Investors are 15 years into the cycle of U.S. equities outperforming international stocks. Leaving aside the seemingly age-old question of whether international equities are finally poised to reverse course versus their U.S. counterparts, market participants may want to take a fresh look at the international equity market. There’s a notion the U.S. drove all the outperformance these past few years while international stocks languished. But that's not entirely accurate. Some of the strongest markets over the last several years that kept pace with the NASDAQ are India and Japan: India as a function of flows out of China and in response to improving sovereign and corporate governance; Japan because of much-needed corporate reforms, the desire to reignite inflation and end decades of stagnation.
In today's environment, international equity investors should focus their efforts on economically sensitive sectors and markets. Recent substantial government measures, including monetary easing and stimulative fiscal policies, bolstered pro-growth activities and benefited strong, competitively advantaged companies. There are promising examples of companies generating resilient free cash flow growth and trading at attractive valuations in sectors like mining, defense, and insurance, offering investors attractive equity opportunities outside the U.S.
Free cash flow and implied alpha: economic power, not index weights
Equity investors are best served by identifying companies where free cash flow growth is underestimated by the market. Unlike earnings, EBITDA, and other metrics, free cash flow genuinely reflects a corporation’s economic strength as it captures the cash generated relative to the cash invested in a company’s growth and expansion. When identifying international investment opportunities, leveraging free cash flow enables investors to strip away local differences around accruals and assumptions and differences across sectors, industries, regions and countries. Investors can assess future investment success by drilling down to forward cash-generating power.
Building on this focus, implied alpha plays an equally critical role in constructing international equity portfolios than traditional measures, which generally focus on absolute positions relative to the benchmark. In contrast, implied alpha considers the cross-volatilities of each security across an entire portfolio, offering a clearer and more precise measure of capital at risk for individual positions. So, active managers can allocate capital deliberately and target the best risk-adjusted return potential for each position. This should facilitate building a portfolio with greater resilience and a higher potential for alpha over time. Implied alpha is particularly effective in bottom-up international equity portfolio construction as it allows for greater insight across geographic boundaries.
Valuations and stimulus: the UK and China deserve attention
Depressed valuations in markets such as the United Kingdom and China are intriguing. The UK faced significant challenges from a lingering post-Brexit impact, making it one of the most undervalued markets globally. Interestingly, many UK companies are multinationals generating a significant portion of their free cash flows from markets like the U.S. Frequently, these ex-UK revenues exceed their domestic revenues. However, their stock prices often do not fully reflect this global exposure, presenting potential arbitrage opportunities. UK companies that re-listed their shares in the U.S. often experienced notable increases in market value, driving significant shareholder appreciation.
It’s no secret that investors currently look at Chinese stocks with pessimism. Beijing faces significant longstanding economic structural issues, geopolitical tensions, and concerns around the rule of law. Nevertheless, market pessimism seems extreme, especially with valuations deeply discounted versus its history and economic peers. Recent policy actions from the government and PBoC are pro-market and pro-growth. Although there is a heated debate among investors about whether these steps are sufficient to turn the economy and solve China’s structural issues, recognition is emerging that important key structural issues are being addressed in a meaningful way. Corporate governance in China has improved in the past few years, making the risk-reward setup for China intriguing. These factors create an opportunity for investors to use free cash flow analysis and implied alpha to create attractive international portfolios.
