Asking the right question: what is the business, not where is the business

The investment world has lots of strange traditions and conventions that can seem out of place in the 21st century. COVID-19 has challenged several of them already.

Until March this year, traders on the floor of the London Metal Exchange (LME) had to have their leg touching a central sofa in order for a trade to be valid. Entertaining to observe, the practice didn’t survive social distancing, and the LME is now embracing electronic trading.

Another convention, though, is far more widely embraced than an idiosyncratic commodity trading floor. It’s the idea that a country and its main stock market are meaningfully connected. That’s just not the case.

A historical habit

The investment industry has a bad habit of talking about ‘UK stocks’ or ‘US equities.’ Like many bad habits, it started for understandable reasons.

When public companies first came into existence they did so to raise money from local investors, in order to carry out their business. Stock exchanges sprang up as convenient places for these investors to trade their shares, and for companies to issue new ones. The point, in the pre-information age, was to have an agreed place to carry out financial transactions. 

Up until the early 20th century, links between stock markets and economies made sense. Local businesses raised capital from local investors. While these companies’ commercial activities were often global, the profits came back to the home country – where they were spent, taxed, or reinvested. If the shareholders were doing well, so was the economy (most of the time).

Modern markets

Today, stock markets look very different, for two main reasons. The older companies have outgrown their domestic roots, while many newer businesses ignore geography altogether.

The FTSE 100, for example, includes lots of companies that started small and local, but nowadays the UK is just a handy place to keep a head office. Drinks brand Diageo makes roughly 5% of its revenue from the UK. AstraZeneca and GlaxoSmithKline rely on the UK for less than 10% of their sales. Even the London Stock Exchange Group makes only about half of its money in the UK!

And for newer large companies, the country or city where they choose to list their shares often has nothing to do with their business models, or where they make their money. It tends to be a matter of tax optimisation, prestige and availability of global investors.

Take Aramco, the huge Saudi Arabian state oil company, which was at one point looking to list in either New York, London or Hong Kong. 

Focus on sector exposures

Many investors are making the wrong connections, by focussing on the prospects for a certain economy, then deciding whether to invest or not in its market. For example, Japanese equities might do well thanks to a new prime minister or the country’s inflation outlook.

We believe that’s wrong. The differences in performance between countries’ equity markets largely comes down to sector exposures. Whether a result of historical accident, different listing rules, or tax treatments, every equity market is different, tending to be dominated by one or two large sectors.

The US, for example, is dominated by technology stocks, due to the magnetic draw of Silicon Valley and the promise of easy financing. But those companies – Apple, Facebook, Google and so on – have a reach that far exceeds the US. To like the US market you have to like the prospects for technology companies.

However, the UK market is global banks and oil companies, with no technology worth mentioning. Emerging markets have lots of financial sector exposure alongside a large consumer sector, but precious little in the way of industrials or healthcare.

Digging deeper

The financial industry is still working with outdated tools. Investors aren’t looking at sectors, so providers don’t create products. 

When we build our asset allocations, we take these limitations into account. We know about our tools – the regional indices, and their various biases. Our strategic asset allocation process implicitly and explicitly considers sectoral exposures as well as regional ones. We end up with portfolios which are structurally distributed across global sectors, which feeds into our tactical decision-making.

We can invest in specific sectors – healthcare for example. Or we can tilt our portfolios towards regions with sectoral exposures that we believe are appropriate, such as our ‘COVID recovery’ basket, which tilts portfolios towards the cyclical sectors in Europe and Japan.

At 7IM we don’t think our clients’ capital should be run in particular ways just because convention says so. Instead, we look for a robust and repeatable process that sees the world for what it is rather than in terms of outdated traditions and tools.

Find out more about the products based on our Strategic Asset Allocation, including our Pathway Model Portfolio range at 7im.co.uk. 

Ben Kumar, Senior Investment Strategist