Einblicke
Time for EAFE
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Insight Article
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März 07, 2022
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Time for EAFE
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März 07, 2022
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Time for EAFE
Time for EAFE |
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Is now the time to own reasonably priced quality companies with pricing power, many of which are in EAFE? Bruno Paulson explains why the International Equity Team believes so.
Even after the mild falls in January 2022, we still see markets as stretched, with the MSCI World Index on 18x forward earnings1, a multiple never seen between 2003 and 2019, on forward earnings up a massive 52% on the trough in June 2020. There are only two ways of losing money in equities - if the earnings go away or the multiple goes away, but unfortunately we would argue it is now time to worry about both of them happening, given peaky multiples on peaky earnings. On a more positive note, we would also argue that there may be two relative havens, which have struggled in relative terms over recent times, namely EAFE and reasonably priced quality and the Portfolio offers exposure to both.
After a long and sustained period of relative underperformance, the MSCI EAFE Index marginally outperformed its U.S. equivalent in January, down only 4.8% in U.S. dollars (USD), versus -5.7% for the U.S. We are not suggesting that the tide has turned based on 90 basis points of outperformance in a month, but there are good reasons to be relatively optimistic on EAFE versus the U.S.
The U.S. market is expensive, as reflected in Robert Shiller’s CAPE – the ‘cyclically adjusted price earnings’ ratio, based on average inflation-adjusted earnings from the previous 10 years. The current approximately 38x level of the CAPE implies negative real returns over the next decade. This is a notoriously poor predictor of short-term returns, as shown in 2021, but it does suggest that the S&P Index is not likely to be a lucrative safe haven over the next decade. It also looks pricey on the more conventional forward earnings multiple, at 20.4x, while EAFE sits at a 30% discount at a mere 14.3x. This discount to the U.S. oscillated around 10% until 2015; since then there has been a steady relative de-rating for EAFE.
Part of the U.S. premium is down to mix, and the tech mega-caps which have grown their share of the global profit pie. But in addition, the U.S. economy outgrew Europe across the 2010s, with annualised gross domestic product (GDP) growth for the decade of 2.3% versus the euro area’s 1.4% . This growth differential may not hold over the next couple of years, with the Organisation for Economic Co-operation and Development (OECD) estimates2 suggesting the euro area may have higher GDP growth in 2022 (4.3% versus 3.7%) and again marginally in 2023 (2.5% versus 2.4%). The U.S. emerged faster from the pandemic, giving Europe the chance to catch-up, and is also facing higher inflation and tighter labour markets, meaning more tightening is likely to be required, with the associated risks of economic damage. The OECD estimates Q1 2022 inflation of 6.4% for the U.S., twice the 3.2% of the euro area. The cost pressures on corporates also seem tougher in the U.S., where unit labour costs were up 3.2% in the first nine months of 2021, while they stayed flat in the euro area. If it does prove to be the case that Europe can combine faster growth with less inflation and cost pressure, that may well drive a relative re-rating.
Time for Reasonably Priced Quality?
2020 saw a growth bubble in expensive and loss-making technology companies, which was followed by a value rally as the massive government interventions and the vaccines miracle drove a far stronger economic outlook. Reasonably priced quality therefore got left behind. One proxy for this is the Consumer Staples sector, by far the biggest overweight for the portfolio, which lagged the overall EAFE market in both 2020 (up 6% as against 8% for the index) and 2021 (up 7% vs 11%). The sector has also had to deal with the sharp rise in commodity costs, which has put pressure on margins, given the lag until companies are able to raise prices for customers. Arguably, Consumer Staples companies have already faced much of the inflation pressure, which may now spread to other sectors during 2022. We also believe that the sector still has pricing power, and will therefore be able to preserve or restore its margins by passing on the cost rises to customers.
Within the Consumer Staples sector, our holdings have been skewed towards cheaper plays, and those exposed to re-opening, as shown by the 16% discount they traded at relative to the Staples index at the start of 2020. This did not work in 2021, as the growthier names continued to re-rate and COVID waves continued. Indeed, the discount widened to 24% during the year, though the earnings growth of our names matched those of the sector. On a positive note, this left our holdings attractively priced at the start of this year, as well as positioned to benefit from the ‘post COVID’ re-opening, whenever it happens.
Looking at the Portfolio more broadly, it is far higher quality than the EAFE Index, with a 24% return on operating capital and a 40% gross margin, which are both 50% higher than the index, along with a net debt/EBITDA ratio at 1.6x, which is 15% lower than the index. Less quantifiably, we believe it has stronger pricing power than the index, given this is a focus of our investment process, which could prove a useful asset as inflation bites. Despite this big difference in quality, it is only trading at an 11% earnings premium to the EAFE Index, and on a free cash flow basis this premium drops to a mere 4%.
In a world of elevated multiples on what may be unsustainable levels of earnings, the focus should be on preservation of wealth, rather than chasing another year of outsized gains. In this environment, the EAFE market looks relatively attractively priced, particularly if Europe can match or exceed U.S. growth over the next couple of years. Within EAFE, we would also make the case for a portfolio skewed towards the higher quality, defensive sectors and built on companies with superior pricing power. It is time to keep the lights on, rather than trying to shoot them out.
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Managing Director
International Equity Team
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