International Markets, Mean Reversion and 5 Picks

An article in last month's Financial Times stated, "Investors are flocking back to European equities and propelling a rally across continental stock markets," noting the stark contrast with 2016 when "investors pulled roughly $100 billion from the asset class."

It's easy to see why investors may have been ready to throw in the towel on international markets. Over the past 10 years, the MSCI EAFE has shown an annualized return of a measly 1.2%. The S&P 500, on the other hand, has earned an annualized return of 7.2%. Over the last 3 years, the performance gap is even wider.

The difference in performance, however, has set up a big difference in valuations-with the U.S. market looking expensive compared to most international markets. Just yesterday, at the Sohn Investment Conference, DoubleLine Capital's Jeffrey Gundlach recommended shorting the S&P 500 and going long emerging markets. Part of the thesis was a relative value play and part of it seemed to be a play on the U.S. dollar.

Mean reversion is a very powerful force in the market. Returns can vary widely over time, but when they are far below or above their average for an extended period of time they eventually will gravitate back towards their long term average. Since the MSCI's inception in 1994, the annualized return on the index is 4.83%, which is lower than the returns of the U.S. market. It's important to keep in mind, however, that the figure is influenced by the very below average performance over the past decade.

In an article published last year, Ben Carlson of Ritholtz Wealth Management commented on the outperformance of U.S. stocks: "There are two ways investors tend to look at these types of numbers-either Europe is a bargain or the U.S. is overpriced. It's probably some combination of the two, but mean reversion doesn't operate on a set schedule. Fundamentals don't matter until they do."

And they eventually do. An Associated Press article last month printed comments by Luca Paolini, chief strategist at Pictet Asset Management (a U.K.-based firm that manages $165 billion in assets) regarding the appeal of overseas stocks: "It's good news, and now investors have a reason to focus on the fundamentals in Europe, which are strong."

According to BlackRock's Global Investment Outlook, "Global growth expectations are on the rise-and we see room for more upside surprises." While neutral on U.S. shares because of "lofty valuations and the risk that expectations for tax reform and deregulation may be too high," the paper says the firm likes emerging market equities "on reform progress in countries such as India and our view that near-term risks to China's growth are overstated."

Using stock screening models I created based on the strategies of legendary investors such as Warren Buffett, Peter Lynch and Benjamin Graham, I have identified the following overseas stocks that score well based on underlying fundamentals:

VALE SA ( VALE ) is a global producer of iron ore, iron ore pellets and nickel. The company earns a perfect score under our Joseph Piotroski-based investment strategy by virtue of its book-market ratio of 0.96, which falls in the top 20% of the market as required by this model. Operating cash flow of $6.76 billion is favored by this screen, as is return-on-assets of 3.35%. Our Peter Lynch-based stock screening model also likes the company's P/E/G ratio (ratio of price-earnings to growth in earnings-per-share) of 0.22, which indicates fairness in price (anything under 0.50 is considered exceptional by this model).

Companhia De Saneamento Basico ( SBS ) is a Brazil-based water and sewage service provider that earns high marks from our Lynch-based investment strategy due to its P/E/G ratio which, at 0.35, is considered exceptional. Our Dreman-inspired model likes the company's rising earnings trend over the most recent quarters, and its price-earnings and price-cash flow ratios of 6.74 and 4.86, both of which fall within the bottom 20% of the market, as required by this model. Pre-tax profit margin of 29.29% is well above the best-case level of 22%.

Toyota Motor Corp. ( TM ) is an automobile company with automotive and related finance businesses. The company earns a perfect score under our James O'Shaughnessy-inspired investment strategy given its cash flow-per-share of $17.48 versus the market mean of $1.65. This model also likes shares outstanding to exceed the market average. With a total of 1.5 billion shares outstanding, TM more than meets that criterion (market average is 627 million shares). The dividend yield of 3.46% is a plus. The company also earns high marks from our Piotroski-based screen due to its book-market ratio which, at 0.95, falls in the top 20% of the market (as required by this model). Operating cash flow of $40.89 billion is a plus.

Autohome Inc. ( ATHM ) is engaged in the provision of online advertising and dealer subscription services that delivers content to automobile buyers and owners in China. Our Lynch-based screening model likes the company's PEG ratio of 0.50 and debt-equity ratio of 0.49%. Inventory-to-sales has decreased over the past year, a plus under this model. Our Validea Momentum model favors the company's quarter-over-quarter sales growth (sales have more than tripled) and consistency in earnings-per-share. Current share price of $36.24 is within 15% of the 52-week high, a plus under this model.

NK Lukoil PAO (ADR) ( LUKOY ) is engaged in oil exploration, production, refining, marketing and distribution, and earns a perfect score under our O'Shaughnessy-based investment strategy due to its size (market capitalization of $41.2 billion) and cash flow-per-share of $10.67 (compared to the market mean of $1.67). The number of shares outstanding (713 million) satisfies this model as it exceeds the market average (630 million). Trailing 12-month sales of $21.3 billion are more than 1.5 times the market mean, another plus. The company also scores well under our Kenneth Fisher-inspired investment strategy for its price-sales ratio of 0.46 (anything under 0.75 is considered attractive) and its debt-equity ratio of 23.86%. Three-year average net profit margin of 5.40% exceeds the minimum requirement of 5%.

At the time of publication, John Reese and/or his private clients were long VALE, SBS, TM & LUKOY.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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