International equities: How companies are closing the value gap

David Herro: I started in this business in 1986, and I started here in 1992, and certainly we've gone through periods of international outperformance and underperformance, but never in my career has there been such a long period of underperformance of international versus domestic. I do believe, based on the fundamentals, that it is setting us up for a long period of outperformance. 

And I say this because the valuation differentials have almost never, never been greater. Not only do we have this huge valuation differential in terms of local stock market valuations, but you also have at the same time that international stocks have been derated, you've had an extremely strong U.S. dollar. 

In fact, over the last ten or eleven years, the dollar index has gone from the mid-seventies to the low double digits, so almost a thirty percent appreciation in the dollar index. So, when you combine those two factors, strong dollar with contracting valuation differentials, you get exactly how the rear-view mirror looks. Not so good. 

We believe this is unrealistic that companies that generate high single-digit to low double-digit value, per year, will eventually have this valuation reflected in their share price. So, it's been tough, as you can see, by looking at this graph that goes back to 2007, there's never been such a long period. And, keep in mind, there have been periods where foreign stocks have actually looked more expensive than U.S. stocks. 

So, we're certainly in an unprecedented period in terms of evaluation differentials. Again, it's a double discount. Discount one is an evaluation themselves of the local markets of stocks. Discount two is the undervalued currencies we are buying with the overvalued, what many would deem as an overvalued U.S. dollar. 

What is the catalyst? Why would this change? Before we go into possible catalysts, I want to just go back to a little reminder. When we're buying shares in a company, we're buying ownership stakes. We are owning the part of a real asset via a financial asset. Eventually what makes this financial asset valuable is what makes any financial asset valuable, and that's the cash flow stream, which those assets generate.

And to us, if there's a high free cash-flow yield, that is the cash that the company generates, free cash divided by the denominator, whether it be the market cap or the enterprise value. The higher the free cash-flow yield to us, the more attractive the asset is. And with these low valuations, what it has done is made an overabundance of attractive names, based on those economic fundamentals. Now, as we know in the short- and medium-term, fundamentals often do not drive price. But our view is that these financial assets eventually are no different than anything else, and they will get priced based on fundamentals.

In the meantime, what's happening? Well, companies are not sitting on their hands just watching their valuations drop. I mean, we look at the fundamental factors that drive this: cash flow stream, sales growth, margins, investments. We see good improvement in our own companies. We see good earnings growth, generally speaking. 

Now, external factors. Think of two big shocks that happened just in the last six or seven months. June had the European elections, followed by French elections, which dramatically altered the price of European-listed equities. Did it alter the underlying intrinsic value? Really hard to make an argument that anything, as a result of those elections, impacted our company's ability to generate cash for the owners. There's all kinds of things out there that can continue to happen. They always will. Again, I've been doing this since 1986. I can give you a litany of geopolitical shocks that have impacted price but have had very little or no impact on underlying intrinsic value. 

So back to the topic, these are the big things that could impact price. What are our companies doing to take advantage of the low valuation of their businesses? Number one and, of course, most important, is what the Japanese called Kaizen: continuous improvement.

Making sure that you're operating your business in an efficient way. Optimizing your cost base, successfully investing in sales growth through R and D, making competitive products, distributing them in an efficient way. So very, very important are what I would call the blocking and tackling of business 101: Efficiently using your assets to create income streams, which then convert into cash, which is the number the number two block behind their capital allocation. 

Then you have free cash and you're able to keep that perpetual cash flow machine going either by investing it into your business through M and A, through de-leveraging your balance sheet or by rewarding shareholders. And then if some of those things don't work, and your share price still isn't responding, you could do other things. You could spin off companies, you could list businesses, you could break up your company, et cetera, et cetera. And in small-cap land, what we have seen is, it’s much easier for small companies that don't do these things, that sell at low prices, to actually get acquired. 

So, we have a situation today where we are witnessing extreme valuation and we're happy to say, our companies are responding in a very desirable way. As owners of the businesses, we want to see proactivity out of our management teams.

You've heard me speak before about what I call the two C's: the capability and the commitment to build shareholder value. And we're really pleased that we're seeing this. Look at the big picture versus the U.S. Who would ever imagine that the return on capital is significantly higher to owner?

This is the return of capital to owners, to shareholders in Europe today, is significantly higher. And a lot of this is coming from increased buyback activity, as if your share price is trading at bargain-basement valuations. It makes a lot of sense to be buying back your stock. And this is exactly what we're starting to see throughout our portfolio of companies.