International stocks are gaining traction with investors -- but passive strategies may not be the best guide to opportunity. ClearBridge's Eliza Mazen explains why an active approach to diversifying international growth stocks may make more sense.
Paced by broadening global economic growth, international equities are gaining traction with investors. Strategies benchmarked to the MSCI All Country World ex-U.S. Index have seen positive flows for the five quarters through December, attracting an average of $23.6 billion in new assets over the last two calendar years.
That index would have delivered average returns of more than 15% over that same period -- but a passive strategy tracking that index would have left investors underexposed to growth opportunities in hot sectors like information technology, in companies with attractive growth potential obscured by short-term weakness, and in smaller capitalization companies with lower benchmark weights.
That’s why at ClearBridge we apply a more diversified perspective in selecting companies for our international growth strategies. We consciously seek diversity among company size, business models and the stage of a company's growth cycle, as well as by country and sector. This all occurs within our broad objective of identifying attractively valued businesses that can compound growth with below benchmark risk over the long term.
In addition, we find it useful to consider three separate types, or buckets, of growth companies: structural, secular and emerging. We believe this approach gives us the best chance to fully participate in the growth available in varying market environments, including both narrow and broad growth markets. Emerging growth stocks, for example, tend to do well in momentum periods, structural growers provide idiosyncratic sources of alpha, while secular growth companies can provide consistency through a full market cycle. This approach also helps us better understand the risks we’re taking on a portfolio level.
International Growth Stocks: Our Three-Bucket Approach to Diversification
Source: ClearBridge Investments
Structural: What we look for in this group are growth companies where the consensus has yet to recognize their growth potential. They may have misunderstood earnings, may be trading at discounts to historical performance, or may be engaging in self-help stories that can accelerate earnings. European financials are a good example of a sector where opportunities afforded by positive structural change may not be fully reflected in current pricing. Steepening yield curves and the repair to balance sheets has provided us with opportunities to buy improving earnings power at a discount. With banks, we pay close attention to the effectiveness of changes and will own the stocks for a period of time when improvements are making the greatest impact and be disciplined sellers once the valuation reaches our target or the turnaround story is losing momentum.
Secular: This group is the anchor within our international portfolios, typically representing 40% to 60% of assets. Secular growth companies are long-term compounders of cash flows and capital returns that can help provide stability through varying market and economic conditions. The companies we like in this category typically feature established, superior business models and have sustainable (but often underappreciated) long-term growth opportunities on both the top and bottom line. From an earnings volatility standpoint, secular growers pose the lowest risk level of the three groups.
Emerging Growth: The relative stability provided by our secular growth holdings allows us to venture further out on the risk spectrum and participate in dynamic growth trends caused by innovation or disruption. We group the companies driving these shifts into our emerging growth segment.
Think of emerging growth stocks as franchises becoming recognized for their above-average growth rates. In addition to high revenue or market share growth, they are also high risk and when they invest for growth, earnings can go sideways or even decline, generating volatility. As a result, we carefully monitor the risk levels in our emerging growth holdings with the goal of understanding and minimizing those risks -- but maintain exposure because they are often taken out in acquisitions. The ones that remain independent and successful can eventually become large and mega cap growth companies.
We believe buying quality, attractively-priced growth companies with the ability to compound over long periods of time is a sound way to approach the international growth market. We construct a portfolio of these companies by applying our valuation approach to growth to an all cap mandate focused on three categories of growth across developed and emerging markets.
Having an opinion different from the market can lead us to companies with better growth characteristics trading at attractive prices. This differentiated view leads us to seek stocks whose earnings are inflecting ahead of, or in contrast to consensus expectations. We want to be early in recognizing these companies and disciplined in monitoring risk and potential upside. This entails continuously assessing position sizes and being active in trimming and adding to positions based on what is happening with each company’s growth trajectory and valuation compared to our target price.
 Source: eVestment
 Source: FactSet based on the 2016 and 2017 performance of the MSCI ACWI Index.