International equity markets have favored value stocks with low valuations and slower or more-cyclical earnings for a good stretch now, but Fidelity Portfolio Manager Bill Bower remains undeterred in his view that companies with the most durable, consistent earnings growth can outperform in the long run.
“I believe the long-held tenet of longer-term investing will hold true and that the best companies will distinguish themselves in the next three to five years,” says Bower, portfolio manager of Fidelity® Diversified International Fund (FDIVX).
In screening for these names, he looks for strong businesses with durable or improving growth prospects that are benefiting from competitive advantages and are structured to achieve consistent profitability. He also covets solid balance sheets, free cash flow to fund growth, proven track records, high returns on capital, and capable management teams, while remaining conscious of valuation. Some consider this a quality approach, and growth at a reasonable price.
Stocks with these characteristics lagged the MSCI EAFE Index (a proxy for non-U.S. developed-market stocks) last year, hampering the fund’s relative performance. In 2022, inflation in the U.S. and many countries abroad accelerated to levels not seen in decades, driven in part by Russia’s aggression in Ukraine, which impacted many commodities, along with global monetary stimulus and China’s economic shutdown, which damaged supply chains, according to Bower.
With inflation on the rise, he says, many central banks around the world began rapidly raising interest rates, which caused investors to question the value of future earnings, especially those with faster growth or growth potential in the future. The premium that is typically given to these quality businesses decreased dramatically.
Durable growth stocks had higher valuations coming into 2022, and many investors are much less willing to pay the same multiples (i.e., price-to-earnings ratios) for long-duration growth stocks as they had for several years prior to 2022, according to Bower. Growth stocks within the MSCI EAFE have significantly lagged their value counterparts, creating what Bower considers a challenging environment for the fund’s style.
Still, Bower remains focused on the longer term. “I feel confident that the quality businesses I favor are most likely to be the distinguishable winners over a multiyear period,” he says. “Many companies with these characteristics continue to execute well, but their stock valuations have declined due to shifting macroeconomic conditions and investor sentiment.”
One such name in the portfolio at the end of January was ASML Holding (ASML), a Netherlands-based maker of extreme ultraviolet lithography equipment for the manufacturing of semiconductor chips. The company is a dominant leader in EUV lithography, and it’s at the forefront of tech that allows for faster, more powerful chips that require less energy and less surface area for more computational power, according to Bower.
“I believe demand for ASML’s products could be high for several years, and the next wave of capital investment seems pointed in its direction,” says Bower of the fund’s top position as of January 31, noting that ASML produced solid earnings growth the past year, and demand is outpacing supply. Still, shares of the company fared poorly for much of 2022 amid weak sentiment for growth stocks, before rebounding strongly in recent months, demonstrating how quickly these dynamics can change.
Another illustrative holding is freight forwarding firm DSV (DSDVY), whose shares have followed a similar trajectory. “The company executed its business extremely well throughout the pandemic, when supply-chain logistics became incredibly important to its customers,” says Bower. “DSV has a strong balance sheet and has demonstrated the ability to grow through acquisitions and gain market share.” The stock struggled as business across freight forwarding slowed down, but nonetheless Bower says he remains confident in the company’s management team, which has been buying back stock with its free cash flow.
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