At a time when a handful of mega-cap stocks have come to dominate U.S. indexes, is home-country bias causing investors to miss out on opportunities? In this Q&A, Research Affiliates’ Chairman Robert Arnott and CIO Christopher Brightman, portfolio managers of the PIMCO RAE strategies, provide their views on how widening price gaps between growth and value stocks and among equity sectors are creating value opportunities in emerging markets – and why long-horizon U.S. investors should consider systematic value strategies that look beyond the border.

Q: In what regions are you finding the most appealing opportunities for the RAE portfolios today?

Arnott: U.S.-based investors have a natural tendency to focus on the U.S. markets. Stories about domestic companies tend to resonate with us more than those about foreign firms, while foreign investments can feel riskier and, well, foreign. In finance, this is called home-country bias. As a result, U.S. investors often miss opportunities outside of the U.S.

We believe now is not the time to succumb to such home-country bias. Not only do foreign equities have far cheaper valuations than U.S. stocks, but the valuation dispersion between cheap and rich firms is also more pronounced outside of the U.S. than it is domestically, particularly in emerging markets. RAE has a strong value bias, and we designed the RAE strategies to seek to outperform by taking advantage of mean reversion. Because non-U.S. stock markets are generally cheaper than our own, and because value today is cheaper relative to growth outside the U.S. than within the U.S., we estimate the RAE portfolios will offer attractive performance potential outside of the U.S.

Research Affiliates creates 10-year real return estimates for asset classes using a “building block” approach. If we know the yield, growth in income and changes in valuation multiples on any investment, we can gauge the potential total return. This is a powerful tool both for attribution of historical returns, and in seeking to forecast future returns.

We calculate point estimates for equity returns by combining observed dividend yield, historical real earnings growth, mean reversion in valuation and mean reversion in foreign currencies. It’s important to note that for both valuations and currencies, we do not assume full mean reversion back to historical norms. Perhaps there’s a new regime and there will be no mean reversion, or perhaps the markets are stretched and full mean reversion will occur. Recognizing that either may be possible, we assume mean reversion halfway toward historical norms over the coming 10 years. This simple and intuitive model currently suggests a significant advantage for equities in emerging markets relative to the U.S. (see Figure 1).