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.