Markets are rallying in sync worldwide, but valuations in certain areas carry undue risks
We’re now in the eighth year of a global bull market, and the positive effects are being felt in all regions. The Organization for Economic Cooperation and Development expects gross domestic product (GDP) for all of its member countries to grow in 2017 — a feat that has not occurred since 2007.1 But a synchronized rally doesn’t mean that all opportunities are equal. To illustrate the differences that the Invesco International and Global Growth team is seeing, I’m going to highlight two areas: Asia and Brazil.
Asia: Improving fundamentals, but a narrow stock rally
Exports continue to improve across Asia, and companies are revising their sales and earnings expectations upward. Importantly, the breadth of revisions is beginning to broaden, with more countries and sectors experiencing positive revisions.
However, the stock rally in Asia is very narrow, with just a handful of companies driving performance. In the first three quarters of 2017, five stocks accounted for more than one-third of the performance of the MSCI All Country Asia Pacific ex-Japan Index.2 All five are tech companies, and on average they were up 68% year to date through Oct. 13, 2017.3 However, they were also trading at valuations that are 15% above their historical averages.2
In particular, Chinese tech companies Alibaba and Tencent have been the life of the party in Asia (both 0% of Invesco International Growth Fund, as of Sept. 30, 2017). They are great businesses, generating cash flow return on investment (CFROI) of 22% and 24%, respectively.3 In short, these are businesses that are growing like weeds — but they are priced for it. When you factor in the stock-based compensation plans that their executives have earned, these companies are trading at 43 times and 38 times earnings, respectively.2
To see the effect that such a multiple can have, consider Alibaba. We calculate that if the company’s long-term cash flows were to grow just 1% slower than market expectations, it would translate to a 17% hit to the stock price. There is a lot of risk built into that multiple.
Over our careers, we have seen many cases in which the market gets particularly excited about a company’s potential — but in our view, the list of zeros is ultimately much longer than the list of heroes. The narrowness of the market’s performance in Asia has limited our view of available opportunities — which we assess on the basis of Earnings, Quality and Valuation (EQV) characteristics. Instead, our team prefers investing where we believe the odds are stacked in our favor. That brings me to Brazil.
Finding opportunities in Brazil
Brazil’s GDP growth turned positive in the second quarter, and economists are steadily lifting their expectations for 2018. The central bank cut interest rates 200 basis points in the third quarter, and there is scope for further cuts with interest rates above 8% and inflation now below 3%.4 The market as a whole is trading at 13 times its forward price-to-earnings ratio, which is a 15% premium to the historical average.5 However, it is important to remember that the earnings base continues to be depressed. The economy is just coming out of recession and earnings before interest, taxation, depreciation and amortization (EBITDA) margins remain about 140 basis points below full-cycle levels.6
In Invesco International Growth Fund, most of the new positions we’ve initiated this year have been in Brazil. Below are two examples to illustrate the opportunities we’re seeing there.
- We initiated a position in Kroton, the largest post-secondary education company in the world, paying 11x for a 26% CFROI.7 (1.14% of Invesco International Growth Fund as of Sept. 30, 2017.) In Brazil, a relatively small portion of the population gets a post-secondary education, and we believe private colleges (such as those operated by Kroton) are the most cost-effective way for governments to invest in and improve access to a college education. Kroton boasts the industry’s highest profitability and strong cash flow generation, which we attribute to its seasoned management team and well-executed business plans.
- We also initiated a position in Cielo, the largest credit and debit card payment processor in Brazil, paying 13x for a 42% CFROI.7 (1.53% of Invesco International Growth Fund as of Sept. 30, 2017.) Cielo collects point-of-service terminal fees on Visa, MasterCard, American Express and other credit card transactions. The company has significant market share, but credit card usage in Brazil is low, so we believe there is a long runway for growth.
We’re pleased to see the synchronized global rally taking place, but the EQV characteristics of individual companies are most important to us, and that’s how we assess opportunities for our investors.
Learn more about Invesco International Growth Fund.
1 Sources: Citi, BCA, as of Sept. 30, 2017
2 Source: FactSet Research Systems, as of Oct. 13, 2017
3 Source: Credit Suisse, as of Oct. 13, 2017
4 Sources: Central Bank of Brazil, Bloomberg L.P., as of Sept. 30, 2017
5 Source: FactSet Research Systems, as of Sept. 30, 2017
6 Source: Credit Suisse, as of Aug. 31 2017
7 Sources: Bloomberg, L.P., IBES, Credit Suisse HOLT, as of Sept. 30, 2017
Brent Bates, CFA, CPA
Senior Portfolio Manager
Brent Bates is a Senior Portfolio Manager with the Invesco International and Global Growth team, focusing on large- and mid-cap equities in Asia Pacific and Latin America. Mr. Bates is a co-manager of the Invesco International Growth, Invesco Asia Pacific Growth and Invesco Developing Markets strategies.
Mr. Bates entered the investment management industry in 1996 as a mutual fund accountant with Invesco. Between 2002 and 2005, he served as an equities analyst with Invesco’s US Multi Cap Growth team, which he joined after serving as an analyst on the firm’s Quantitative Analysis team from 1998 to 2002. He joined the International and Global Growth team as an equities analyst in 2005, and was promoted to senior equities analyst in 2007 and portfolio manager in 2011. He assumed his current role in 2015.
Mr. Bates earned a BBA degree from Texas A&M University. He is a Certified Public Account (CPA) and a Chartered Financial Analyst® (CFA) charterholder.
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Past performance is not a guarantee of future results.
Cash flow return on investment (CFROI) is a valuation model that assumes the market sets stock prices based on a company’s cash flow rather than its earnings.
One basis point is equivalent to 0.01%.
Price-to-earnings ratio measures a stock’s valuation by dividing its share price by its earnings per share.
The MSCI All Country Asia Pacific ex-Japan Index is an unmanaged index considered representative of Pacific region stocks, excluding Japan. An investment cannot be made into an index.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
Stocks of medium-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.
The information provided is for educational purposes only and does not constitute a
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