Over the past 30 years, the pace and scope of globalisation has significantly accelerated the integration of financial markets.
Today, the increasingly global nature of businesses – and therefore revenue streams – means that regional analysis based on the domiciles of companies’ headquarters is now far less relevant for global equity investing than hitherto.
Traditionally, globally equity investing had been structured around country asset allocation, due to the misunderstood but ingrained notion that economic growth was a major influence on a country’s stock market.
However, evidence shows that there is no relationship between economic growth and stock market returns. In their 2002 book, Triumph of the Optimists, economics professors Elroy Dimson, Paul Marsh and Mike Staunton found that in a broad cross-section of countries, long-term stock market returns are negatively related to growth in per capita GDP.
Correlation
In the authors’ 2005 and 2010 Credit Suisse Global Returns Yearbooks, they found a negative relationship over time between past GDP growth and stock market returns. The chart above provides an update of this finding. It depicts a correlation between real GDP changes, measured in international dollars using the Geary–Khamis formula, and real equity returns of −0.29.
For companies today, the opportunity set is a marketplace comprising of mature and growing economies. In such an increasingly competitive integrated world, prosperous companies provide a compelling opportunity for investors.
Examining the sources of company earnings provides a clearer insight into future prospects than the locations of their headquarters or where their stock is traded. In the US, for example, the S&P 500 index derived almost 40 per cent of revenues from abroad in 2010 compared with just 25 per cent in 1990. Within the UK, approximately 75 per cent of the revenues earned by FTSE 100 companies now come from overseas. Vodafone and BP, for example, may seem very British companies, but in fact a large proportion of their revenue base comes from outside the UK.
Portfolios
From an active management perspective, understanding revenue sources is an important factor in creating a diversified portfolio of stocks. Diversification provides strong motivation for investing across developed and emerging markets and for gaining cross-regional exposure to different sectors. Single-country indices, are, in comparison, often dominated by one or two industries. The UK stock market, for example, is heavily weighted towards financials and energy, with each sector comprising some 20 per cent of the FTSE 100 index.
At the other end of the scale, technology merely makes up a little over 1 per cent of the FTSE 100, reflecting the narrow focus of the index. The benefits of a diversified exposure are greatest when correlations are low. Analysis shows that correlations between developed and emerging market indices, as well as within separate baskets of developed and emerging markets, indicate scope for risk reduction. The potential of reduced volatility of a global equity strategy is of paramount importance.
Globalisation
The impact of globalisation on financial markets has led global equity markets to become highly correlated. This is most notable during periods of market turbulence when, as correlations tend to rise sharply, risk assets are more likely to fall together. Indeed, academic studies support the theory of rising market correlations. Bertoneche (1979) found that correlations between global markets were below 0.20 in the 1970s. By the 1980s, Odier and Solnik (1993) found many correlations to be around 0.50. Goetzman et al (2005) substantiated these findings, concluding that diversification was enhanced by exposure to newer markets.
For active managers investing in global equities, it is crucial to undertake research at the geographic, sector and stock level with the aim of identifying valuation anomalies. By searching globally the aim is to exploit these anomalies. For some active managers, it is valuation which drives investment decisions, levels of investment risk and ultimately investment returns. In simple terms, this means trying to establish the intrinsic value of a business, and buy its shares when its current price is well below what is believed to be its intrinsic value. Valuation is also the key to managing risk: by buying shares in companies below their intrinsic value it is possible to limit the exposure to downside surprises (the company’s share price is already pricing in low expectations of future growth) while looking to maximise the upside potential. It is the extent of this positive asymmetry (upside versus downside) which often determines which stocks will make it into a portfolio.
In contrast, a top-down asset allocation approach driven by the macro-economic environment is not an efficient investment process for large cap stocks. For starters, markets anticipate GDP growth, and to use such readily available information is to run with the herd. Secondly, shares of companies in economies performing well tend to be more highly valued. Ultimately, a ‘good’ business can still be a bad investment if its shares are bought at the wrong price. Similarly a ‘bad’ business can become a good investment if bought into at a low enough price.
Fortunately for active stock pickers, markets are inefficient, and companies are often mispriced. To base investment decisions on valuation and investment opportunity, rather than by the macro-economic backdrop, supports a long-term fundamental stock-picking approach.
Nick Mustoe is chief investment officer for Invesco Perpetual
CHART:
Real equity returns and per capita GDP, 1900-2013.
Source: Credit Suisse Global Returns Yearbook, February 2014.
Key points
* The increasingly global nature of businesses means that the locations of companies’ headquarters is now far less relevant.
* Understanding revenue sources is important in creating a diversified stock portfolio.
* It is crucial to undertake research at the geographic, sector and stock level to identify valuation anomalies.
