Portfolio Manager Q&A - Tom Tibbles

Tom Tibbles, Head of International Equity, provides insights into the performance of international markets in 2023. He discusses factors influencing their relative strength compared to U.S. markets, strategies for navigating geopolitical risks, and potential opportunities.

International markets started the year strong out of the gate but have since lagged U.S. domestic markets. What’s been the cause of that weakness as we've progressed into 2023?

For international investing, it’s not at all surprising for liquidity to dry up in the summertime, and it coincided with a couple of macro and geopolitical events that really caused flows to subside. Central banks surprised the markets by suggesting their work was not finished and expectations, particularly in equity markets, had gotten ahead of themselves. So, there was a bit of a step back over the summer. More recently, geopolitical turbulence has been a dark cloud over not only international but global markets. The other thing to take note of is what's happening with currencies. Given that the expectations for interest rate cuts have had to circle back, that has supported the U.S. dollar. All other currencies, across the board, have lagged, which also shows up in the returns. It is a significant headwind, but it is also an opportunity going forward.

By almost any valuation metric, international stocks are depressed relative to the U.S. How should investors think about valuation, and what does this say about the opportunity in international markets?

International equity valuations are at record lows relative to the U.S., and that presents a potential opportunity that, at some point, we see being unlocked. It could be that international markets catch up to the U.S., or alternatively, the U.S. declines more than international. I could see that occurring with the topping out of the U.S. dollar. There is also a political cycle coming up in the U.S., which could cause some flows to be diverted to international as well.

How are you taking the geopolitical risks into account with respect to your portfolio?

Over the decades, geopolitical risks are something we have always had to adjust to. It circles back to one of the fundamental premises in our approach. We focus and invest in solid, high quality franchise companies that can handle turbulence in the macro economy, whether from a political or economic source. That provides us with tremendous confidence in our companies. On top of that, when it comes to managing our portfolio construction, we have a method that we refer to as our Portfolio MATRIX framework. The simple idea is that we don't want to put all our eggs in one basket. We've seen too many times how things can turn on a dime, especially in the international environment. Our Portfolio MATRIX framework gives us a picture of all of our portfolio holdings at a point in time against the backdrop of the sources of volatility, be it regional, by sectors, and so on. The combination of great companies and our risk control framework is what we’ve utilized for over two decades to handle events as they regularly come up.

What is your outlook on China, and where are the opportunities within Chinese equities right now?

China is a perfect example of why you need to have your wits about you. Having experience with that market enabled us to negotiate the twists and turns coming from politics, the regulatory environment, and their inherent volatility. They've down-geared the backdrop growth rate, and we can no longer count on the good old days of double-digit economic GDP growth. We’re now looking at mid-single-digit GDP growth, with lingering risks coming from the property sector and potential regulation. So again, it circles back to finding companies that can weather any particular storm and have good prospects going forward, and then overlay that with our discipline so that we're pricing in heightened risk. One of the metrics we focus on is a dividend discount model so we can adequately adjust for risk as it changes. In China, the risk has elevated, and valuations have come down.

Putting it all together, we currently have three holdings in China. These are fantastic, world class companies. They've been beaten up. But we have confidence in their future. So you have to be wary, you have to be disciplined. You have to approach it with eyes wide open.

With respect to a strong U.S. dollar and rising interest rates, there has been concern in the past about some emerging market economies being able to pay dollar-denominated debt. How are you feeling today about the opportunities and risks in emerging markets?

There has always been elevated risk in emerging markets. But, as I described concerning China, there are ways to incorporate that in your analysis. When we talk about investing in strong companies, part of our focus is that our candidate firms have strong balance sheets. We explicitly focus on companies that will not have any difficulty with debt, no matter what happens to the interest rate cycle. This applies right across the portfolio, but most specifically for emerging markets.

The most significant risks we face on a day-to-day basis are not the fundamentals of the companies. Because we've pre-cleared those, we have a strong conviction and strong discipline when it comes to stock picking. We feel like we're incorporating those risks in specific valuations for stocks and the timing of ownership and increasing and decreasing weight.

When we think about emerging markets, a distinct cycle is brought about by developed country monetary policy, such as tightening interest rate regimes in the Fed and other developed countries. We have been through this cycle numerous times before. And you are absolutely correct; if the country or the company has outstanding dollar-denominated debt, that can be a toxic situation. So, we try to avoid that at all costs. However, the other thing we know about this cycle is that once interest rates plateau and the central banks have done what they've needed to do in the developed economies to squeeze out inflation, we come into what I refer to as the sweet spot for emerging markets. Economies in developed jurisdictions have constricted growth to the point where they're satisfied that inflation will come down. However, it takes many, many quarters for mature, developed economies to be able to turn around and start to grow again. As a result, in this phase of the monetary policy cycle, excess liquidity builds up in developed economies. And in looking for the best current investment opportunities, it is hard to ignore the combination of secular growth, such as that found in many emerging economies and their companies, with low valuations because they've gone through either a slowdown or recession. That's where we think we will be in the next couple of quarters.

Emerging markets is a generic term. And it doesn't really represent a homogeneous region. It's very eclectic. It's just a group of countries outside the international sphere when they broadened the indices. So you have this broad collection, spanning from frontier countries to leading lights of the current and future world economy. Think of it as tiers. Countries like Korea, India, China, Brazil, and Mexico are in the top tier. We tend to invest in this top, highest quality tier within emerging markets where there are a lot of world class companies.

Are there any particular regions or industries around the world where you're finding the most opportunities?

As we just mentioned with emerging top tier countries, take a country like India, where we project that there will be continual growth opportunities. India is just getting going, and there are some really world beating companies there. Now, you have to be selective in your timing. We have some great investments there and candidates we've been tracking for years.

In developed countries, there has been a substantial rotation by sectors, and opportunities are starting to unfold in some of the more defensive areas like health care, food ingredients, and luxury goods. Industries that Europe, in particular, excels at. So, we are monitoring for declines in stocks. In many cases, we are very familiar with the companies that are growing the most; it’s just a matter of their region or sector coming out of favor.

I think Japan has a lot of challenges in its future. Within the global auto sector, they have poorly managed the transition to electrification, and as a consequence, that area is somewhat risky. In other areas, however, such as electronics and semiconductor capital equipment, there are some amazing companies that have world class franchises. As you see this theme of friend-shoring and diversifying global supply chains play out, the high technology area could give Japan a renaissance of competitiveness, and it could really benefit from global multinationals wishing to diversify away from being so dependent on China.

While there are a lot of crosscurrents, our approach works at the sector level and across regions. It’s that simple formula of finding great companies and waiting patiently for their stock price and fundamentals to arrive at the right position – where the forward fundamentals are positive, but for whatever reason, their stock price does not currently reflect that.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Investing in foreign markets involves additional risks, including exchange rate changes, political and economic unrest, relatively low market liquidity and the potential difference in financial and accounting controls and standards. The portfolio may invest in small, mid-sized, or emerging companies, which are susceptible to greater risk than is customarily associated with investing in more established companies. The portfolio may invest in high yield or lower-rated securities, which may provide greater returns but are subject to greater-than average risk.

Diversification does not assure a profit or protect against loss in a declining market.

The MATRIX portfolio construction framework distributes the weight of individual stock holdings across a two-dimensional, checker-board grid assigning geographical exposures to regional columns and industry exposures to sector rows. For example, Ferrari is a European auto company; the weight of this stock holding in the portfolio would be placed (like a piece in a game of checkers, having a size reflective of its weight) in the square that represents the intersection of the column for Europe and the row for Consumer Discretionary. By performing this distribution of all position weights twice, once for the portfolio and again for the benchmark index, it can be clearly seen how over- or under-weight the portfolio is relative to the market in the various cells of the matrix. As a risk-control practice, we limit stock weights to control the amount that the portfolio can diverge from the benchmark to within modest tilts ( i.e. +/- 10%). These limits act as “guardrails” to ensure that the portfolio remains well diversified and broadly in-line with market exposures by region and sector.