Why International?

Dear Fellow Partners & Friends,

As a global investor for over two decades, one of the most often asked questions over the years has been whether there is more value domestically or internationally. Our assessment and answer may change depending on the environment. At times, we can clearly see when one is more or less attractive than the other, while other times the answer is not as clear-cut and absolute. In fact, they can often both be overvalued (as in 1999) or undervalued (as in 2009). We have also observed that after long periods of underperformance by one or the other, the performance advantage may flip to the previous laggard.

As illustrated below, when comparing the S&P 500 Equal Weighted index versus the MSCI EAFE Equal Weighted index from the top of the technology bubble in 2000 to the trough in 2003, the international index fell by 33% versus the 18% loss posted by US stocks. That would reverse from 2003 to the end of the credit bubble in 2007, as non-US stocks ran ahead of US stocks by a cumulative return of 199% versus 125%. The credit bust proved to be the great equalizer, however, with both measures declining roughly 50% during that period. The post-financial crisis bull market again reversed the previous trend as US stocks have risen nearly 250% versus 142% for their non-US counterparts (as of November 30, 2016).

We believe that there are several reasons which partially explain the relative weakness of non-US equity returns since the financial crisis. Among others, these include growing doubts over the viability of the European experiment, the cyclical collapse of raw-material prices, the global impact of China’s decision to alter its growth model and Japan’s ongoing saga as the “canary in the coal mine” of global deflation and aging demographics.

Certainly the US has had its own share of challenges, but global investors seem to have given the benefit of the doubt to the US and its stock markets. In fact, the S&P 500 index trades at a forward Price to Earnings (P/E)¹ ratio of 16.9x versus 14.6x for the MSCI EAFE index. This increasing P/E premium versus non-US stocks has also contributed to the relative outperformance of US stocks post financial crisis.

As bottom-up global value investors, we have observed the tendency towards mean reversion² over the years — not always, but often enough to acknowledge the presence of a metaphorical “pendulum” that swings from one extreme to another over time. In our case, the Centerstone Funds are substantially exposed to foreign markets and, in theory, could benefit if non-US stocks regained favor. In addition to foreign market exposure, the Funds also have several US companies with substantial foreign presence. Indeed, when looking at exposure from a revenue-sourcing perspective (as opposed to domicile), the Centerstone Investors Fund’s (CENTX) foreign equity exposure is nearly two-thirds its total equity exposure. This exposure has not changed much from launch despite the many crosswinds in 2016, perhaps not surprising given our long-term investment approach.

US Dollar Impact

In addition to the effect of the noted factors on non-US equity markets is the impact that the dollar’s moves have had on the performance of non-US investments. For instance, since July 2014, the beginning of the recent move higher in the US dollar, major European markets (as represented by the Euro STOXX 50 index) have risen 1% annualized in Euro terms, but this compares with minus 9% in US dollar terms. Clearly, performance measured in dollars can be influenced by moves in counterpart currencies, which is one reason why the Centerstone Funds tend to partially hedge their foreign currency exposure.

When looking at our foreign equity allocation, a majority of our exposure is in European companies. Our bottom-up search for value has led us to this region, however most of these companies are exposed to markets outside the Eurozone.

Centerstone’s currency hedging policy is straightforward. We aim for a 50% hedge under normal circumstances, but may deviate from that based on a number of factors. First is valuation, for instance with the British pound we are lightly hedged, which due to its recent depreciation is now relatively undervalued on a purchasing power parity basis. The second factor is the tendency for many foreign companies to be naturally hedged due to their global presence, in which case we will adjust the target hedge accordingly. Finally, real interest rate differentials may elevate one currency versus a basket of others even if the currency is already overvalued, which we will also consider.

Foreign Equity Allocation

When looking at our foreign equity allocation, a majority of our exposure is in European companies. Our bottom-up search for value has led us to this region, however most of these companies are exposed to markets outside the Eurozone. For example, Air Liquide³ of France derives the majority of its revenues outside Europe, including 43% now from the US. Swatch Group⁴ of Switzerland derives the majority of its sales outside Europe. These are just two examples showing that domicile does not necessarily tell the full story.

Are We There Yet?

It seems fairly obvious that non-US equities are facing and have been facing a great deal of headwinds. Nonetheless we believe it might be helpful to try to understand where the “pendulum” might currently stand in regards to international versus US stock returns (assuming that one accepts the concept of “reversion to the mean”). Since international markets have already been lagging US stocks for the bulk of the bull market, we can at least say that we are somewhere in the middle of the cycle. Second, as it relates to the dollar, as illustrated above, the Trade-Weighted US Dollar index has risen 35% since bottoming in 2011 and it has been rising nearly uninterrupted for almost six years. There have been two other dollar bull markets since the end of the Bretton Woods agreement in 1971 (AKA the “Nixon Shock”). The bull market from 1995 until 2002 lasted nearly seven years and resulted in a 40% gain for the dollar. The bull market from 1980 through 1985 lasted nearly five years and resulted in a 55% gain for the trade-weighted dollar. That is not to say that the dollar bull market could not continue. In fact, while the dollar rose 55% during the Volcker years against a basket of currencies, it rose 100% versus the Deutsche Mark for instance.

As we move into another year, I am sure we will face a new set of circumstances and the many previously heretofore “unknowns” will make themselves “known” whether in the currency market, interest rate market, equity market or elsewhere. This is why at Centerstone we tend to focus on quality businesses with little balance sheet and business model risk and why we take a somewhat pragmatic and balanced view on currency hedging — you just never know what is around the corner.

Thank you for your continued interest and support and we wish you a happy and prosperous New Year.

Sincerely,

Abhay Deshpande, CFA
Chief Investment Officer