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International Value – It’s What’s for Reflation

Source: istockphoto.com

Lost in the ‘Value vs Growth’ debate is how the investment style boxing match is playing out internationally.  With the post-pandemic recovery largely tracking the pace of vaccination progress, investors may want to turn their attention to some of the ‘values’ being served up in international developed markets across Europe and Asia.

Although having been late to the vaccination rollout and still wrestling with post-Brexit trade issues, investors are starting to price in a strong reflationary recovery across the Eurozone, whether in currency appreciation versus the U.S. dollar, rising inflation expectations priced into sovereign debt, or the recent outperformance of regional stock markets versus the U.S. and Asia (at least so far in May).

Will Developed Markets Take the Global Growth Lead from Emerging Post-COVID?

Although the U.S. retains the lead on post-COVID recovery with early and aggressive vaccine rollouts and massive fiscal spending, the Asian growth story is presenting a different picture, particularly in China where pro-cyclical indicators such as credit impulse (a measure of change in total social financing) and broader money supply growth are exhibiting signs of deceleration and possible outright contraction.

Figure 1 displays the Bloomberg China Credit Impulse juxtaposed against the IFO Pan Germany Business Climate Index, a proxy for business sentiment across the Eurozone.  Unlike the pre- and post-Great Financial Crisis period of 2008-2009 where both China credit and European business sentiment fell and rose together, the post-COVID period has witnessed a growing divergence.  We believe one of the bigger macro debates to emerge over the next year is whether the export-driven global growth baton is being passed from China to Europe (really Germany) or whether China will continue its position as the gravitation center of global growth trends as it has served in the past several cycles.

Figure 1 – Bloomberg China Credit Impulse Diverges from Germany Business Sentiment

If the latter, then we very well could see a shift in the global growth narrative that has both Europe and Japan (a leading manufacturer in automation and robotics) leading the post-COVID recovery through increased industrial spending and export growth, despite longer-term issues related to aging demographics and slowing population growth.

An Even More Compelling Value Opportunity Outside the U.S. Market?

The ‘Value’ investment style has been heavily out of favor, not just in the U.S. but across global markets, for the past several years up until the COVID vaccines were announced last November.  International value investing has suffered even more than the U.S. since ex-U.S. companies are generally less profitable with lower and returns on capital versus their U.S.-based counterparts.

By definition, ‘Value’-based portfolios and indices will trade at a discount to the broader market on market capitalization-weighted basis, but we saw these valuation spreads widen dramatically throughout 2020 as ‘growth’ style investing took off driven by technology and high-flyer initial public offerings focused on digital disintermediation.  The dour sentiment among value-focused in 2020 was only matched by similar experiences felt during the late 1990s Internet Boom.  With post-COVID reflation on investors’ minds as pent-up demand meets headlong into bottlenecked supplies, 2021 has witnessed a strong comeback for ‘Value’ over ‘Growth’.

For international stocks in particular, what we find interesting is that the valuation of ‘value’ stocks as proxied by the iShares MSCI Intl Value Factor ETF (IVLU) has not meaningfully appreciated relative to the valuation of the broader international developed markets as proxied by the iShares MSCI EAFE ETF (EFA).  Using 12-month forward price/earnings multiples (based on Bloomberg consensus EPS estimates), Figure 2 displays the historical quarterly valuations of IVLU and as a % of the valuation of the broader market (EFA).  Even with the market renewing its love affair with value style investing, the valuation discount remains significantly wider versus five years ago.

Figure 2 – Little Love for ‘International Value’ as P/E Valuations Have Remained Stagnant Over Time and Whose Discount Versus the Broader Market Remains Wide Versus 5-Years Ago

Source: Bloomberg

Now this valuation discount is understandable because value stocks tend to be less profitable (or generate lower returns on capital) versus the broader market.  This lower profitability helps explain the historical risk premium afforded to value investing when seen through a Fama/French lens (although behavioralists would argue otherwise).  Yet, the ‘quality’ of international value stocks has actually improved coming out of COVID while the projected return on equity (ROE) gap between IVLU and EFA has narrowed (Figure 3).  In today’s post-COVID recovery, value investors are enjoying more ‘quality’ bang for your ‘value’ buck.

Figure 3 – IVLU Valuations Have Stagnated Despite an Improving Return-On-Equity Profile

Source: Bloomberg

Why so little love for value?  Is this quality improvement just ‘transitory’ and largely a result of base effects from prior year pandemic troughs?  Could international value face peak profitability (and disappoint long suffering investors yet again), succumbing to longer-term headwinds of poor demographics and lower capital efficiency? Perhaps, but at least for now, investors are paying for about as much for international value as they were five years ago despite an improved return-on-equity profile coming on top of a clearer runway for a post-COVID driven recovery, especially if the ex-U.S. developed regions take the lead on global growth.  Borrowing from an old American beef campaign, “Value: It’s What’s for Reflation.”

Disclosure:

At the time of this writing, 3D held positions in IVLU and EFA.  The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D/L Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. 

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By: Benjamin Lavine