I recently participated in a webinar, providing my views on the international equity space. As a member of the Invesco International and Global Growth team, I look at companies on an individual basis, focusing my analysis on their earnings, quality and valuation (EQV).
During the webinar, we received a number of questions that I was not able to address in the allotted time, but I am happy to provide my thoughts here.
Q1: Can you share your thoughts on the European recovery fund as set up by the French and German governments? Do you believe this will be the turning point of the euro zone for growth?
A: Germany and France took the lead with the European Recovery Fund – this is a huge fund of approximately €750 billion, designed to help Europe recover from the coronavirus pandemic. Spain and Italy have been hit particularly hard and the plan includes ways for Southern Europe to receive debt forgiveness.
The fund will be made up of a combination of grants and loans, with the money being raised on the capital markets and paid back over 30 years starting in 2028 – in part this will be via new taxes (i.e., a carbon tax, a digital tax, and a tax on non-recycled plastics). The budget still needs approval by all member states so plenty of negotiations remain with the aim for it to come into effect in 2021. This should be viewed positively for European equities, as it should act as an important stimulus for the region.
Europe may see a more muted economic recovery than North America, as it still needs to implement reforms to address some structural hurdles to growth. However, relative valuations in Europe look attractive, expectations are low and it has more cyclical leverage to a pick-up in trade and a post-recession economic recovery. The European Recovery Fund could provide a positive catalyst for growth, thus helping improve investor sentiment and fund flows into Europe. The region offers a wide universe of quality growth, EQV companies from which to cherry pick. I suspect that the post-Brexit era and a weaker USD may be other potential positive catalysts.
Q2: How do you view income-generating stocks, such as REITs or Canadian banks? Are dividends a sign of strength or a form of misallocation of capital (i.e., would you rather own companies that reinvest their surplus cash for growth)?
A: Invesco International Growth Fund’s stated objective is long-term growth of capital – so dividend income is not part of the stated objective. Historically, the portfolio has tended to have a lower dividend yield than the MSCI EAFE Index (currently 2.5% vs. 3.0%) and partly this reflects underweight exposure to some of the higher yielding sectors. For example, the portfolio is underweight to Real Estate, Utilities, Energy and Materials (jointly 3% vs. 18% EAFE) as most companies don’t share our investment philosophy regarding capital allocation and strong balance sheets. Many companies in these sectors tend to have more inflated debt ratios which is counter to the “Q” leg of our more conservative, balanced EQV discipline. The International Growth Fund/Class is an “ex-Canada” strategy, so the portfolio does not invest in Canadian banks or Canada as a whole.
The “E” in our EQV process is for sustainable long-term growth so we like to invest in companies which allocate capital prudently, reinvesting for future growth. That said, we do tend to invest in more established companies – so they do tend to pay dividends, but that is not the prime attraction of why we invest in them.
Q3: With the focus on U.S.-China trade issues, China continues to do a lot of business with the EU and Japan, etc. What are your thoughts on Chinese equities?
A: As at May 31, 2020, the portfolio had about 10% exposure to China. This exposure has increased over the last two years as we have taken advantage of market volatility to initiate several new positions. Interestingly the Chinese market was one of the more resilient global equity markets in the first quarter of 2020, having entered the coronavirus crisis earlier, and addressed it more aggressively, than most countries.
China has seen a “twin-speed” economy in recent times with the consumer market side performing better than the manufacturing side (which has been impacted by the trade war frictions with the U.S.). The consumer has been impacted by coronavirus, but in the long-term should continue to benefit from the Government’s drive to transition the economy from export-led to consumer-led. China is a global leader in e-commerce, again consistent with the Government’s pro-tech, pro-innovation objectives.
Our portfolio’s EQV exposure to China is heavily biased towards the attractive dynamics of long-term secular consumer growth. For example, holdings include Alibaba Group (specializing in e-commerce, retail, internet and technology), Yum China (leading fast-food restaurant chain, including KFC) and recent Q1 2020 purchases China Mengniu Dairy (leading manufacturer and distributor of quality dairy products) and Tencent (leading gaming and social media company).
In contrast, we do not have exposure to Chinese banks; although their valuations appear cheap, we have reservations over potential governance issues, government influence and potential under-reserved loan losses.
Q4: While China is always in the spotlight, what are your thoughts on Indian equities?
A: Until Q1 2020, we had not had exposure to India for many years. The key reason for this has been the “V” in our EQV discipline. Although the Indian market includes quality growth companies (that check the “E” and the “Q” boxes) they have tended to sell at valuation levels that we believe did not offer attractive risk/reward profiles. That said, we did recently initiate a position in HDFC Bank during the sharp “coronavirus” market sell-off in Q1 2020. This provided a good opportunity to purchase the stock at a much more attractive valuation level than we’d seen for quite a while.
HDFC Bank is the largest private sector lender in India with roughly 5,000 branches. We believe it is best-in-class and has a very attractive franchise in a banking system that is dominated by large and poorly managed state-run banks. In addition, the Indian market has attractive long-term growth potential with a young population, as well as low banking and low credit penetration. Our watch list of Indian stocks includes other companies but – as with HDFC – we will remain patient and true to the valuation discipline in our EQV process.
Q5: Can you provide more colour on the Industrials sector, which is the Fund’s largest absolute and relative exposure?
A: As at May 31, 2020, the portfolio had a 23% exposure to Industrials (vs. 15% in the MSCI EAFE Index), This was comprised of 15 different holdings which were all selected using our bottom-up EQV process, as opposed to any “top-down” analysis. It’s important to note that the “Industrials” sector includes a very diverse range of companies/industries, so it’s not just dominated by the more heavily cyclical companies that intuitively one might expect. To illustrate, here are a few of our current Industrial holdings:
The portfolio’s #1 holding is DCC (UK), a mid-cap, long-term position. It’s a distributor (primarily of liquified petroleum gas (LPG) and fuel/oils) with about 80% revenue visibility, so it’s much less cyclical than one might expect. Other holdings include Wolters Kluwer (NL) and RELX (UK) which provide global information services for professional end markets (e.g., legal, accounting, medical). These have transitioned from print to digital format and their subscription models provide a high level of recurring revenue. Again they are less cyclical and not very sensitive to economic swings. We also own two Japanese stocks (FANUC and SMC) which are leading beneficiaries of the growing trend towards automation and robotics as companies seek to cut costs and increase efficiency. Homeserve (UK) is another good example of how diverse the Industrials sector is – it’s a mid-cap UK-based company that provides home warranties and emergency home repair services in the UK, France/Spain, U.S., Canada and Japan.