- Meaningful shifts in the long-term investment landscape could affect the performance of price- and momentum-driven passive equity solutions.
- We believe active managers are better at discerning changes in market or economic leadership and have more agility to make portfolio changes ahead of long-term trend reversals.
- The timing and pace of fundamental improvements in international markets gives active managers ample opportunities to add value.
Major transitions in markets and economies do not occur frequently. As active value managers, we closely monitor signals from equity prices, bond yields and company managements, among other factors, to stay ahead of inflection points that will impact the companies we own and target. Viewing the global economy from a broader economic perspective, we can link the trends of the last 10 to 20 years to a recurring cycle of policy distortions that tended to inflate asset prices and suppress real economic activity. Companies least dependent on the real economy have thrived with a mix of financial engineering, cost cutting, lower interest expenses and technological disruption. In this environment, passive investors have unwittingly benefited, while active managers have suffered from the expanding disconnect of price from fundamentals. Many assets have fallen to historic levels of underperformance, led by non-U.S. stocks, real assets, value equities, emerging market small companies, cyclical firms and banking shares.
As central bankers end the experiments of quantitative easing and negative interest rates, companies' cost of capital and yield curves are normalizing and the world is moving into a period of stronger and more balanced growth. The global economy is also expanding in sync, with the majority of countries and regions now growing more rapidly than the U.S. As cyclical trends and policies begin to support the job market more than the bond market, wages will begin to rise. These increasing costs should pressure the historically high margins of the past leaders in profitability, as the growth in earnings has been unusually concentrated. These reversing trends will likely lead to a rotation in market leadership in which price-driven momentum and passive strategies are poorly positioned.
As institutional interest in international equities is picking up from multi-decade lows, we believe now is a particularly important time to consider how active and passive investment styles target the asset class. In particular, we wish to focus on key shifts in the long-term investment landscape that could affect the performance of passive equity solutions.
The strong relative performance of passive portfolios has significantly shifted fund flows and generated a self-reinforcing dynamic based upon imitation and herding. Yet as mathematician Benoit Mandelbrot points out in his work on the behavior of markets, such periods of serial correlation or "momentum" eventually reverse. This momentum effect is especially powerful in index-mimicking strategies as these funds will buy more of something just because it is going up in price. For a certain time period, any other competing stock selection approach would seem inferior. Passive investing's focus on price change as distinct from valuation has driven the gap between price and value to levels that have historically led to low subsequent long-term returns for passive strategies. Empirical Research has found that among U.S. large cap stocks, high passive ownership has had a negative impact on subsequent returns of those companies (Exhibit 1). We believe that passive strategies currently expose investors to crowded trades and timing errors just as great as with chasing "hot" active manager performance.
Exhibit 1: Stocks with High Passive Ownership Have Underperformed in the Short Term
In contrast, active managers tend to embrace investment disciplines that are rewarded by a shift away from crowded and highly-valued assets to more fundamentals-based stock selection and portfolio construction. Given the large performance gap between price and value, an active strategy can also limit the exposure to overpriced stocks and better avoid companies with unsustainable levels of profitability.
Better Prepared for Trend Changes
One of the more powerful lessons we have learned in more than 30 years managing international value portfolios is that current market leadership will not work forever. The transition of a particular factor or theme from leader to laggard can be rapid and powerful, with significant negative consequences for strategies overexposed to such drivers. We believe that, by their very nature, active managers are better at discerning changes in leadership and have more agility to make portfolio changes ahead of long-term trend reversals. The return of synchronized global growth is one such signal we view as confirmation of leadership change.
Active returns of international managers reflect the greater inefficiency in non-U.S. markets. The universe for international active mandates encompasses countries and regions where there are more opportunities to find companies underfollowed by the research community or facing some kind of disruption or reorganization. Whether it's a local or regional economy in transition or even sectors like banking in Europe, which are experiencing a major restructuring, there are more moving parts to keep track of in these markets.
Earlier in recovery phases and profitability cycles, there are often significant gaps between the U.S. and the rest of the world. The U.S. banking system, for example, addressed the toxic assets on bank balance sheets more expeditiously after the global financial crisis than Europe did. As a result, profitability has rebounded more rapidly (Exhibit 2). When profits are depressed, as they are in many non-U.S. markets, active managers can apply fundamental analysis on the individual security level to better identify the stocks most likely to recover. This is preferable to owning a sector broadly as passive vehicles must do. In scenarios with a lot of moving parts, particularly when business conditions are improving - as they have been in international markets, emerging markets in particular - active managers have an opportunity to be more selective.
Exhibit 2: Earnings in Non-U.S. Developed Markets Have Lagged the U.S.
From a bottom-up standpoint, the rebound in stock prices since the 2009 lows has been driven by the largest expansion of valuation multiples in history. Not only have equity prices diverged sharply from underlying fundamentals, but the drivers of earnings growth have also shifted from operating leverage to financial factors such as lower interest expense, wage suppression, limited investment spending, reduced taxes and debt-fueled share repurchases. These dynamics have favored the relatively narrow number of firms that could maximize profits on current production and disadvantaged those that need to grow the volume of goods and services they sell.
The combination of artificially low interest rates and sluggish real economic activity has led investors to crowd into the assets which have benefitted the most: bond-correlated and companies with high expected growth, such as the FAANG stocks. Such crowding has also created a supportive feedback loop for passive investing strategies that respond to price driven factors like momentum and ignore fundamentals such as cash flows, earnings, dividends and valuation. Consequently, the "average" stock has become highly valued as judged by the historically high P/E multiple of the MSCI EAFE Index (Exhibit 3).
Exhibit 3: International Stock Valuations Remain Elevated
More Discerning in Identifying Value
We believe these trends are largely exhausted and may even begin to reverse as interest rates, wages and input costs rise. In short the market environment is shifting from being driven by multiple expansion to being driven by earnings growth. This will reduce the disparity or inequality of profitability between companies, regions and countries. By using valuation metrics that analyze individual stocks versus their own history, sector and country, active managers purposely seek to eliminate the excesses created by expanding multiples and crowding. Active managers tend to have an advantage when stock prices have diverged from underlying fundamentals because they focus on what a business is worth. By selecting a subset of stocks that are selling for less than their expected longer-term value, an active manager can deliver better real returns with a lower risk of material drawdowns. Active managers also generally include small and mid cap stocks in their opportunity set, as these suffer less crowding and distortion from passive investing flows and financial repression. Passive funds tend to be mostly built around price-driven metrics with no focus on intrinsic value.
One way to uncover valuation opportunities is to identify the disconnect between the implied earnings growth embedded in a stock's price and the expected earnings growth the market projects for that company. Focusing on the spread or gap between the two growth rates can help active managers avoid the value traps that can result from formulaically investing in the cheapest stocks in a given benchmark or universe. Exhibit 4 illustrates the gap between implied and expected growth in the ClearBridge International Value Strategy. Today, earnings are taking off in tandem with global growth, a shift best captured through the individual company analysis practiced by bottom-up active managers.
Exhibit 4: Mind the Gap (ClearBridge International Value Strategy)
More Nimble in Diversification
Increasing globalization is blurring the lines between where a company is domiciled and where it does business. Multinational companies, whether they're based in Boston or Berlin, often serve the same markets and thus their stock performance is influenced by the same factors. Now, that doesn't mean countries aren't important. But as active managers, we can be more discerning about what a company's domicile means to its business. Simply buying the largest companies located outside the U.S. - as passive investors do in market-weighted ETFs and index funds - won't promote diversification. From a bottom-up standpoint, we may not care about a company's country of domicile. We talk to managements and analyze which countries a particular company is doing business in and which currencies matter to that company. Country analysis is more meaningful and can better identify opportunities when viewed in the context of individual company characteristics.
Country risk is also crucial. Depending on the types of companies owned, an international portfolio can be tilted toward global multinationals and have a high correlation with the S&P 500 Index. Or it can hold more local companies that cater to domestic or regional demand and thus have a lower correlation to the U.S. and other markets investors are seeking to diversify away from. The level of correlation with an investors' home market is important because international diversification only works when it provides access to sources of returns distinct from those driving a home market. Active strategies will include large multinational companies, but they also have the ability to include non-benchmark names that provide exposures not captured in passive or index strategies.
Global central banks are moving from distorting interest rates to steepening yield curves. China is transforming the world's second-largest economy from a super-cycle-driven commodity and industrials complex into a leading services and consumer-led market. Japan, trapped in a deflationary spiral for the last two decades, is delivering its best profit growth on record while household income is growing 40% faster than in the U.S. All of these factors are beginning to lower correlations and increase dispersion among international stocks.
Active managers, through subjective and qualitative research and selection methodologies, are more likely than passive strategies to successfully adapt to such a changing investment environment. We believe such a shift in global investment fundamentals is currently under way, from both top-down and bottom-up standpoints. Cyclical and structural conditions that have supported passive outperformance are showing signs of reversing, or may have been historically anomalistic and will simply cease to exist. While others will debate whether we are headed for a "new" or "old" normal, we believe the key is the coming exit from the abnormal environment of the past cycle. We are at a meaningful inflection point in the global economy where the ways equities are valued will change. As a result, we believe it is time for international investors to think about alpha, not beta, and embrace active strategies that seek to deliver excess returns driven by fundamentals.