Over the past decade, international stocks have significantly underperformed their U.S. counterparts. Some investors assume this trend will continue, causing them to question the need for international exposure. This may be a mistake, in our view.
Over the long term, we’ve seen outperformance alternate between the U.S. and international markets, with leadership cycles that can persist for several years. Additionally, an investor who categorically ignores international stocks may risk missing out on some of the highest-quality, best-performing companies available. Here, we explain why we believe now is a great time to consider an allocation to international.
Can International Lead?
In the last ten years, international stocks have significantly lagged their U.S. counterparts, as shown in Figure 1. In a post-GFC era1 marked by persistently low interest rates and accommodative Fed policies, companies often saw incentives to optimize for growth at the expense of profitability. This macro environment was a powerful tailwind to many high-growth and often tech-centric companies. With tech hubs such as Silicon Valley being a fertile breeding ground for such enterprises, the U.S., and its equity markets disproportionately benefited as capital flowed to American companies. Moreover, the past decade has seen the inexorable rise of a handful of dominant technology platform companies, most of which are domiciled in the U.S.
Figure 1: Trailing 10Y Cumulative Performance, MSCI EAFE vs. S&P 500
Source: Bloomberg as of December 31, 2022. Please see Important Disclosures for more information.
Given the magnitude and duration of the U.S. stock market’s relative outperformance, many investors have understandably questioned the need for an international allocation. After all, if the strongest, most dominant companies are in the U.S., why bother investing elsewhere?
However, with history as a guide, we’ve observed cycles of leadership between the U.S. and international that tend to transition amidst bear markets and across multiple decades. For instance, from the Technology, Media, and Telecommunications (TMT) bubble2 low in October 2002 through the end of 2007, the MSCI EAFE index outperformed the S&P 500 index by over +8.6% annualized. Extending the timeframe back to the 1980s and early 1990s, we see other periods of MSCI EAFE outperformance relative to the S&P 500. Historical patterns suggest that U.S. and international leadership cycles tend to mean-revert over time, with bear markets often catalyzing transition.
Why Now?
In 2022, we saw a swift interest rate hiking cycle as global central banks attempted to contain rising inflation. Equity markets saw multiples quickly de-rate, with outsized weakness in growth stocks. Another feature of the macro landscape was a persistently strong U.S. dollar, which posed headwinds for multinationals and international companies. In late 2022, we began to see dollar strength start to roll over, perhaps due in part to market participants’ beginning to anticipate an end to the U.S. rate-hike cycle. We note this because of the long-term correlation between U.S. and international relative performance and the US Dollar Index, as seen in the chart in Figure 2. Continued dollar weakness may also be a catalyst for international outperformance.
Figure 2: Rolling 5Y Annualized Excess Returns (MSCI EAFE vs. S&P 500), US Dollar Index Returns
Source: Bloomberg as of December 31, 2022
Importantly, these developments are happening when international stocks are trading at historically cheap valuations relative to the U.S. On a price/earnings (P/E) basis, the MSCI EAFE index traded at a -24% discount vs. the S&P 500 at year-end 2022. As Figure 3 suggests, there is particular weakness in Europe, where concerns over inflation, geopolitics, and the health of the consumer have driven the discount to -33% vs. the S&P 500 index.
Figure 3: Relative P/E Discount vs. S&P 500
Source: Bloomberg as of December 31, 2022
While it’s fair to argue that the U.S. may deserve a valuation premium given, on average, its companies with higher returns on capital and higher growth, we think it’s worth asking whether relative valuations have more than overshot to the negative. Mean reversion is a powerful force over time and could offer a relative tailwind for international stocks looking ahead.
Understanding Quality in International
Going beyond the argument that international stocks broadly represent an attractive opportunity, we think the more interesting dynamic is at the individual business level. In our opinion, investors often underappreciate the uniqueness of several international companies, particularly in Europe. While the region faces plenty of challenges as noted earlier, it is still home to certain businesses that, in our view, are assets that simply cannot be found anywhere else. Perhaps the best example is in luxury goods, where the timeless heritage of some European brands is impossible to replicate. The Moët & Chandon champagne brand began in the 1740s, Louis Vuitton founded his namesake fashion label in the 1850s, and the House of Gucci dates back to the 1920s.3 Newer brands cannot draw upon the same history and heritage. In this regard, we see select European luxury brands as highly unique assets with attractive competitive advantages.
Beyond luxury goods, we see other European businesses as distinctive, with robust positioning and growth profiles not seen in other parts of the world. Examples include ASML, the dominant manufacturer of EUV lithography machines for the semiconductor value chain; ICON Plc, one of the world’s leading contract research organizations for the pharma industry; Siemens Healthineers, a global leader for imaging and diagnostics equipment; and Evolution AB, the world’s leading provider of online gaming solutions. Many healthy European businesses with robust underlying fundamentals saw their valuations compress significantly during 2022 as the crisis in Ukraine and other factors triggered substantial fund flows out of European equities.4
On the heels of more than a decade of relative underperformance vs. the U.S., we believe international stocks are well positioned to thrive in the years ahead. The combination of historically attractive relative valuations and abating currency headwinds at a bear market inflection point gives us optimism as we look ahead. We think that some of the highest-quality businesses in the world can be found internationally, with valuations today not reflective of their scale and dominance. To us, this spells opportunity.
Important Disclosures
1 The Global Financial Crisis (“GFC”) refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009. During this period, the S&P peaked in Oct-2007 and bottomed in Mar-2009.
2 The TMT bubble was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-based companies in the late 1990s. During this period, the S&P peaked in Mar-2000 and bottomed in Oct-2002.
3 The Moët and Chandon brand and the Louis Vuitton brand are both owned by LVMH. The Gucci brand is owned by Kering Group. LVMH is a holding in the Polen Capital Global Growth and International Growth strategies as of February 28, 2023. Kering Group is a holding in the Polen Capital International Growth strategy as of February 28, 2023.
4 ASML, ICON Plc, Siemens Healthineers and Evolution AB are holdings in the Polen International Growth strategy as of February 28, 2023. ICON Plc and Siemens Healthineers are holdings in the Polen Global Growth strategy as of February 28, 2023.
This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of February 2023 may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.
The information in this document has been prepared without taking into account individual objectives, financial situations or needs. It should not be relied upon as a substitute for financial or other specialist advice. This document is provided on a confidential basis for informational purposes only and may not be reproduced in any form or transmitted to any person without authorization from Polen Capital Management.
The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index. The performance of an index does not reflect any transaction costs, management fees, or taxes.
Past performance does not guarantee future results and profitable results cannot be guaranteed.
Definitions
The S&P 500® Index is a market capitalization-weighted index that measures 500 common equities that are generally representative of the U.S. stock market. The index is maintained by S&P Dow Jones Indices.
The MSCI EAFE Index is a market capitalization-weighted equity index that measures the performance of large and mid-cap segments across developed and emerging market countries, excluding the U.S. and Canada. The index is maintained by Morgan Stanley Capital International.
The MSCI Europe Index is a market capitalization-weighted equity index that measures the performance of large and mid-cap segments across developed countries in Europe. The index is maintained by Morgan Stanley Capital International.
The MSCI AC Asia Pacific Index is a market capitalization-weighted equity index that measures the performance of large and mid-cap segments across developed and emerging market countries in the Asia Pacific region. The index is maintained by Morgan Stanley Capital International.
The U.S. Dollar Index (USDX) is a measure of the U.S. dollar’s value relative to the majority of its most significant trading partners. The index is maintained by ICE Data Indices, a subsidiary of the Intercontinental Exchange (ICE)