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).

Why wealthy South Africans are investing in Global Equity

A recent report found that South African High Net Worth Individuals (HNWIs) substantially increased the share of their assets allocated to equities from 23% in 2007 to 28% in 2017, with the majority of this growth in equity exposure having been through increased foreign equity allocations.

Although local political uncertainty likely played a role in the shift to offshore equity, lower costs and improved access to equity markets also contributed significantly. This is particularly apparent on the global front where exchange controls have been relaxed allowing investors to take as much as R11m per person per year offshore.

Overexposed to South Africa

Having been restricted from investing offshore in the past, many South African HNWIs have the vast majority of their wealth concentrated in South Africa. They live here, work here, and own businesses here – often in addition to holding local property portfolios and even local equity portfolios.

Given that South Africa represents less than 1% of the global opportunity set, it makes sense to look at the other 99%, which includes some of the best run businesses in the world.

Earning Potential, Practicality, Diversification

The report shows that while exposure to foreign cash, bonds and property has also grown, the vast majority of money being taken offshore by South African HNWIs has been allocated to foreign equity markets. This preference comes down to a matter of earning potential and practicality, for the most part. Foreign cash earns close to nothing in interest and the yields on foreign bonds aren’t much better. While offshore property may be a fair consideration, it is far simpler to invest in and manage a foreign equity portfolio than a foreign property portfolio.

It is also easier to achieve diversification through global equities. This is because one can invest in stocks across multiple countries, industries and currencies for the price of one property.

Other major advantages to global equities include liquidity and easy access to funds. Investors can access all, or a part of your investment within days, and at very low cost. Properties generally take months to sell, at higher cost, and one can’t simply access a small part of their value at any time.

Risk Perceptions

When talking about perceived risk that is often associated with equities, much of this sensitivity has to do with the fact that equity prices are visible on a daily basis, making the volatility plain to see. You can’t see how the price of a property or a private business reacts to events as they unfold, creating the impression that these assets are somehow less risky.

But we would argue that a portfolio of high-quality, multibillion-dollar businesses spread across various countries, industries and currencies is fundamentally less risky than any individual property or private business – despite the short-term volatility.

Low-Cost, Simple Process

Another common misconception is that investing offshore is an expensive and complicated process. Opening and managing a direct global equity portfolio can be as easy and cost-effective as opening and managing a local portfolio, when done properly. With the right platform investors can log into their accounts and see their portfolios in real-time, draw statements, and request withdrawals.

Trading costs are generally much lower than for local accounts – well under 0.1% on a good platform. For those who haven’t already moved funds, taking money offshore is very easy – individuals can take up to R11m a year without much hassle.

Wider Opportunity Set, Strong Investment Process

When looking for a global portfolio manager, dealing with a specialist who can cover a very wide opportunity set is very important. Some of the best investments can be made in lesser known companies that are nevertheless very well-managed multibillion dollar businesses. Many investment managers are unable to cover the opportunity set widely enough and have significant biases towards the largest companies with household names listed in major markets like the UK, US and Switzerland, for example.

This barely scratches the surface of what is available to global investors and familiarity is a poor substitute for sound investment process. A good investment process should cover much more than just the big names.

Investment Case: Netflix

Over the last decade, Netflix, the world’s largest online TV subscription service, has grown its revenues roughly 10 times, its earnings per share 15 times and its share price nearly 100 times. Netflix has become a household name and an investor favourite, earning its place among the market’s most high-flying tech stocks, the FAANGs.

But should investors expect the performance of the last decade to persist? In our first Investment Case post we put Netflix through our process and try to make an investment case for the stock.1

The Causality of Return

While many investments are made on the basis of predictions, narratives, or statistical correlations, our process is based on the causality of return, which is defined by the following mathematical identity:

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

This identity forms the foundation of our investment philosophy and process, so we’ve written about it on several occasions here, here, here and here.

While this framework can be applied in many different ways, one useful application is to identify companies where optimistic assumptions nevertheless result in weak returns, or where conservative assumptions result in strong returns. We believe Netflix falls into the former category.

Sustainable Return

Netflix is a high sustainable return business, and most of the investment cases in favour of Netflix are based on the premise that this will continue.

According to Bloomberg, analysts expect Netflix’s per share revenues to grow between 15% and 20% p.a. over the next 7 years. While this growth rate is slower than in recent years, it is normal for any high growth company to start tapering off as the base effects kick in.

Netflix doesn’t pay a dividend, so we would suggest that 20% p.a. is an optimistic estimate for Sustainable Return over the next 7 years. We’ll revisit this assumption shortly.


Since we’re measuring Sustainable Return in terms of revenues, we need to do the same with Revaluation. To this end we need to determine a “fair” Price/Sales ratio and compare it to the current multiple.

Price/Sales = Net Margin x Price/Earnings

According to Bloomberg, analysts expect Netflix’s net margins to reach mid-teens within 5 years. This is in the ballpark for peer companies, but well ahead of Netflix’s own historic margins, which have averaged less than 5% over the last decade. Margins have reached nearly 9% in 2011 and again in 2018. We think a 15% normal net margin is a generous assumption to make at this stage.

Netflix currently trades at 106x earnings, a demanding multiple that requires significant revenue and margin growth to be justified. As growth and margins mature in years to come, it is reasonable to assume a lower exit PE. We’d consider 25x to be optimistic. This number is well above norms for more mature companies, even in the tech space.

25 PE x 15% Margin = 3.75 Price/Sales which is nearly 60% lower than Netflix’s current 8.9x revenue multiple. If we annualize this over 7 years, our Revaluation assumption becomes -14% p.a.2

Total Return

The following graph shows how Netflix’s Sustainable Return (blue) and Total Return (green) have developed over time. The dotted blue line shows where Sustainable Return would go if it grows at 20% p.a. for 7 years:


If this somewhat optimistic scenario plays out and Netflix trades at 3.75x revenue, Total Return will be 6% per annum.

Total Return = Sustainable Return + Revaluation = 20% – 14% = 6% p.a.

6% p.a. is somewhat shy of the ~56% p.a. return delivered by Netflix over the last decade, but remember that Netflix’s PE ratio a decade ago was around 18x vs 106x today and growth was higher.

We doubt many Netflix bulls would be happy with 6%. Presumably they would assume higher growth, margins and/or exit PEs, which would be necessary to deliver a higher return, or otherwise they’re overlooking one of the causal drivers of return.

What about Financial Strength?

Let’s revisit that earlier Sustainable Return assumption, because we haven’t considered two of the most important causal drivers of Sustainable Return: Profitability and Financial Strength. We cannot simply rely only on analyst forecasts in this regard. We need to understand whether the causal preconditions of high Sustainable Return are present or not.

Profitability is a most important driver of sustainable return over time – it determines the trajectory. A profit can be returned to shareholders in the form of Yield or reinvested in the business for organic per-share Growth. Yield and Growth are the two constituents of Sustainable Return. Absent consistent profits, few businesses can deliver high Sustainable Return over long periods of time. Netflix has been consistently profitable since 2004, so no problems there at face-value.

Financial Strength is the second most important driver of Sustainable Return over time. It doesn’t say much about the trajectory, but it says a lot about the riskiness of the business and the probability of a sudden, steep decline in Sustainable Return should the business run into financial difficulty.

In this regard we have two concerns about Netflix:

  1. Despite declaring consistent profits, free cash flows have been negative as Netflix has invested heavily in new content to drive subscriptions. Profits absent cash flows are a red flag;
  2. Netflix has recently returned to the bond market, increasing their debt pile to $10.4 billion, no doubt to fund new content for which they actually need cash. While $10.4 billion is only ~8% of Netflix’s current market cap, remember that this is based on a valuation of 106x earnings. If that multiple was 20x, debt would be 40% of market cap, which is significant. What if they burn through that cash? Will they keep returning to the bond market?

These concerns over Netflix’s financial position indicate significant downside risk to our already optimistic 20% p.a. Sustainable Return assumption.

Probabilities vs Possibilities

A decade ago Netflix traded on a 18x PE and had no debt. It subsequently returned 56% p.a. as it blew past expectations and rose to ever higher valuations.

Today the company is on 106x PE and has significant debt, with no free cash flow in sight. Valuations are higher, growth is likely to be lower than in the past, and financial risks to the growth outlook are far more significant. These causal preconditions are vastly different (and less favourable) than what they were a decade ago.

While returns higher than 6% p.a. are obviously possible for Netflix, we believe our inputs to be an optimistic base-case. Anything is possible, and there is a range of likely outcomes rather than one specific outcome set in stone. But investors should be concerned with probabilities, not possibilities. It is quite possible (perhaps even probable) for growth, margins and PE to be lower than our estimates, in which case return would be lower too. In the case of Netflix, the probabilities seem to favour disappointing outcomes over the next decade.

A good way to think about this is what Jim O’Shaughnessy describes as Base Rates. If you invest in 100 stocks with similar preconditions, some of them would do well, but how often would the overall portfolio outperform and by how much? Since these preconditions speak directly to the causality of return, we’d suggest not very often, and not by very much.

Ask yourself: What return would you be happy with from Netflix? What assumptions would need to hold to deliver that return? Are those assumptions probable? Are they conservative? What would the base rate look like for a portfolio of 100 stocks with the same preconditions? If the base rate isn’t good for the 100, is it worth speculating on the 1?


1 Note that this is just a high-level overview of a more thorough analysis.

2 Technically, Return = Growth + Yield + Revaluation x (1 + Growth), but since the Growth interaction with the Revaluation term is usually quite small, we just group it into Revaluation for the sake of simplicity. Our calculations always factor this interaction in though.

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:


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:


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:


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.



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.



 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.

What do Investing and Insurance have in Common?

We came across an interesting product recently launched by a South African company – the world’s first equity fraud insurance. This insurance covers investors against losses suffered as a result of fraud or management impropriety. The idea is that investors pay a small percentage of their portfolio value as a regular premium, and are then covered against losses suffered within that portfolio which stem from fraud/accounting related issues. Sounds good, right? Wrong.

To understand why equity insurance is a bad idea, one first needs to understand why traditional insurance adds value. Take life insurance as an example: An individual has only one life, which if lost could have serious financial consequences for his/her dependents. The timing of the loss of life is usually unpredictable. The only way an individual can manage this risk is through life insurance.

Why does traditional insurance work?

A life insurance company essentially builds a portfolio of 1 000s of insured lives, something that no individual can do. While the risks are unpredictable on an individual basis, the aggregated risks are far more predictable. The insurance company can thus set an accurate premium across its portfolio of risks, which allows it to pay claims as they arise, cover its costs and earn a profit. Homeowners insurance, hospital plans and car insurance all work on the same principle.

Insurance companies are in the business of selling diversification for a profit. This only makes sense when a) the risk being insured is significant, and b) the risk cannot be freely diversified on an individual basis.

How is equity fraud insurance different?

This is why equity insurance doesn’t work. Regardless of the terms and conditions of the specific cover, the reality is that an individual can achieve diversification for free. The premiums paid to an insurer will exceed insured losses for a diversified portfolio over time, so it makes no sense to buy insurance against an already diversified portfolio.

This raises some important questions: Why insurance against fraud specifically? Surely there are other risks that investors could insure against. Why is this world-first being launched in South Africa, and why now? The answer is, of course, Steinhoff. To a lesser extent Resilient and Capitec have also played their part. This is the opportune time to launch a product like this, following a flurry of typically rare events that are still fresh in everyone’s mind. Clever timing, but ultimately a flawed product.

Global diversification beats equity insurance

For an equity portfolio, diversification is actually much better than fraud insurance. First, it’s free. Second, it covers much more than just the risk associated with fraud. With a broad enough opportunity set it can cover political risk, currency risk, balance sheet risk, event risk, etc.

For South African investors, political and currency risk are far more relevant concerns than fraud. The best insurance against these risks is to invest globally. This has the added benefit of a much wider opportunity set, allowing investors to be far more selective in terms of the quality of assets they invest in and the price they pay, without sacrificing diversification.

Risk and reward

Finally, the point of investment isn’t to eliminate risk, because without risk there is no reward. The point is to bear good risks in exchange for a return. In this sense, investing is exactly like insurance:

  • Insurers write policies subject to certain underwriting criteria. Investors make investments subject to certain quality/valuation criteria;
  • Insurers accept that despite their underwriting, there will be claims. Investors know that despite their process, they cannot eliminate risks associated with individual holdings;
  • Insurers manage individual risks by aggregating them. Investors manage individual risks through diversification;
  • Insurers earn a profit because they charge more in premiums than they pay to claimants. Investors earn a return because their successful investments outweigh their losses.

The keys to success in both of these models are a good underwriting/selection process and adequate diversification. Where they differ is that insurance relies more heavily on diversification, while selection process is far more important in investing.

Urban Outfitters: Patience Rewarded

We closed 3 successful investments in the last quarter: Robert Half International (+60% in 2 years), (+84% in under a year) and Urban Outfitters (+82% in 2 and a half years). While Robert Half and Kakaku rewarded us from the outset, it was Urban Outfitters that gave most of our clients their first real taste of what it means to be a long-term investor, despite being a fairly short-lived investment.

We are long-term investors. This means that we make an investment with the understanding and the expectation that it may take 5 to 10 years for our thesis to play out. At Bellwood Capital, our clients have not yet been invested for 5 years, so their investments are still in the early stages. Those stocks that have been sold have either exceeded our expectations very quickly, or in some cases have seen their investment thesis change. The temptation to judge any individual investment a success or a failure after year 1 or year 2 is immense (people are naturally inclined towards short-termism), but it would be a mistake to do so. Urban Outfitters demonstrates this well.

We started investing in US apparel retailers late in 2015 – notably The Gap and Urban Outfitters. Their stock prices had fallen following a period of weakness in US retail. The common sentiment was that Amazon was killing the bricks-and-mortar retail industry. These were not popular stocks.

Our investment process, however, is not based on sentiment, stories or popularity, but rather on the presence of certain preconditions that have a direct causal link to long-term returns: Good sustainable return, consistent profitability matched by cash flows, strong balance sheets, all combined with attractive valuations. We concluded that these companies met our preconditions, and were priced for good returns on the back of the negative sentiment.

Unfortunately that sentiment was about to become much worse. Within a couple of months, Urban had fallen nearly 30%. The consensus was that US retailers were doomed. Many sentiment- or story-driven investors would have agreed that these were failed investments, and sold their shares amidst the onslaught of negative press and falling share prices. Psychologically, holding a stock in the face of what seems like a mountain of disconfirming “evidence” is extremely difficult.

This is where having a strong process and an understanding of the drivers of return is critical. Return = Sustainable Return + Revaluation. Sustainable Return is the fundamental performance of the underlying business – its quality. Revaluation is driven by investor sentiment, which is often irrational, unpredictable and volatile. In the short-term, return is driven almost entirely by revaluation, which is why short-term returns are so unpredictable.

If a stock drops by 30% in two months, it is unlikely that the sustainable return of the underlying business was -30%. As time passes though, sentiment tends to ebb and flow, cancelling itself out, while sustainable return compounds and contributes more and more to total return. Over very long periods of time, annualized revaluation tends towards zero, while total return tends towards sustainable return. When a stock returns 1 000% over a decade or two, it is most likely that the vast majority of this would come from sustainable return.

The best long-term returns come from buying high sustainable return businesses at low valuations (implying negative sentiment), holding them for the long-term and selling them if they become too overvalued. While sentiment is completely unpredictable in the short-term, the probability is that if we give our investments enough time (5 to 10 years) they are likely to experience the full range of sentiments and resulting valuations. This provides us with the opportunity to buy some very good businesses cheaply, benefit from their sustainable return and sell them expensively should the opportunity arise at the other end of the sentiment scale.

The key to executing this strategy successfully is to overcome the emotional hurdle that arises in those cases when irrational sentiment moves further in the wrong direction. This means differentiating between sentiment and sustainable return. The ability to do so is one of the best edges any investor can have. Having a strong process and an understanding of the drivers of return is the critical difference between success or failure in this regard.

Having lost 30% off the bat on Urban Outfitters, we retested our investment case against our process (which involved much internal debate and consternation) and concluded that the fundamentals of the business had not changed. The business had no debt, remained profitable, was returning large amounts of capital to shareholders (a form of sustainable return) and was likely to grow revenues in time. Further, the valuation was more attractive than before. Instead of selling we invested more at the lower prices.

Before the end of 2016, Urban had nearly doubled (sentiment had improved!) and we were far less concerned about our investment, perhaps even feeling the job was done. The stock was trading around fair value, we trimmed a few overweight positions, but we were happy to keep holding the majority of our shares. Up to this point, most investors would agree that losing 30% off the bat wasn’t too bad given that the stock doubled quite quickly after that.

By June 2017 the stock had fallen more than 50% again, and was now 20% lower than in December 2015. Sentiment towards retailers was rock bottom, not only in the press, but in our office too. In aggregate we were down nearly 40% on Urban Outfitters after 18 months. At this point, any normal person would feel that Urban was a failure. We weren’t immune to the pervasive negativity either, but we stuck to our process, retested our thesis and bought more shares in Urban at these prices. This wasn’t a comforting decision per se, but it would have been impossible without a strong process.

Over the next 12 months, Urban rallied 187% from its low. Now overvalued and priced for weak returns, we decided to sell the stock for an aggregate profit of 82% in 2 and a half years (27% p.a.). Urban Outfitters has been a successful investment for us, but it wasn’t a smooth ride and it required a lot of patience and intestinal fortitude.

Now consider the bigger picture: This was still only a 2 and a half year investment. We are making investments with a 5 to 10 year horizon. Sentiment and revaluation have provided us with unusual opportunities to buy Urban cheaply and sell expensively in a short space of time. Sustainable return was a lesser contributor to total return (contributing roughly a quarter) – though this would have become more meaningful in time.

While some of our investments will run their course quite quickly, like Robert Half, Kakaku and even Urban, many of them will take longer. Fortunately they won’t all be as challenging as Urban. Some of our best investments will deliver excellent returns over several years without becoming expensive (NetEase and TSM are good examples of this) but they too will have their ups and downs along the way. What is important is that in each case we are making investments that meet the preconditions set out in our investment process, and that we give them enough time.

To reap the rewards of long-term investment we need a strong, unemotional investment process and, at times, patience. This is what it means to be a long-term investor.

The One Percent

When it comes to long-term investment performance, two of the biggest advantages an investor can have are 1) a Strong Investment Process, and 2) Low Costs. We stress the importance of both in every presentation we do. They are two of the fundamental pillars around which we have built our business. Good investment managers should talk about their process, while cost-effectiveness has been topical in investment media in recent years.

There is a third big advantage that every investor should look for, but almost no one talks about it: 3) Breadth of Investment Opportunity Set. To put it plainly – how many stocks are you looking at? It’s all very well to have a great process, but if you’re applying it to 100 stocks your results over time aren’t likely to be as good as the same process applied to 1 000 stocks, or 5 000 for that matter.

There are about 7 000 stocks listed across the globe that offer sufficient liquidity for us to make sizeable investments in. Of these 7 000, roughly 30% are of potential investment quality by our standards. Further, of the 7 000, roughly 30% are reasonably priced at present. This means that only 9% of the available investment opportunity set warrants potential investment under current conditions. Within this 9% there is a small group of companies that really ticks all the quality boxes and is very attractively priced – call this group the One Percent. A good stock selection process is all about finding that One Percent. Consider the following visual interpretation. The small red square is where Bellwood Capital aims to invest:

opportunity set

But… What if you’re only looking at 100 stocks in the first place? Are you going to put everything into 1 company? Of course not – it doesn’t matter how good the investment merits for any specific company are, something can always go wrong. So maybe you’ll buy 9 companies – accept slightly lower quality and higher valuations for a bit of diversification – you’re still in the top 9%. Unfortunately you’re still not well diversified, particularly if the 100 companies in your opportunity set are all in the same country/market. So maybe you’ll invest in 20 companies. But now you’ve invested in the 20%, not the 1%, so clearly you’ve made big sacrifices in terms of quality and valuation (i.e. long-term return) for the sake of reasonable diversification.

This needless balancing act between quality, price and diversification can be avoided by considering a much wider opportunity set. But herein lies another problem: Very few investment managers (multinational institutions included) have the capacity or tools to properly consider a really broad investment universe. Common hallmarks of this are portfolios consisting predominantly of large cap stocks with well-known names from major markets in the USA, the UK and Switzerland. This barely scratches the surface of what is really available to investors.

This is also the reason that it makes very little sense to focus all your investments in one country, one industry or one market. Far better to be a global investor and invest in the 1% representing your best ideas than to invest in 20% or 30% of a limited opportunity set. With a good process you will have better quality, better valuations and better diversification.

There are two important questions to ask any investment manager: 1) How many stocks do you hold? 2) What is your investment universe, and how much of it have you properly analysed? This will give you a good indication of the level of diversification in the portfolio, as well as the percentage of the opportunity set that has been invested in. If that percentage is too high your portfolio is unlikely to be invested in good quality companies acquired at attractive prices.

At Bellwood Capital we are truly global investors. We have the capability to give all 7 000 stocks fair consideration. How? Our process is focused on a few non-negotiable quality characteristics that have direct, mathematically demonstrable causality with return. Our analysis tools are geared to working through a very large number of companies and tracking them in real-time. We know which are the potentially high quality businesses, and we know as soon as they become priced for potentially attractive returns. With the 9% squarely in our sights we are able to spend time applying the rest of our process to identify the final 1% that makes it into our portfolios.