QUICK Q&A: International Value

By USAA Investments

Wellington Management is one of the sub-advisors to the USAA International Fund (USIFX).

The USIFX team at Wellington takes a contrarian approach to international value – they seek to identify stock-specific opportunities trading at extreme, multi-year lows. They describe their process as “low conviction,” meaning they make a large number of smaller bets for which they believe the upside can be high but the time horizon is uncertain.

Three questions from us, three answers from portfolio managers James H. Shakin, CFA, and Andrew M. Corry, CFA.

How are you thinking about the return of market volatility, particularly given your style of investing?

In the context of a long period of low volatility and upward trending equity markets, the dip we saw in February was not extreme or persistent enough to throw up many new opportunities, unfortunately. We look for those stocks showing extreme lows in valuation, price and negative consensus expectations viewed in the context of a decade or more. Importantly, we also tend to look for strong balance sheets to reduce downside risk and allow time for fundamentals and valuations to normalize. As contrarians, we tend to be liquidity providers, so some volatility tends to be good for our process. In that context, a modest pick-up in market volatility would not be bad.

Where are non-U.S. developed markets in the economic cycle, and how does this impact your opportunity set?

We do not position the portfolio based on forecasts for the economic cycle. Instead, we look at the expectations embedded in individual stocks and focus on those with extremely negative outlooks where there is a reasonable chance that the consensus is too pessimistic. For example, in 2014, the Japanese market was priced at a 40-year low relative to the rest of the world (see chart), and many stocks were discounting extreme negative outcomes. It should come as no surprise that we found a lot of individual Japanese stocks, which led us to a big portfolio overweight. As these holdings have done well, we have been trimming our exposure and recycling profits into U.K. and emerging market stocks, where expectations had become more pessimistic.

Two sectors you're embracing (and why) and two sectors you're avoiding (and why)?

Two sectors where we are finding unloved ideas that meet our low-valuation and price criteria are energy and financials. The oil price collapse starting in 2014 eventually helped to provide a sector-wide opportunity within energy, where valuations remain cheap and balance sheets are strong. Companies are constraining capital expenditures, which will likely improve free cash flow. In financials, historically low interest rates, tight regulation and anemic economic activity helped provide a broad sector opportunity. While they are not as inexpensive as they were a year ago, balance sheets have improved, interest rates are rising, regulatory constraints are easing, and economies are doing better.

Two areas of the market that have already done very well – consumer staples and health care – are less interesting to us. After the global financial crisis, these stocks generally benefited from business models not geared to the economic cycle, as well as changed investor preferences for low volatility and high “quality.” After a decade of strong performance, valuations and expectations are high, and it shouldn’t be a surprise that these days our contrarian value approach finds few opportunities.