When we as active managers talk about high conviction, that doesn’t only mean we have confidence in the securities we buy – it also means we’re willing to be patient and wait for the right opportunities to come along. In the first quarter, we didn’t add a single new stock to Invesco International Growth Class because we didn’t see any new opportunities that met our criteria for EQV (Earnings, Quality and Valuation).
In the longer term however, there are a few positive glimmers that may light the way toward future opportunities. Below, I discuss what the team is seeing on an EQV basis.
Earnings: Downward revisions slowing
The difficult earnings scenario we’ve experienced over the past few years continues, as the global earnings growth forecast for 2016 has been consistently revised downward from 13% in April 2015 to only 3% currently.1 We’re seeing negative revisions in all regions, including the U.S., Japan and Europe.
The good news – and everyone is looking for some out there – is that analysts are now trimming their earnings estimates at a slower pace than before. But unless there’s a pickup in top-line growth, it’s hard to see where upward earnings revisions would come from, considering that cost saving has run its course, merger and acquisition activity is at a record high and leverage has increased, which limits the potential for stock buybacks.
The areas with the largest potential for upward revisions, in our view, are the commodity sectors in countries such as Brazil and Russia, which we believe stand to benefit from stronger commodity prices and currencies that have depreciated significantly over the past few years. We’ve already seen some of this during 2016, accompanied by currency appreciation and a strong market rally.
Quality: Returns continue to drag
Looking at quality characteristics, which consider the financial strength of a company, we’ve seen returns on equity (ROE) trending down on a global basis since 2012, without any signs of improvement. As with earnings revisions, we think ROE improvement is unlikely to happen before a top-line recovery.
Valuation: Dispersion indicates opportunity
Because earnings and cash flows have been significantly revised down over the past few quarters, valuations are no more attractive today than they were two quarters ago. But there are areas where we see significant valuation dispersion, which usually indicates opportunities. Two of those areas are emerging markets and Asia. But we’ve seen that this dispersion (which refers to the wide range of valuations seen among companies within a market) is also almost entirely driven by the sharp fall in the financial sector, which comes with the risk of being in the early stage of a negative credit cycle.
Looking at valuations, we see that
- From a price-to-earnings (P/E) perspective over the next 12 months, the U.S. now trades at a 30% premium versus other world markets – the highest since 20122
- From a price-to-book (P/B) perspective, the U.S. trades at an 80% premium – a 15-year high – versus an average of 40%2
- Looking at projected earnings over the next 12 months, developed markets are at a P/E premium of about 40% and a P/B premium of 47% versus emerging markets, levels not seen since the early 2000s2
Defensive stocks are also at a multi-year high versus cyclicals, trading outside the U.S. at a 100% premium based on P/B ratio2
Currency volatility continues
Currency volatility in 2016 – a continuation of what we’ve seen in previous years – has been driven by weakness in the U.S. dollar versus emerging-market currencies such as the Brazilian real, the Russian ruble and the Malaysian ringgit (all up over 10% in the first quarter of 2016 against the U.S. dollar)3 as well as the yen and the euro. We’re often asked how our international strategies manage this volatility. And our answer hasn’t changed over 23 years of our strategy: We don’t hedge our currency exposure for four main reasons:
- While foreign-currency exposure may introduce volatility in the short term, it doesn’t have a significant impact on long-term performance, in our view
- A key benefit international funds can provide to Canada-based investors is low correlation to the Canadian market. Hedging currency exposure increases correlation, lowering the potential diversification benefit
- Currency hedging is largely redundant because many foreign companies have global operations with exposure to many different currencies and hedge their own currency exposure directly
- Hedging is costly and can introduce unwanted leverage to a portfolio
