David Herro and Rajiv Jain: Should US Investors Renew Their Passports?

Episode Summary

Executive Summary: At Morningstar’s Long View panel, David Herro and Rajiv Jain argued that international and emerging-markets equities remain compelling after years of U.S. outperformance, citing valuation gaps, currency tailwinds, and mean reversion. They discussed China, Japan, geopolitics, energy, AI/semiconductors, and lessons from failures like Credit Suisse and Russia, emphasizing fundamentals, risk control, and long-term patience.

Main Topics: Case for international diversification (Priority: 5/5): Both managers said long stretches of U.S. outperformance can distort investor expectations, but long-run equity returns are driven by earnings and valuation cycles. They argued diversification matters because markets do not move in lockstep. Valuations and currency as opportunity in non-U.S. markets (Priority: 5/5): Herro emphasized that non-U.S. equities are cheaper than U.S. stocks and that undervalued foreign currencies create a 'double positive' for future returns. Jain said he incorporates currency effects indirectly through earnings and inflation assumptions. Emerging markets, correlations, and portfolio role (Priority: 4/5): Jain argued that emerging markets are becoming more independent from U.S. Fed policy and are large enough to behave as standalone systems, improving diversification and expanding the opportunity set. China: state-owned enterprises vs. private sector (Priority: 5/5): The guests offered different China frameworks: Herro invests only when management, transparency, and valuation justify it, but uses a high hurdle rate; Jain prefers SOEs over private firms because of current policy direction and alignment with shareholder returns. Geopolitical risk and historical drawdowns (Priority: 5/5): Both discussed how geopolitics affects prices more than intrinsic value, using Russia and Credit Suisse as case studies. They stressed cutting exposure when macro risk cannot be quantified and learning from losses without becoming paralyzed. Japan, autos, and sector selectivity (Priority: 4/5): Neither manager is broadly bullish on Japan despite positive sentiment; they view it as too expensive relative to growth and frustrated by slow reform. In autos, they prefer premium European names and Toyota for specific strategic reasons. Technology, AI, and semiconductors (Priority: 4/5): Jain said tech looked frothy in 2021 but now sees real AI-related demand, especially in semiconductors and hardware cycles, while reducing software exposure because AI may commoditize parts of that industry.

Key Arguments: Long-term international investing remains valid because corporate earnings and valuation cycles, not recent performance, ultimately drive returns. U.S. valuation premiums are now unusually wide, and foreign equities are cheaper partly because foreign currencies have also weakened. Currency hedging should be opportunistic and based on long-term fundamentals such as purchasing power parity, not constant trading. Emerging markets are less tethered to U.S. monetary policy than before, making them better diversifiers than in the past. China requires a much higher valuation hurdle because governance, policy risk, and state influence can impair shareholder outcomes. Geopolitical shocks often hurt prices more than intrinsic value, creating opportunities if investors can remain patient and disciplined. Russia showed that even apparently durable markets can collapse; managing macro tail risk matters even when underlying businesses are healthy. Japan’s corporate reforms have been too slow to justify current pricing, and the market’s low ROE and weak growth remain a concern. AI is a real catalyst, but the best opportunities may be in semiconductors and hardware rather than software, which could be disrupted. Auto investing should focus on capital allocation, cash generation, and competitive positioning; premium European automakers and Toyota offer different value propositions.

Data Points: U.S. weight in global all-cap index: around 70% - Herro said U.S. equities dominate global market cap despite representing far less of world GDP. U.S. share of global GDP: around 25% - Used to contrast market cap and economic output. U.S. valuation premium vs. non-U.S.: from 14-15% premium to almost 50% premium - Herro described a decade of valuation compression favoring non-U.S. assets. Dollar trough: 2014 - Herro said the dollar bottomed then, affecting foreign currency valuations and returns. Currency hedging trigger: more than 20% overvalued - Herro hedges currencies when they exceed fair value by roughly 20%. Yen exchange rate: around 160 per dollar - Discussed as an indicator of cheap Japanese currency and travel appeal. Yen level in 2011: 75 per dollar - Used to illustrate long-term pendulum swings in currency valuation. G7 share of global GDP: about 35% - Jain used this to argue non-G7 economies have become more important. Non-G7 share of global GDP: about 65% - Context for broader global diversification. U.S. developed market cap: around $22 trillion - Jain contrasted with India’s market cap to show emerging market scale. India market cap: almost $5 trillion - Example of emerging market scale and opportunity set. China corporate earnings growth: declined around 3% to 4% - Jain cited MSCI data to argue China has been weak fundamentally. Japan ROE in 1989: about 7% to 8% - Jain used historical comparison to show limited long-term improvement. Japan ROE today: about 8% to 9% - Despite reforms and yen weakness, he said profitability remains modest. Japanese market peak: Nikkei just under 40,000 in 1989 - Illustrates long-run valuation history and current context. Japanese valuation in 1989: 60-70x earnings, 5x book - Used to show how expensive Japan once was. Current Japanese valuation: 15-16x earnings, 2.5x book - Even after compression, Jain said Japan is not cheap enough. Global smartphone sales: around 1.6 billion units in 2016 - Jain referenced this to support an upcoming semiconductor upgrade cycle. PC shipments: around 250 million units - Still about 20% below peak, suggesting another hardware cycle. iPhones older than model 12: 40% - Used to support the case for a future upgrade cycle. Credit Suisse purchase price by UBS: about $2 billion - Herro described the rescue acquisition after the bank’s collapse. Credit Suisse book value at takeover: about $45 billion - Herro used this to frame the scale of the loss and valuation reset. Swiss government backstop for UBS: up to $9 billion - Mentioned when discussing takeover risk and UBS’s deal terms.

Pivotal Quotes: "if it looks bad in the rearview mirror, the front windscreen looks really good" — David Herro: On why international value stocks may be set up for better future returns after years of underperformance. "The lesson is we need to manage risk more tightly" — Rajiv Jain: Reflecting on the Russia investment experience and how geopolitical shocks can force rapid reassessment. "I like Japan, but as a tourist" — Rajiv Jain: His shorthand for why he remains cautious on Japanese equities despite positive sentiment.

Implications: For investors, the panel suggests staying globally diversified, focusing on valuation and cash flows, and treating geopolitics as a risk to manage, not predict. If U.S. leadership fades, non-U.S. assets, EMs, and select sectors like semis may benefit most.