- A valuation approach to growth leads us to opportunities not properly appreciated by the market and is also a contributor to risk management.
- Having a different view than the consensus helps identify under covered and out of benchmark growth companies that can improve the portfolio’s growth and risk-return profile.
- We seek to participate wherever growth occurs with risk characteristics in line with more core-like benchmarks through a diversified approach that focuses on three categories or buckets of growth companies: structural, secular and emerging.
Paced by a broadening of global economic growth and competitive relative performance, international equities are gaining traction in institutional portfolios. Strategies benchmarked to the MSCI All Country World ex U.S. Index have seen positive flows for the last five quarters through December and have attracted an average of $23.6 billion in new assets over the last two calendar years, according to eVestment. As we have discussed in recent commentaries, outperformance has been driven by both local market results and positive currency movements. Simply owning the market would have delivered average returns of more than 15% over the last two calendar years (MSCI ACWI ex U.S.) but would have also left investors underexposed to growth opportunities in sectors like information technology – the index had a 11.5% technology exposure at the end of 2017 compared to 23% for the Russell 3000 Index – as well as companies with attractive growth potential obscured by short-term weakness and among smaller capitalization companies with lower benchmark weights.
Recognizing that a company’s growth potential can be analyzed in a number of different stages and under a number of different scenarios, ClearBridge applies a diversified perspective in identifying companies for our international growth strategies. We diversify across business models, company size and the maturity of a company’s growth cycle with the objective of identifying attractively valued businesses that can compound growth with below benchmark risk over the long term. We systemically evaluate all stocks in our universe through a proprietary model to identify candidates for investments, focused on attractive quality and valuation characteristics with rising momentum in earnings, growth and price.
The result is a portfolio that targets companies across the wide spectrum of growth available in non-U.S. markets in three growth categories or buckets: structural, secular and emerging (Exhibit 1). We seek to own this range of growth companies in a portfolio broadly diversified by market capitalizations, countries and sectors. We believe this approach gives us the best chance to fully participate in the growth available in varying market environments, including both narrow and broad growth markets. Emerging growth stocks, for example, tend to do well in momentum periods, structural growers provide idiosyncratic sources of alpha, while secular growth companies can provide consistency through a full market cycle.
Exhibit 1: Diversification Across the Spectrum of Growth: Fundamental Analysis Drives Portfolio Construction
Structural growth stocks generally have misunderstood earnings, may be trading at discounts to historical performance, or may be engaging in self-help stories that can accelerate earnings. These are growth companies where the consensus has yet to recognize their growth potential. European financials are a good example of the opportunities afforded by positive structural change. Steepening yield curves and the repair to balance sheets has provided us with opportunities to buy improving earnings power at a discount. With banks, we pay close attention to the effectiveness of changes and will own the stocks for a period of time when improvements are making the greatest impact and be disciplined sellers once the valuation reaches our target or the turnaround story is losing momentum. Austrian company Erste Bank is a good example of a bank that is successfully restructuring and cleaning up its balance sheet to more effectively compete in the key growth markets of Romania and the Czech Republic.
Our fundamental, bottom-up research also tends to uncover company-specific growth turnarounds that are not being properly recognized by the market. The best current example is Shiseido, the Japanese cosmetics company that has benefited from a streamlining of operations by new management. Through cost cutting and a focus on its core business lines, the company is now strongly profitable in Japan and on track to reach similar profitability levels in its overseas operations. A strong secular backdrop for the beauty business provides further support and strengthens our confidence in holding the stock longer term.
Secular Growers Provide a Measure of Stability
The secular growth bucket comprises the bulk of our portfolios, ranging from 40% to 60% of assets. Secular growth companies are long-term compounders of cash flows and capital returns that can provide stability through varying market and economic conditions. The secular growth companies we invest in typically feature established, superior business models and have sustainable, but often underappreciated, long-term growth opportunities on both the top and bottom line. From an earnings volatility standpoint, secular growers are the lowest risk segment of our overall portfolio. Japanese industrial automation firm Fanuc, for example, is developing new applications for robots by combining them with better sensors and software to expand beyond its traditional end markets of autos and semiconductors to include warehousing (where strong demand for automation is driven by online commerce), medical and general manufacturing. The company is also leveraging innovations in cloud and artificial intelligence to offer new services to existing clients such as predictive maintenance, which act to de-risk earnings volatility. British pest control company Rentokil, meanwhile, is applying its management efficiencies to a highly fragmented global market, driving growth through accretive acquisitions.
The relative stability provided by our secular growers allows us to venture further out on the risk spectrum and participate in dynamic growth trends caused by innovation or disruption. We group the companies driving these shifts into our emerging growth bucket.
"Our research uncovers company-specific growth turnarounds that are not being properly recognized by the market."
Think of emerging growth stocks as franchises becoming recognized for their above-average growth rates. They may be emerging from obscurity in the case of a company like British online apparel retailer Asos, which has rapidly expanded beyond its UK base, or they may be just beginning to deliver high growth on a consistent basis from a new and unique business model like Alibaba, which has successfully monetized the shift in retail from offline to online and PC to mobile device in China. In addition to that high revenue or market share growth, they are also high risk and when they invest for growth, earnings can go sideways or even decline, causing volatility. We have trimmed our position in Alibaba, for instance, as the company invests in growth initiatives and will monitor its efforts before taking further action.
We carefully monitor the risk of our emerging growth holdings because they represent the riskiest part of our growth portfolios and valuations are the highest. We want to understand and minimize the risks of these types of growth companies, but maintain exposure because they are often taken out in acquisitions. The ones that remain independent and successful can eventually become large and mega cap growth companies.
Exhibit 2: Each Bucket Delivers Distinct Growth Characteristics
|Portfolio Weight %||TTM EPS Growth (Ex. Neg)||1-Year Sales Growth (%)|
The objective of having this bucketed approach to growth is to understand the risk we’re taking. We can broadly categorize that risk by bucket and this helps to create a portfolio that provides many different opportunities with different growth targets (Exhibit 2) where we can control risk relative to the broad international equity market.
Having an opinion different from the market can lead us to companies with better growth characteristics trading at attractive prices. This differentiated view leads us to stocks whose earnings are inflecting ahead of, or in contrast to consensus expectations. We want to be early in recognizing these companies and disciplined in monitoring risk and potential upside. This entails continuously assessing position sizes and being active in trimming and adding to positions based on what is happening with each company’s growth trajectory and valuation compared to our target price.
We believe buying quality, attractively-priced growth companies with the ability to compound over long periods of time is a sound way to approach the international growth market. We construct a portfolio of these companies by applying our valuation approach to growth to an all cap mandate focused on three categories of growth across developed and emerging markets.