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.

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.

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 7^th percentile deviation in mid-2011 to its 85^th 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 19^th percentile in 2011 to their 99^th 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 26^th percentile valuations to 77^th.

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 (7^th percentile) and low valuations (19^th percentile), today the S&P 500 is at the 99^th percentile of historic valuations, and the dollar index is around the 85^th 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 77^th 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 25^th percentile in aggregate, and at their 1^st 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 99^th percentile valuations. For our portfolios the comparative number is 13% on 25^th 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.

We closed 3 successful investments in the last quarter: Robert Half International (+60% in 2 years), Kakaku.com (+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.