Too Much Information

The conventional wisdom in investing is that more information is better than less. In the past Peter and I have sometimes questioned whether we have an informational deficit, but over time we’ve realized that it is not quantity of information that counts, but knowing which information is important and analyzing it correctly. In fact, to the extent that too much information leads to overconfidence and emotional bias, more information can become a stumbling block.

Last year we wrote an article in which we compared insurance to investing. The focus was around diversification: How insurers are in the business of selling diversification for a profit. We feel there is a lot that investors can learn from the way insurers go about their business, which in many ways is very similar to the business of investing.

This time our focus is around information, and how that relates to the selection side of the process.

Focus on key variables and aggregate outcomes

Insurance is about aggregate outcomes. You isolate a few key variables – age, gender, smoking, family history and other health markers (for life insurance) – which largely explain variations in aggregate claims (or base rates). These variables are readily determined at low cost and can be applied broadly. This is called underwriting, the insurance equivalent of selection.

Further variations in individual claims are treated as random, either because they are random, or because the cost of collecting and assessing further information that might explain these variations outweighs any potential benefit of doing so.

Your life insurer probably won’t send someone out to interview you and find out about your life. The conclusions would likely be unreliable, especially to the extent that they differ from what the key variables are suggesting. Apart from the added expense, your insurer wouldn’t disregard the base rates in favour of a compelling story when setting your premium.

Your life insurer also won’t waste too much time second-guessing its underwriting process for every random deviation from the average, as long as the aggregates are in line. Claims are expected.

What is important about this approach to selection is that it is logical, business-like, and reasonably free from emotional bias. And it works.

The informational deficit mirage

In contrast, the investment world is obsessed with specific outcomes and individual stories. There are huge stakes attached to correctly predicting big winners and losers, which drives the investment community to generate and consume as much information as possible – as though this would somehow enable us to see the future.

The idea is that more information leads to more accurate predictions. This seems intuitive. The reality is that more information leads to greater confidence in forecasting, but not greater accuracy. This information-driven overconfidence causes investors to take big bets on specific outcomes without the required accuracy.

 Stories appeal to our emotions

The obsession with individual stories creates another problem: Investors are far more likely to allow emotional biases to bypass logical reasoning when stories are involved. In their paper On the Psychology of Prediction, Kahneman and Tversky demonstrate how compelling, but ultimately irrelevant information, can cause people to disregard prior base rates when making predictions, leading to systematic prediction error.

This sort of thing happens all the time in investing. Overconfident from all the information we have about a company, we fall in love with the story and often lose sight of the few key variables that determine aggregate outcomes.

It is staggering to see how different the approaches of the insurance and investment industries are, considering how similar their businesses are.

What are the key variables in investing?

Perhaps one reason why investors consume so much information is because there isn’t broad understanding of what the key variables in investing are. Understanding the causality of investment returns helps to isolate which variables are important. There are only three broad variables that really matter:

Higher profitability is associated with higher reward and lower risk. Higher leverage is associated with higher reward and higher risk. Higher prices are associated with lower reward and higher risk.

These are the three key variables that drive aggregate outcomes in the stock market. Every bit of information that you consume should be directed at trying to understand these three aspects of a business. Every bit of information that draws your attention away from these variables is probably impairing your judgement. The investment community generates far more of the latter.

Let’s do an example, then add a story to make it interesting…

You have the opportunity to invest in a persistently loss-making business that is operating in one of the most competitive and capital-intensive industries in the world. The company is highly geared, issues a lot of new shares every year, and burns through cash. The industry is cyclical. If the company was as profitable as its competitors, it would be trading at a PE of 30x – 40x.

Loss-making, leveraged, expensive… What do you think the base rates of return look like for a group of companies with these characteristics? Would you invest? Maybe this one is an exception.

What if I told you the company is a fast-growing, high-flying, tech company that is disrupting one of the most established industries in the world. The CEO is a billionaire genius who has successfully grown several startups into multibillion-dollar businesses.

How about now? The story tells you little about profitability, leverage or price, but it is representative of a mental model of success. Would you disregard the prior base rates in favour of the story? The market does this every day.

Investing like an insurer

We’ve always preferred a more actuarial approach to investing. The idea is to drill down to the key variables, and to ignore marginal information when it is no longer useful, or when it is introducing emotional bias that might cause us to lose sight of the key variables.

Though we often talk about individual companies, we always think in terms of base rates and try to build a portfolio of highly profitable businesses, with prudent leverage at attractive prices. It makes it difficult to keep portfolio updates interesting when the reasons we bought company X are always the same.

Finally, in investing as in insurance, there are always claims. Some periods are worse than others. High base rates combined with small samples can be dangerous. This is why diversification and time horizon remain critical to achieving investment success.

SA Foie Gras

AfrAsia’s latest South Africa Wealth Report found that wealthy South Africans have 83% of their assets invested locally. According to the report, their asset class breakdown between South Africa and the rest of the world is:

Let’s exclude properties, businesses and alternatives, which tend to be illiquid and might correlate with where you live or work. Let’s focus on the 44% made up of local and foreign stocks and fixed income – the liquid, more readily investible assets where investors have greater flexibility. The splits within this category are consistent with traditional asset allocations in terms of both asset allocation and global allocation:

The split between stocks and fixed income might be justifiable. The split between local fixed income and foreign fixed income might also make sense to the extent that local cash is needed to meet short-term liquidity requirements.

Too much invested in local stocks

What doesn’t make any sense is investing twice as much in local stocks as in foreign stocks, when:

  • More than half of your wealth is already tied up in illiquid local assets;
  • You have enough local cash to meet your short-term liquidity needs;
  • The local stock market is <1% of the world.

The purpose of investing in the stock market is to grow wealth and match long-term liabilities like retirement or leaving an inheritance. Surely investors in this position should be aiming to diversify their risk, which is very concentrated in South Africa, and to take advantage of the widest opportunity set possible. This means investing as much of your stock portfolio as possible in the global markets.

This doesn’t necessarily mean excluding the local market (though you probably already have exposure through your retirement annuity/pension). It means that local stocks should have to justify their place in your overall portfolio on more than the fact that they are listed where you live. They should compete on merit with every other stock in the world.

 

So why do so many South African investors and their advisors still seem to favour local, despite the obvious risks associated with such concentration?

“No one-size-fits-all”

I think it’s time to retire this line. We know that every investor has unique circumstances, and of course everybody doesn’t have the average allocation in the AfrAsia report. But when the averages are so skewed towards local, we can’t keep pretending that this is the perfect end-product of every individual’s unique financial plan. We also can’t keep using this line to avoid debating this important issue.

Isn’t the JSE Internationally Diversified?

“More than half of the JSE’s revenues come from outside of South Africa.” – another line often used to justify local market bias. But those revenues come from a handful of stocks – Naspers alone is more than 20% of the local market, with the top 4 companies making up half the index.

You cannot build a diversified global portfolio with a handful of stocks. There’s simply no benefit to limiting your options like this.

Ask yourself the following question: If these stocks weren’t listed in South Africa, how much of your global portfolio would you invest in them?

Where are your liabilities?

Ideally you want your assets structured in such a way that they match your liabilities. If you’re living in South Africa, it stands to reason that most of your liabilities will be local.

As far as your short-term liabilities are concerned, it makes sense to have sufficient local fixed income exposure to meet these liabilities. The primary goal here is low volatility in Rand terms.

Once you start talking about building wealth and matching your long-term liabilities, you should be less concerned by volatility and you’re probably investing in the stock market.

You might think that adding currency volatility can interfere with your long-term asset-liability matching, or with your dividend flows, but different sources of volatility are often offsetting rather than additive. Stocks are already volatile. Dividends are also volatile in times of crisis. Adding currency volatility doesn’t make them more so, especially since the Rand tends to weaken during times of crisis.

In 2008 the JSE Top 40 index lost 26%. The MSCI World index lost 21% in ZAR. The following year JSE Top 40 dividends fell by 37%, while MSCI World dividends fell by 24% in ZAR terms. Currency volatility in the stock market is a bit of a red herring. If anything, it reduces overall portfolio and dividend stream volatility.

A globally diversified portfolio of your best investment ideas chosen from the widest possible opportunity set is far more likely to meet your long-term goals than a locally concentrated portfolio. The risks are also lower.

Strong Rand keeping you up at night?

Every debate about local vs offshore seems to devolve into a discussion about whether South Africa or offshore will do better. Apparently South Africans worry that South Africa might do well – that Rand strength might somehow make us poorer. They are worried about the possibility that 99% of the world might underperform 1% of the world, despite the fact that they already have 83% invested here. This is insane.

First, this argument ignores the fact that there are many more cheap assets outside of South Africa than inside. Simple Bayesian inference.

Second, it’s not about which will do better, it’s about risk management and where your exposure is. When you are 83% invested in one small country where you happen to live, return expectations become secondary to risk management.

If Turkey, an economy twice the size of South Africa’s, was your best investment idea in the world, would you invest two-thirds of your stock portfolio there, on top of your property and your business?

We need to stop mis-framing this issue as a return issue when it is in fact a risk issue. We can’t keep dangling far-from-certain return potential as a carrot to force-feed local investors something they already have too much of. As advisors and asset managers, is our job to sell SA, or to represent our clients’ best interests?

If you’re anything like the average SA investor, you are already hopelessly overinvested in South Africa. If South Africa recovers and the Rand strengthens, you’ll benefit more than 99% of the rest of the world. Your business, your properties, your local cash will all be worth more in real terms. This is a good thing. You will survive a strong Rand.

Be more concerned about what might happen if, heaven forbid, South Africa and the Rand don’t do so well.

Consistent Profitability

Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation

This understanding of return is central to our investment philosophy and process. We’ve written about this on numerous occasions. Those who have followed our writing will recall that revaluation, though dominant in the short-term, tends to cancel itself out over long periods of time.

The result is that over very long periods of time, Return Sustainable Return.

This makes sustainable return incredibly important as it is the underlying fundamental source of value creation to all investors in aggregate. Businesses with low or negative sustainable returns might deliver high returns at times when revaluation is strong, but because this isn’t a persistent source of return, these businesses ultimately fail to create value for their shareholders over time.

Revaluation acts as a transfer of wealth between investors, rather than wealth generated by the business itself. This doesn’t mean that revaluation isn’t worth pursuing, but because of its unpredictability it makes sense to own strong businesses that are likely to generate high sustainable returns, and to approach revaluation more opportunistically over and above this.

What causes high sustainable return?

So, what causes sustainable return to be better for some companies than others? The most important factor is profitability. If a business makes a profit it can reinvest it in the business to drive growth, or it can return it to shareholders as yield. Since Sustainable Return = Yield + Growth, it stands to reason that the base rates for sustainable return of consistently profitable businesses should be superior.

To demonstrate the fundamental relationship, we calculated the annualized sustainable returns of nearly 1 200 of the largest US-listed companies with at least 10 years of financial data history (as of June 2018), and categorized them by consistency of profits:

The base rates for those that were profitable 10 years out of 10 were significantly higher, whether measured in terms of earnings, sales or book value. Less consistent profitability was associated with lower annualized sustainable return, as we would expect from the causal relationship.

While this is quite a simplistic way of assessing profitability (because it doesn’t account for capital employed, cash flow, leverage or cyclicality), it nevertheless demonstrates just how powerful consistent profitability is in driving the base rates for long-term sustainable returns.

Don’t let the Rand dictate your portfolio

For many South African investors, the Rand exchange rate is the single most important variable they consider when deciding whether to invest money offshore. It crowds out every other consideration. We think this is a mistake.
If you’re thinking about investing globally, but you’re worried about timing the Rand, ask yourself the following questions:

1) How much of your wealth is focused in South Africa?

This is probably the most important consideration: If you’re overexposed and something goes seriously wrong here, your wealth could be permanently impaired.

This is an emotive topic for many investors and advisors who have strong views about what will happen one way or the other, ranging from doomsayers and fearmongers to the fervent “we’ve always recovered in the past” crowd.

We fall into neither camp, preferring a more probabilistic approach to risk management. Risk events have two elements: 1) Probability of occurring, and 2) magnitude of loss. A failed state is generally a low probability event, but the magnitude of loss is very high. Low probability, high magnitude risks are risks worth managing. This is the reason young, healthy people buy life cover. We think about country risk the same way. Global diversification is a form of country insurance.

Depending on where the Rand is trading, country insurance may be free, cheap or expensive. Free insurance is a no-brainer. Whether or not you decide to pay for country insurance should depend on two factors: 1) Price, and 2) how much insurance do you already have?

So how much of your wealth is focused in South Africa?

If, like many South African investors, you have a local business, a house, a pension and/or retirement annuity, chances are high that most of your wealth is focused in South Africa. If most of your liquid, discretionary assets are also invested locally, paying a fair premium for some country insurance might not be such a bad idea.

If, on the other hand, you are a global investor with very limited exposure to South Africa, your mindset is totally different. You have become the insurer, and for you it may make sense to be moving in the other direction, collecting premiums in exchange for bearing country risk as part of your globally diversified portfolio. This is a good position to be in.

Discussions about how cheap South Africa and the Rand are should be framed within the context of your global asset allocation and the size of the currency premium, if any. The higher your country risk exposure, the more it makes sense to pay a reasonable premium to manage it. The lower your exposure, the more you can afford to be opportunistic.

2) Is the Rand cheap or expensive?

In December 2001, the USDZAR reached a high of 12.45, 80% above the “fair” value based on inflation differentials and long-term trends. The premium for country insurance at this point was extreme. The perceived risks did not play out, and within 3 years the exchange rate had halved. The short-term pain was compounded by the simultaneous popping of the tech bubble.

Long-term investors who bought the S&P 500 in December 2001, and held on until March 2019, would be up 321% in ZAR, or 8.7% p.a. – not great, but not as bad as one might expect for the worst timed investment of the last 20 years. Also bear in mind that things might have played out differently. We only see what did happen in hindsight making it seem like the only possibility, but the reality is that the future is uncertain.

More recently the 2016 USDZAR high of 16.87 was about 40% above our estimation of fair, still very high, but nowhere near the extremes of 2001. We estimate today’s premium at roughly 15%. For a long-term investor, this premium could easily be a lesser consideration when weighed against other factors.

The “always recovered” commentators often use 2001 as a warning against rushing for the exits when the Rand is cheap. But cheap and expensive aren’t black and white. The current exchange rate premium is much closer to fair than it is to 2001 levels.

Your context may be one of 100% exposure to South Africa, in which case you may be happy to pay the current premium to get some global exposure. A global investor’s context may be one of only 1% exposure to South Africa, in which case the premium may warrant further investment in the country.

Within the context of your exposure to South Africa, is this a reasonable premium or not?

3) Cheap relative to what?

So, the Rand is fairly cheap. But relative to what? The US Dollar? Ironically, we tease Americans about their perceived lack of awareness when it comes to the diversity of “Africa”, but many of us make the same mistake when investing “Offshore”. There is a whole world out there that isn’t pegged to the US Dollar. There’s also more to global equity markets than the S&P 500.

By our estimation Sterling, Yen, Euros, Canadian Dollars and the Swedish Krona are also cheap relative to the US Dollar. You aren’t paying much of a currency premium to invest in these places.

The relative valuations of other currencies should also be factored into your decision to invest globally.

4) Are Rand-based assets cheap or expensive? What about other countries?

One of the major benefits of a global portfolio is having access to a very broad opportunity set. This allows you to make better investments and achieve a greater degree of diversification. You might find very cheap assets in a country where the currency isn’t as cheap. Think of Hong Kong, where the currency is pegged to USD. One of our portfolio holdings is a Singaporean company, listed in Hong Kong, which does business globally. It reports and trades in HKD, but how relevant is HKD really in this equation? Should the strong HKD put us off investing here? No.

The same applies to many companies listed on major exchanges around the globe, as well as our own local exchange. Some advisors say that investors should invest locally because a) the Rand is cheap and Rand-based assets are cheap, and b) because some of our prominent local listings like BAT, Naspers and Richemont have nothing to do with the local economy. These two points are contradictory. The fact that these companies are priced in Rands on our local exchange means nothing if they earn almost nothing in Rands. These companies stand to benefit no more from a domestic recovery than Altria, Tencent and LVMH.

There are also companies listed in the US that are cheap despite the strength of the USD.

The valuation of an asset’s trading and/or reporting currency is less important than where the company does business. It is also less important than the overall valuation of the asset, where currency effects are but one factor.

In the global investment opportunity set where South Africa represents less than 1%, it is highly unlikely that our local assets are the only cheap assets in the world. Shunning the rest of the world’s investment opportunities because “the Rand is weak” makes no sense.

Investors should Ignore Annual Predictions

After reaching new all-time highs in September, the S&P 500 lost nearly 13.5% in the fourth quarter of 2018, while MSCI World ex-USA declined by 11.4%. Equity markets have recovered somewhat from their December lows – the S&P 500 came within a hair’s breadth of official bear market territory (-20%) on 24 December, before rallying 5% in the following trading session, the largest one-day gain since March 2009.

2018 was one of the rare years in which none of the major asset classes generated returns for investors. This rarity has many investors asking “So where to from here? Have we bottomed?” The real answers to these questions are unknowable. Market movements like these are inevitable, but unpredictable.

Despite this inherent unpredictability, this time of year is always marked by an influx of predictions and forecasts for where the market is headed next, which sectors are likely to do best, which stock picks will do well in 2019, and so on. Ignore them. 85% of the major investment banks expected the S&P 500 to end 2018 higher, with the lowest price target still 5.7% higher than the final outcome.

Allowing short-term forecasts to influence your long-term financial planning is a sure way to destroy wealth. Short-term predictions – despite their popularity – don’t work. Ignore the noise and use the new year as an opportunity to reassess your financial plan and make sure you’re well positioned for the long-term.

To assist with your planning, ask yourself the following three questions:

1. Does your asset allocation adequately match your future liability profile?

  • Do you have enough liquidity to meet short-term/contingent liabilities?
  • Do you have enough equity/growth assets to counter the creeping effects of inflation and to build wealth sustainably over the long-term?

2. Is your overall investment portfolio being managed transparently and cost-effectively, or are there too many layers between you and your money?

3. Are you sufficiently diversified, particularly in terms of a global portfolio?

  • How much of your wealth is concentrated in South Africa? Are you comfortable with this?
  • Outside of South Africa, are you overexposed to any other country?

A globally diversified portfolio of consistently profitable businesses, with strong financial positions is likely to deliver good sustainable returns over time, through the inevitable highs and lows.

In our view, the best approach will always be to invest in a global portfolio of good businesses at good prices, ignore the noise and the unpredictable swings of the market, and allow the effect of compounding to do its work as the years roll on.

Global Diversification: Are you doing it right?

Most investors would agree that diversification is a good thing, but how many of us really understand what it means? All too often, South African investors think about global diversification as fleeing risk.

Diversification is about managing risk. It is not about avoiding or eliminating risk, which cannot be done without sacrificing investment goals. It also isn’t about trading one risk for another presumably lesser risk, nor should it be about taking risk indiscriminately for the sake of diversification. It is about making good investments but spreading them across different risks.

With this in mind, we address two misconceptions that many South Africans have about global diversification:

1. Moving your assets from South Africa to the UK is not global diversification

South Africa is an emerging market country with significant political and currency risks. The local stock market represents less than 1% of the global opportunity set. By now, most of us know this. This doesn’t make South Africa a bad place to invest, but it does make it a risky place to invest everything, which is what many local investors do.

For those South Africans who have decided to invest offshore, there often seems to be a significant bias towards the UK – possibly because the UK is familiar: Shared history, language overlap, similar time zones, etc. The idea is that the UK, a more developed market, has lower political and currency risk. Global diversification done.

There are two problems with this thinking. First, the UK only represents about 4% of the global opportunity set. Second, as Brexit has made it abundantly clear, the UK also has political and currency risks. The UK can still be a great place to invest, just not too much.

Have a look at two recent Business Insider headlines:

The mega rich are bailing out of Britain in the thousands, and many are moving to Australia

These incredible graphs show that the pound is starting to look like the rand

These articles demonstrate how any country, not just emerging markets, is subject to political and currency risk. Developed market risk may be lower than emerging market risk, but it is still there, and it needs to be managed.

A South Africa/UK portfolio might be better than South Africa-only, but this strategy remains vastly inferior when compared to true global diversification. The SA/UK portfolio still only represents 5% of the world, and 50% or more of your money will still be subject to the political and currency risks of just one country. Even worse, as recent events in both South Africa and the UK have demonstrated, the probability of simultaneous turmoil in any two countries remains uncomfortably high.

The answer also isn’t to move everything from the UK and concentrate it somewhere else, like Australia. This doesn’t solve the problem, it just moves it. Outside of the United States, no single country represents more than 10% of the global opportunity set, and even the Americans would do well to consider the rest of the world.

Global diversification means avoiding overconcentration to any country and taking advantage of the widest opportunity set possible: South Africa, UK, USA, Switzerland, Canada, Australia, Hong Kong, Japan, Europe, and so on.

2. The argument that “other places have their own risks” is not a valid case against diversification.

When making the case for global diversification, we’ve at times been countered that other countries have their own problems, and “fleeing” South Africa is just “swapping one devil for another”. This argument misses the point of diversification.

First, global diversification isn’t about fleeing one country for another, and in doing so exchanging one concentrated risk for another. This doesn’t manage risk, it just transfers it somewhere else.

Second, global diversification as a strategy doesn’t rely on finding places without risk. As the first point of this article suggests, no such place exists. Instead, it relies on spreading exposure between risks that are less than perfectly correlated.

To the extent that we can find two investments with similar merit that have different risks, it is better to hold both than just the one. Our risk of loss is lower because the probability of both risks playing out is lower than the probability of any single risk playing out. To the extent that we can find many good investments with different risks, it is better to hold many than just two.

Global diversification remains the best way to find many good investments with different risks.

This does not mean that indiscriminate diversification is a good strategy. Making inferior investments for the sake of diversification is a big mistake that will result in poor returns. Fortunately, having a wider opportunity set makes it easier to achieve diversification without sacrificing investment quality or returns.

 

In a nutshell, diversification is about exposing yourself to a wider opportunity set in order to find many good investment opportunities with uncorrelated risks. If you want to manage your risk properly, invest globally.

Get the Most out of your Global Equity Exposure

Investors who ignore offshore opportunities deny themselves the significant benefit of exposure to a far wider range of stocks. While more South African high-net-worth individuals (HNWIs) are investing globally, many are still missing out on the opportunity of including direct offshore investing in their financial plan.

Purchasing foreign equities is a great starting point for long-term investors wishing to unlock the value of investing offshore. The South African market is less than one percent of the global market. Allocating a portion of your investments offshore provides access to markets, sectors and companies not available within the very limited investsable universe of the JSE, increasing the possibility of better returns and spreading the risk through diversification.

However, there are some simple – yet surprisingly often unheeded – guidelines you need to follow in order to extract maximum value from holding offshore equities.

Beware complexity and costs

Find the most transparent investment solution available when looking at offshore investments. Avoid highly opaque, layered structures, with limited flexibility and high costs. These often include complex tax structures, which may or may not add value.

A common example of layering would be where you invest via a local broker, onto a platform, into a feeder fund, into an international fund of funds with numerous underlying fund managers. Structures like this add layers of fees, reduce flexibility to access or change investments and make it very difficult to know who is actually managing your money and what their process is.

A direct account held with an international low-cost brokerage firm, which allows you to log in via a secure website to view holdings and draw detailed statements, is usually the most transparent and cost-effective solution.

Don’t turn a blind eye to costs. 2% p.a. may sound negligible but saving just 2% p.a. in fees will increase your terminal investment value by 50% over 20 years. Make sure you fully understand the fees you are paying, especially when there are layers involved.

You should strive to bring total costs down to 1% p.a. or less. You can achieve this by removing unnecessary layers, avoiding high cost structures, upfront fees, performance fees calculated on conservative benchmarks, and ensuring your trading costs are minimal.

Look for hidden agendas

Another red flag you need to watch out for is conflict of interest. Make sure that the interests of the people managing your investments and giving you advice align to your best interests. Watch out for “independent” advisors who receive commissions from product providers when they direct business their way, or earn commissions based on activity.

Also, be careful of performance fees. While performance fees may appear to align interests, they are often one-sided, with you paying more if performance is above a certain target but still paying the management fee if performance is poor. These fees can lead to excessive risk taking on the part of your investment manager and add an extra layer of cost.

Don’t underestimate the power of personal service

Investing offshore does not mean you need to deal directly with a company based offshore. In fact, South African-based investors are often disappointed with the service they receive from overseas institutions which is why a reputable local operation, which delivers a highly-personalised service and offers direct access to the portfolio manager, is a far better option.

Having someone local in your corner that understands both the South African context and the global playing field makes the whole process that much smoother.

Process is king

Understanding the investment process that will be used to manage your money is very important. It is the foundation for generating returns. Make sure your investment manager is able to articulate a clear investment philosophy and demonstrate a strong underlying process.

Also ensure they can adequately cover the available opportunity set, which includes several thousands of companies.

Do your due diligence

Select a creditworthy, properly-regulated institution to manage your offshore investments.

Businesses run by a single individual, with little or no regulation, are a red flag. Make sure your partner for investing offshore is a creditworthy institution. Also ensure you are dealing with a properly-regulated institution which, if operating in South Africa, should be regulated by the Financial Sector Conduct Authority (FSCA).

JSE Rand-Hedges are a Poor Substitute for a Global Portfolio

With local news agendas often dominated by the rand’s dismal performance, GDP woes and an economy slipping into a technical recession – South African investors are increasingly seeking shelter via offshore exposure. But with easy access to foreign markets, investors need to seriously consider the implications of counting on locally listed rand-hedge stocks as a substitute for a truly global portfolio.

Pure vs poor rand-hedges

While a number of local stocks are referred to as “rand hedges” – and are said to benefit from a weaker rand – the majority of these are not pure rand hedges and, as such, do not offer the same protection against rand weakness and local political issues as a global portfolio would.

All too often, South African investors see ‘rand hedge’ and, because they are overexposed to South Africa and are so concerned with managing the associated risk, they overlook the causal drivers of return for these investments. The causal drivers of a stock’s return are business quality and price paid. Investing at the expense of these, for the sake of rand-hedgedness, is likely to lead to inferior long-term returns – all-the-while maintaining significant exposure to South Africa, depending on how pure the rand hedge is.

A pure rand-hedge stock as a company with very limited exposure to South Africa by revenues or operations. There aren’t many pure rand hedges listed on the JSE, though there are a number of less pure rand hedges with varying degrees of protection against rand weakness. The most significant JSE-listed rand hedges are Naspers, Richemont, BAT, AB InBev, BHP Billiton and Glencore.

With this in mind, investors should only include JSE rand-hedge stocks in their portfolios if they are high-quality businesses trading at attractive prices – the same considerations that would apply to any other investment.

 

A limited opportunity set

However, given the very limited opportunity set for rand-hedge stocks listed on the JSE, putting together a diversified portfolio of high-quality businesses trading at attractive prices is near impossible. In total, there are roughly 100 reasonably liquid stocks listed on the JSE, of which maybe 40 could be considered rand-hedged, at a stretch.

If we consider that roughly 30% of all companies are high-quality businesses, this leaves more or less 12 high-quality JSE-listed pseudo rand hedges – of which potentially five are attractively priced. Limiting your opportunity set means you forgo at least one of quality, price, or diversification, which has a direct impact on your expected returns and risk profile.

Unrestricted access to funds

Another significant drawback of trying to emulate foreign exposure through these stocks, is that investors won’t have direct access to their funds from abroad. South African investment accounts are not directly accessible from anywhere else in the world because of exchange controls, which is a major risk factor. All investors should aim to build wealth that would be accessible from any country, including South Africa, and for this, you need a truly global portfolio.

Going global

Furthermore, the opportunity set is far wider on a global level, with more than 7 000 reasonably liquid stocks. A good process applied to this opportunity set is likely to be vastly superior in terms of quality, price and diversification when compared to a portfolio selected from a smaller subset, such as JSE-listed rand hedges.

The larger opportunity set also affords us the luxury to walk away from anything that we’re not entirely comfortable with, at almost no opportunity cost. This can be a big problem for investors limited to smaller opportunity sets, where there is a greater tendency to ignore red flags for lack of alternatives. In today’s volatile economic environment, it makes no sense for a South African investor to limit their options to anything less than global.

Time to rethink the standard offshore allocation models

pax americana

Wealthy South Africans have more than 83% of their wealth concentrated locally and many are missing the benefits of being true global investors. South Africa represents less than 1% of the global investment opportunity set, has significant political and currency risks and is subject to capital controls. Most of the nation’s high-net-worth individuals (HNWIs) are not global investors, and aren’t enjoying the options and flexibility they should be aspiring to.

There is a very real need to rethink the standard offshore asset allocation models for the emerging market context, which is very different from the developed world. When your home country represents less than 1% of world economic activity and is subject to capital controls, you can’t divide the world into local vs. offshore and place the two groups on an equal footing. Too many investors and advisors still cut and paste models that were originally intended for the developed market context.

Live here, but be a global investor

To be truly wealthy in a financial sense you need to be a global investor – which we define as someone whose lifestyle is not overexposed to the political risks of any one country. Global investors can live anywhere in the world, South Africa included, move anywhere at any time, and send their children to study in the country of their choosing. A global investor has options and flexibility.

Essentially, it comes down to two requirements: You need a globally diversified portfolio of liquid assets and you need unrestricted access to funds from anywhere in the world.

Where you live and where you invest needn’t be the same place. A global portfolio is usually the best funding model irrespective of your choice of residence. While there may be many lifestyle perks to living in an emerging market country, doing so is far less stressful without being fully invested there too.

Have unrestricted access to your funds

While many advisers and investors are starting to realise the need for global diversification, most are still unaware of the importance of unrestricted access to their funds from anywhere in the world.

While a Rand-based offshore investment (a feeder fund or a local unit trust that invests offshore, for example) might satisfy the need for global diversification, the proceeds of such an investment are not accessible from elsewhere in the world.

There are two major problems with an indirect offshore portfolio based solely in Rands. First, should investors want to access these funds globally, they would need to divest, apply for exchange control clearance, and then move the funds offshore. You might not be able to move your entire Rand-based investment at once because of exchange controls, particularly if you build a large investment over time. Second, exchange control regulations might be different in future. While the window to move funds offshore might be fairly open at the moment, it is possible that this window could close should unforeseen political risks arise in future. Under this scenario, however unlikely one might perceive it to be, the exact time that you most need access to your funds offshore will be the worst time to try and make it happen. There is simply no upside to bearing this risk.

Investing directly offshore may not be as complicated or expensive as you may think. Investors might already own uninvested foreign currency or they can take Rands offshore through exchange controls. At the moment, individuals can take R1m per annum without the need for tax clearance, and an additional R10m per annum on application. With the right partner, this is a cheap and simple process.

Measure your returns in hard currency

We should also question the conventional wisdom of measuring investment returns in local currency, specifically for investors living in emerging economies with volatile exchange rates. Many South African investors have a mindset of measuring their returns in Rands – they assume Rand strength is their risk when investing offshore, and that Rand weakness is good for their offshore investments. As a result, they only see offshore investing as an attractive option if the Rand falls, and as a bad decision if it strengthens.

They see themselves as South Africans investing outwards. A global investor living in South Africa has the opposite mindset – we view ourselves as global citizens investing inwards, so we measure our returns in hard currency. Instead of viewing offshore investment as a success or failure based on what the Rand does, we see South Africa as one of many investment destinations, and while we have investments here we want South Africa to do well and the Rand to trade fairly.

Consider that Apple, at $1 trillion market capitalization, is roughly the same size as the entire JSE. We wouldn’t consider the rest of our global portfolio a success or failure based on what Apple does. We’d sooner assess whether Apple was a success or failure based on how the rest of our global portfolio performed. We should apply the same logic to our South African assets.

 

While South Africa may be a wonderful place to live, study and invest, no amount of optimism offers a logical reason for any wealthy individual to be over-exposed to the country. The same logic applies to other countries, particularly emerging markets where political and currency risks are more significant.

The Only Game in Town

Last month we came across a chart on Twitter, posted by Michael Antonelli of Baird, which caught a fair amount of attention:

baird

The chart shows how the US has dominated stock market returns in 2018. As of 30 September the S&P 500 has returned 10.6% year-to-date (YTD) in USD while the MSCI AC World ex-USA has returned negative 3.1% over the same period. If you’ve invested outside of the USA, you’ve probably underperformed this year.

In fact, this has been the story of the last decade. You’d have to go back to 2009 to find the last time the rest of the world meaningfully beat the US stock market:

relativeperf

Since 2011 the S&P 500 has returned 173% while the rest of the world has delivered only 36%, leading many investors to the conclusion that the US is the only game in town. This conclusion, however, is deeply flawed.

 

It wasn’t always this way

Bloomberg has data for the MSCI AC World ex-USA index going back to 1999. The following chart shows the cumulative performance comparison between the S&P 500 (white line) and the rest of the world (orange) since then:

bloomberg

What is clear is that the US hasn’t always been so dominant. Between 1999 and 2009, 11 years which started with the dotcom bubble and ended with the financial crisis, the S&P 500 returned only 10% in total, while the rest of the world returned 71%. If investors stretch their memory back to 2011, they’ll remember that at the time emerging markets (China in particular) were all the rage and the US was regarded as stagnant. The relative returns of these markets have been the opposite of what prevailing sentiment at the time would have predicted. This alone should act as a clear warning for any investor who thinks the US is the only game in town today.

 

What drives return?

To understand why we shouldn’t necessarily expect the continued outperformance of the US, despite current sentiment and a decade of experience to the contrary, we need to understand what drives return:

Mathematically, Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation.1

In the short-term, return is dominated by revaluation, because revaluation is driven by volatile investor sentiment. As the years roll by, however, sustainable return (the underlying fundamental performance of the business) begins to compound and has a greater impact on return. In the ultra-long-term, return is driven almost entirely by sustainable return, while annualized revaluation tends towards zero.

Our investment horizon is typically 7 years – a time period long enough to allow superior sustainable return to compound, but still short enough for revaluation to have a meaningful impact. Our investment philosophy is to benefit from businesses with superior sustainable return, while also harvesting positive revaluation along the way, for which an investment horizon of 5 to 10 years is required.

 

Where has the return come from?

With an understanding of what drives return, we can now assess where the outperformance of the US stock market has come from, and make a judgement about whether this is sustainable going forward.

Since mid-2011, the real USD sustainable return of the S&P 500 has been 4.3% p.a.2 For the MSCI World ex-USA, real sustainable return measured in USD was only 0.1% p.a. At first glance this seems to confirm that American businesses have had superior sustainable return, and should thus be expected to outperform over the long-term. But there is another very important factor that we need to consider before making any conclusions.

In order to compare apples with apples, when we compare businesses in different countries, we need to measure their inflation-adjusted (i.e. real) sustainable returns in their own reporting currencies. It would be incorrect to include currency volatility in sustainable return – like revaluation, currency volatility is not a persistent source of return over the long term. Because the MSCI World ex-USA index consists of businesses from different countries with different reporting currencies, MSCI aggregates everything in USD. So we need to strip out the impact of the dollar from our sustainable return analysis and consider it separately.

As a proxy for this we use the dollar index, a measure of the dollar’s value relative to a basket of major currencies around the world. Relative to its long-term trend the dollar index has moved from its 7th percentile deviation in mid-2011 to its 85th percentile, strengthening by 3.5% p.a. This implies that the real reporting currency sustainable return of the rest of the world has actually been roughly 3.6% p.a., which compares reasonably to the 4.3% p.a. of the S&P 500.

What about revaluation? The valuations of the S&P 500 index have moved from their 19th percentile in 2011 to their 99th percentile today – a whopping 7.9% p.a., dwarfing the 3.3% p.a. revaluation from the rest of the world, which has moved from 26th percentile valuations to 77th.

In summary, since mid-2011:

S&P 500 Real Return = 4.3% Sustainable Return + 7.9% Revaluation = 12.2% p.a.;

Rest of World Real Return = 3.6% Sustainable Return + 3.3% Revaluation – 3.5% Currency Volatility = 3.4% p.a.

 

What this means is that 92% of the outperformance of the S&P 500 since mid-2011 has come about through excess revaluation and dollar strength, neither of which are persistent sources of outperformance over the long-term.

While the US stock market was primed for strong performance in 2011 because of the weak dollar (7th percentile) and low valuations (19th percentile), today the S&P 500 is at the 99th percentile of historic valuations, and the dollar index is around the 85th percentile of deviations from its long-term trend. Investors should seriously question whether the US is going to continue to dominate global stock market returns from this position over the next 10 years. While the US may have been the only game in town for the last decade, anyone chasing these returns now is very late to the party.

 

Where to invest?

Reading this, you might think we’re making the case for shifting investments out of the US into the rest of the world, but we are actually working towards a different conclusion.

Although the S&P 500 looks expensive as a whole, the MSCI World ex-USA isn’t that cheap either. While we believe there is an above average probability that the rest of the world will outperform the US over the next decade or so, valuations are still at their 77th percentile, and the sustainable return is nothing to get excited about. So where to invest?

Our approach to global investment has never been about targeting broad exposure to different markets, but rather about taking advantage of the enormous global opportunity set to find investments with superior sustainable returns trading at attractive valuations, wherever those may be.

Because the US stock market is such a broad opportunity set in itself, many of our best ideas are American companies. We also have a large portion (more than half) of our portfolios invested in other countries. This is not directly by design – we don’t target geographic exposures. It is the result of a sound process focused on the mathematical causality of return, applied to a broad opportunity set.

Without making any dollar index adjustments for our international exposure, the real sustainable return of our current holdings has been 13.3% p.a. over the last decade, 9.1% p.a. over the last 3 years and 9.3% over the last 12 months, which compares favourably to any broad benchmark index. In terms of valuations, our current holdings are trading at their 25th percentile in aggregate, and at their 1st percentile relative to the S&P 500. This is by design. We deliberately invest in high sustainable return businesses at low prices and harvest the revaluation gains on holdings that have become expensive.

Another important causal driver of future returns for any business is financial strength – a company’s ability to meet its obligations. While this doesn’t tell us much about base-case expected return, it does tell us about the downside risk to sustainable return should a company be forced to raise significant capital. In this regard, the total debt of the S&P 500 index (excluding financials) is 25% of its total market value on 99th percentile valuations. For our portfolios the comparative number is 13% on 25th percentile valuations. This, again, is by design as we deliberately avoid over-indebted businesses.

 

Conclusion

Short-term performance differences between our portfolios, the S&P 500 or the MSCI World index are of little concern to us, as long as they come from non-persistent sources of return like revaluation and currency volatility. That the S&P 500 and the dollar have gone from expensive to more expensive year-to-date, and have dominated global returns as a result, is a terrible reason to invest everything there.

As long as our holdings deliver high sustainable return, are financially sound, and we acquire them at good prices, we know we’re on the right track. Over time superior sustainable return, stronger balance sheets and the successful harvesting of revaluation from cheap to expensive can only deliver good results. These are the causal drivers of long-term investment returns.

Finally, it is important to always invest globally in order to take advantage of the widest possible opportunity set. A good process applied to a wider opportunity set should always be expected to deliver better sustainable return, better quality and better valuations, with wider diversification than the same process applied to a narrower opportunity set. As our analysis demonstrates, there is simply no reason to limit yourself to the US or any other country, even if recent returns suggest that one of these may be the only game in town.

 

Notes

 1 A more detailed explanation of what drives return can be found here.

 2 For stock indices with cyclical earnings, we generally measure sustainable return and revaluation in terms of revenues. If we were to measure in terms of earnings our sustainable returns would be a little higher for both indices (7.2% p.a. for US and 5.8% for RoW), and our revaluation a little lower (5% p.a. for US and 1.1% for RoW). 84% of US outperformance would still be driven by differences in revaluation/currency volatility, so we would still reach the same conclusions.