Looking Ahead and Abroad
Published On: May 15, 2018
Written by: Ben Atwater and Matt Malick
When we started Atwater Malick, gaining on a decade ago, we found fault with what we believed was “overdiversification” in managed portfolios.
We felt managers were buying things like international and emerging market equities, commodities, managed futures and hedge funds in the name of diversification when, instead, they were really chasing performance. This is a difficult phenomenon to grasp today because it is easy to forget how poorly U.S. large cap stocks did from 2000 to 2009 and how people craved other options.
We decided to take the contrarian route, offering tailored portfolios using mainly individual securities that were, broadly speaking, more U.S. focused. Indeed, we hit this big theme right. It wasn’t perfect by any means. For example, we have a value orientation in a time when growth is better. But, by and large, our portfolios fared well thanks to the superior performance that occurred in U.S. stocks from 2009 through today.
Price matters. What you pay for an investment, over the long-term, is of vital importance. U.S. stocks, given their substantial outperformance during this bull market, are expensive. And, U.S. growth stocks are particularly pricey.
Looking longer term, over the next ten years, we believe outperformance is more likely to occur in emerging markets and developed international stocks than in U.S. domestic equities. Although not dirt cheap, foreign stocks offer a significant discount to U.S. stocks.
Emerging market stocks are from countries that are in an emerging growth phase and offer higher potential returns, with higher risk (more volatility), than developed countries. The largest weightings in the emerging markets index are China, South Korea, Taiwan, India, Brazil and South Africa. Many of these emerging market nations are experiencing significant growth from middle class consumers who are driving increased demand.
Developed market international stocks, on the other hand, are from countries like Japan, the U.K., France, Germany, Switzerland, Australia, the Netherlands, Hong Kong, etc. These more established markets include companies with household names, among them Nestle, HSBC, Toyota, Novartis, Roche, Royal Dutch Shell, BP, etc. The most recognized international developed market benchmark is the Morgan Stanley Capital International Europe, Australia and Far East (MSCI EAFA) Index. Its largest sector weightings are in Financials, Industrials, Consumer Discretionary, Consumer Staples and Healthcare – more value-oriented corners of the market.
A few numbers tell a big story. The price-to-earnings (P/E) ratio for emerging markets is 13.5 and for developed international it is 15.3, whereas the P/E ratio for the Standard and Poor’s 500 is 22.8. The price-to-book (P/B) ratio for emerging markets is 1.65 and for developed international it is 1.72, whereas the P/B for the S&P 500 is 3.14. As for the 12-month trailing yield, emerging markets yield 2.32% and developed international yields 2.60%, whereas the S&P 500 yields 1.85%.
Over the ten years ended on March 31, 2018, the S&P has returned 9.49% per year, while emerging markets have returned a paltry 3.20% per year, barely outpacing international developed that have returned 3.19% per year.
We see a reversion to the mean occurring over the next decade. In the 1990s, we saw similar significant outperformance from U.S stocks (particularly U.S. growth). Then coming into the 2000s, we saw a major reversal with international stocks trouncing U.S. equities. And in the 2010s, it reversed again and we’ve witnessed big U.S. outperformance (again, particularly U.S. growth). Our considered bet is that ten years from the now, the U.S. will have seen another cycle of underperformance while international will again have its day.
Because of the inherent volatility of individual emerging market stocks and currencies, it’s not sensible to buy the common stock of individual companies. Furthermore, emerging market countries don’t usually have the same legal standards for transparency and financial reporting that developed countries require. As fiduciaries, managers mandated to work in your best interest, we believe that offering you emerging market exposure is the correct long-term decision, which leaves the question of how best to accomplish this.
We are utilizing IEMG, which is the iShares Core MSCI Emerging Markets ETF (an ETF trades like a stock with its pricing continuous throughout the day). IEMG is meant to track the investment results of the MSCI Emerging Investable Markets Index, composed of large, mid- and small-capitalization emerging market equities. The fund has exposure to about 1,900 companies. While we’ve often advised against over-diversification, our concern about single-stock risk in emerging markets outweighs our preference for individual stocks.
The same is to be said about developed international investing. Although we can make a much stronger argument for owning individual developed market stocks, the currency risk also gives us some pause in this asset class. Furthermore, the compelling valuation of international developed markets as an asset class is driving our investment thesis, so picking a couple of international developed market stocks for the portfolio has a reasonable chance of backfiring against our broader, more obvious, valuation thesis.
For developed international exposure, we have chosen IEFA, which is the iShares Core MSCI EAFA ETF. iShares designed IEFA to track the investment results of the MSCI EAFA Investable Markets Index, composed of large, mid- and small-capitalization international developed market equities. The fund has exposure to about 2,500 companies.
We are still skeptical of today’s stock market, and that includes foreign markets in the shorter-term. We believe the market is currently facing a period of adjustment as investors look to identify future catalysts. Although U.S. growth stocks are overvalued, we think U.S. value and international stocks have the best prospects over the next long-term cycle. Exactly when the cycle turns, though, is anyone’s guess.
Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.