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Part I: Widen Your Perspective in International Growth

Rising regional brands are tomorrow’s global leaders.

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Part I: Widen Your Perspective in International Growth

Emily Levielle: In my opinion, some of the best businesses with the most exciting growth prospects in the world today are actually found outside of the US. And, you know, I would go so far as to say that they’re really becoming global leaders.

Zack Wehner: Welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments. I’m Zack Wehner, a client portfolio manager at Thornburg. We’re joined today by portfolio managers Emily Lavielle, Nick Anderson, and Sean Sun, who cover international growth equities. In part one of this two-part series, we are discussing this ever-changing pandemic world now punctuated by higher inflation and an involving rate landscape, and we’re also going to discuss the historical backdrop for international growth equities, inflation, higher rates and what the future looks like for international growth investing. Sean let’s start with you. Over the past 15 years, it was a relatively favorable environment for international growth equities with lower rates and broadly favorable conditions. In your view, how has the international growth investing landscape evolved over this historical timespan?

Sean Sun:   Thanks, Zack. So, in my career, having invested in equities in both the US and abroad, I think it’s never been a better time to be invested internationally, because of how increasingly important this space has become over the years, and because of the many positive trends we see that just continue to support allocating assets internationally. Some of the few, some of the structural trends we are seeing are, one, the majority of the world’s GDP is generated outside the US, and that percentage has been steadily increasing over time. Secondly, the world economy is becoming flatter and flatter. Companies are becoming more globalized, and, you know, international trade now accounts for nearly two thirds of global GDP, up from less than 10, up from less than half 10 years ago. And key secular themes and disruptive trends like digital payments, e‑commerce, Cloud computing and the Metaverse are not confined by borders. Thus, having a global perspective and investing internationally is more important than ever. You know, while the US has its share of truly exceptional companies, there’re plenty of international companies that are global leaders in their own right, and it’s important not to exclude them from any diversified portfolio. Basically the opportunity of c, the opportunity costs of not investing internationally is huge. If you take, for example, the constituents of the AQI index which has roughly 3,000 stocks, and, if you look at the top 100 of those stocks in the index rank ordered on terms of performance over the past 5 years, those top 100 stocks in the AQI index returned over 80 percent annualized, over the past 5 years. And you may be surprised to learn that, of those top 100 stocks in the AQI index, only 25 of them are actually based in the US. So, if you’re only invested in US companies and US stocks, you’ve, you’ve left out 75 of the top 100 stocks in the AQI index over the past 5 years. And the best represented country in that list is actually China with 29 out of the top 100 stocks over the past 5 years. So, in my mind, limiting yourself to just US stocks doesn’t make sense. You lose performance and you lose diversification benefits. And I think a global perspective also matters because it used to be that, if you wanted to own the leader or best company in a region, it was oftentimes a US company in that region. For example, if you wanted to own the biggest e‑commerce company in Europe, it was often time, it was Amazon. If you wanted to own the biggest search company in Europe, it was Google, but increasingly what you’re seeing is the rise of regional or national champions that you can only access the business value creation by investing in those companies directly. For example, if you want to own, you know, the Amazon of Latin America, it’s Mercado Libre. They’ve become, you know, a regional champion there. If you want to own a leader in cell phone towers, it’s not American Towers in the US. It’s Cellnix in Europe, so I think it’s important that you, widen your perspective so that you can gain exposure to these various regional or national champions in really dynamic high-growth international markets. So overall we think the international growth landscape is a rich-and-growing universe of investment opportunities and that it’s continuing to evolve in a way that really favors our process and plays into our strengths, that being performing intensive, fundamental, bottom-up research that is really focused on identifying great companies with durable growth prospects at a discount to their intrinsic value.

Zack Wehner:   Sean, those are some really interesting points on regional champions, and I think that’s certainly an important development over the past 15 years. Nick, outside regional champions, what do you see as something that has been really important in international growth investing over the past 15 years?

Nick Anderson:   I think that Sean, really touched on the important point here which is the rise of regional champions. and if you look at how the international growth investing landscape has evolved over the last 5, 10 or 15 years, we’ve just seen an incredible amount of innovation and entrepreneurship and investment. Rewind 10 years ago, and the international growth benchmark was dominated by materials companies, consumer staples companies, still-growing consumer staples companies, cyclical industrials, and just generally lower-quality, slower-growth businesses. But, because of the rise of these regional champions and, you know, the incentive to entrepreneurship, the landscape has really evolved in a way that favors our process. to give a few examples, the IT sector weight in the international growth benchmark today is 20 percent, which is more than double the 8 percent it was 10 years ago. The number of IT sector stocks was, 74 10 years ago. Today it’s 180. And many of the companies that we invest in and that dominate these markets were barely in existence when this strategy started, including some of the largest, capitalization companies, in, in the, in the index. So we’ve just seen a rise of investable leaders, whether it’s in internet, or payments, or, semiconductors, and this favors our process. These are companies that we think have many years of attractive growth ahead of them. And I think that, as you see more and more examples of success, and success stories, it provides an incentive to local economies and to students and to entrepreneurs and, frankly, to investors and venture capitalists. So we expect this is a virtuous cycle that will continue to, to spin for many years to come and continue to throw up good and exciting opportunities. Sean also mentioned some of the trends that we’ve participated in, and that we think will continue to drive markets and companies, such as digital payments and e‑commerce. It’s worth pointing out that some of these trends actually began in international or even emerging markets and have, leapfrogged into developed markets. or said differently, many of these trends began in international or emerging markets and it’s actually the developed worked that’s catching up. So, to give a couple examples, social commerce as a concept, the idea of e‑commerce being a social experience that you share with your friends, that’s something that began in China and increasingly is how people engage in e‑commerce in the west. digital payments using apps to pay for things offline again began in emerging markets. so many of these countries have leapfrogged the west. So, overall, I would say that the composition of the international growth investing landscape has shifted significantly over the last 10 or 15 years. It’s shifted in a way that favors our process, and we think that, the market will continue to throw out many exciting opportunities for us over the next 10 to 15 years.

Zack Wehner:   Nick, it does sound like there are a lot of opportunities out there internationally, especially when you’re thinking about investment themes. Emily, I want to get your take here, because you’ve lived abroad over the course of your life. So, I wanted to see, from your perspective, living in Europe and Latin America, what you think the trend is in international growth equities in investing?

Emily Leveille: Yeah, thanks, Zach, for the question. I really echo what Sean and Nick have already said. I mean, in my opinion, some of the best businesses with the most exciting growth prospects in the world today are actually found outside of the US. And, you know, I would go so far as to say that they’re really becoming global leaders. if you look, for example, at TSMC in Taiwan, it’s the largest, most advanced semiconductor foundry in the world all the way to LVMH in Europe, which is the leading global luxury platform. Very, very difficult to compete with the size of the platform and the brands that they have. And then Adyen, as Sean mentioned, is really a leader and disrupter globally in the payments base and offering better payment processing and analytics to their clients. So I think it’s just a really exciting space to be in now if you’re a long-term investor looking for high-quality businesses with durable growth.

Zack Wehner:   Emily you brought up some interesting points about the power of a brand and the importance of having brand awareness and that really makes me think about inflation. Are there any other attributes a company should have in order to succeed in an inflationary environment?

Emily Leveille: This is something that we’ve been talking a lot about within the team and, and, you know, thinking about in our portfolio, and, um I think, if you look at some of the price action recently, you wouldn’t necessarily think that high-growth companies, the, you know, the types of companies that we like to invest in, are, are necessarily good companies to own in inflationary environments, but we actually think that that, that’s a misplaced assumption. you know, if we look, for example, just at the impact of, of inflation and price increases on businesses that have higher margins, which are the types of businesses that we normally own, relative to, businesses that have lower margins, you know, having higher margins means a lower impact of cost inflation on your earnings, all else being equal relative to a lower-margin business. And I’ll give you a really basic example there. If you’ve got, you know, $100.00 in revenue and $80.00 in gross margin, if you have a 10‑percent increase in your cost base, that’s only $2.00 of incremental cost, which, you know, if I assume nothing else about increasing prices or cutting other costs, only impacts my gross profit by around 2½ percent. But, if I had a lower-gross margin business of, say, 40 percent gross margins, then a 10‑percent increase in my cost base is a $6.00 impact which is a 15‑percent impact on my gross profit. So higher-margin businesses tend to be able to absorb cost increases more effectively and, therefore, have lower volatility in earnings, all other things being equal. And there are other considerations to take into account as well, like pricing power and asset intensity of businesses.

Zack Wehner:   Nick I want to turn to you and talk about something a little bit different—I want to talk about what pricing power— how important is that in an inflationary environment?

Nick Anderson:   You seek to own companies that have, pricing power Zach, but, you know, that’s not unique or novel. Many investors will talk about, owning companies with the pricing power, but I think what, differentiates our process is, we try to really understand the sources of that pricing power and, analyzed it well and understand it deeply. So, what you really care about is a company that can not only increase prices faster than inflation but can do so without causing a reduction in demand. It’s no good if you raise prices and it leads to people buying less of your products. So, we’re looking at the price elasticity of demand and, looking for companies that have pricing power that they can pass it through without reducing their, their unit volumes. this requires an analysis of, a company’s brand, and market position, industry structure, the barriers entry, and the switching costs that the customers will incur for trading down, so we think pricing power is really important. It’s a critical element of our analysis in all market environments, because it’s a reflection of the underlying strength of the business. But especially in inflationary markets, when companies do have to exercise their pricing power, it becomes an, especially important part of our analysis.

Zack Wehner:   Sean, so we’ve covered pricing power and margins and they really are important in an inflationary environment, but I heard Emily mention one more thing, which is asset intensity of a business. Can you help me unpack that idea why it’s important in this environment?

Sean Sun:   The, the reason asset intensity matters is because, when you have high inflation and a lot of assets, what that does is, it basically compresses your ROE over time by inflating your asset base. And many investors think about how tech stocks underperformed in the ’70s. And relate, you know, higher inflation with bad performance for tech stocks. But, when you look at the tech stock composition of the ’70s, when we last had a lot of inflation here in the US, you know, those companies were very different than the companies we see today. Those companies back then are, were companies like IBM, Xerox, Kodak that actually had a lot of assets and had a high asset intensity. But the tech stocks that exist today are really asset-light companies with a lot of revenue and profit per employee, and, you know, the tech industry today I think will do much better in an inflationary scenario than the tech industry of the ’70s. Because, when you look at com, tech companies today, they’re, they’re, they’re very much asset light. You know, they have a lot of very valuable and tangible assets. And for certain businesses, such as businesses that sell advertising like a Google or Facebook, or businesses that sell goods, or businesses that, are involved in digital payments like in Adyen, you know, they’re, they’re positively exposed to inflation, because, you know, their, their take rates track overall gross, gross, merchandise volume or, or total payment volumes. So, you have this natural kind of hedge, this natural growth with inflation, in terms of what those types of companies are doing today.

Zack Wehner:   So, Nick we talked a lot about the fundamentals of a company and how important that is in an inflationary environment, but let’s switch gears and take a step back. Let’s take the bigger picture approach and talk about how inflation impacts stock prices and why that matters.

Nick Anderson:  Yeah, when evaluating how inflation impacts equities, there are two totally distinct effects to consider. One is on stock prices and then the second is on con, company fundamentals. The first effect, on stock prices, is pretty clear. Stock valuations will suffer as interest rates rise through a higher discount rate on future earnings. the reality is, that will have a greater effect on growth stocks than value stocks. growth stocks drive a greater portion of their value from earnings that will occur many years in the future, and they’re thus more sensitive to changes in interest rates than value stocks, which have shorter-duration cash flows. but, when it comes to fundamentals, higher-quality companies should be able to grow their earnings above the inflation rate and, thereby, outgrow some of that initial repricing risk. balancing these two competing effects of inflation, you know, on stock valuations versus on company fundamentals, is really what we do. It’s the focus of our analysis in building a portfolio, and it’s why we focus on the reasonableness of the valuation when we buy the stock to ensure that we’re not taking too much of that duration risk when, interest rates change.

Emily Leveille: Yeah, and the other thing that I would add to Nick’s point is just that, you know, this disconnect between, the company valuations and the impact that inflation is having on that and then the impact that it’s having on the underlying businesses is, they’re moving in diverging directions right now. And that’s creating for, for us, what we think is a really exciting opportunity, to potentially invest in some really high-quality businesses, on, at discounted valuations that we haven’t seen in a number of years because, inflation has been so low and rates have been on a, on a downward trend.

Nick Anderson:    Absolutely. I would agree with that. I mean, the effect of, inflation and interest rates favors value stocks over the growth stocks, but the market is forward looking, and in recent moths, you know, recent weeks, the market has already begun incorporating higher rates into the appraisal of stocks so, I think it’s some, uh comfort to investors in growth stocks that some of this repricing has already occurred, and on a forward-looking basis, the outlook for growth stocks, especially growth stocks with, high quality, is, is very favorable on a longer-term view.

Sean Sun:  I agree, Nick. And then, and then actually if you look at where nominal rates are at, and where equity prices are, are, versus nominal rates, we’ve seen, you know, rates move up from kinda near-zero levels, but nominal rates remain fair, relatively low. And if look at the long end of the curve and you look at kinda the demographics of some, some of the countries we invest in, like Europe, you’ll, to me it seems like – well, it, valuations are actually very reasonable when you consider where nominal rates are at, historically. But there’s been, you know, relative volatility recently as kinda shorter-term rates and central banks, are, are poised to raise rates.

Emily Leveille: One other thing that I wanted to mention on, you know, that, that we have as a benefit of being global investors instead of just being focused in the United States, as well, is that, you know, not all countries are, are at the same point in the inflationary or interest rate cycles as the United States is, either, so, you know, we have the opportunity to diversify our portfolio outside of places where, inflation and interest rate expectations might be, putting pressure on valuation so, you know, for example, if we look at China, which is a really important market for us in, in, in our strategy, China is actually gonna be entering into what, what we think will be a monetary easing cycle in, in 2022, at the same time that the United States is, is actually entering into a tightening cycle. So inflation in China, and interest rates, are on a very different trajectory, and we think that that allows us an opportunity to potentially find, you know, diversification and, more c, cushion in performance at times when, stocks in the United States, and companies in the United States, are suffering from a lot of fear and, expectation around where inflation will normalize and stabilize, and, and what that will do to interest rates and valuations.

Zack Wehner:   Emily I think that’s a great point about inflation, how rate expectations and inflation can vary country to country and present different opportunities at different times. But, I want to switch topics a little bit to something else. Because over the past decade growth seems like it was the relatively dominant style until this latest market rotation, what do you think it’ll take for growth to start leading again?

Emily Leveille: You know, Zack, we’re long-term investors, and we still think that quality and duration of growth are paramount for long-term returns. Stocks follow the power law. Very few companies generate most of the alpha over the long term in the stock market, and those are the names that can grow profitably for long periods of time. Energy and large-cap develop market banks, for example, they might exhibit a couple of years of strong earnings growth on the back of a more inflationary environment with higher interest rates, but we don’t believe that this growth is sustainable for 5 or 10 years when we look at the fundamentals of, of the businesses and the industries. So once that valuation gap starts to narrow with some of the higher-quality businesses, derating while at the same time some of what we perceive to be the lower-quality businesses rerating, we think the market will start to view the relative opportunity and more in favor of the names that have durable growth characteristics.

Well, thanks a lot Sean, Nick, and Emily.  We certainly covered a lot of ground today.  I also want to thank you for listening. Stay tuned for part two of this series  focusing on how the nature of businesses change in a digital world, particularly for international growth companies. You can find this and other episodes of Away from the Noise at thornburg.com/podcasts.  You can also find this episode on Apple Podcasts, Spotify, or wherever you prefer to listen to podcasts.  Please rate, subscribe, and review us.  You can also visit thornburg.com to see all of our market commentary.  Thank you and please join us for the next episode of Away from the Noise.

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