As managers of a global equity strategy, we take a bottom-up approach to seeking companies with attractive valuations, solid business franchises, and compelling management and cash flow characteristics. We assess these attributes to determine the quality of a stock, a factor that we consider to be critical to effective security selection.
Valuation remains another key element of our investment process, especially now, as we believe that global equities overall remain relatively expensive on a valuation basis. If anything, the enthusiasm that’s helped drive global equities higher since the U.S. presidential election in November 2016 has stretched earnings multiples—ratios that measure stock prices relative to earnings—even further.
The last time multiples were comparable to those of today was in the early 2000s, when profit margins had declined in the wake of the dot-com bubble’s bursting. Margins had plenty of room to recover, and they eventually did rebound. In contrast, margins today are much healthier, and they’re closer to their recent peaks than they were in the early 2000s.
Market expectations tethered to a growth outcome
With margins relatively high, expectations for growth today appear to be directed at revenue. These expectations are supported by investors’ apparent enthusiasm over the United States’ intent to emphasize fiscal policy and increased spending to stimulate economic growth rather than rely on accommodative monetary policies.
Expectations for global earnings growth appear to be around 13% for 2017, a level comparable to current forecasts for nearly 11% growth in the United States.1 Assuming that we do experience growth of this magnitude, it will be interesting to see whether companies use the additional cash flow generated by increased earnings to invest in their businesses or to strengthen balance sheets that, in many instances, we view as stretched.
Whichever scenario plays out, we view equity valuations as being more attractive in non-U.S. markets than in the United States, and we’ve recently been finding more opportunities outside U.S. equities. In aggregate, valuations aren’t as attractive as they were a year ago, and we continue to pursue opportunities in stocks that we view as possessing quality attributes with attractive valuations.
Policy uncertainty remains high
We believe that these types of stocks offer upside potential as well as a measure of downside protection—a characteristic that could become particularly attractive should current market risks trigger volatility. The changing political and economic landscape in Europe presents one potential trigger. France is preparing to hold presidential elections, and the outcome could strengthen the hand of populist, antiestablishment forces. Elsewhere, the Brexit negotiations on the terms of the U.K.’s exit from the European Union are likely to create heightened economic uncertainty throughout this year and into 2018. In the developed markets, we need to be aware of the potential for surprises, as we saw with the Brexit referendum in June 2016 and the U.S. election victory of President Donald Trump a few months later.
Seeking balance, with an emphasis on quality
Should we experience such surprises, currency markets are likely to see the primary impact; the effect on equities could be of a secondary nature. Considering these prospects, we’ve recently been drawn to bottom-up stock opportunities in an interesting mix of companies: firms that primarily generate domestic revenue and European companies that rely heavily on exports.
In the current environment, we also think it’s sensible to maintain a reasonably even balance between stocks with defensive characteristics and cyclical stocks that tend to be more sensitive to changes in economic trends. This view helps explain the wealth of opportunities we’ve seen recently in stocks in the U.S. financials sector and, to a slightly lesser extent, in global consumer staples stocks. As for U.S. financials, further positive momentum in U.S. economic growth could provide support. Regarding global consumer staples, many of these companies offer strong potential to continue generating stable free cash flows and to maintain appealing dividend yields.
Aside from these opportunities, we continue to take a bottom-up approach to identifying securities in a global equity market that we view as relatively expensive overall. As a result, we’re emphasizing high-quality companies whose strengths may not be fully reflected in their stock prices, resulting in attractive valuations. We’re wary of companies with excess leverage, and we’ll continue to focus on firms with sustainable cash flow streams that appear well positioned to drive profit margins in a global economy that faces an abundance of current policy risks.
1 FactSet, 3/31/17.
In the equity market valuations chart, the United States is represented by the MSCI USA Index, which tracks the performance of publicly traded large- and mid-cap stocks of U.S. companies. The world is represented by the MSCI World Index, which tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies. Europe is represented by the MSCI Europe Index, which tracks the performance of publicly traded large- and mid-cap stocks of 15 developed-market countries in Europe. Japan is represented by the MSCI Japan Index, which tracks the performance of publicly traded large- and mid-cap stocks of Japanese companies. Emerging markets are represented by the MSCI Emerging Markets (EM) Index, which tracks the performance of publicly traded large- and mid-cap emerging-market stocks. Total returns are calculated gross of withholding tax on dividends. It is not possible to invest directly in an index.
Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Value stocks may decline in price.