Balancing opportunities in the international marketplace
- Markets posted gains in response to the European Union sticking together and investors embracing aggressive actions taken by central banks in developed markets.
- While our defensive position in Europe was early, we continue to hold it based on our long-term outlook for continued slow growth; this has benefited performance year-to-date.
- We believe emerging markets will be one of the few places to experience significant growth in the foreseeable future.
- Valuations relative to fixed-income counterparts remain very supportive for international equities.
John C. Maxwell, CFA
As economies around the globe struggle to overcome slow-growth trends, Portfolio Manager John Maxwell takes a look at past, present, and future global economic and market environments and the intricacies involved in positioning the Fund to capture opportunities.
Pain in Europe
In 2012, the Fund’s positioning, based on our economic outlook, left us generally wrong footed. After visiting many companies across Europe last summer, we became concerned about the prospects for stocks in the region. As a result, we began to position the Fund with a defensive tilt. While these expectations proved accurate when earnings estimates declined, markets posted gains in response to the European Union sticking together and investors embracing the extremely aggressive actions taken by central banks in developed markets. Our more defensive stance hurt returns in the Fund as, by and large, cyclical sectors outperformed their defensive counterparts in the second half of 2012.
While our defensive position in Europe was early, we continue to hold that position based on our long-term outlook of continued slow growth, which has benefited performance year-to-date. We believe Europe has a long way to go and it is unlikely we will see a robust, self-sustaining economic cycle in the foreseeable future. Despite continued headwinds, we are finding opportunities on a stock-by-stock basis, such as Bayer AG1, a major drug manufacturer in Germany. Bayer AG is a “growth at a reasonable price” position that we believe has a strong balance sheet, a faster-than-average pharmaceutical pipeline and a strong emerging markets presence that continues to grow. The stock has already done very well for us and we expect 2013 to be another solid year.
Appeal of dividend-paying stocks
Another area we continue to invest in is international dividend-paying stocks. The current and projected slow pace of global economic growth, especially in the developed world, could mean slower corporate earnings growth in the years ahead, adding to the appeal of dividend-paying securities. Many companies outside the U.S. are paying dividends at higher rates than their U.S. counterparts and their valuations aren’t nearly as high as dividend-payers in the U.S. International firms on average have higher payout ratios than those in the U.S. because of tax incentives. For example, we can gain exposure to the integrated oil and gas industry through a solid multinational firm like Total SA2, based in France, with a dividend yield roughly 3% higher than some of its U.S. competitors (such as Exxon Mobil Corporation and Chevron Corporation).
That said, we are not simply looking for the highest dividend-paying companies alone. For instance, we generally do not have much, if any exposure to the high-yielding utilities sector because those firms typically have to borrow in order to pay their shareholders. We continue to look for what we believe is the whole package – a company with above-average growth potential, lower-than-average leverage and strong free cash flow. If it also pays a solid dividend and is positioned to gain from emerging market growth, that’s really what we would consider a home run.
Emerging market consumers – a growth story
We believe emerging markets will be one of the few places to experience significant growth in the foreseeable future. The growing populations in countries such as China, Brazil and India will likely continue to strive toward higher standards of living over the long term. As a result, this will require vast infrastructure and increasingly productive economies. Emerging middle-class populations in many of these markets are showing their economic impact through purchases of cars, high-end goods and other products beyond the basic staples, all while often maintaining better personal balance sheets than consumers in developed markets. As the populations in these growing countries flourish in number and sophistication, so do the economies themselves. Emerging economies are expected to grow at 4% or more per year, while advanced economies will likely settle into growth rates of 2% or less on average through 20503.
Because of this, the Fund is focused on companies with a combination of products or services that are geared to the emerging middle class. We not only seek growing companies in emerging markets, but also multinational firms domiciled in developed countries that benefit from this growth indirectly. For example, we recently purchased Standard Chartered, PLC4, a UK-based bank, with a goal to be a market leader in Asia, Africa and the Middle East. Approximately 90% of the company’s income and profits are derived from those regions. We believe the company to be relatively inexpensive when considering its conservative balance sheet and good dividend.
Historically, the Fund’s direct exposure to emerging market investments (roughly 10% on average) has boosted relative performance. However, in recent years, everything from “hard landing concerns” in China to political uncertainty and slowing growth rates globally have heightened volatility and detracted from the Fund’s returns compared to its benchmark, the MSCI EAFE Index, which has no direct emerging market exposure. Despite the pause in strong returns, we still believe the allocation is appropriate, and we will continue to look in the emerging market universe for some of what we believe are the best growth opportunities available, keeping in mind that economic growth does not always translate to stock market growth.
Japan on the move
The opposite of the above holds true as well, meaning slow economic growth doesn’t always translate to slow stock market growth. Japan’s economy has been growing at some of the slowest rates among developed markets, has the highest debt/GDP ratio in the world, and yet the NIKKEI has rallied more than 60% in the last year. The aggressive shift in Japanese monetary policy to weaken the yen in order to jumpstart its economy, has greatly benefited Japanese stocks.
We have looked unfavorably on Japan for some time, underweighting the country as a whole, specifically the companies that are dependent on domestic demand in a country that was stagnant, if not declining. Simply put, the Fund was not positioned to fully take advantage of Japan’s market rally. And while we’ve increased our position over the last six months and eliminated our hedge on the yen, we are unconvinced fundamentals have improved in the country. We remain cognizant of the political and investment risks linked to Japanese stocks and we continue to look for the best relative opportunities, such as exporters, that should benefit from local policies.
Onward and Upward
We believe any significant improvement in economic growth will eventually lead to tightening of the extremely loose monetary and fiscal policy that exists across developed economies today, but we do not envision this scenario unfolding in the foreseeable future. Still, valuations relative to fixed-income counterparts remain very supportive for international equities. Compared with the last 25 years, stocks are trading approximately at their average price to earnings with above-average margins. Given government involvement in markets and our low-growth outlook, we intend to maintain our defensive tilt – buying stocks that we believe are poised to do well in this slow environment. As always, we continue to prefer stocks in companies that demonstrate strong cash generation, less-leveraged balance sheets and what we consider solid opportunities for growth.
1 2.0% of net assets as of 04/30/2013
2 2.3% of net assets as of 04/30/13
3 Source: PwC World in 2050
4 1.5% of net assets as of 04/30/2013
Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 31, 2013, and are subject to change due to market conditions or other factors.
Risk Factors: As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Dividend-paying investments may not experience the same price appreciation as non-dividend paying instruments. Dividend-paying companies may choose to not pay a dividend or the dividend may be less than expected. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers. Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently.
MSCI EAFE is an unmanaged index comprised of securities that represent the securities markets in Europe, Australasia and the Far East. The NIKKEI is a stock market index for the Tokyo Stock Exchange. It is not possible to invest directly in an index.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.