in the current environment?
Steve Nguyen: We think that clear opportunities within value in the current environment are in cyclical companies where near term earnings are impacted by COVID, but where valuations relative to modern term earnings power of these companies are close to all-time lows. In particular, we think banks and financials look attractive here. European banks are trading at record lows in terms of forward PEs relative to the market trading at less than half of the market PE. One thing to emphasize is that this time around this is a healthcare crisis, it's not a financial crisis, so while earnings have come down for banks, the vast majority of the reduction in earnings is due to increased loan loss provisions, which we think will clearly normalize to lower levels once economies begin to recover from COVID.
Steve Nguyen: It's actually less of an impact than you might think from lower interest rates. Even with heightened blown loss provisions, we think European banks have healthy levels of capital. They have more than tripled their capital levels since the global financial crisis. For this reason, we don't expect European banks to have to raise equity capital, which is a stark contrast to the global financial crisis where shareholders got massively diluted. We do think that these banks will emerge from this with an excess capital position, and they're poised to buy back significant amounts of stock, which can be extremely creative given that some of these banks in Europe are trading at discounts of up to 70% of tangible book value. In fact, one of our European bank holdings, a major Italian bank has excess capital that amounts to over 100% of the current market capitalization.
Jenna Dagenhart: Steve, I know you're not the only one on this panel who's bullish on non-US financial companies. That being said, I'm going to pass it over to you, Danton. Your international portfolio contains some non-US financial companies. Why do you think non-US financials are compelling today? Could you highlight some of your top ideas?
Danton Goei: I would start with the fact that you want to be selective obviously. It is a huge world out there, and so the number of international financials runs the gamut. When we look at international financials, we've chosen a few select ones in very strong economies. For example, we've invested in the leading bank in Norway, DNB, the leading bank in Denmark, Danske Bank. Those are two strong economies are actually navigating the COVID waters relatively well. We've invested in the top bank in Singapore, which is one of the rare AAA-rated economies and countries out there, a very well-run bank as well. You want to really choose rather than some of these maybe large mega banks, really choose some really well-run banks in strong economies. For example, DNB in Norway is three times, for example, the size of the number two, so it's a real competitive advantage in terms of scale and presence.
Danton Goei: It also helps that the Norwegian government's a 30% owner, so you have a strong backing from the government there as well. They have a very, very strong capital ratio with 18% tier one capital ratio, so they're entering this recession with a very, very strong balance sheet, low costs as well. It's an economy where, because of the oil fund and the sovereign wealth fund that they've invested, there's over $200,000 for every man, woman and child in Norway earmarked for them in the sovereign wealth fund. It's a very strong economy, and it's also one where the government and the social support system is very strong, so unemployment benefits are very, very high.
Danton Goei: When you think about loan losses during a recession or during this pandemic, they've actually been very low because unemployment has been low. Actually today, unemployment is back down to 5%, so a very manageable level of unemployment, strong social safety net, very well-run economy, and the leading bank there with a very strong capital ratio, and all this trading below book value and about nine times earnings. You can think about the earnings deal to being around 11% and what kind of dividends can they eventually pay on that, that will be a very strong dividend as well. We expect strong capital return to shareholders as well. You find these real gems if you look hard enough, and then hold onto them for the long-term. This looks like a great long-term holding, DNB.
Jenna Dagenhart: Steve, anything you would add to that?
Steve Nguyen: We would agree with a lot of Danton's comments about European banks broadly, but also specifically looking for those that operate in strong markets and have strong positions. I think maybe one thing also is that we really want to make sure that we believe in management, especially throughout this time period where there's so much volatility. It's really important to make sure that management teams are doing what they can to manage the cost structures, provide visibility to investors and really position their companies to outperform once we come out of the crisis. We've tried to step up our engagement with management teams throughout this cycle, especially with greater advent of video conferencing, we're actually finding it in some cases easier to have more frequent access to management teams to make sure we're all on the same page.
Jenna Dagenhart: I see you nodding your head, Danton.
Danton Goei: Yeah, that's a great point to the fact that even though unfortunately, we can't meet management teams in-person, access has actually been quite good. Steve's absolutely right. You want to focus a lot of management. I mean, I'm thinking of, for example the management team at Development Bank of Singapore. It's been the same CEO for the last decade. He has compounded earnings at 13% a year for the last decade, and he's still in place, still young. We expect them still to be there for the next decade, and it's a very well-run bank and again, another strong economy. You want to find opportunities like that where you've got stable managements, strong track record, and a good position to run over the next five to 10 years as well.
Jenna Dagenhart: Eric, are there any regions or sectors where you're particularly bullish?
Eric Braz: Yeah. We actually try not to be too aggressive on either the sector or region bats, and that's not to say that we can't be over or underweight to a given sector or region at some point, but generally we want stock selection to drive our returns because we think that's really where we can differentiate. For us, it's worked. We look at 80% of our cumulative performance over the last five years has really been driven by stock selection, so we feel we're going to kind of continue to leverage the MFS global footprint and research platform to kind of turn over those rocks and find the best global companies. We try to stay away from making the big bats either way on sectors or regions.
Jenna Dagenhart: Yeah, and I'll ask you a little bit more about your process in just a moment, but before we get there, Steve, why do you think value is underperformed and what catalyst do you anticipate that could bring value back into favor with investors?
Steve Nguyen: It has been a frustrating period as a value investor. There's a lot of different ways to measure relative performance of value. One thing we've looked at recently is if you look at one year of trailing performance of value relative to growth, we've now reached extremes, exceeding levels going back to at least 1997, so it is a remarkable run of under-performance. Certainly, some of this under-performance of value, we think could be explained by lower interest rates. In a lower interest rate environment, there's more of an encouragement for investors to ascribe a greater value to longer duration growth stocks that in some cases can have little to no earnings today, but a very long promising runway of potential growth ahead. We'll be the catalyst to reverse this streak of value under-performance.
Steve Nguyen: We do think that this current situation we're in with COVID could be one we think that there ultimately could be a sharp recovery from COVID where a value stocks that tend to be more cyclical and more economically sensitive will suddenly fall back into favor, particularly as earnings growth for these companies really begins to benefit from the recovery cycle. As a kicker, we would expect that some of these value stocks could also re-rate on higher earnings as investors learn again to appreciate the attractive attributes of some of the stronger cyclicals, such as oligopolies stick markets, barriers to entry, economies of scale, characteristics that today are really being thrown to the wayside just because of some of the near-term headwinds that these companies are facing. One final thought on catalyst is that for some companies, Danton mentioned banks, some companies may actually have as scope to return capital to shareholders as the recovery kicks in, and we do think that shareholder returns such as buybacks, especially at very low valuation levels can often serve as a catalyst to kickstart stock out-performance.
Jenna Dagenhart: Yeah. Spending a little bit more time here on your different approaches to international investing, Eric, what would you say is the differentiator in your process?
Eric Braz: I really think there's three things that differentiate MFS and our strategy. I think the first is that in MFS, we really pride ourselves in this collegial, collaborative culture where we feel that the sum of the whole is greater than the parts, and so there really are no superstars at MFS, either amongst the PMs or analysts. We are genuinely trying to help each other in any way that we can to drive our performance. The second one is what I've touched on a little bit earlier is our global footprint. We have the feet on the street and the ability to turn over a lot of rocks. I referenced the broad investment opportunity set that wasn't well covered. Well, we have nine global offices where we have PMs and analysts, so we feel that we can canvas that opportunity set pretty well.
Eric Braz: The third one is really taken a longer-term view. Time arbitrage is our friend, and we think market volatility creates opportunity. When you put these three things together, in our strategy, we feel as though we're able identify long-term winners and more importantly avoid losers. Going back to the first question you asked me regarding international global versus domestic, again, we have this broader opportunity set that is less well-known. I think that creates again more opportunity to differentiate, and we have 95% active share, and so we are differentiated from the benchmark. Again, that stock selection drives 80% of our accumulate returns, so we feel as though the process is working. We're going to continue to stay the course.
Jenna Dagenhart: Yeah, and you mentioned volatility, there's been no shortage of that.
Eric Braz: Certainly.
Jenna Dagenhart: Steve, what would you say differentiates Causeway's value investing approach?
Steve Nguyen: Causeway's process for international value is centered around a bottom up fundamental research with collaborative team approach as well. We do find that the team approach is valuable for our clients as we're not overly reliant on any single individual. Also, a critical component of our process is the incorporation of our in-house quant team, which helps manage our risk insights into the portfolio. We think also really enables this collaborative portfolio construction process. What I mean by that is that we allocate capital into our fundamental value portfolios according to something that we call a rank sheet, and this ranks all of the companies that we have researched on a risk adjusted return basis. It takes all of the return inputs from the work that our fundamental analysts have done from the bottom up, meeting with companies over time, meeting with management teams, doing the analysis on the industries. Then it combines that fundamental work with quantitative risk factor inputs from our multi-variable risk model that our team has developed and has been managing since really the inception of our firm back in 2001. This rank sheet ends up serving as an impartial arbiter of our process, and it allows the fundamental portfolio managers to more productively collaborate when we get together and we discuss the portfolio, helps us determine the optimal mix of the securities in our portfolios.
Jenna Dagenhart: Danton, your investment approach is focused and highly selective. Your portfolios look nothing like the index. They're low turnover with a strategic long-term time horizon. Why do you think this is the best way to invest?
Danton Goei: Well, we start with the premise that if you want different results, you can't do what everyone else is doing, right? Start with that premise, and you look at our portfolios and you're right, they look nothing like the index in terms of there being very selective, low turnover with a long-term time horizon. Our approach is a bottom up approach looking for best of breed companies, let the power of compounding in terms of growth work its magic over time and pay an attractive price in making sure they're run by great managers. You list all those things together, and of course, it'd be great to find those type of companies. It makes sense there's not a lot of them out there.
Danton Goei: The index has about 2,400 companies. There's certainly not 2,400 great or even good companies out there, so when you do come across a great investment opportunity, you want to make it matter, and so you want to make a focused portfolio rather than a cast of thousands out there with an average weighting of four basis points. We have a focused approach. Then if you think about the long-term horizon, really that's what you want to focus on. You want to think about the business over time rather than what is optimized for this current period, rather than thinking this is what's going to happen over the next 12 months. 2020 is a great example of sort of the folly of short-term forecasting, right? Who would've thought a year ago that we would be here today in this environment? You want to think about-
Jenna Dagenhart: Probably no one.
Danton Goei: None of us, I don't think. We want to also be ready for whatever might happen that can come out of left field, and so you want to have strong companies, strong balance sheets, strong cash iterations that will stand whatever happens, and often, it's bad things that happen, and make sure that your company comes out the other end. We've had this strategy at Davis is a focused, low turnover, valuation sensitive approach for over 50 years, so five decades, and it's produced outstanding results over that time. It's a time-tested approach that makes a lot of sense to us or based in common sense, but hard obviously to do in practice. It's all about sort of the on the feet research and finding the right companies, following them for many, many years and eventually making a few focused bets.
Jenna Dagenhart: Yeah, and with this year, it really has been unprecedented, to use a word that's been used quite a bit in 2020, but that being said, Danton, how are you making sure that you are prepared for those left tail risks?
Danton Goei: It starts when we look at a company with the balance sheet, the strength of the balance sheets, whether it's a bank like we were talking about and there in terms of the capital ratios or an industrial, thinking about having a low leverage, or some of these tech companies that actually have a lot of net cash on the balance sheet. Then you also look at their liquidity, and that matters more than ever, right? Before this period, probably it was sort of low on the list, but when we look at investments, we think about balance sheet, liquidity, and then also just the durability of the business. Can it adapt, right? Is it a business where it has tailwinds or is it a business where they're just fighting all these headwinds and they're trying to do a great job, and they actually have a good management team, but all these headwinds are making their job very, very difficult, so is it a business with strong tailwinds? In general, we'd like to find these trends where companies can benefit from them.
Danton Goei: We didn't know that the pandemic would happen, but we have a number of, for example, eCommerce companies in our portfolio just because we felt like the retail was going that way, the convenience is there. We all know that from the number of boxes sitting on our doorstep more and more every year. Then now, something like the pandemic happened and it just accelerated that growth. Even a company, for example New Oriental Education, which is a Chinese education company. That company has been investing in the last two or three years over $100 million a year in online education. They didn't know that the pandemic was going to happen either, but when it did in January and February in China, they were able to put 100% of their two million plus students that were in classrooms into online seamlessly over a two- or three-week period. Just having that foresight of making those investments ahead of time makes a huge, huge difference. You want to also have companies that have the R&D and the foresight for investing for the future.
Jenna Dagenhart: Certainly. Going back to your global collaborative approach, I wonder, Eric, how have you maintained that in the midst of a global pandemic?
Eric Braz: I guess when you think about everything that's going on, there's a lot of things that have stayed the same and there's things that have changed. I think what's most important for us is what hasn't changed is really the investment process. We're still working with our global teams identifying ideas. I think what has changed, and I think the two other panelists spoke to that, is just how you interact, right? Before, I would go to conferences or visit management teams or I'd go on team trips with my counterparts to Asia or to Europe, and now everything's virtual, but at the same time is that everyone's accessible because we're all at home in the same boat. While I's prefer to be face-to-face, I think the technology allowed us to kind of continue what we were doing, at least for the time being and be as productive. There's a lot more Zoom calls or Skype calls or whatever we might have, and management teams are available. Everyone's home and accessible, and so I think management access and even access to some of my colleagues has actually been greater in the pandemic than it was beforehand.
Jenna Dagenhart: Yeah. I think a lot of people would agree with you there and this focus on leadership, management, governance is just really front and center for a lot of people right now. Steve, how does ESG investing fit into your value framework and how do you incorporate it into your process?
Steve Nguyen: Over the past several years, we have actually allocated and dedicated research, resources to developing an ESG framework that we think will help us identify key topics with which we can engage management teams as well as areas of ESG that can lead to superior returns for our clients. Our first area of focus within ESG was governance where we have developed a scoring system that we employ currently across all the companies that we research, both our holdings as well as other companies on our rank sheet that we've done a lot of work on. Our governance framework employs a combination of both top down and bottom up scores with both quantitative and fundamental inputs, and we don't believe an increased focus on governance has to come at the expense of returns. In fact, we've back tested our framework and we find that investing in companies with higher governance scores as we've defined it is actually additive to returns.
Steve Nguyen: Now that we've done governance, we're currently developing similar frameworks for the environmental and social components of ESG. One of the key objectives there is to come up with criteria that we can use to really rank our portfolio holdings and perspective holdings from an ESG standpoint as well as identify key ESG issues on which we can engage with management teams and boards when we communicate with them on a regular basis. One thing that is consistent across how we're looking at E, S and G is identifying factors that can also be additive to returns. As I mentioned, we've back tested these factors, and we think that we can find a balance where there's E, S and G factors that are also have been shown to be additive to performance. We do think that if we're successful in our ESG framework, this will actually enhance our performance over time.
Jenna Dagenhart: Eric, as you really get to know companies and do your research there, how are you thinking about ESG?
Eric Braz: Much like Steve, we actually have some [inaudible 00:27:19] ESG resources and they're globally. We have a gentleman in Boston, someone in London, and we have someone in Asia, and so we're really attacking it on a global basis. What I think is interesting for us or what I've found at least from an analyst and now a portfolio manager perspective is MFS in general has probably a higher quality bias to the names that we typically invest in. What we've found is that we really haven't found very many smoking guns amongst our holdings that are enlarged violations of some of the ESG requirements, but we have found is that there's definitely room for improvement in the companies that we own, and we're becoming more active and engaging the boards and also pushing management on some of the ESG issues. I think that our quality bias has actually put us in a good position, and now obviously with some dedicated resources and those resources has actually been around for years now, and so I think we're taking it seriously, but I think our quality bias has actually put us in a pretty good place.
Jenna Dagenhart: So you're doing that quality screening before a company ever really makes it into your portfolio?
Eric Braz: Exactly. Again, we're typically looking for those higher quality companies, and I think what we've found over time is that the higher quality companies simply don't have some of these ESG issues that you see, but now what we're doing is really pushing them to make sure that they're up to the standards that are necessary to be ESG compliant, and that goes across the E, S and G
Jenna Dagenhart: A lot of other countries are more advanced in terms of ESG compared to the US. Danton, how are you monitoring this as a global portfolio manager?
Danton Goei: ESG is definitely crucial, and it's a crucial component, I think of the very fundamental research that everyone needs to do. We all agree that a publicly traded company needs to generate an acceptable return for shareholders such as pension funds to meet their obligations and financial needs in the future, but you also need to provide acceptable wages and competitive wages for employees. You need to also provide products that consumers think are fair and safe. Then of course, we all want to breathe fresh air, and we all care about the environment, so meeting the needs of all those stakeholders is complex, but at the end of the day, if you're looking at a durable business that is going to last for a long time for the next five or 10 years or even beyond that, you can't have a business that is noxious to the environment, that is flouting social norms and of course the rule of law.
Danton Goei: You need to incorporate that research directly into the basic research you're doing and analysis on the company. We incorporate that initially in our research rather than after the fact and rather than sort of outsource it to a third party. I think those are such important metrics that you want to actually incorporate and do the work yourself, and ensure that the environment, the government, the social contract and guarantees that the company needs to follow are there in the first place. We would say that it's important to actually have this as part of your basic analysis and research, especially if you're a long-term investor.
Jenna Dagenhart: Being proactive rather than reactive.
Danton Goei: Absolutely. Also, just taking ownership and making those decisions on your own rather we think than relying on other people.
Jenna Dagenhart: Yeah. Well, ESG is not going away and a very important topic. Now, I want to spend a little bit more time on the current landscape. Eric, how would you describe the global market environment? I know you mentioned volatility earlier.
Eric Braz: Yeah. If I had to choose one word to describe the environment, I think it would be volatile. Needless to say, and maybe unfortunately, there's a lot going on domestically and international that can move a stock or a market on any given day. We feel as though our job is to filter through that noise and take advantage of the volatility, so when you take a long-term view like we do at MFS, we ultimately think volatility is our friend and provides opportunity. When you think about market dislocations like we saw in March, we think that provides an opportunity to kind of either increase the quality of portfolio or start new ideas that might've been on your watch list. It's kind of the idea of throwing the baby out with the bath water.
Eric Braz: Maybe we own a stock that we don't have a full-size position, but all of a sudden, the market sold off and it got a lot cheaper. Maybe we can make that bigger and we can sell a name in our portfolio that maybe is not as high quality or on the same side, we do a bunch of work on a name, a couple of names are on the watch list, but we couldn't get their evaluation, now everything sells off. Again, it gives you that opportunity where you can add it to the portfolio. At the end of the day, volatiles the word I'd use to describe the environment, but again, we look at volatility as an opportunity to make the portfolio better.
Jenna Dagenhart: Yeah. Volatility is certainly very important for investors. Now Steve, how has this cycle differed from past cycles?
Steve Nguyen: An obvious difference with this cycle is that it's as a result of a healthcare crisis, which certainly contrasts at least with the last cycle where it was a financial crisis. Because it is a healthcare crisis, our healthcare research team has been spending a lot of time this year trying to understand various aspects of COVID from how the infection is spreading across different states and different countries to how therapeutics, diagnostics, and testing as well as vaccines could ultimately help our economies adapt and recover. On the positive side, what's unique about this cycle is that a healthcare solution, meaning the development of one or more vaccines that can be deployed on a widespread basis could ultimately provide an immediate panacea, which is not something that was available in prior cycles. Not to say that the recovery will be instantaneous, but at least there's an event out there that could really provide an immediate catalyst to recovery. It's certainly true that investors are to some degree anticipating the eventual development of a vaccine. We do believe that the uncertainty surrounding the timing and efficacy of any vaccine is still driving this extreme aversion to owning cyclical stocks right now where the shape of earnings recovery remains highly variable, especially in the near term.
Steve Nguyen: We're trying to take a longer-term view, probably two or three years out and we do see some tremendous opportunities to purchase high quality companies, in some case cyclical companies at deeply discount evaluations. This is actually where we think the cycle will play out similarly to past cycles. If you look at previous cycles like the tech bubble and like the global financial crisis, there were cyclical industries such as banks, industrials, and materials that did significantly outperform during the recovery phase of the cycle. Now this year, the markets bottomed back in March and cyclicals have done okay since then, but returns have still fallen well short of what has been seen in past recovery periods. This is not surprising. It's because we still don't have that healthcare solution yet. We haven't actually successfully developed a vaccine. We think the time to own these stocks is now because they will move so quickly once the markets do begin to anticipate in near term recovery, that at that time we think it might be difficult to build up a more meaningful position
Jenna Dagenhart: Danton, I know you've had some success investing in China. You mentioned the e-learning example, and seeing Eric mentioned about sifting through volatility made me think how do you navigate the daily headlines coming out of China to find the right opportunities? Can you share some of your top ideas?
Danton Goei: Certainly. I mean, certainly China has been a volatile area the last couple of years for a number of reasons, but if we take a step back and think the headlines have been there, the volatility has been relatively high in recent periods, why bother with China? If you take a step back and think about the fact that, just like a business, you want to look at the track record there and management's track record, and then of course at the valuation. If you look at the track record there, obviously it's been quite stellar. You think about since 1979 to 2010, the last 30 plus years, their GDP grew by 9.9% a year, almost 10% a year for 31 years, so an amazing track record of growth. In that year in 2010, they became the second largest economy in the world surpassing Japan, and only second to the United States. They have a number of huge competitive advantage if you think about the future.
Danton Goei: If you think about the fact that they graduate 4.7 million STEM, science and technology graduates every year, that's eight times to what we have here in the US and we have a great university system here in the United States, but they've got eight times as many STEM graduates every year. They've world-class infrastructure in terms of telecom, airports, high-speed rail and the highway system. They have a lot of competitive advantages that should bode well for the future. They also have a track record of just adding to the middle class. They're raising people out of poverty. If you just think about the last 25 years, there've been 1.1 billion people raised out of poverty, and two thirds of those, 730 million came from one country, China. The track record is very, very positive there. They also have a very high savings rate that is positive in terms of investing for the future, investing in the economy and companies and infrastructure as well.
Danton Goei: What we would say is rather than focus on the headlines, what we're seeing right now, focus on the businesses, right? You don't want to invest based on headlines, you want to invest on a business forecast, and I'd give you a good example. In Q4 of 2018, which was a very, very volatile period if you recall, in fact that December of 2018, I think was the worst December for the market in over 70 years. We saw a lot of the Chinese stocks underperformed during that period because of the trade war that was started in that period. People became very, very worried about what that meant for these Chinese companies, but when we look at the companies that we owned, we own companies that are focused on the Chinese consumer. These are domestically focused companies, have no exports, not in the export part of the economy, and our overall thought is also that because the economy has shifted towards a much more consumer-driven economy, it is no longer dependent on exports.
Danton Goei: The overall economic growth that was going to only have a very limited impact by the tariff conflict. That's what we saw. The stocks that we own, for example, we took the top four stocks that we own in our international portfolio. These will be Alibaba, JD.com, New Oriental Education, and Maiduan, so large companies, but they're all domestically focused. Those stocks were down 38% in the second half of 2018, so pretty dramatic decline, but if you look at the next five quarters of results as opposed to the headlines and the stock performance, if you look at Q4 of 2018 and the next quarters in 2019, their revenues are up 39% on average for those five quarters year over year. Hard to see with 39% revenue growth and very strong earnings growth any impact on their business. Of course, the stocks performed quite well once people became comfortable with the idea that the impact was limited, and actually the impact on these individual companies was almost immaterial.
Danton Goei: In the subsequent sort of year and a half during 2019, and then the first half of 2020, those stocks were up 169% on average. It's just kind of teasing out the signal from the noise, it's teasing out for the headlines from the actual business performance, which we think is the key. As a long-term investor, that's sort of the approach that we have is really focusing on the business. Like one of the panelists said, sometimes volatility can be your friend, right? In Q4 of 2018, we're adding to these positions, which over the next year and a half proved to be a very good decision. In this period too right now, there's a lot of uncertainty out there, but that also provides a lot of opportunity for long-term investors as long as you're focusing on the businesses rather than sort of the media headlines.
Jenna Dagenhart: Eric, in addition to the heightened volatility, how have things changed in the world of political uncertainty as well as COVID?
Eric Braz: On the political side, it's clearly something that we obviously have paid attention to, but I don't think it's anything that really changes our process, again being fundamental bottoms up investors. Things change and political landscapes can change the environment, but I think for us, if the political environment is what's going to be the sole determinant of whether we buy or sell a stock, my guess is there's probably a better place where we can invest over a multi-year period to make money. If anything becomes too polarizing and is really going to drive one equity one way or the another, we try to stay away from that. We're trying to be cognizant of what's going on in the political environment, but again, being fundamental bottoms up, we do try to stay away from prognosticating on what's going to happen. If there is something that's going to drive a stock yes or no, then we'll try to probably stay away from that. We can invest in a better-quality company that should outperform over a multi-year period.
Jenna Dagenhart: How about COVID?
Eric Braz: Same thing. I think its kind of the same thing on COVID. Actually, the other day at MFS, our small cap value manager came up with this idea of a quadrant where you have long-term winner COVID winner, long-term winner COVID loser, COVID winner long-term loser, and then loser. At the end of the day, we're really trying to identify that top quadrant or the one, either the COVID winner and a long-term winner or a COVID loser but a long-term winner. Those are the places we want to play and what we're trying to identify, and we're trying to stay away from the other stuff. We're not going to explicitly try to play the stay-at-home basket if we don't think that stay-at-home basket is sustainable over a multi-year period. We're not trying to play the game where we get a one-year pop and we're going to buy some stocks outperform to play a short-term trend. Again, we're looking for high quality franchises over a multi-year period, again being a long-term investor.
Jenna Dagenhart: Now, Danton given everything we've just talked about, what risks are you focused on when investing overseas and anything else you'd like to highlight about your process?
Danton Goei: Yup. When we're looking about overseas, it's similar to investments here in the US in terms of the business risks, of course around the financial strength of the business, the long-term prospects, and then management, but then you also have, of course the added layer of the international aspect, the different political situations, economic situations, and then today, of course health situations in each of these countries. That is a big focus. We try to be very selective in terms of the countries that we invest, so you want to have countries where there's a real political stability, a real rule of law, and also just a government support for businesses, right? There's just an idea that businesses are going to be part of the solution, that the country is going to do well with a stronger business and a stronger sort of industry in the future.
Danton Goei: We want to hitch our wagon to those types of countries. We want to be very selective, for example, in our fund. We're in only three or four of the emerging markets where the index is in 26. I think that selectivity at the end of the day is going to be very, very beneficial for shareholders in terms of avoiding risks because like we're seeing, the response for COVID for example, and the results and the impact on the climate has varied a lot by countries. Some countries have been relatively successful and then some countries have had a much harder time, and so just focusing on the strength of each of these countries and the long-term stability, I think is important, and so that's something that we focus on a lot.
Jenna Dagenhart: Steve, what's your macro outlook in the coming quarters and how does it relate to how you're positioning the portfolio?
Steve Nguyen: We think that economic recovery is ultimately not possible realistically until the virus is contained, and that doesn't seem likely until we have safe and effective vaccines that can be widely distributed across major economies. On the vaccine front, we are encouraged by the developments over the past several months. I think vaccines are one of the rare success stories in all of this amidst COVID. Human innovation we think has indeed come together. There's been an unprecedented level of government investments mounting to by account over $15 billion, which has really helped compress development timelines for vaccines that would typically take years and years to develop into what's now looking like it will be less than a year to ultimately come up with a vaccine on last count, and this is changing on a constant basis, but we've counted over 25 vaccines that are in various stages of human trials, including 10 that are in the latest phase or phase three, of which five have received significant investments from the US government. Pretty much all of the leading vaccine and pharma companies in the world are involved in developing a COVID vaccine, so we wouldn't bet against this effort.
Steve Nguyen: We also think that the chances of success in terms of vaccine development are bolstered by the fact that there are multiple vaccine platforms being tested right now ranging from newer technologies, such as MRA and adenoviruses to more established platforms, such as adjuvanted protein subunit vaccines. Even if one platform is not successful, we still think there's decent chances of success for other platforms. We do think that there's a chance that we could get a preliminary vaccine approval before year end, at least in the US in which case we could have broad distribution of the vaccine take place in the second quarter of next year, but even if this timeline is pushed out into early next year for the initial approval, we would still likely have broad distribution of the vaccine by third quarter of next year. That's how we're thinking about the potential pace of normalization of economies once we have vaccine development and distribution.
Steve Nguyen: In the meantime, in the near term, it's clear that policymakers are committed to providing ample stimulus to keep our economies running and try to offset some of the impact from the ongoing lockdowns. In as little as one to two months from the onset of the COVID crisis, we saw central banks around the world immediately act and then act really decisively increasing the size of central bank balance sheets by 40%. There's massive amounts of stimulus being pushed through by governments really around the world, not only in the US but also in Europe and in Asia where you're seeing stimulus amounting to around 15% of GDP in the US and far more in some other countries, and so we do think that governments are incented to try to bridge the gap between now and the ultimate development of a healthcare solution. We think that once we do have that healthcare solution, then the consumer is well positioned for a strong recovery.
Steve Nguyen: This time around, you don't have the same issues with excessive consumer credit or housing oversupply or over-consumption of certain items like autos that you had say the last time around. With stronger consumer balance sheets, we would expect a vigorous economic recovery coming out of COVID, and so we're positioning our portfolios accordingly. While we certainly do have plenty of exposure to higher quality longer term winners, we're also picking our spots in stocks that have been left for dead due to their exposure in the near term to travel or to economic lockdowns. We're of course very cognizant of balance sheet positions at these companies and trying to make sure that from a cashflow perspective, even in this intermediate period, they can bridge the gap and generate some amount of free cash flow. We think that these companies that are really bombed out because of the near-term environment will be well positioned for a rebound once the economy begins to recover.
Jenna Dagenhart: Eric, looking forward, anything that you'd add about your bottom up strategy?
Eric Braz: Yeah. I think at the end of the day, we're really focused on identifying the best in breed, highest quality companies we can on a global basis. To say that we ignore the macro would be wrong. We definitely pay attention, but I'm the economist and I feel like economists are typically wrong, so we're not trying to predict where something's going to go left or right. What we're trying to really do is thinking about more from a [inaudible 00:48:18] analysis perspective, and if this happens and how does that impact our holdings, if this happens, how does that impact our holdings and make sure that we're not outsides when we think about positioning. We talked earlier about how we're not making big sector or region bets, and that's kind of one of the reasons why is because there's a lot of things that can happen and we want to take some of that risk out.
Eric Braz: We're really just focusing on, again identifying those higher quality franchises that we want to own for multi-year periods. When I talk about high quality, it's not to say that we wouldn't own a cyclical company. There's a bunch of companies, like Steve was just talking about, that have not participated in a rally and have maybe left for dead that are high quality franchises. If you think the world goes back, that we can own those. High quality does not mean expensive. It just means someone with good market position and a lot of other attributes that we would like. Again, we're just really focused on being fundamental long only bottoms up stock pickers and identifying those franchise that we want to own for a long period of time.
Jenna Dagenhart: Danton, what will you be watching as we move into 2021 and beyond?
Danton Goei: First, I guess we can't wait to get to 2021 and leave this year behind us. There's a number of trends that you want to see. One would be just interesting to see a lot of behavior has changed during this pandemic, and so will that behavior remain and continue once the recovery starts? For example, work from home, how sticky is that? What are the implications for commercial real estate, for example or even our purchasing and retail habits in terms of eCommerce, will that be as sticky as we expect that to be and continue? For example, buying groceries online rather than going to the supermarket, will that continue?
Danton Goei: What about education on Zoom? We're very interested in kind of looking at some of these trends and seeing what's sticky. There's other ones where we're sort of doubtful. I mean, the sales of Campbell Soup have been very strong, what is the likelihood that we'll be eating canned soup at this level in two years? Maybe less likely if the vaccine is successful, so that's one thing. The other thing of course is that governments, because they've been very supportive during this period have incurred huge debts and fiscal deficits, and so what is going to be the policies going forward in terms of addressing those fiscal budget deficits and those rising sovereign and national debt levels, right? Does that mean we're going to have higher taxes, does that mean more regulation, but we also want to get the economy started, so thinking about the policies that are going to be going forward also.
Danton Goei: Then as part of that, also just thinking about interest rates and inflation is the other area that we're thinking of. These are kind of big picture things. Of course, we're bottom up investors, but these macro things can also over long period of time, over three, four, 10 year period have a big impact, and so the direction of long-term direction of interest rates and will these low levels of rates coupled with large government spending and eventually an economic recovery drive up inflation, which is something we haven't seen for a decade plus now. It's been a long time, but we're also concerned, so keeping our eye on that. While we're focused on the companies that we own, we also have one eye on the road in the future and where things are going to go, and what's going to stick from here and what's going to change over the next few years.
Jenna Dagenhart: Yeah. Cannot get to 2021 soon enough. As we wrap up this panel, discussion, Steve, any final thoughts on your end?
Steve Nguyen: Yeah. There's been a lot of discussion on volatility and the degree to which volatility, especially this year, can act as an opportunity. One of the ways that we evaluate risk in our portfolios is considering portfolio level volatility, and our multiple variable risk models I mentioned will evaluate the impact of any new position on the ultimate volatility of the portfolio as a whole. We are looking to constrain overall portfolio volatility, but balance that against any additional unit of return. What we're finding is that even the volatility has increased, and it certainly has increased both for our portfolio as well as for the broader index. The return that we see, the ultimate return potential that we see towards our fundamental long-term price targets in many cases more than exceeds that increased volatility, and so that's why even if on a risk adjusted return basis, we're so excited about the opportunities that we're seeing throughout this cycle. It will take a bit of a longer-term view. It's certainly been a very rocky ride in 2020 with so much near-term uncertainty, but we do think that if we can sort of stick to our meetings and maintain that longer term view, we'll see out-performance, especially factors like value, same way that we've seen them in previous cycles.
Jenna Dagenhart: Eric, any final thoughts on your end?
Eric Braz: Yeah. I would just say for those investors who have been kind of tentative to jump into the global international arena, I would just say come on in, the water's warm. There's a lot of opportunity there. The opportunity set is broad. The knowledge about that opportunity set is more limited than what you see domestically, and I really think there's a tremendous opportunity there where we can generate nice returns for everyone.
Jenna Dagenhart: Yeah, well said. Danton, anything you would add in terms of welcoming investors who might've been a little bit timid about going international.
Danton Goei: Absolutely. There's so many things to worry about today. Of course, the pandemic, inflation, deflation, geopolitical instability, we have a US election coming up. I think if you take a step back and just think about what we're investing in, in terms of the overall class, equities still seem to be a great place to be. Their relative valuation versus fixed income looks very attractive. The fact that federal reserves and central banks around the world are being very supportive is very helpful for companies and equities around the world. Economic growth, we think will continue, and some parts of the world is still very, very strong. Overall, equities, their ability to adapt to different situations and become part of the growth in the future is very important, and so we think equities continues to be a great, great class to be in, probably the best class to be in. Then international equities is also very interesting. The last decade has been one where US tech companies have outperformed for a number of reasons that we spoke about in terms of the evaluation, in terms of their future growth prospects, in terms of their business models and management teams. International equities today do look very attractive.
Jenna Dagenhart: The tides could be turning. Well gentlemen, it's been a pleasure hosting you today. Thanks very much for joining us.
Danton Goei: Thank you, Jenna.
Eric Braz: Thank you.
Steve Nguyen: Thank you, Jenna.
Jenna Dagenhart: Thank you for watching this International Investing Masterclass. I was joined by Eric Braz of MFS Investment Management, Steve Nguyen of Causeway Capital Management and Danton Goei of Davis Advisors. I'm Jenna Dagenhart with Asset TV.