There is enormous scope to enhance returns through global investment. But what does global investment actually mean? Combining two ultra-generic words to give us something doubly generic certainly hinders our quest to answer this most basic question.
There is enormous scope to enhance returns through global investment. But what does global investment actually mean? Combining two ultra-generic words to give us something doubly generic certainly hinders our quest to answer this most basic question.
Global investing has meant different things to different people. To some, it has meant allocating funds passively to a spread of markets around the world; to others, chasing the latest theme, be it technology or emerging markets. To me, it is about enhancing returns by investing for the long term in reasonably priced, well managed businesses outside Australia, uncovered through careful research, in the process reducing exposure to Australia-specific risks such as extreme weather or sharp falls in the price of commodities.
Let’s look at eight ill-conceived preconceptions – call them myths – about global investing in the hope that by exploding them, a sound appreciation of the true benefits of investing beyond our shores can be gained.
Conventionally, a benchmark is a standard or reference by which others can be measured or judged. In the world of investing, there is a temptation to use benchmarks, or indices, not just as measuring devices but more actively to construct portfolios. Yet anyone employing this approach would have invested 40.3% of his international equity portfolio in Japan in December 1989 and only 1.5% in non-Japan Asia. And we all know what happened subsequently: Japan experienced a “lost decade” of economic sloth that arguably continues to this day. Meanwhile, post Asian financial crisis, non-Japan Asia has surged. As disturbing, the same index approach would have seen 56.9% allocated to the US in December 2001 and ownership, at various times, of Enron, Worldcom and Global Crossing, not to mention the resulting exposure to the weak US dollar.
Index funds and “benchmark-hugging” strategies now account for a sizeable portion of ownership in most markets, although it is impossible to know their precise size. Such short-sighted investing, borne of the misguided belief that markets are efficient and that diversification is always a good thing, can help to prop up poor companies and leave good ones ignored. Thus by joining the herd and buying the index you can end up owning overvalued companies while missing out on the gems, hidden or otherwise.
The belief that diversification is necessarily a good thing has its roots in one of modern portfolio theory’s core (and most misguided) assumptions: that markets are efficient. If markets are efficient, it was argued, one should aim to eliminate specific risk and the way to do this was through diversification. Although Eugene Fama in the 1970s demonstrated that there were different strengths of market efficiency, and Warren Buffett has shown us empirically that it is possible to consistently outperform, the Efficient Market Hypothesis remains on the curriculums of most business schools and investment associations. Buffett himself summed up his thoughts on the issue when he noted that, “if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat” (Berkshire Hathaway annual letter to shareholders, 2006 p22)
Efficient Market Hypothesis states that all knowable information is reflected in share prices. However, some people, by virtue of being better-read for example, know more than others and even if you have the same knowledge as someone else your interpretation will probably be different. Then if you are still on level terms you may behave differently, and so forth.
The point is that it is possible to have an edge and to take advantage of it. How? By running a more concentrated portfolio whose positions reflect one’s convictions.
John Maynard Keynes said that, “To suppose that safety-first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.” (Collected Writings, Letter to FC Scott, February 6, 1942)
Warren Buffett remarked that even if you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stockmarket. We can read this statement in two ways. On one hand, it says the stockmarket is a great discounting mechanism and your own beliefs about the future path of the economy, even if correct, may have already been discounted by the market. On the other, corporate profit growth does not necessarily follow economic growth, an idea supported by a recent study Mind Matters, 10 April 2008 carried out by Societe-Generale strategist James Montier.
This latter observation is particularly relevant for emerging markets in which high economic growth may require huge reinvestment of cash flows by companies, often without regard for the rate of return from the investment. Add in the generally poor quality of corporate governance in most emerging markets and the result for shareholders can be an unhappy one. A good example of this would be China, where stockmarket behaviour in the first half of this decade did not follow the very high levels of economic growth.
The solution here is to apply a bottom-up investment approach. Such an approach allows one to gain a valuable understanding of the issues that affect companies, both as a whole and on an individual basis, something that would not be possible with a top-down approach.
With the invention of the jet engine, one did not have to be a genius to foresee the huge growth in commercial aviation. But investing in airline stocks, particularly in the US, would have been a very distressing experience. Buffett noted in Berkshire Hathaway’s 2007 letter to shareholders that in the airline industry “a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.” (Berkshire Hathaway annual letter to shareholders, 2007 p8)
We’re not sure if Buffett’s proposed act of terrorism would have helped, but we do know that thematic investing – the airline industry being a case in point – is often unprofitable, particularly if approached from the top down. Thematic sectors, essentially new industries, tend to attract large numbers of participants and require massive capital investment. Sector or country themes should thus be derived only from where the investment manager identifies value.
Themes also attract huge media attention, which in turn fuels speculative investor interest, driving valuations to often absurd levels. One must therefore remain very level-headed to avoid getting sucked into the stampede and crushed by the inevitable fallout. Investors in green technologies and climate change funds be warned!
Over the past decade or so we have witnessed crises relating to the Mexican peso, Russian debt and Asian currencies. The perception that has arisen from these, and others, is that emerging economies are high risk. Part of the problem rests with the way in which investors have tended to approach emerging markets, not with the markets themselves. Certainly, emerging markets are more volatile than their developed counterparts but getting involved only once bull markets are well under way risks missing out on the early, and profitable, part of the cycle.
The belief that emerging markets companies are more risky is itself being challenged. Balance sheets at both a country and company level are generally in good shape and corporate governance is improving, albeit at a slow pace. Also, one need only observe the absurd levels of executive pay in many Western boardrooms to conclude that the improvement is perhaps even faster relatively than it is in absolute terms, as standards in developed economies deteriorate.
However, going overweight in emerging markets does not lead to higher returns per se. In fact, in no other area of investing is a bottom-up approach more important and, indeed, effective. While companies in developed markets are often like competitors in a 100 metre dash, tending to cross the line at roughly the same time, those in emerging markets resemble participants in a marathon – strung out over a long distance, some not making it to the finish at all.
In some respects this makes emerging markets investing less challenging as the victors in this natural selection process are often easier (or rather less difficult) to identify. Further, emerging sharemarkets tend to be less efficient, so misvaluations can be more apparent. That said, mispricings can persist for several months … even years, and thus emerging markets investing requires discipline and patience: one must take a long-term approach.
Notwithstanding the above, emerging markets investing is not for just anyone. The tens of thousands of emerging markets companies, combined with the numerous potential pitfalls, require one to have a well-resourced, highly skilled team of researchers. Application of forensic procedures, such as thorough accounts analysis, is crucial and statements by company management should never be taken at their word. A criminal prosecution that relied solely on witness statements would be doomed to failure; hard evidence is everything.
Thanks to Harry Markowitz and the pioneers of modern portfolio theory, who needed a precise measure of risk to make their theories work, we have been programmed to associate risk with the standard deviation of historic returns. This quantitative measure, often referred to as volatility, mostly follows a normal, predictable, distribution. But is such volatility really risky? As an aeroplane’s wings must bend during turbulence, to prevent them being subjected to dangerous levels of stress, so too must stocks and markets fluctuate.
Of course, turbulence during a flight can be an uncomfortable experience but we have no choice but to sit tight, knowing deep down that we’ll reach our destination. In the world of investing, however, there is little to stop us baling out at the slightest wobble as our emotions get the better of us. In fact, one should welcome volatility because shares do not go up without it. Risk that should really keep us awake at night relates to sharp discontinuities in volatility – what former US Defence Secretary Donald Rumsfeld might have referred to as “unknown unknowns” – not volatility itself.
Active management, the alternative to passive strategies, is not guaranteed to outperform the benchmark. If anything, the opposite has been the case. In most markets about 70% of actively managed funds underperform their benchmark, which has only provided further ammunition for the indexers. Many active managers attempt to outperform by making predictions about market movements over short time frames (three to six months), then acting on them, resulting in high levels of turnover. Not only is such an approach more costly but it also tends to underperform, even without transaction costs.
Being an active manager does not necessarily mean trading for short-term gain; it is about holding on to stocks in which there is strong confidence in the long-term prospects. Doing nothing, although difficult, can be an active – often wise – decision.
Aiming to have all stocks performing strongly at the same time is an unrealistic exercise. What matters is good overall performance over time. Bill Miller’s Value Trust outperformed the S&P 500 index 15 years running (the streak ended last year) but a number of his stocks performed poorly during this period, and he certainly wasn’t trying to outperform each and every year.
It’s a little like golf, in which trying to hit the ball deliberately tends to result in a duff shot. Much better to swing the club and let the ball-contact be the consequence, not the conscious intent.
Stuart James is associate director, business development, of Aberdeen Asset Management.
This article first appeared on Business Spectator
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