Widen the Universe—Narrow the Focus

The geographic weightings in our global equity strategies look quite different than the major global indices. For example, there are 302 Japanese companies in the MSCI All Country World Index, representing 13% of the index (on an equal weight basis). However, we typically hold few Japanese companies. On the other hand, there are 579 U.S. companies in the index, representing 25% of total constituents, yet the U.S. is typically our largest allocation. At times we’ve had no exposure to major economies or economic regions.

The country weightings in our portfolios are generally a byproduct of our bottom-up stock picking approach. Unless there are identifiable country-specific risks, we gravitate to where undervalued, high-quality companies can be found. We look for businesses with competitive advantages that lead to the generation of strong and predictable free-cash-flow streams. Examples of competitive advantages are scale, low costs, network effects, and ownership of brands or intellectual property. Without these competitive advantages, high returns on invested capital are unsustainable.

Some countries are home to more high-quality companies than others. To illustrate this, we ranked the MSCI All Country World Index constituents, excluding financials, using our proprietary Moat Score methodology. A composite measure comprised of trailing return on invested capital, gross profitability, and historical analyst earnings revisions, the Moat Score serves as a screening tool to help us uncover high-quality businesses.

Table 1 highlights six countries where the majority of their companies fall in the bottom half of all Moat Score rankings. These companies have low returns on invested capital, volatile earnings, or low profitability. Of this group, 276 fall in the bottom half of Moat Score rankings, nearly 20% of total ranked companies. Unless our analysis revealed a compelling reason to own one of these businesses (e.g., business transformation, compelling sum-of-the-parts valuation, significant near-term catalyst, etc.), they would be unlikely candidates for inclusion in our portfolios.

TABLE 1. Select Countries with the Majority of Companies in the Bottom Half of All MSCI All Country World Index Moat Scores

SOURCE: FACTSET, GENERATION PMCA CORP.

Not surprisingly, over 40% of Canadian and Australian constituents are in the energy, non-energy minerals and utilities sectors–all lower quality industries. In Japan, many of the poorly ranked companies are found in auto and auto-related sectors. The country’s numerous sōgō shōsha (general trading companies) rank poorly due to their low returns and volatile earnings. South Korea’s poor rankings are a product of heavy representation from the electronics manufacturing, health technology, and process industries sectors. These three sectors have an average return on invested capital of just 6.7%.

Countries with the majority of companies ranked in the top half are presented in Table 2. These countries are home to companies with high returns on invested capital, often from strong intellectual property, global consumer brands, and low capital intensity. In the United States, companies such as Intuit, NVIDIA, Adobe, Microsoft, Hershey, and Clorox sit near the top of the rankings. In Denmark, health and health technology companies like Lundbeck, Novo Nordisk, and GN Store, generate strong returns on invested capital and consistent earnings. Companies from Table 2 would likely be ideal targets for our analytical team to focus their efforts. These high-quality companies tend not detach materially from their fair market values. Opportunistic purchases can be made after short-term events such as disappointing earnings, temporary production issues, or a broader market correction.

TABLE 2. Select Countries with the Majority of Companies in the Top Half of All MSCI All Country World Index Moat Scores

SOURCE: FACTSET, GENERATION PMCA CORP.

For us Canadians, known for our strong home bias, these stats should give pause. A high concentration of Canadian stocks can easily result in overweighting low-quality business and an absence of enduring multinational organizations.

Our message: go abroad, but narrow the focus to high-quality companies. The resulting portfolio will look quite different than any major index, a challenge for many professional managers that are hesitant to stray too far from their benchmarks. More enterprising investors will be rewarded with a portfolio of companies with superior profitability, high returns on invested capital and consistent earnings. As we pointed out in The High-Low Approach to Identify Outperformers, companies that generate high ROIC with low year-to-year variability in their ROIC tend to have smaller drawdowns during market corrections, too.

Going abroad does introduce currency risk but a basket of diversified currencies and opportune hedging can minimize the impact of currency fluctuations. Geopolitical risk can be mitigated by sticking to countries with strong democracies, judicial independence, and transparent government practices.