- A carefully maintained exposure to risk in our growth holdings enabled the portfolio to hold up better than the market through a period of turbulence.
- Despite a historical performance gap between growth and value, we believe multiples of non-U.S. growth stocks remain compelling.
- Normally after global money supply starts picking up, asset values rise, and manufacturing starts turning. Absent a hardening of the trade war, this could be the case again
Uncertainty reigned over international markets in the third quarter. The last three months saw attacks on energy infrastructure in the Middle East, brinksmanship around Brexit from a new prime minister and increasing ferocity of protests in Hong Kong. These added to ongoing risks posed by U.S.-China trade tensions, which have expanded to other regions, and provided little relief to a slowing global economy, particularly on the manufacturing side.
The benchmark MSCI All Country World Ex-U.S. Index declined 1.8%, the MSCI All Country World Ex-U.S. Small Cap Index fell 1.1% while the MSCI Emerging Market Index retreated 4.3%. International growth stocks held up better than their value counterparts with the MSCI ACWI Ex-U.S. Growth Index down 0.9% for the quarter compared to a decline of 2.8% for the MSCI ACWI Ex-U.S. Value Index (Exhibit 1).
Exhibit 1: MSCI Growth vs Value Performance
On a regional basis, Japan (+3.1%) and North America (0.3%) delivered positive returns while developed Asia Ex-Japan was down 5.1%, hurt by a 12% loss in protest-ravaged Hong Kong, and emerging markets fell 4.2%. Export-driven Germany, Brazil and China were all down more than 4%.
On a sector basis, defensive consumer staples and utilities as well as information technology (IT) outperformed. Health care stocks were also positive, in stark contrast to the U.S. health care sector which is being buffeted by political rhetoric about changes to Medicare and scrutiny of prescription drug prices. Cyclicals underperformed, with energy, materials and financials suffering the widest losses.
The Strategy held up better than the benchmark, driven by strength in our emerging markets and United Kingdom holdings, and a diversified approach to growth that saw solid contributions across sectors. The performance of stocks like London Stock Exchange (LSE) and Brazilian payments provider StoneCo illustrate that non-U.S. growth companies with differentiated business models, sound fundamentals and astute management teams can thrive through the most difficult macroeconomic and geopolitical backdrops.
Hong Kong Exchanges & Clearing saw enough value in LSE to make an unsolicited offer for the company in September that was rebuffed. We have been holders of Hong Kong Exchanges for several years and started to doubt the reasoning of its bid. While creating a global platform with 24-hour trading makes sense, we were surprised that management did not acknowledge the regulatory hurdles and the high bar for convincing LSE shareholders to abandon the highly accretive deal the company announced in August to acquire financial data provider Refinitiv. Worried that there is another motive behind the deal proposal, and about the potential for less friendly regulatory changes that could harm Hong Kong Exchanges status as a gateway to China for foreign investors, we sold the shares.
The divergence in performance between value and growth reached quite an elevated level in the third quarter, with many strategists calling for mean reversions and a shift to value. We believe the challenges in the macroeconomy will render this a difficult switch. For non-U.S. value stocks to sustainably deliver outperformance will also require long-term confidence that earnings will grow enough to expand currently low multiples.
We acknowledge that growth multiples are indeed higher than value multiples. However, public equity market valuations for growth stocks are not particularly elevated, relative to private equity market valuations where cash has been plentiful, and valuations extended. Our approach to finding attractive growth companies starts with a valuation approach to growth within our categories — secular, structural and emerging. We also diligently maintain very controlled risk in our exposures to the riskiest growth companies in the emerging bucket which has allowed the Strategy to perform well even in market downturns. Volatility provides us with opportunities to own growth at better prices and we await any potential downturns with that mindset.
As we sit on the cusp of the fourth quarter, we ponder whether global economies will indeed go into recession despite most central bankers’ best efforts to avoid them. Monetary stimulus has been picking up and interest rates remain low. Given the portfolio’s focus on free cash flow and higher-quality companies with strong balance sheets, we believe our portfolio can weather inevitable economic volatility.
In addition to Hong Kong Exchanges, we were active during the quarter, taking advantage of elevated volatility to establish five new positions and eliminate four others. The additions were divided among our secular bucket of companies in developed markets that are delivering steady, above-market growth in revenue, earnings and cash flow, and the structural bucket of stocks poised to improve their earnings profile that have not yet been recognized by the market.
Secular grower Constellation Software is a high-performance Canadian conglomerate that acquires and manages software makers targeting specific vertical industries. The company is an earnings compounder with an attractive business model that is asset light, a wide moat around its underlying businesses and a core M&A strategy. We like Constellation’s high recurring
revenue and stable cash flows. The company is currently expanding globally and increasing the volume of larger deals, which should enable it to sustain double-digit cash flow growth for years to come.
Thomson Reuters (TRI), in the structural bucket, is the market leader in providing information services for the legal and tax industries. We believe the Street is underestimating the company’s earnings power over the next five years. TRI was undermanaged for years, which led to underinvestment in new products and a less optimal margin structure. It recently sold off a majority stake in its finance and risk business Refinitiv to LSE, which should enable it to focus on expanding its core products and cutting costs. Also in the structural bucket, commercial aircraft maker Airbus sports an underappreciated earnings profile driven by strong secular drivers and the company’s product development cycle. Airbus cash flow and earnings are supported by a strong backlog, the ramping up of key model platforms (A320 and A350) and fading headwinds on legacy platforms (A400 and A380). Without major new development platforms on the horizon, free cash flow should increase significantly in the next few years.
Valuation discipline is a core tenet of our portfolio construction and stock selection approach. We use market movements opportunistically to sell or trim and initiate a new buy or add to ideas we currently own. We used the market’s strong performance earlier in the quarter to trim on strength a few of our consumer staples that had outperformed and added to our position in Anheuser-Busch InBev. Overall, our staples position marginally declined for the quarter. We have also reduced our weight in financials, primarily through the elimination of Hong Kong Exchanges, although we did re-initiate a position in KBC Group in Belgium.
"Geopolitical risks are a constant and not something to be feared but rather something to be managed."
The industrials sector can have a higher degree of macroeconomic exposure. We sold two positions that have done well for the portfolio, IHS Markit and Canadian Pacific Railway, after both reached price targets and we couldn’t justify materially higher valuations. We invested the proceeds in more attractive future growth ideas Airbus and Thomson Reuters. Overall our exposure to industrials remained steady. We believe our industrials holdings have a lighter degree of cyclicality than the overall sector, primarily due to higher exposure to services companies such as UK pest control provider Rentokil, CRM outsourced service company Teleperformance in France and IT engineer staffing provider TechnoPro Holdings in Japan.
We did increase our exposure on the IT side — largely through re-initiating a position in Samsung Electronics and adding to Taiwan Semiconductor early in the quarter. Both performed strongly and added to our IT weighting. We believed that IT share prices had bottomed and were reflecting a cyclical downturn. Capacity increases have been well controlled while demand has remained strong from the logic and foundry semiconductor players. Additionally, hyperscale data center spending returned and capex from the new 5G smartphone cycle, while still early, is beginning to ramp up.
The sense of gloom in most international markets worsened over the late summer as the usual suspects — European politics, Brexit and the U.S.-China trade war — again reared their heads. Economic data continued to weaken in the manufacturing segment, yet consumers held up relatively well. We see reasons for optimism that are underpinned by policy moves. In his last month as European Central Bank president, Mario Draghi opened the money tap again by announcing a measured program of quantitative easing. China continues to flood its economy with stimulus as well and even the U.S. Federal Reserve has started cutting rates. Normally after money supply starts picking up, asset values move up and a few months later the manufacturing sector starts turning. If we do not see a hardening of the trade war, this could be the case again.
Valuations in the UK and Europe are attractive, particularly compared with U.S. equities. Near-term risks in Italy are contained for now with a new moderate government in place. Fiscal stimulus is being discussed within the EU, but no sizeable commitment has been made so far. Such policy would be a clear positive. Brexit remains a wild card with Prime Minister Boris Johnson keeping the hard Brexit rhetoric up. October 17 is an important date to watch as the EU might offer a slightly modified deal that could be palatable to the new British leader. If not, another extension of the deadline for resolution could still be an option.
Japan, China and emerging markets are very dependent on progress in trade talks. How Beijing deals with the violence in Hong Kong and the off-again, on-again trade standoff with the U.S. will provide important signs of where the global economy and equity markets are headed. Major Mainland intervention in Hong Kong would likely postpone trade discussions. At this point, the Trump administration seems willing to do whatever it takes to protect U.S. technology and military supremacy. Geopolitical risks are a constant and can provide opportunities to trim, add and remain invested. They are not something to be feared but rather something to be managed.
The ClearBridge International Growth Strategy outperformed the benchmark MSCI All Country World Ex-U.S. Index for the third quarter. The Strategy delivered gains across four of the nine sectors in which it was invested (out of 11 total), with the primary contributors coming from the consumer discretionary, IT and industrials sectors.
On a relative basis, overall stock selection and sector allocation both contributed to performance. In particular, stock selection in the industrials, consumer discretionary and materials sectors as well as an overweight to IT drove relative results. Conversely, stock selection in the health care and communication services sectors detracted from relative performance.
On a regional basis, stock selection in the United Kingdom and emerging markets had positive impacts, offsetting weakness in Asia Ex Japan.
On an individual stock basis, the largest contributors to absolute returns in the quarter included London Stock Exchange Group, Taiwan Semiconductor, ASML, Burberry Group and Rentokil. The greatest detractors from absolute returns included positions in SAP, HDFC Bank, Hong Kong Exchanges & Clearing, AIA Group and Erste Bank.