Where to find value today in international developed-market equities

The recent end of the era of near-zero interest rates and moderate inflation has produced a fundamentally different investment environment than the one that existed a few years ago, when low borrowing costs and high earnings multiples helped to fuel outperformance for the growth equity style relative to value. With today’s elevated rates, costs of capital are variable, and those companies that are trading at attractive valuations while possessing strong fundamentals and positive business momentum are likely to stand out from peers that lack those attributes, in our view.

With greater differentiation among companies, we believe it’s a fertile environment for security selection based on fundamental measures of long-term financial sustainability, and one where the value style will reassert itself as a core building block of diversified equity portfolios. Currently, we’re seeing these themes play out in four equity sectors that are traditionally considered value oriented: energy, materials, industrials, and financials. In the first three areas, we believe that recent years have yielded underinvestment in tangible assets as the broader market instead leaned into growth-oriented stocks in sectors such as information technology and communication services.

New opportunities in a transformed energy sector   

Within energy, a global supply-demand imbalance has grown in recent years, in our view. For example, the war in Ukraine resulted in a massive removal of Russian petroleum resources from the global oil market in 2022. Much of the gap was filled by stepped-up production from other oil-exporting countries, along with periodic releases from supply-stabilization sources such as the U.S. Strategic Petroleum Reserve. However, the reserve in September 2022 was drained to its lowest level since 1984, and we believe that global petroleum supplies are likely to remain tight over the long term—independent of the course of the war in Ukraine—as post-COVID-19 pandemic demand rises.

Not so long ago, energy companies would respond promptly to perceived supply shortages by ramping up exploration and production (E&P) as commodity prices climbed. However, that dynamic appears to us to be changing, as many energy companies have been more inclined of late to return cash to shareholders in the form of increased dividends or share buybacks rather than plowing money into E&P.

While such trends may not bode well for the world’s energy needs, for a value investor they offer a growing number of opportunities to invest in energy companies that are committed to generating shareholder value through dividends and buybacks while also taking prudent, measured approaches to spending on any new E&P initiatives. Such caution could prove to be wise in a world in which energy companies are likely to face elevated interest rates and challenging credit conditions for some time to come. As a result, we maintain an overall positive view on energy, where we currently see an abundance of companies trading at high free cash flow yields.

A supply-constrained world yields opportunities in materials

Our similarly positive outlook within the materials sector is driven by factors that are comparable to those in energy. One key trend that we’re monitoring is the global electrification of automobiles, which we expect will drive steadily rising demand for copper, nickel, cobalt, and lithium. The latter two minerals are critical for the world’s energy transition because of their uses in rechargeable lithium-ion batteries that power electric vehicles (EVs). Copper is a critical element in EV charging infrastructure and EV manufacturing, and nickel is used in the production of EV batteries; both are also used in solar panels and wind turbines.

The growth of EVs is one reason that global copper inventories sank in early 2023 just as China was reopening its economy and stoking further pent-up copper demand by removing restrictive zero-COVID-19 policies. Copper stockpiles and prices have since stabilized as prospects for a robust Chinese economic recovery dimmed. While the inevitable swings in prices of commodities such as copper are hard to predict, we maintain a positive long-term view for materials used in EVs as well as for other select commodities, especially if near-term prospects of a global recession turn out to be unfounded.

Within materials and a wide range of supply-constrained segments of the global economy, we view ex-U.S. equity markets as generally offering a wider range of these company-specific opportunities than the U.S. market by virtue of the number of providers across different geographies.

_{Source: MSCI Inc., Boston Partners, 2022. The MSCI World ex USA Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies, excluding the United States. The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks of the U.S. market. It is not possible to invest directly in an index.}

Industrials sector stocks that are on the leading edge of today’s macroeconomic trends

Within industrials, we also see strong investment potential in companies that supply microelectronics to the EV industry. More broadly, we see abundant opportunities among suppliers of semiconductors used in industrial applications in areas such as EVs and healthcare, where leading suppliers appear to face less competition than suppliers of chips used in personal computers and other consumer electronics.

Financials sector opportunities in European banks

Financials is another traditional value sector where we currently maintain a favorable view, especially regarding European banks. While U.S. regional banks have recently been pressured by rising interest rates and deposit withdrawals at selected institutions—in a few instances leading to bank failures—their European counterparts have largely escaped such existential challenges. We believe that European banks on the whole remain better capitalized today than their U.S. peers, despite having initially built back their capital bases more slowly than U.S. banks following the global financial crisis of 2008/2009. In recent years, Europe has caught up and surpassed the United States in this regard, and we believe European depositors have less incentive than those in the United States to withdraw deposits when banks come under stress, given the still-sizable spread between many European banks’ current deposit rates and the European Central Bank’s benchmark rate, which rose to 3.50% after a June 15 increase.  

Time for a U.S. to international equity mean reversion?

Aside from the above catalysts that we see in ex-U.S. markets broadly, geographic differentials in equity valuations support our favorable ex-U.S. views. At midyear 2023, U.S. equities have enjoyed a long run of outperformance relative to their developed-market counterparts outside the United States. We consider the MSCI USA Index to have outperformed the MSCI World ex USA Index for most of the period since the global financial crisis that began in mid-2008 based on long-term returns that account for the effects of compounding¹—the increasing value of an asset due to interest earned on both the principal investment amount and accumulated interest. While that differential is familiar to investors who have long seen their international equity allocations underperform U.S. equity holdings, perhaps less well known is the fact that ex-U.S. equities had outperformed for a long stretch leading up to the financial crisis. In fact, the outperformance of ex-U.S. equities was so substantial through much of the 1970s, 1980s, and 1990s that the two indexes were roughly breakeven with one another as recently as 2014 during the preceding 44-year period that began in December 1969.¹

_{Source: MSCI Inc., Boston Partners, 2022. The MSCI World ex USA Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies, excluding the United States. The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks of the U.S. market. It is not possible to invest directly in an index.}

From our perspective, it’s important to take a long view and to be mindful of the potential for mean reversion, or the general—but not guaranteed—tendency of asset prices to eventually converge to their averages over time. Independent of the case that we present above for international ex-U.S. value equities, we believe mean reversion is likely to become a powerful force sooner rather than later.

_{Source: Bloomberg, MSCI Inc., 2023. The MSCI Europe, Australasia, and Far East (EAFE) Index tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the share price of a stock with the underlying company’s estimated earnings per share over the next 12 months. Standard deviation is a statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund’s periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk.}

Moreover, within the MSCI EAFE Index, a common international equity benchmark, the index’s value component was recently trading at a historically large discount relative to U.S. indexes while its growth component was trading at a premium to its average. 

_{Source: Bloomberg, 2023. Trailing price-to-earnings (P/E) ratios measure a company’s current stock price as a multiple of its trailing 12-month earnings. The MSCI Europe, Australasia, and Far East (EAFE) Index tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The MSCI Europe, Australasia, and Far East (EAFE) Value Index tracks the performance of large- and mid-cap securities exhibiting overall value style characteristics across developed-market countries around the world, excluding the United States and Canada. The MSCI Europe, Australasia, and Far East (EAFE) Growth Index tracks the performance of large- and mid-cap securities exhibiting overall growth style characteristics across developed-market countries around the world, excluding the United States and Canada. It is not possible to invest directly in an index.}

Paired with valuations, improving fundamentals make a strong case for ex-U.S. equities

From our experience, valuation advantages for ex-U.S. equities relative to their U.S. counterparts haven’t necessarily created attractive entry points for adding exposure to ex-U.S. equities unless those advantages are paired with some sort of a catalyst. Today, we’re seeing just such a catalyst: the dramatic improvement in business fundamentals outside the United States in recent years. For example, one fundamental measure that we monitor closely is free cash flow yield—a measure of a company’s cash available for distribution to shareholders per share after capital expenditures and taxes, divided by the company’s share price. Among metals, mining, and machinery companies—three industries where we see abundant current opportunities in ex-U.S. equities—we’ve seen free cash flow yields within the MSCI World ex USA Index surge past their peers in the MSCI USA Index since early 2021. 

_{Source: MSCI Inc., Boston Partners, 2022. The MSCI World ex USA Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies, excluding the United States. The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks of the U.S. market. It is not possible to invest directly in an index.}

In our view, free cash flow yield is a valuable measure of a company’s fundamental business strength relative to its valuation, and we expect that free cash flow yields for ex-U.S. equities will remain elevated for the next couple years.

The case for international value equities—the world has changed

In our view, the forces that have recently reshaped the investment environment—higher rates and inflation paired with more normalized earnings multiples—point to a more favorable outlook for ex-U.S. equities than for their U.S. peers and better prospects for value stocks than the growth style. Moreover, we believe that improvement in business fundamentals such as free cash flow yields creates a powerful combination when paired with today’s attractive valuations for ex-U.S. equities.

Current global macroeconomic risks present challenges across markets, and we’re likely to see continued episodes of volatility across geographies in the near term. However, we believe it’s an environment in which we’ll see increased differentiation at the sector and company levels, along with unique opportunities for active managers to stand out from the crowd in a positive way, particularly within ex-U.S. value equities.

1 MSCI, Inc., Boston Partners, as of June 2022.