Finding selective stock opportunities outside the U.S.

Julian McManus: Some of the major themes driving global equity markets today, most obviously is AI [artificial intelligence]. That’s at the front of most people’s minds. I would say that along with that the corollary is semiconductors. So, a lot of focus in markets right now is on semiconductors and the supply chain that makes the equipment that goes into them.

But there are, there are other less obvious themes around the world to be aware of, such as undervalued financials in both Europe and Japan. So, Japan is about to normalize their interest rates regime. They’ve had zero interest rates for some time. They’re the last central bank to do so, and so, in the case of Japanese financials, higher interest rates are extremely beneficial. In the case of life insurance companies, it’s because their liabilities are then discounted at a higher rate, which really helps their capital. Similarly, in the case of Japanese banks, as interest rates rise they pay out less to depositors than they gain in interest income and that really causes their earnings to explode.

Christopher O’Malley: So, we’re seeing opportunities in European banks where many of the players operate in markets that have little competition versus what you see here in the U.S. Their balance sheets are longer duration in nature, which means that they will continue to benefit off the rise that we saw in interest rates for years to come, and they are returning a substantial portion of cash to shareholders.

McManus: There’s a lot of investor bias right now, particularly expressing itself in FOMO. So, that fear of missing out (FOMO) is leading a lot of people to chase not just Nvidia, but everything that has a perceived exposure to it, including semiconductors. In some cases, [it’s] warranted, but in some cases probably a little overdone.

O’Malley: Two of the biases that we see quite often in the market are something we call recency bias and something we call anchoring. And recency bias just means that investors tend to overemphasize things that have happened in the recent past. In anchoring bias, [that] just means investors tend to anchor on a reference point in the past.

So, I think what we’ve seen in European banks is that investors have anchored on low growth that we’ve seen over the past decades, when Europe was in a zero- to negative-interest rate environment. And the fact is now, that environment has changed drastically. The days of zero or negative interest rates in Europe are gone. And as economic growth reaccelerates and as banks continue to redistribute their capital to shareholders, we’ll continue to see a rerating in the names.

McManus: A lot of these, these biases in the market where people are chasing growth at any price cause people to lose sight of what the free cash flows are really going to be. And free cash flow is a really helpful reality check. It helps you ground your understanding of a stock and value of a stock in reality.

O’Malley: In the U.S., we’ve seen the Mag 7 outperform the rest of the market and valuations become bifurcated. So, free cash flow is a good tool for investors to gauge what types of growth rates are embedded in those current valuations. For instance, in the U.S., there are companies that would have to grow at 20% for the next several decades to justify the valuations. Whereas in other parts of the world, there may be other companies that are going to benefit from the same trends that are trading at much more reasonable growth rates.

McManus: I think there are some good reasons why the U.S. has done so well. It’s primarily been driven by a lot of technology companies. They’re actually seeing growth accelerate at the best margins they’ve ever produced. So, that’s a powerful combination and that’s underrepresented outside the U.S. So, it’s difficult to say that that non-U.S. is going to close the gap.

But that’s why rather than buying the whole index, active stock pickers can look for the best opportunities. So, think of some of these financials that are a little off the radar or off the beaten track both in Europe and Japan, and defense companies. You know, we think defense is going to do extremely well for a really long time. And so, it’s not just about technology. There’s still a lot of opportunity for really good companies that are really undervalued outside the U.S. to close that gap. And so, that’s why it pays to be selective and not just by the whole index.