Episode #201: The Case For Global Investing
Guest: Episode #201 has no guest, It’s a Mebisode.
Date Recorded: 02/04/2020 | Run-Time: 45:34
Summary: Episode 201 is a Mebisode. In this episode, you’ll hear Meb discuss his favorite research pieces on international investing from 2019. He covers diversification through the lens of company revenue exposure, international stock dividend yields, and valuations.
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Links from the Episode:
- 0:40 – Sponsor: AcreTrader
- 1:36 – Welcome
- 3:12 – The Case for Global Investing (Faber)
- 3:43 – Global Investment Returns Yearbook (Credit Suisse)
- 4:04 – Triumph of the Optimists: 101 Years of Global Investment Returns (Marsh, Staunton)
- 4:57 – The Meb Faber Show – Episode #100: “High Valuations Don’t Necessarily Mean That We’re Going to See Asset Prices Collapse”
- 5:46 – Global stock markets in 1900 vs today
- 9:14 – Real returns for countries around the world
- 11:39 – Land value of the Emperor’s palace in Tokyo
- 13:49 – Global equity investing: The benefits of diversification and sizing your allocation (Scott, Stockton, Donaldson)
- 19:03 – A New Perspective on Geographical Diversification: Revenue Exposure by Region (Morningstar)
- 22:11 – A Closer Look at Value vs. Growth Performance (Lauricella)
- 24:28 – Guide to International Investing: how to go glohal in an international world (Capital Group)
- 24:51 – Rolling 10-year performance of international vs US
- 25:26 – Percentage of top 50 stocks outside of the US
- 26:41 – Revenue exposure of 10 largest companies in Europe
- 27:02 – Company specific fundamentals
- 27:58 – Foreign company dividend levels
- 29:39 – Sponsor: AcreTrader
- 30:41 – Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated (Saphier, Karniol-Tambour, Margolis)
- 32:06 – Equity market returns since 1900
- 32:49 – Equity return by decades
- 35:28 – Are Valuations Now Irrelevant? (Arnott)
- 35:53 – The Meb Faber Show – Episode #18: Rob Arnott, “People Need to Ratchet Down Their Return Expectations”
- 39:48 – Top Dogs? Downward Dog (Stephen Rogers)
- 41:37 – Summary
- 42:33 – Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies (Faber)
- 42:49 – Meb’s Top global stock valuation resources
- 42:58 – The Idea Farm
- 43:04 – Star Capital Research (Germany)
- 43:14 – Research Affiliates Asset Allocation Interactive Module
- 43:24 – Barclay’s – CAPE
- 43:38 – Online Data Robert Shiller
- 44:02 – Frama French website valuation resources
- 44:18 – The Meb Faber Show – Episode #155: Aswath Damodaran, “They [Uber And The Ride Sharing Companies Collectively] Have Disrupted This Business…That’s The Good News, The Bad News Is I Don’t Think They’ve Figured Out A Business Model That Can Convert That Growth Into Profits” and his Valuation resources and YouTube videos
- 44:28 – Global Financial Data (paid) The Meb Faber Show – Episode #110: Bryan Taylor, “At Some Point, the Stresses Are Going to Be So Great that Some of the Countries (In the European Union) Are Eventually Forced to Leave”
Transcript of Episode 201:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Woman: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor Message: Today’s podcast is sponsored by AcreTrader. You’ve heard me talk about farmland investing for years. It’s an attractive asset class with strong, stable, and non-correlated returns. Not only that, it can serve as a hedge against much of your portfolio. There’s always been a disconnect, though. Investors are left with a question, “How do I actually invest in farmland?” Now there’s AcreTrader, where you can invest in shares of farmland and just minutes online.
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Meb: Hey, podcast listeners. Today we have a “Mebisode,” which means you’re gonna hear my beautiful, monotone voice for the next 10, 30, 60 minutes. I don’t know how long it’s gonna take. But what I’m going to do is we’re gonna talk about a topic that I’ve been droning on, trying to just smash repeatedly into everyone’s brains over the past one, three, five years. And that’s the topic of investing beyond your shores, not just Americans investing outside the U.S., but everyone who invests usually in their own country. We’ll do this from the perspective of an American investor, but it applies to everyone around the world. Because everyone tends to make the same mistakes.
This is based off what I considered to be my top six favourite institutional research pieces focused on this topic of global investing that came out in 2019 from some of the top shops in the world. And what I did is… By the way, the all-time hack, if you want a productivity hack, is to set something up that you wanna get accomplished, and then find something you wanna do less. So in my case, I was trying to organise some thoughts about this topic of global investing, but there was something else I really, really, really didn’t wanna do, which is probably sign a bunch of compliance forums and go through some training, something like that. I don’t know.
So I ended up doing a 104-tweetstorm summary on Twitter, which is the longest one I’ve ever done by a measure of probably 90 tweets. And I don’t know if I’ve ever seen anyone do 104, probably people thought I was a little psychotic. But we also summarised it on the blog. We will include a link with all the download links to the pieces we talked about today, to the graphics, to everything else on the blog at mebfaber.com. And the name of this post is called “The Case for Global Investing.” Let’s get started.
First up, we’re gonna talk about my favourite research piece almost every year. It comes out in February. So it’s sort of like Christmas Eve right now, any day. It’ll drop. It’s published by Credit Suisse, and it’s called the Global Investment Returns Yearbook. They’ve been doing this for about a decade. You can find all the old archives on their website. We’ll also put the link, again, on the show notes, mebfaber.com/podcast.
And this is based on some work that Professor Dimson, Marsh, and Staunton out of the U.K. had done in my favourite investing book called “Triumph of the Optimists,” which is a beautiful coffee-table book, and they update it each year, partnered with Credit Suisse, and they usually tack on an additional theme. Sometimes it’s ESG. I think last year was emerging market. Sometimes it’s factor investing. Everyone, literally, read the last 10, and it’s like getting a master’s in investing, all topics, foreign exchange, etc., etc.
Anyway, last year has touched on this topic, global investing, and it takes long run returns on stocks, bonds, bills, inflation in currencies in 26 global markets all the way back to 1900. So we’re looking at 120 years of totally varied market conditions, booms, busts, bear markets, bull markets, stock markets going to zero, stock markets going to the moon, everything in between.
We also did a podcast with the author of the studies, Professor Elroy Dimson, in episode 100 titled “High Valuations Don’t Necessarily Mean that We’re Going to See Asset Price Collapse.” Here are a few highlights from the piece. And again, you can download it for the full transcript. “Put in the context of the 119-year history in the yearbook and an equity risk premium over the period of just over 4%, it underlines how rewarding and how anomalous the most recent past has been for equity investors. A more tempered view is a natural consequence of what, by historical standards, remains a world of low real interest rates. The long run history of real interest rates in 23 countries since 1900, when real rates are low, future returns on equities and bonds tend to be lower.”
So we posted then a chart they have from the piece of global stock markets in 1900 and today. And if you go back to 1900, U.S. wasn’t the biggest stock market in the world. The U.K. was at almost a quarter. U.S. was second at 15%. But there was a bunch of countries that were pretty close, Germany, France, both in the low teens. And then rounding out surprised some people, Russia, Austria, Belgium, Australia.
Fast forward 120 years later, guess what happened? Well, the U.K. went from 25% to 5%. So one of the biggest economies in the world of the turn of the 20th century got hugely reduced, but that’s largely because the U.S. had a massive run. It went from 15% to the 55% today. That is a huge expansion to where the U.S. The second biggest country today is Japan, and then U.K. still third. China, France, Germany, Canada, Switzerland, Australia, round out the rest. But the U.S. is over half. Next biggest country is literally under 10%.
And so they reviewed in this piece, “Austria-Hungary was not a total investment disaster. It was the worst performing equity market and the second worst performing bond market out of the countries with continuous investment histories. Of the U.S. firms listed in 1900, over 80% of their value was in industries that today are small or extinct. Even industries that initially seems similar have often altered radically. Compare telegraphy in 1900 with smartphones in 2019. Both were high-tech at the time. Similarly, within industries, the 1900 list of companies includes the world’s then largest candle maker and the world’s largest manufacturer of matches.”
Continued on the quote, “In the 2015 yearbook, we asked whether investors should focus on new industries, the emerging industries, and shun the old, declining sectors. We showed that both new and old industries can reward as well as disappoint. It depends on whether stock prices correctly embed expectations. For example, we noted that in stock market terms, railroads were the ultimate declining industry in the U.S. in the period since 1900. Yet over the last 119 years, railroad stocks beat the broad U.S. market. Investors may have placed too high an initial value on new technologies, overvaluing the new and undervaluing the old. We showed that an industry value rotation strategy helped lean against this tendency and had generated superior returns.”
And if you look at the industry weightings, which we include on the blog post, you know, again, the big one was rail, you’re basically a rail investor in 1900, ditto in the U.K. and in the U.S. And the number two would have been banks. You have mines, textiles, utilities, tobacco, one of the best performing industries of the past 120 years. So things look a lot different today, but there’s some similarities.
Continuing quote, “U.S. equities return 9.4% per year versus 4.9% on bonds, 3.7% on bills, and inflation of 2.9% per year. We should be cautious about generalising from the USA, which, over the 20th century, rapidly emerged as the world’s foremost political, military, and economic power. By focusing on the world’s most successful economy, investors could gain a misleading impression of equity returns elsewhere, or a future equity returns for the USA itself. For a more complete view, we also need to look at investment returns in other countries.”
So we published a chart of various countries and what we call the world, and a summary of real returns after inflation for broad global stocks is 5%, in bonds 1.9%. So we often love to say in this podcast that a good rule of thumb for global returns for stocks, bonds, and bills after inflation is 5:2:1, okay? So you can add on inflation of, say, 3% or 4% or whatever. To get you the nominal numbers, say, if you add on 4%, we’ll use 3% because that was the historical, that gets you to 8%, because that’s 5% plus 3% equals 8%, and then the 2% plus 3% equals 5% for bond returns, and 4% for bills. But after inflation, 5:2:1, a good rule of thumb to remember.
They also talked a little bit about the yield curve, which is something that has been in the news a lot this year because it’s inverted. “Yield curve has historically, on average, been upward sloping. That is long bonds have typically offered a higher yield to redemption than shorter dated bonds and bills. Extrapolating recent remarkably high bond returns and maturity premiums into the future would be fantasy.”
I also like that they had a couple fun Japan quotes as we are all watching the screen with Tesla recently, which, whether you think it’s a mania, whether you think it’s just the beginning, here’s some fun Japan stats from the 1980s, again, because I think it’s really important to look back in history at all the various times the markets to see how they behaved.
First stat, futures have a long history in financial markets, and by 1730, Osaka started trading rice futures. So trading in futures has been around for almost 300 years. From 1900 to 1939, Japan was the world’s second best equity performer, but World War II was disastrous, and the Japanese stocks lost 96% of the real value. Tokyo Stock Exchange also, by the way, goes back to 1878. And I think the oldest is Amsterdam. I have to look that up.
By the start of 1990s, the Japanese equity market was the largest in the world, with a 41% weighting in the world index compared to 30% for the USA. And remember, I’ve talked a lot about on this on the podcast, they hit a long-term price earnings CAPE ratio in 1989 of almost 100. So if you were a market cap index investor that ignore valuations, you put 40% of your money in a stock market that was trading at P/E ratio of almost 100, one of the biggest flaws in market cap weighting.
A 1993 article in the “Journal of Economic Perspectives” reported that, in late 1991, the land under the Emperor’s Palace in Tokyo was worth about the same as all of the land in California. Then the bubble burst. From 1990 to the start of 2019, Japan was the worst performing stock market. At the start of 2019, its capital value is still close to one-third of its value at the beginning of the 1990s. Its weighting in the world index fell from 41% to 9%.
Listeners, this is not a backwater economy. This was the world’s arguably largest, or second largest. Now it’s second or third with U.S. and China in the mix. But as a reminder, the stock market was almost half the world. U.S. is about half the world today and also one of the most expensive. Can you extrapolate into the future that this will continue? Hard to say.
Again, for global returns, I used to say to use that old 5:2:1 rule for expected return on stock, bond, bills. And that includes, by the way, two markets that registered a total loss. You got to remember, Russia in 1917 and China in 1949 essentially went to zero as the governments decided that capital markets were not a great idea and shut them down.
The professors then turn their attention to emerging markets, which, by the way, this always surprises people, they have most of the world GDP, most of the world population, but a fraction of the world’s stock market cap. It’s down around 12%. So a thoughtful investor who might assume that emerging markets will actually emerge from emerging to developed as they already have a large part of the world’s GDP population, etc., etc., but not yet stock market capitalisation, it seems like it would be a reasonable bet.
We’ll skip over to FX. And I don’t think people really understand this, so I’m not gonna spend too much time on it. But, “Changes in countries exchange rates versus the U.S. dollar have been approximately equal to inflation differential with the U.S. over the same period,” meaning relative purchasing power parity has held to a reasonable approximation.
And what that means, let’s say you have, for example, no inflation in the U.S. this year, and in a country like Brazil, you have 10% inflation. Purchasing power parity says that you should expect the Brazilian currency to go down 10% versus the U.S. And in real terms, meaning that things stay the same. And so over this period, they’re saying that, not surprisingly, markets are efficient and currency returns tend to be stable over time. Of course that doesn’t mean they can’t go up and down 20% in a year, but over time they tend to do a good job of approximating inflation.
So their report this year talked a little bit about emerging markets. So, “In the early part of the 20th century, emerging markets outperform but were hit badly by the October 1917 revolution in Russia, when investors in Russian stocks lost everything. During the global bull market in the 1920s, emerging markets underperform, but they were affected less badly than developed markets by the Wall Street crash.
From the mid ’30s until the mid ’40s, emerging equities moved in line with DM, but from 1945 to 1948, they collapsed. The largest contributor was Japan, where equities lost 98%. Another contributor was China, where markets were closed in 1949 following the communist victory, and where investors effectively lost everything. Other markets such as Spain, South Africa also performed poorly in the immediate aftermath of World War II.
From 1950 to 2018, they achieved an annualised return of 11.7% versus 10.5% for developed markets. This was insufficient, however, to make up for their precipitous decline in the 1940s. Annualised return from a 119-year investment in emerging markets was 7.2% compared with the 8.2% from developed and 8.1% overall for the world index.”
So Meb quick summary here. Historically, stocks, bonds, and bills have returned about to 5%, 2%, 1% after inflation. Country’s assets and sectors can and have essentially gone to zero. Extrapolating the experience of anyone into the future is dangerous. Diversifying your bets is a proven idea. I think this is particularly important as everyone extrapolates the 13% returns of the U.S. stock market over the past 10 years.
Next up, we will now focus on the second research piece, which is from Vanguard Group, called “Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation.” “As of September 2018, U.S. equities accounted for 55% of the global equity market, and non-U.S. equities accounted for the remainder.” Then they post a nice chart that shows how this kind of waxes and wanes over time. We talked a little bit already about how Japan was the biggest in the 1980s.
“While the U.S. is the largest developed market, the size relative to the entire global equity market has fluctuated over time as low as 29%. A portfolio invested solely with an investor’s home market, regardless of domicile, excludes a large portion of the global opportunity set. The benefit of global diversification can be shown by comparing the volatility of a global index with that of indexes focused on individual countries. While the U.S. had the lowest volatility in any individual country, its volatility was higher than that of the global market index. Other countries examined had volatilities that were 15% to 100% greater than the global market index.”
So the point they’re trying to make, this is Meb, is that every single country is more volatile than had you diversified across all the countries in a market cap-weighted fashion. So that should make sense as markets are not perfectly correlated. Expanding your opportunities around the world means you have lower volatility.
“Scott and others found that, in practice, most investors in these markets exhibit a strong home country bias and overweight domestic equities relative to their global market cap weight. A combination of imperfectly correlated returns across countries in lower global market volatility means that investors in each market examined will likely realise diversification benefits from incremental allocations to international stocks.”
Continued on, “Another benefit of global diversification is the opportunity to participate in whichever regional market is outperforming. This is a critical component of diversification that correlation does not effectively capture. For example, while the U.S. may lead over some periods, another country or region will invariably lead at other points. Domestic investors should consider allocating a part of their portfolios to international equities in determining how much of an allocation between domestic and international. A helpful starting point for investors is the global capitalisation weight.”
Now, let that sink in for a minute, because this was actually a big debate between Vanguard founder, John Bogle, and Vanguard itself. Vanguard recently, I think, came out and said, “U.S. investors should put 40% in global ex U.S.,” which is funny because the global market way is around half. And, you know, I think as long as you’re in that ballpark, I think that should be a good starting point.
So there’s some good charts in there. They show how basically in every country, investing a large chunk in the global X of that country, and they do it for Canada, Australia, U.K., etc., it shows that it’s a really smart idea for reducing volatility.
So quick summary. This one, again, makes sense to diversify globally, adding international stocks reduces volatility and helps average all the potential outcomes. So you’re never gonna have a situation where you have the worst performing stock market, Austria, or the ones that went to zero like China or Russia. You may not be the single best, which I think was South Africa over the past 120 years, but you’ll be somewhere in the middle. And again, a good starting point is the global weight, which is roughly half U.S., half ex U.S.
Next up, we have Morningstar with “A New Perspective on Geographical Diversification Revenue Exposure by Region.” And this is something I’ve been thinking about for a long time that I think is a good example of talking about this time is different or talking about how markets change structurally. We talk a lot about how you need to look back at history and at least understand, has something actually changed? A lot of people always want to talk about markets have changed, this time it’s different, but is there a structural change?
The one example we always give is income investors who have not started accounting for buybacks, which really started incorporating more of the way companies distribute their cash flow in 1980s, 1990s, and certainly over the last 20 years. They distribute more money through buybacks than they do through dividends. And a lot of investors who are still stuck in the 20th century focusing on dividends are missing how half the way the companies distribute their cash.
Another example is thinking about where companies are in stocks or domicile. So quote from the Morningstar article, “Domicile has long been an investor’s only way of geographically diversifying a portfolio. In certain instances, this can give a misleading interpretation of the actual diversity of a portfolio. As the world has grown, so as the reach of large, multinational companies. Now, where a company is headquartered can have little bearing on where its underlining revenues come from. The tobacco company, Philip Morris International, for example, has long been one of the largest stocks in the S&P 500 index without ever having any U.S. revenues. Similarly, the pharmaceutical firm GlaxoSmithKline is a large fixture in Britain’s FTSE index but gets minimal revenue from the U.K.”
Continued on, “Morningstar’s revenue exposure by region capability allows investors to better understand the global makeup of their equity portfolios. Geographical revenue diversification isn’t evenly distributed throughout sectors within utilities, real estate, and financials tending to be the most provincial, and technology materials the most multinational. Revenues generally become more domestic as one moves down the market cap ladder and toward value-oriented market segments. They become more global as one moves up the market cap ladder and toward growth-oriented market segments. Home country bias is especially pronounced for U.S. investors. Only Australia’s ASX 200 index rivals the U.S.’s S&P 500 for the percentage of revenue it receives from its home country, 58% versus 62%.
At the other end of the spectrum, France’s CAC index garners just 17% of revenue from its home country. The MSCI All Country World ex U.S. Index receives 17% of its revenue from the U.S., even though the benchmark excludes U.S.-domiciled companies. Those industry groups with the lowest U.S. revenue percentage tend to have a heavier weighting in growth-oriented benchmarks and funds, while those with the highest U.S. revenue percentages tend to have a heavier weighted in value-oriented benchmarks and funds.”
So if you look at the U.S., for example, percentage of industry revenues derived from the U.S., utilities, telecom, real estate, banks, are all, like, 18% plus, and on the other end, semiconductors, tech, hardware, and equipment materials tend to be much lower. So Morningstar has some tools to map the growth and value versions, the Russell Mid Cap, Russell 2000 indexes, to the [inaudible 00:22:15], to the Morningstar Style Box, including the percentage of each benchmark U.S. revenue. So something like small cap value has a much higher percentage than, say, large cap growth.
Anyway, the point of this, in Meb’s mind, is that borders and sectors are becoming increasingly meaningless. Anytime you move away from the global market portfolio to a segment, like a region, a country, or a sector, you’re gonna introduce bias until it’s your portfolio. And look, that can be better. It can be for worse. For maximum breadth of opportunities, investors should focus on the entire world.
However, if you do decide to segment your portfolio, at least be aware of the intended or unintended effects. And probably P.S. to this, as others may interpret this piece differently, you know, anytime you segment a market, whatever your approach may be, it may be discretionary, it may be quantitative, it may be sector-based, it may be country-based, you’re gonna have a bias.
An example I like to give is, if you’re looking at, say, I’m gonna look at the world, maybe I’ll do bottom-up, and I’m gonna pick the 100 cheapest stocks. Vice versa, if you say, “I’m gonna do top-down, and I’m gonna pick countries,” well, if you do countries, for example, you have a scenario that if you’re comparing Czech Republic to Japan, well, Japan has, I don’t know, 100 times as more companies that are large and liquid than Czech Republic does. And so you have a bias. If you’re just picking Czech, you’re gonna bias toward smaller stocks, much less breadth, than someone in Japan. But if you’re saying going bottom-up, well, the chances are you gonna end up with a lot more Japanese stocks simply because there’s a lot more choices.
So regardless of how you go about it, the whole point in my mind as a quant, first, you want maximum breadth, but two, at least understand that some of these decisions will give you a bias one way or the other. And it’s not necessarily clear the bias is what you’re expecting. If you’re expecting to, say, “Hey, I’m investing in only U.K. companies,” but then, again, you have the domicile of, say, Glaxo that doesn’t have any U.K. revenue or much, is that actually a U.K. company or is that a company where it derives its revenue? It’s a bit complicated, the point being is at least to be aware of it whether you intend it or not intend to make that bias.
All right, next piece. Let’s talk about Capital Group, piece number four, with “Guide to International Investing: How to Go Global in an Uncertain World.” I really like this piece. They have a lot of beautiful graphics. They say, “If you feel like international equities in your portfolio aren’t holding up their end of the bargain, then you’re not alone. It’s one of the most common investment concerns we hear today.”
And they have a nice chart of rolling 10-year performance of international versus U.S. And we say this all the time in the podcast. Historically, as far back as you go, U.S. versus ex U.S. over any period is 50/50. It’s a coin flip. Whether U.S. outperforms or global ex U.S., it doesn’t feel that way because over the last 10 years the U.S. has creamed everything in sight.
“International equities have trailed U.S. markets over the past 10 years, but the index base returns the most investors followed don’t tell the whole story. On a company-by-company basis, the picture is quite different. In fact, it may come as a surprise that the companies with the best annual returns each year have mostly been based outside the U.S.”
They have a nice chart that shows what percentage of the top 50 stocks each year are outside the U.S., and the average is 75%. And that should make sense simply because of breadth. Again, if you have a couple thousand stocks in the U.S., but you have even more outside, the odds are simply that, by random dart throwing, you would end up with a lot more of the best performers outside the U.S. So focusing only on one country means you have a much more siloed, narrow-fueled vision.
“As companies have become more global, the lines between U.S. and non-U.S. indexes have started to blur and correlations between the two arisen.” So this makes sense. You know, we talk a lot about this where we say, in a globalised world, a lot more threads across countries and sectors, it’s become a lot more intertwined. There’s still equities. There is still some diversification. But you would expect correlation to go up, I think, and that’s just globalisation. Some may blame central banks. I wouldn’t.
Then they go on, “If real estate is all about location, location, location, investing may all be about revenue, revenue, revenue. As the shift towards globalisation continues, the address of a company’s HQ has become less important to its growth prospects than where it makes its money.” And they say, “The bottom line, follow the money, not the mail.”
And this ties in to what we were just talking about. And there’s a nice chart of a lot of the largest revenue exposure of the 10 largest companies in Europe and where they get their revenue. It’s totally across the board. They have a really wonderful chart. Because people a lot of times like to talk on Twitter and other places about what drives most of the stock returns. Is it their country, is it their sector, is it their region? And they all have an influence, but they have a beautiful chart that shows the main driver is still company-specific fundamentals. And they say it’s right around two-thirds of the driver of stock returns.
“There are many reasons for lackluster non-U.S. returns over the last decade, a strong U.S. dollar, political turmoil, and trade tariffs, just to name a few. But another factor is the way in which we typically measure international markets. International indexes generally have a higher concentrated of value-oriented stocks in old economy sectors such as materials, financials, and energy. Contrast that with the U.S. where technology, health care, and consumer tech dominate the S&P 500 composite index.” And so it actually shows a beautiful chart of U.S. and non-U.S. by sector and what the regional exposure of each sector is within the MSCI ACWI.
“If you were gonna go fishing,” I love this analogy, by the way, “if you were gonna go fishing, would you limit yourself to just half the lake? Would you want to seek opportunities wherever they were available? Investing shouldn’t be any different.” They show a chart of outside the U.S. More companies have tended to pay dividends and have done so at higher levels. There were more than six times as many non-U.S. stocks with yields over 3% as of…this is August 21st 2019.
Again, think about that. So the number of companies with dividend yields higher than 3% in the U.S., there’s 158. In emerging markets, there’s 518. International, developed, there’s 498. And that’s incredible. So if you combine those 2, that’s like 10 times, almost 10 times. They said six times. Six times as many high yielders, and that just goes along with valuation, in my mind.
Oh, by the way, and they said, “The index dividend yield, international 3.4%, emerging markets 3%, U.S. down around 2%.” And depending on the index, if you total this value, I think you can get that even quite a bit higher.
“Valuations matter. There’s evidence that stocks trading in a discount average higher long-term returns in future periods than those selling at a premium. But the key phrase here is long term, because there’s almost no correlation between valuations and short-term returns. When it comes to answering the question, how much international equity do you need, the simple answer may be more, whether it’s due to home bias or a lack of rebalancing during the long U.S. bull market. Many investors may find themselves underexposed to non-U.S. stocks.”
So again, Meb summary of this one. Internationals underperformed over the past decade. That’s normal. That goes through cycles of over-under performance. If you’re a bargain hunter, you should consider focusing on companies all over the world due to breadth, higher dividend income, and lower valuations.
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Meb: Numero five. This may be my favourite, and this is from Bridgewater, and it’s called “Geographic Diversification Can Be a Life Saver, Yet Most Portfolios are highly geographically Concentrated.” It rhymes a lot with a Credit Suisse one in that it looks back at markets all the way to 1900, so I’m gonna read a long quote here.
“The best way we know to earn consistent returns and preserve wealth is to build portfolios that are as resilient as possible to the range of ways the world could unfold. To uncover vulnerabilities that are outside of investors’ recent lived experiences, we find it valuable to stress test portfolios across the various environments that have cropped up across countries throughout history. One common vulnerability is geographical concentration.
In the past century, there have been many times when investors concentrated in one country so all their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets and other countries remain resilient. Rather than try to predict who the winner will be in any particular period, a geographically diversified portfolio creates a more consistent return stream that tends to do almost as well as whatever the best single country turns out to be at any point in time.
So geographic diversification has a big upside and a little downside for investors. Geographic diversification felt less urgent during the recent decade of great returns for most assets and portfolios. Low asset yields going forward make diversification and efficient risk taking all the more important to investors.
Then we include a chart of equity markets returns since 1900. And it shows returns above cash to real returns back to 1900 for the equity markets where they have reliable data going back over 100 years. An investor concentrated in Russia or Germany in the early 20th century would have lost most or all of their wealth. While an equally weighted mix of the five countries shown below, which was Germany, U.K., U.S., France, Russia, does almost as well as the best performer. Looking at a broader set of stock and bond markets back to 1950, you can see an equally weighted mix has consistently performed well.”
And you guys can’t see the charts, but we’ll post them on the show notes at mebfaber.com/podcast. More importantly to me, they had this beautiful chart of equity returns by decade all the way back to 1900. And this past decade, the U.S. has been the best performer, but it was also one of the weaker performers in the previous decade following the dot-com bust. It was one of the best performers in the ’90s, but before that, you have to look back to the 1920s to find a decade in which U.S. equity performance was better than middling.
There are plenty of instances in which geographic diversification has been a lifesaver, preventing wealth from being wiped out. They show a few perspectives on this, and they show equity drawdowns. The deepest drawdown, so peak to trough loss, so the last two in the U.S. were about 50 percenters, but in the Great Depression, the U.S. lost, I think, 85%. And how long it took to recoup those losses? So it took 16 years after the Great Depression to recoup.
And what this shows is that equal-weighted portfolio, and you can market cap-weight it, you could weight it many different ways, GDP-weighted, all those would be fine. But it basically shows that any way you weight it, as long as you diversify, has a lower drawdown than all the individual countries. I think the only one in their example that had a lower drawdown, and it was, I mean, it’s a rounding error, was Switzerland, which makes sense. But you would think the diversification would be a much better approach.
“There are plenty of instances where a given country’s equity market was decimated, and it often takes decades to recover from the losses.” And a great example, Meb here, is Japan. I mean, again, we’ve talked about this, and people roll their eyes. “You’re still talking about Japan.” But again, it’s been three-plus decades, and you’re still not back to break-even.
“Developed world investors are similarly under allocated to the rest of the emerging world and tend to have a large home country bias, leaving them geographically concentrated overall.” Below they show an example of a typical U.S. investors portfolio geographic exposure. And we’ve talked about this ad nauseam, and I apologise to you, guys, but the typical U.S. investor has around 75%, 80% in the U.S. when in reality the global market portfolio starting point should be 50%.
So summary, again, a simple diversified equal-weight can achieve nice returns, low vol, and help avoid going bust, which, in my mind, is the whole point of investing, is you want to stay in the game. The U.S. stock market has underperformed, equal-weighting in 8 of 12 decades. Let me repeat that. The U.S. stock market has underperformed, equal-weighted in 8 of 12 decades. And let that sink in if you wanna extrapolate the recent 2010s into the 2020s.
Lastly, final one paper is from Rob Arnott. It was actually presentation from Research Affiliates, which is a PowerPoint called “Are Valuations Now Irrelevant?” So valuations hasn’t even really creeped into this whole discussion. We’ve just been talking about volatility. We’ve been talking about drawdown. So we’ve been talking about breadth, the whole point of diversifying. But when you actually think about including valuations, it becomes even more important here in 2020.
We’ve had Rob on the podcast. We’ll link to his episode in the show notes. But they walk you through sort of current equity factor return forecasts. And so the highest return potential is available from the value factor. So they look at value and momentum, international, all these good things, and they show what is the sources of historical returns, what we have called on this show many times the Bogle formula, which is, if you want to extrapolate future stock returns, and they show an example that goes back all the way to 1871, amazing, is that you can decompose it into the three main things.
The first one is dividend yield, which historically, since 1871, has been 4.4%. Gone are those days, right? We’re at 2%. And then you can decompose it into earnings growth. And for the nerds out there, you can change that. You can expand it into two parts, which is real earnings growth, or dividend growth, and inflation. So they show a historical inflation of around 2% and real growth around 2%. And then lastly, valuation change. And so over the past, man, I can’t even do the math on this, but 150 years since 1871-ish, you had a slight bump in valuation. As valuations ended this period, we’ll use CAPE ratio at the end of 2019 of around 31. So you end up with this 9% historical return since 1871.
But if you wanna use valuation, they go to show that valuation is powerful at forecasting long-term horizon returns, but almost useless for market timing over the next year. And it doesn’t really matter what valuation metric you use. They show a chart of what we used, like the Shiller P/E, but also market cap to GDP, Tobin’s Q, yada yada, on and on. And they go on to look at the link between starting valuations and subsequent return is robust across all equity markets. They show it in Australia and Canada and France, Germany, Hong Kong, Italy, Japan, yada yada, all the way down. Then they show a very high correlation of 75% of returns, starting valuations and returns.
And so if you look at long-term return expectations, it’s not surprising that U.S. large caps, they got at low, single digits. Off in the top right quadrant is Russia, which, by the way, a lot of people don’t know, has outperformed the U.S. stock market for the past 5 years but still trading at a single-digit P/E ratio, has long been one of my favourite markets. And then if you focus in the regions or developed versus emerging, etc., emerging market equities, emerging market debt tend to be two of the best projected future returns versus on the bottom-left corner, U.S. TIPS and U.S. stocks and U.S. 60/40.
So a couple comments. You know, the link between starting valuations and subsequent returns is powerful. Valuation levels are not useful for market timing tops and bottoms. Chasing returns can be very costly. High valuations can go higher but not indefinitely. And they had a concept that Rob talked about on the podcast, which is this idea of over rebalancing into laggards.
So, you know, if you’re, say, a 60/40 investor, and you consistently rebalance, rebalance back to 60%, maybe there’s a concept that you actually rebalance more into the cheapest stocks and countries. That should add an additional tailwind at performance as you consistently buy the cheap and sell the deer, he talks about in the podcast, which I got one out.
And, again, across asset classes, higher return potential exists in international and diversifying markets within developed and emerging. The value factor even one step further offers the highest return potential today. So Meb is extrapolating by saying, “Look, emerging markets are the best of U.S. developed and emerging, but also emerging value is even more of an extreme projected future return.
And then they talk about something that I think is one of the most important topics we’ve talked about on the podcast, which is one of the simplest, is that thinking about market cap investing. And so they go on. Rob talks about the largest stocks in the market are often expensive, and they have historically underperformed after reaching the top 10. I mean, there’s a piece that he has, we’ll link to called…something about the top dog. And we didn’t touch on this much in the talk today, but if you’re going to express your views, instead of doing, say, market cap-weighted globally or emerging markets, there’s a big flaw there. And there’s no tether to valuation fundamentals.
So they talk about this, where, in their research, they show that investing in the largest stock in each market or sector goes on to underperform by at least three percentage points per year for the next decade, you know. And to me, that makes sense. That’s just capitalism. That’s just creative destruction. And it’s the way that it should be.
There’s a chart that we’ve been posting for years from Ned Davis that compares the S&P 500 to investing in the largest stock on the market at the time. So I think that’s Apple right now, but it’s a laundry list of famous companies, AT&T, IBM, Cisco, Walmart, Microsoft, and it underperforms by a massive amount, and it’s a horrible idea.
So as we start to wind down, you know, we’ll start to summarise. Despite all the evidence of everything I’ve been saying, almost all my listeners will continue to concentrate massively in their own markets, not just the U.S., but this is more egregious, by the way. If you’re in Canada, the average allocation is 60% to Canadian equities. You Canucks love your junior miners and cannabis stocks. But in reality, your market cap is under 5%. So you’re like a 10X. So this is even worse.
The U.S. is half the world market cap. You put in 8%, that’s pretty bad. But if you’re in these countries that only have 3%, 4%, 5% of the total, and you’re putting in, in the case of U.K., it’s 26%. This is a Vanguard chart, by the way. Australia 67%, Japan 55%. These are really foolish, in my mind, because you’re highly concentrating in markets that actually as a percentage of global market cap are tiny.
So summary, diversifying globally can save your butt, simply stated. Number two, investors should start with the global market allocation, which, in stocks, and also in bonds. We didn’t even get the bonds today. But that’s roughly half U.S. and half ex U.S. for the full opportunity set in breadth.
After that starting point, you could consider adding value tilts. This is uncomfortable for a lot of people, because that would push you even further away from the U.S. into certain places that sound scary. And lastly, relax and sleep tight. Set up an automated system way to do this so that you don’t have to fret about it, so you don’t have to think about it, but really that it just automates the whole process of rebalancing into the cheap countries. That’s it. I think we got in there for under an hour, summarising those 104 tweets. For those people that wanna dive in more, you can always download my books that talk about this, “Global Asset Allocation,” “Global Value,” for free on cambriainvestments.com.
And if you or someone… This used to be a pinned tweet, but it’s on Twitter, we’ll put in the show notes on this episode, we have links to what I consider to be my top global stock valuation resources. And we’ll feature, say, about the top 10 here. We send out quarterly CAPE ratio updates on The Idea Farm. And that’s just theideafarm.com.
Our friends at StarCapital in Germany do a lot of fantastic research, publishing global valuation metrics, as well as how they’ve actually worked out historically. Research Affiliates, we mentioned in the last piece. They have an asset allocation interactive module that lets you look at how they come up with their valuation estimates for future asset classes and countries and everything else.
Barclays actually has individual CAPE ratios. You can download from many countries going back many decades. It’s not comprehensive, but they have quite a few. The OG, Shiller, Nobel laureate, he’s got a downloadable Excel sheet on his website that lets you download CAPE ratios, a couple different variants on CAPE ratios, also housing prices, all sorts of great stuff. He’s even got some fun white papers that look at CAPE ratio sectors. So he talks about how…I think it was utilities in the 1920 that went to a CAPE ratio of, like, 50. Who knew there could be a bubble in such a boring asset class sector like utilities?
French Fama. The professors have a wonderful website that has valuation resources on a million different countries and sectors and asset classes and factors. You can spend all day on there.
Former guest Aswath Damodaran, he’s an NYU professor. He’s been on the podcast. He’s got a lot of downloadable valuations for countries, etc. He does some amazing YouTube videos.
A paid service, but one that we use a lot is Global Financial Data. We’ve had Brian on the podcast, Brian Taylor, before. They have sort of infinite amount of time series analysis as well.
So you, guys, we’ll, again, link to all these on the show notes, all the resources, everything else. I would love to hear your feedback on this topic, and hopefully it’s been a fun one. If you guys liked this episode, shoot us an episode feedback at mebfabershow.com. We’ll do more of them. There’s a lot of topics that we like to talk about that you guys, I feel like, you may get bored of my monotone. But sometimes people like it, so we never know.
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