Three reasons to revisit an international equity allocation

What’s not been as widely noted as the tech-fueled rally in U.S. stocks is the parallel trend that’s been unfolding in the global equity markets at the country level. Consider that the United States now represents nearly two-thirds of the MSCI All Country World Index, up from just over 40% in the wake of the global financial crisis of 2008/2009.

These two related trends have made building a diversified portfolio more challenging for equity investors of all stripes. Domestic-focused investors would be wise to mind the potential pitfalls associated with making a large allocation to a handful of tech-related securities. Global investors, meanwhile, face a similar challenge, with benchmark-oriented allocations now involving an unprecedented bias toward U.S. markets and, in turn, toward those same tech-focused companies. Casting a wide net isn’t as useful a diversification tactic as it once was. Building a truly diversified portfolio in today’s market requires a more targeted approach, in our view.

International equity allocations can play a vital role in diversifying a portfolio

Perhaps the simplest means for counteracting today’s dual concentration risks is to dedicate a portion of a portfolio to non-U.S. strategies. Now could be a good time to consider such a move. There are three major reasons why we believe revisiting an international allocation looks attractive in today’s market.

1 The fundamentals in non-U.S. equities are solid across multiple dimensions

Publicly traded companies outside the United States in aggregate tend not to offer quite as strong a fundamental profile as U.S.-based companies do. There are several reasons why—from the regulatory environment and transparency to competitiveness factors and liquidity—but the bottom line is that U.S. stocks tend to trade with something of a built-in premium relative to their international counterparts. While that price gap between international and U.S. stocks still exists, the quality of company that investors are getting through an allocation to international large caps has recently been significantly higher than average, in our view. Why?

•          Higher absolute returns and higher margins—We’re seeing this is particularly true for certain traditional value sectors such as energy, materials, and financials—specifically, in select European banks.

•          Higher free cash flow yields—The additional capital being earned in these sectors in general hasn’t been immediately redeployed through capital expenditures. That translates into higher levels of free cash flow and healthier balance sheets.

•          Better capital allocation—When capital is deployed, typically it’s going to shareholder-friendly initiatives, often in the form of higher dividend payments and/or stock buyback programs.

2 International stocks can be fertile ground for active managers

Despite a broadly attractive landscape in international equities, we believe that the best way to pursue opportunities is through a targeted, active approach. The data bears this out: Consider that more than half of all actively managed large-cap international equity funds outperformed the MSCI All Country World ex-USA Index seven times over the past 10 calendar years; meanwhile, a majority of large-cap U.S. funds have beaten the S&P 500 Index only twice.

There are a number of potential explanations as to why this might be the case. For one, international companies don’t receive quite the level of analyst coverage—and therefore scrutiny—as their U.S. counterparts. That means that earnings surprises—both positive and negative—generally happen more often outside the United States. Having access to reliable research can be particularly valuable in helping to separate the potential market leaders from the laggards.

3 International value companies have been growing faster than growth names

In addition to taking an active approach, we think that investors would benefit from considering value stocks specifically. Coming out of the COVID-19 pandemic, earnings growth for international growth stocks has generally languished, moving more or less sideways over the past three years. Their value counterparts, meanwhile, have seen earnings steadily rise, climbing more than 80% over the same time period.

The best time to mend a roof is while the sun’s still shining

Investors who may have taken on more concentration risk than they intended—either through exposure to mega-cap U.S. growth stocks or to the United States equity market in general—would be wise to revisit their portfolios before the next market downturn, whenever that may arrive. We believe international stocks not only represent a simple solution to this issue of concentration risk, but that the asset class has materially stronger fundamentals than usual, which is a reality not yet fully accounted for in their recent prices. We believe an active approach that targets traditional value sectors offers abundant opportunities in today’s market—and has the added benefit of earnings tailwinds to support it.