There is an ongoing debate about the merits of value versus growth – and whether one is more applicable than the other in today’s environment. This debate has been particularly acute this year as technology companies have dominated the headlines. This shift in the appetite of investors has corresponded with a period of strong overall returns for equity investors, which naturally leads to questions about whether global equities offer good value to a contrarian investor.
Morningstar Investment Management creates valuation models for 199 equity sectors, regions, countries and market-cap groups which we review at least monthly. These models incorporate both long-term fundamental growth expectations as well as an estimate of any valuation-adjustment if an asset moves back to long-term fundamental baseline.
When viewing this data, it becomes clear that expected equity returns have declined sharply across most equity regions and industries over the last two years and the returns currently on offer are considerably below average.
When we break down the sources of return by their components, it is clear that the long-term growth prospects are reasonably robust but the prices are unjustifiably high in many regions.
However, with an abundance of countries, industrial sectors and companies to choose from, it would be foolish to base positioning of a portfolio on a single view of global equities.
Looking Under the Surface
When viewed at a more granular level, we can see a wide range of expected returns; from those that are very unattractive to others that offer unusually high returns. An investor who builds a portfolio from the most attractive securities may well deliver a decent return over the next decade.
US Stocks Look Overvalued
That said, there are some clear themes within this data that investors should bear in mind before seeking to construct a global equity portfolio that offers contrarian value. The first is that many of the largest parts of the global equity market are the most unattractive.
The most obvious example of this is US equities which account for approximately 59% of the MSCI world index and according to our analysis offers a valuation-implied return of only 2.5% after inflation, relative to the rest of the world at 5.4%. Therefore, an investor seeking to build a truly contrarian portfolio must own a portfolio that is very different from the index.
Valuations have a habit of reverting quickly, think of the 2008 financial crisis, but expensive assets frequently become more expensive before rebounding. If a stretch in valuation occurs in a niche asset, such as small-cap technology stocks today, the impact on the overall portfolio may be less significant. However, if an investor chooses not to own US equities and they become expensive, the investor is likely to suffer significant underperformance against the typical global equity benchmark for a time. Therefore, defining success in relative and absolute terms is important.
Comparing Potential Investments
The second factor that contrarian investors must consider is the relative attractiveness of assets. How much more attractive is the most attractive asset compared to other assets?
Jeremy Grantham of GMO often refers to relative attractiveness as the “margin of superiority.” A high margin of superiority would indicate that it is worth investing significantly in the most attractive asset, while a lower margin of superiority would indicate that investors should adopt a more diversified approach.
This insight reflects the fact that expected returns can never be a perfectly accurate reflection of the future. Therefore, when using contrarian expectations to build a portfolio, investors should place a margin of safety around expected returns. Assets with a low margin of superiority often have a low margin of safety. In contrast, when an asset appears to be much more attractive, an investor can invest their capital with a greater degree of confidence and conviction.
Russian equities currently rank among the most attractive global equity market with a margin of superiority of 9.3% a year over our expected return for US equities. Other attractive global markets include UK and Japanese equities with expected returns of 4.7% and 4% above that of US equities respectively.
Concentration and Sizing
While using a margin of superiority approach can help investors assess relative opportunities, it is also important to consider the impact of concentration on a portfolio that is constructed with a contrarian bent.
As asset prices become more expensive and investors increasingly seek out niche opportunities, it is not unusual for the most attractive opportunities to become focused in a particular area of the market. Ignoring such concentration magnifies outcomes – for better and worse – especially if a common fundamental driver performs poorly.
Therefore, being aware of concentration risk is an important step in portfolio construction. While concentration risks are often obvious – for example, commodity-producing countries and mining companies – it is not always so easy to spot. Unchecked this can create a ‘fault line’ that runs through a portfolio and wreaks havoc on the return profile.
A good example of this would be a multi-asset portfolio comprising of hedge funds, property, private equity, high yield bonds and UK equities. Portfolios of this kind were not uncommon before the financial crises and appear to offer a high level of diversification. However, each of the assets has an underlying exposure to leverage.
As the crisis hit, each of these assets suffered and left investors without the diversification benefit they expected. Naturally, this results in declines that often exceed one’s risk tolerance. It is therefore essential that investors understand the fundamental drivers of returns when creating a portfolio.
