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As allocators increasingly overweight U.S. equities, we remind them that some of the best growth businesses lie outside the United States and can also help mitigate downside risk.
This paper takes a top-down deep dive into allocators’ goals and challenges and describes why we believe active, concentrated management is the best solution when investing in non-U.S. equities.
Let’s address the elephant in the room. International equities have underperformed their U.S. counterparts for most of the last 20 years. Even with our long-term investment horizon at Sands Capital, that is a long time. So why do we find international businesses so interesting and exciting?
As active investors, we love a treasure hunt. The opportunity set in non-U.S. businesses is deep, diversified, and ripe with growth—you just need to know where to look. As today’s allocators and investors become increasingly overweight U.S. equities, we remind them that some of the best businesses are often international and can also help mitigate portfolio-level risk.
The Allocator’s Goal: Maximize Durable Returns with Prudent Diversification
Maximizing Durable Total Returns: The Importance of Earnings Growth
In our view, true long-term investors with a goal of creating durable investment results should focus primarily on earnings growth. While valuations matter, and can drive results over the short term, history has shown that the vast majority of total returns over the long term are driven by earnings growth rather than fluctuations in valuations.
Since 2002, earnings growth accounted for all global equity returns
MSCI ACWI - Total Return Decomposition
Fundamentals matter, and it is much easier to forecast a company’s earnings trajectory, in our view, than to time the market. We believe this creates opportunity for investors focused on the long term.
Prudent Diversification: The Importance of Global Allocation
At the end of the day, equities will be correlated with other equities when markets experience stress. However, what matters for long-term investors is their portfolios’ ability to bounce back from stress-induced drawdowns. Allocators shouldn’t forget the important role that internationally diversified portfolios can play over the long term. Globally diversified portfolios have experienced shallower drawdowns and, on average, recovered faster than their locally invested counterparts.
Globally Diversified vs. Single-Country Portfolios
Global Diversification Has Historically Resulted in Downside Protection
us investors are overweight u.s. equities by the largest factor since the financial crisis
Investors allocated for the short term should first remember that outperformance has tended to alternate in multiyear cycles between international and U.S. equities, and we expect that the pendulum will eventually swing back to international. Over the last nearly 50 years, U.S. equities have outperformed over rolling five-year periods about 60 percent of the time.
rolling 5-year excess returns - international equities vs. u.s. equities
1974 - 2023
Secondly, there is more to U.S. equities’ recent multidecade dominance than meets the eye. The United States’ outperformance has not relied solely on earnings growth, and returns are somewhat detached from fundamentals.
Decomposing returns, a whopping nearly three-quarters of U.S. outperformance versus the MSCI EAFE index (a proxy for international equities) since 1990 was driven by valuation expansion.2 Because U.S. relative valuations more than tripled over this period, we believe relative returns of this magnitude could be due for a mean reversion or, at the very least, could be unsustainable going forward.3
U.S. Equity Outperformance Has Relied Primarily on Valuation Expansion
Valuations of U.S. and Other Equity Markets, January 1980 to February 2023
We believe this dynamic creates a largely untapped opportunity for the long-term, fundamentally aware investor. As previously noted, earnings growth rather than changes in valuations drives sustainable long-term returns.
The Allocator’s Goal: Maximize Durable Returns with Prudent Diversification
The earnings growth opportunities in non-U.S. equities are often hidden, and we believe U.S. investors are biased to not look for them.
Growth Obscured by Index Construction
The international opportunity set is vast, and investors who dig deeper would find that a majority of the fastest-growing businesses in the world are outside the United States.
The challenge lies in gaining access to durably growing best-of-breed businesses without diluting their growth potential. In indexes, the existence of growth companies is often obscured by the many slow-growing firms. Just under 20 percent of constituents in ex-U.S. benchmarks have compounded their earnings above 15 percent annually since 2008.
Indexes and Passive Management Miss the Growth
% Stocks Delivering > 15% EPS 5Yr CAGR: 2008 to 2023
Investors using index-tracking investment vehicles are missing the mark. In our view, passive or highly diluted portfolios are a blunt and poor tool to capitalize on the diversification and return opportunity in non-U.S. businesses.
The Home Bias Dilemma
Additionally, many U.S. investors exhibit what behavioral economists call home bias, believing that the safest and best businesses are right outside their doorstep. However, the United States does not have a monopoly on growth and innovation.
While we will not dispute that the United States has some of the top attributes to nurture innovation and growth, investors would be selling themselves short to ignore leading non-U.S. publicly traded businesses delivering above-average growth.
The Allocators’ Solution: Active, Concentrated, Growth-Oriented Portfolios
To us, the solution is clear: apply deep domain experience to seek the on-U.S. businesses with the potential to enhance returns and reduce risk.
We offer a range of global and non-U.S. growth equity solutions to fit your asset allocation needs underpinned by our concentrated long-term business owner’s philosophy and approach.
1 As of the publication date 11/18/2024
2, 3 The Journal of Portfolio Management, International Diversification – Still Not Crazy after All These Years (Asness et al., 2023)
Disclosures:
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change.
This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. All investments are subject to market risk, including the possible loss of principal. Differences in account size, timing of transactions and market conditions prevailing at the time of investment may lead to different results, and clients may lose money. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable.