Many people think about global equity investing as either a diversifier or an opportunity to achieve better returns. By targeting the fastest-growing regions such as China and India, some investors assume they can put a metaphorical rocket under their portfolio.
By targeting the most famous brands – Amazon (AMZN), Google (GOOG), Apple (AAPL) – other investors assume they can obtain truly blue-chip exposure. Yet, at the heart of this decision is an ambition to derive better outcomes than they can otherwise obtain by investing locally.
Therefore, global equities are better thought about as a process of filling portfolios with assets that offer attractive reward for risk. By extension, this requires one to have conviction over the best assets as well as reasoned analysis to support that conviction.
Given the dizzying array of potential opportunities, it is important to have a clear and consistent analytical framework that enables investors to make a holistic assessment of these opportunities.
As future returns are a function of both the cashflow generated by an asset and the price paid for that cash flow, it is essential that any assessment incorporates both these factors together including the future risks to that cashflow.
Invariably, this requires a fundamental assessment of the asset class, and we believe it is important to structure this assessment on four pillars.
These pillars are the foundation Morningstar Investment Management use to derive its asset allocation, so they are important to define as a framework an investor can work with:
Absolute valuation: an investor wants a clear understanding of valuations, including what each asset can be expected to deliver over their desired time horizon for instance, over 10-years or more.
Relative valuation: an investor wants to understand valuations and how well the asset ranks compared to other markets.
Contrarian perspective: an investor wants to identify whether the market’s current expectations, positioning and sentiment are supportive or contrary to the herd. Investors may want to consider out-of-favour assets, since the greatest opportunities often lie in unloved industries or at companies that have recently had bad news but remain fundamentally strong.
Fundamental risk: an investor should want to clearly understand the range of possible scenarios, as well as any risk that would cause investment errors over the investment horizon.
The central idea is to obtain an independent and holistic view of reward for risk among global equities. With this in mind, an investor can then deliberate more broadly about whether the current bull run, claimed to be the second longest in recent history, has anything in common with the 2007 credit crunch, 2000’s dotcom bubble, or 1987’s Black Monday.
What Do Long Bull Markets Have in Common?
Below are three core features that are representative of many bull markets:
Behavioural biases at play: overconfidence, the herd mentality and the recency bias, that is human tendencies to extrapolate recent trends and follow others, are recurring behavioural themes that can cause “irrational exuberance” and exaggerated performance on both the upside and the downside. These behavioural biases are incredibly difficult to overcome, but give clues about investment cyclicality.
Cyclical upswing: driving these behavioural biases are usually several reasons to be confident. Typical of most bull markets, the global economy has been resilient, with falling unemployment and rising consumer confidence. This overlaps with improving business conditions and lofty corporate profitability metrics, such as profit margins and return on equity.
Overheated valuations: price growth tends to exceed any reasonable estimate of fundamental growth, which can prove problematic if the optimism subsides. Stretched valuations are apparent in the current upswing, and to illustrate, one only needs to apply perspective.
Developed markets have rallied by approximately 232% since the bottom of the financial crisis in March 2009 and emerging markets by 187%. By comparison, global corporate revenues have only increased by a paltry 4% over the same period, while corporate profits have increased 22% and corporate dividends by 43%.
What is Particular about the Current Bull Market?
Central Bank intervention: since the 2008 credit crunch and the high-profile failure of banks, central banks have stepped in to shore up the economy. The “whatever it takes” philosophy has been steadying investors’ nerves ever since, with record-low interest rates and quantitative easing enticing investors into growth assets. There was no precedent for this quantitative easing and the ramifications are still largely unknown.
Brexit: locally, investors are feeling the pressure of arguably the most significant change to the UK since the second World War. While its repercussions will likely be felt in every aspect of UK society, political forecasting rarely ends well for investors.
However, one must acknowledge the unknowable elements to the Brexit process and consider the impact of this uncertainty on the inputs into corporate fundamentals. Currency views are especially important for investors considering investing outside the UK.
The rise of technology: investors love a good story, and technology has been exactly that, rising approximately 40% year-to-date and as much as 370% since March 2009. With the rise of online spending and the prospects of artificial intelligence, many investors want part of the action. Ironically, these companies are being purchased for their so-called defensiveness and their ability to beat earnings targets based on their dominant market positions.
This is quite a different dynamic from the late 1990s, where the tech boom was driven on speculative gains, but the reality is that no one quite knows where tech stocks will end. What we do know is that they are looking increasingly expensive.
Donald Trump: while history is decorated with controversial presidents, Donald Trump is considered to be different. Many are looking at his rhetoric as a basis for change, yet we would warn against this inference. Political forecasting is incredibly difficult and should have no place in global equity analysis.
Creating a View of Global Equities
When considering the characteristics of the current bull market, it is all too easy to conclude that “this time it is different”. However, when viewed through the lens of the long-term fundamentals, the similarities with typical bull markets seems far more pronounced than the differences.
As many markets are stretching beyond their fundamental baseline, it is important to remember that risk is not constant but increases as prices rise. For this reason, we believe that prudence is warranted.
So, how should an investor size positions and decide where to allocate? While pockets of opportunity certainly remain, accessing them requires us to control our behavioural urges and look through the market noise when adopting a contrarian position.
On the whole, though, we advocate that every action should come back to the original ambition: does any change improve the likelihood of a positive outcome and therefore help an investor achieve their goal? This is what we obsess about when thinking about global opportunities.
