July 27, 2012 Since the 2008 09 Global Financial Crisis, we have been faced with many challenges in investing where some of the old rules and ideas have been questioned. Such challenges are a healthy part of the long term market dynamics, shaking out shorter term trends from longer term principles. Asset allocation, for instance, had been tested during the crisis, as rising cross asset correlations led to far riskier portfolios than many would have suspected. A quick glance would suggest that asset allocation did not work, but it is more important to look deeper at the approach to judge the validity of the strategy. For instance, a more rigorous approach to portfolio construction is to complement long term asset allocation, which exhibits more stability over extended periods of time, with shorter term views which help account for some of those rising correlations during stressed periods. Striking a balance between the two perspectives is part of the art of investing but is critical to achieving one s long term goals. The real point is to avoid reacting to broad statements on what works and does not, to understand the approach one is investing in, and then to make informed judgments. Those ideas extend from anything such as deep fundamental analysis on stocks and bonds to macroeconomic analysis and risk management. Today we are faced with another out of favor investment: international equity investing. What was considered so core to one s strategy just a few years ago is now being questioned as having any role whatsoever in a portfolio. And for good reason, as markets outside of the US have lagged over the past few years and the news out of Europe and Japan has not exactly been supportive. So why would one continue to invest globally rather than take a pure US approach? We think that there are both long and short term reasons that an investor can rely upon. Long Term Economic and Fundamental Support What are some of the longer term rationales for investing overseas? A few more commonly cited reasons are economic and market diversification, and greater return opportunities through a more globalized world economy. With economic diversification, non US stocks provide a natural hedge against some of the US s challenges: slow economic growth with the twin deficits (trade and fiscal). The excesses of the US economy, which are taking years to be worked out, have led to aggressive Federal Reserve policies to keep the economic recovery on tract. The US continues to run large trade deficits as we import more than non US consumers demand of our exports. And our fiscal imbalances lead to ever growing levels of debt. All these issues call for a long term scenario of a weaker US dollar as the Fed keeps interest rates low, inflation is allowed to rise to devalue our debt load to foreigners, and the dollar depreciates to make our exports more attractive globally. Exhibit 1: Inflation Fighters: Which Asset Classes Work Often Works International stocks High yield bonds and floating rate notes International bonds Hards assets and commodities Alternatives Sometimes Works US Stocks Rarely Works Treasuries and agencies Corporate Bonds Cash Source: DWS Investments With a depreciating dollar comes appreciating international equity prices relative to US stocks, as the earnings tabulated overseas hold greater value here at home. With some of the real issues the US has to face in 1
the coming years, international equity investing may help hedge some of that risk (see Exhibit 1, prior page). Market diversification, meaning adding less correlated non US equities to complement the US stock portion, has been one of the more cited reasons for adding international stocks to a portfolio. Since 1974, the S&P 500 has delivered a return of 10.5% per annum while experiencing 15.8% volatility. Investing in a global portfolio split between 70% US stocks and 30% non US actually yields slightly more return of 10.6% while taking less risk, realizing 15.1% volatility similar return with less risk. 1 such as China and India in years to come is probably too far of a reach in the other direction. While the diversification provided may be more modest going forward, we continue to believe that some benefits will continue to exist. Exhibit 3: Contribution to Global GDP: Developed vs. Emerging Countries GDP based on purchasing power parity share of world total 1980 1995 Exhibit 2: US and Non US Stock Correlations 3 Year Trailing Returns between S&P 500 and MSCI EAFE 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 1976 1978 1980 1982 1983 1985 1987 1989 1990 1992 1994 1996 1997 1999 2001 2003 2004 2006 2008 2010 2011 Source:Bloomberg, HWA Research This is one of the most oft cited benefits of diversification over long periods of time one can improve risk adjusted performance. Yet part of that benefit arrives from lower correlations between US and non US markets. As Exhibit 2 shows, much of that correlation benefit has diminished. This is not surprising, as global markets growing interdependence is leading to more synchronized movements of markets. Macroeconomic forces can have outsized impacts on stock prices over shorter periods and when those forces become more dependent on one another the benefits of market diversification lessens. To think that the US economy will move completely in tandem with some of the growing powers of the world 1 Benchmark: 70% S&P 500, 30% MSCI EAFE (Gross, US Dollars) from 1974 1987, 30% MSCI ACWI ex USA (Gross, US Dollars) from 1988 2012. Period 1/1974 6/2012, rebalanced annually. 2010 2017 Projected US All other Developed Countries Emerging Countries Source: IMF, World Economic Outlook Database (4/12), HWA Research The increasingly globalized economy, with superior demographics in developing nations, paired with freer cross border trade, has led to greater return opportunities throughout the world. As Exhibit 3 shows, the global economy will likely look much different in the future than it did 30 years ago. While the US contributed roughly 25% to global GDP in 1980, that percentage is projected to fall to less than 18% in 2017. In the meantime, emerging market nations contribution is expected to rise to over 50%. There are multiple ways to access these themes, but in the end it is important to gain some exposure within one s portfolio. Knowing What You Own and What You Should Pay With these general concepts of the long term benefits of international investing remaining intact, we next look 2
towards what is happening in today s markets and how that is influencing our current decision making. One of the biggest challenges to international investing today is driven by the issues in Europe and China, as well as Japan. We will not go into a deep analysis of the issues as there is no shortage of commentary from us or others. For now let s just say that such risks exist and the questions are what exactly are you buying overseas and what news has already been discounted by the market. But to be fair, let us also assume that the US is not immune to such risks with its own challenges in the upcoming election, political stalemates, fiscal cliff, debt imbalances, etc. The point being that the US is not exactly the model to admire for economic health. Yet corporations within the US are, given their strong balance sheets, quality management and earnings strength. With the global nature of the world economy, it is important to realize that investment managers buy companies, not countries. where to invest, it has far more to do with the management of the company, its business plan, product offering, etc., rather than where the company is headquartered. We would rather allow a skilled analyst with deep knowledge of global industries to pick the best company rather than pick the best one located within US borders. And while multi nationals are one way to access the themes of the growth in emerging markets, some portion of a portfolio should be allocated directly to companies within these regions. These companies represent more of the pure plays on these investment themes which may offer some of the biggest return potential for investors. Using a skilled investment manager with local insight is a great way to uncover these opportunities. Exhibit 4: European Stock Performance vs. US MSCI Europe (Net, Local) relative to S&P 500. Index based on 100 as of 1974 140 130 120 110 100 40 Year Low 90 80 70 60 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: BCA Research, Bloomberg, HWA Research Some companies are inherently tied to their local economy. For instance, an electronics retailer in Spain is certainly subject to the fortunes of the local Spanish consumer and therefore impacted by the depressed economy there. However, a global energy producer or pharmaceutical company, with a reach around the globe has far less to do with local conditions. At that level, it is more a battle between multinationals based around the world: Sanofi vs. Pfizer, BMW vs. Ford, or Royal Dutch Shell vs. ExxonMobil. When making the decision of So in the context of owning multinational corporations exposed to the developing market growth trends or local companies in those emerging markets, rather than companies with direct exposure to some of the headwinds around the world, we now turn to one of the most fundamental tools for long term investing: valuation. With all of the bad news weighing on international markets, valuations have reached extreme levels outside of the US. As Exhibit 4 shows, prices have reached once in a lifetime levels in Europe relative to the US. At the same time, non US companies across the globe are very cheap (see Exhibit 5) compared to their US counterparts. Could things get worse before they get better in Europe or elsewhere throughout the world? Absolutely, but with valuations as cheap as they are, 3
much of the bad news, including that related to the sovereign debt crisis, has been priced in. That is exactly what valuations reflect a balance between return and risk. Unless one has particular insight that the market has not already discounted, a company s valuation can be thought of as the market s view of all publically available news. Over time, valuations tend to mean revert, meaning cheap stocks tend to rise in price while expensive ones fall. When thinking of valuation based investing, one should not equate it with distressed investing, but instead on purchasing high quality companies that trade at a discount to their global peers. So while things may feel bad overseas, one needs to ask oneself what they know that the market does not. Valuation can sometimes require patience, as it did when buying old economy companies during the tech boom in the late 90s, but when the market does turn, patient investors are typically rewarded. Investment Based on Confidence, Not Crystal Balls We have talked about how international equity investing makes sense given its risk mitigating properties as well as exposure to high quality return opportunities trading at compelling valuations. So if one believes in the long term story as well as the short term one, the last question we will address is timing. Market timing is one of the more debated topics in investing, even more so since the large sell offs during the financial crisis. Pre crisis, the buy andhold philosophy ruled, as numerous academic studies have showed that few had the ability to successfully predict the short term direction of markets. Post crisis there has been a reemergence of the idea of market timing, as the only way one could have avoided the large drawdowns would have been to successfully time exit and reentry points. Importantly, what has not changed is the evidence of one s ability to do so and we continue to look at such strategies with skepticism. Big market returns, both up and down, tend to be clustered together, making it difficult to get both the sell and buy timed right. Further, trailing market returns say little about where the market is going next. For example, as Exhibit 6 shows, the trailing year return of the S&P 500 has a 0.08 correlation with the next year. That low of a correlation essentially says that one cannot use past information to make good investment decisions. The same is true for other periods of time as the chart shows. Are investors doing more damage to their portfolios by timing exit and entry points, especially when considering the costs of doing so which include commissions, fees, market impact and taxes? Exhibit 6: Correlation of Prior Period with Forward Returns S&P 500 Trailing Price Return Correlation with Forward Price Return 0.50 0.40 0.30 0.20 0.10 0.00 0.10 0.20 0.30 0.40 0.50 Day Week Month Quarter Year Source: Bloomberg, HWA Research Our perspective on international equity investing combines all of these views to arrive at what we feel is an appropriate positioning for our clients. We balance what we think we know versus what we are less certain of and avoid the trap of overconfidence. Investors will quickly throw out strong, fundamental and economic arguments due to emotions driven by the day to day noise coming out of the media. As long term investors, we remind our clients that we avoid the noise, base our investment approach on what we have confidence in (e.g., long term economic trends, valuations) and resist the temptation to act on emotion (i.e., market timing). Where that approach takes us today is to continue to hold international equities as part of our diversified portfolios to receive the benefits of what a long term horizon should bring. At the same time, we hold somewhat less than our neutral allocation would suggest given the volatility the asset class has endured over the 4
past couple of years. With the likelihood that both US and non US markets will remain volatile for the remainder of the year, we continue to maintain that positioning. We look to such extreme valuations to begin closing that underweight at some point in the future. In the end, our perspective is to balance the long and the short term by continuing to hold an allocation in international equities but reflect some of the shorterterm risks that are somewhat more difficult to predict. That, we feel, shields us as best as possible from reacting on fear and emotion of the day to day media noise, avoid the bias of overconfidence in the ability to time markets, and keep our clients appropriately invested to capture the eventual market recovery that patient long term investors should reap the benefits of. The Heritage Wealth Advisors Team Telephone: (804) 643 4080 Website: www.heritagewealth.net 5