Before I get into these few topics, I'll note that we're seeing a little bit of a pullback from a market rally that's lasted several months. I hope you're hanging in there; volatility is never fun but it's normal.
If I can be of any assistance in helping translate what's going on in the markets to what's going on in your portfolio, please feel free to reach out and we'll talk.
Okay, onto this newsletter:
If you've been receiving these emails for the last year or so, then you will notice a few topics I revisit fairly often. This is because I think some subjects deserve disproportionate focus on them due to the way they could potentially impact you or any other investor.
One of those frequent topics is Value Investing vs. Growth Investing, which I touch on in this email.
Additionally, I highlight some Basic Investment Principles and I also touch on Emerging Markets investing.
Adam Harding, CFP | Smartvestor Pro
(If you are receiving this for the first time, this email series is just about me sharing thoughts about various financial, economic, or investment related themes. I try to keep it interesting and relevant, so if there's anything you'd like to see me address, definitely email it over and I'll dig in.)
When discussing portfolios and strategy with clients, advisors often focus a lot of energy around 'staying calm when markets and investments are falling in price'.
Of course, not panicking when things get scary is super important.
Equally important, however, is the ability to resist the temptation to buy into euphoric optimism when it occurs.
If you were investing dollars in the late 90s, you probably had to risk feeling like you were missing out if you didn't jump right into the Tech Bubble. In the early 2000s you may have similarly felt that you were missing out by not flipping houses. Right now you may feel like you're missing out on a rally in Big Tech... It's all normal.
There are responsible ways to have participated in the stock and housing markets in each of these previous bubbles, but there were also reckless strategies which destroyed many investors who allowed the euphoria to cloud their judgment.
Most recently, I've been discussing another situation that is starting to present murmurations of historically challenging conditions.
Simply put, growth stocks are on a heck of a run....
I've talked about this a lot over the last few months because I think it's REALLY important.
As a refresher, a "growth stock" is a company which people think will grow at faster rate than the overall market. As a result of this expectation of future growth, the price of the company today ends up being high relative to how much it is currently earning. Simply put, people are willing to pay more for the stock because they believe in its future. Value investing is the opposite: a company whose future prospects are relatively lower, but whose current price is attractive relative to its current earnings.
Growth investing can be a very smart strategy --but it also be very dangerous if it's allowed to run unchecked. This is what happened in the late 90s when everyone was betting on the utopian future of limitless growth of technology stocks. We saw how that worked out and we're fortunate to have that history lesson to give us wisdom moving forward.
Over the last decade, growth stock investing has been a phenomenal approach; which is actually a divergence from a longer term trend of value investing being attractive.
In the chart below we can see years when Value beats Growth and years when Growth beats Value. Of course, past performance is not indicative of future performance, but we still like to make sure we understand history when making choices about the future.
In a different visual of the current Growth/Value relationship, this image below from Vanguard shows the last ~10 years of growth dominance. The largest such period in history.
I'm not alone in observing this wild diversion from the longer term history...Consider the following commentary from Dimensional Co-Founder David Booth:
If studying financial markets for 50 years teaches you anything, it’s to keep things in perspective.
During times of great uncertainty, like we’re experiencing now, investors may feel tempted to project today’s headlines forward or forget the useful lessons we’ve learned from the past.
I’ve been thinking about this a lot lately in the context of the growth vs. value stock debate.
Too often, news headlines distract us from taking the long view. They create a sense of urgency around what’s happening in the market right now. But we have nearly a century’s worth of data, and decades of financial science, to look to for guidance. That evidence reveals many investment lessons. For example, over long periods of time, stocks have generally outperformed bonds. This makes sense when you think about it. Stocks are riskier than bonds, so you expect to earn a premium return.
Most investors are probably familiar with this so-called equity premium, but they may be less familiar with the market’s size and value premiums. The same basic logic applies, and the same record backs them up. Historically, the stocks of smaller companies have outperformed those of larger companies. And relatively inexpensive stocks have outperformed more expensive stocks.
There’s solid theory behind thinking about investments in this way, but the premiums don’t necessarily show up every day. In fact, there can be long stretches when they don’t—stretches that can test the faith of investors.
I haven’t met many people who expect stocks to return less than US Treasury bills. And yet back when we started Dimensional Fund Advisors in the early 1980s, we found ourselves at the end of a 14-year period where T-bills actually outperformed the stock market. I remember a cover of Businessweek magazine proclaiming “The Death of Equities.” People then were saying the stock market would never be positive again. Of course, investors have since experienced one of the longest bull market runs in history.
We’re experiencing a similar historical variance right now with value stocks. Over the past decade, growth stocks have largely outperformed value stocks. But it’s important to keep things in perspective. According to Dimensional’s research, while value’s performance in the US from 2009–2019 was in line with its historical average (12.9% vs. 12.7%), growth significantly exceeded its historical average (16.3% vs. 9.7%). In other words, value has performed similarly to how it has behaved historically—it’s growth that’s been the outlier, performing better than expected. Financial science suggests you should enjoy these unexpectedly good returns, but don’t count on them repeating.
In my view, the rationale for investing in value stocks is as strong as ever: The less you pay for a stock, the higher your expected return. This is simple algebra. Still, some people are questioning whether the value premium has somehow disappeared. If value investing no longer worked, we’d have to throw out our economic textbooks and develop a new algebra.
I’m often asked what investors can do during times like these. The key to capturing any premium is to maintain consistent exposure to it. While we understand that the value premium may not show up every day, every year, or even every decade, sticking with value stocks can help you capture that premium over time.
No one can predict when premiums will show up, but we know they can show up quickly. In fact, some of the weakest periods for value stocks compared with growth stocks have been followed by some of the strongest. On March 31, 2000, growth stocks had outperformed value stocks in the US over the prior year, prior five years, prior 10 years, and prior 15 years, according to research conducted by our firm. As of March 31, 2001—one year and one market swing later—value stocks had regained the advantage in each of those time periods.
Why such a dramatic swing? It’s human behavior to stick with what’s working, and during periods when growth stocks are outperforming, many investors keep piling into those stocks. But many long-term investors think of it another way: The expected return on relatively cheap stocks is getting higher, which means more opportunity. As I like to say, value stocks are crouching lower now so they can spring up higher later.
Over half a century of observing markets, time and again I’ve seen that returns come in spurts. That’s why getting into and out of the market repeatedly is such a bad idea—you’re too likely to get caught on the wrong side of your decision. You can’t time returns. And you can’t predict them. To capture the historical premiums, you have to stay disciplined.
My long career in finance has taught me that there’s great value in keeping perspective, which includes keeping perspective on value. As my friend Robert Novy-Marx says, “I wake up every day expecting to see the value premium.” I, too, wake up every day expecting value stocks to deliver higher returns for investors. Time has only strengthened that conviction.
The commentary above is coming from someone who's lived through a lot more than I have, but the history we study is the same.
I have my specific way I'm navigating this with clients, but everyone's plan is a bit different.
If you'd like to chat about this just reply to this email and we'll schedule time to chat.
There is a lot of complexity in the investment world.
Some of it is required, but much of this complexity is often pretty unnecessary; it just makes the professionals feel like they're earning their dues or proving their expertise.
In the face of uncertainty, I feel like complicated guidance can add moreanxiety to our financial lives rather than less. Reducing "financial anxiety" should be one of the core things an investment professional is here for.
When things get really complicated and scary, I like to go back to the most simple explanations around investing:
You take your hard earned savings and invest it in a company, a loan, or a piece of real estate. That company is motivated to sell stuff and bring in revenue, that borrower is motivated to repay the loan or risk default, and the occupier of your real estate is motivated to pay you rent or risk eviction.
When we consider that all we're doing is taking savings and investing it into a current or future stream of revenue, it starts to present a simpler path to understanding our investment principles.
Here are three principles I think are worth focusing on right now:
The revenue stream of a single company/loan/property, a handful of these entities, or even an entire category (like bank stocks, subprime loans, or hurricane-laden coastal real estate) is too risky to trust in concentrating a significant portion of your savings. You don't want to own a ton of Enron stock or a big portion of a lagging industry (like energy or financials, in recent years).
In 2020, there are a few big names which have carried the stock market as a whole (Amazon, Apple, etc.). In environments like this it can be tempting to want to dive all-in to what you think is going to be the 'best thing'; I'd urge you to avoid that temptation.
Going forward, the earnings of those few names can be affected by a myriad of factors: interest rates, the economy, geopolitical risks, the health of a CEO, competition, etc. Similarly, the interest received from a single bond (loan) or one rental property can be affected by a few factors as well.
Simply put, there is more 'stuff' that can happen to an individual investment than can happen to A LOT of investments simultaneously. Thus, diversification is important.
When you buy something, the price you pay for it matters. Most of you would undoubtedly try to find the best deal on a car, computer, gallon of milk, etc...
So when we invest, why wouldn't we also want to find the best deal on that future stream of revenue? Buying companies which trade at a lower price relative to the company's earnings is the definition of value investing. When the argument is positioned like this, it becomes intuitive to want to buy these companies over ones trading at a higher price...
After all, earnings are earnings, right? Yes, but there is some nuance.
Some companies will reinvest their earnings back into the company so they are more competitive in an attempt to solidify their claim to future earnings. This is growth investing; an expectation that these companies will grow until their competitive advantage allows them to dial back their reinvestment and begin paying out earnings to the owners of the company.
In the bond market, we see a credit premium, which means we should get paid more when the borrower is less creditworthy. We also often see a term premium, which means we want more income if we're letting someone borrow our money for longer (unless the yield curve is flattened, but we'll save that for later).
If a renter of a piece of property will sign a longer term lease, then we may reward them with a lower rent payment in exchange for securing long term rental income for ourselves. But if they have a low credit score and may not be able to pay their rent, then we may charge them more for our adoption of that risk.
In short, the price you pay for a revenue stream matters, but so does the long term security of that revenue stream. It's dangerous to go too deep into either value or growth investing when buying stocks, or into junk or long term bonds, or in any segment of the real estate market. There are ways to sensibly blend these factors together, but avoiding a deep concentration in any one of them is often wise.
Getting comfortable with being uncomfortable is more important today than at any time in my career.
Why? Because 'comfortable' investments aren't poised to produce attractive returns with interest rates at their current very low levels.
Thus, to pursue returns it will require having the guts to stick with riskier investments.
As an advisor and portfolio manager, I have two choices in an environment like this:
(1) Dial up the risk of a portfolio to try and hit return targets but, in doing so, also risk losing more in a downturn
(2) Encourage investors to lower their expectations which reflect the realities of the world we find ourselves in.
There is no 'right' or 'wrong' answer to this determination, as it's very client-specific. If you can't tolerate or adopt risk, then lower expectations are needed. If you can tolerate and adopt risk, then get prepared to hold on tight.
In any case, aim to grant yourself the time and the emotional fortitudeto increase the odds that you'll have a good investment experience.
Before I get into this third 'Thing', I have to give some insight into how I put together these newsletters. Here's how it goes:
I come up with a long list of topics, write about them when I'm feeling inspired, and then piece some subjects together for a newsletter.
A lot of the time it's cohesive and follows a theme.
Sometimes it doesn't.
In this case, I just got done explaining how things should be simple and now I'm going to follow up with one of the more complex pieces I've released.
Unfortunately, I can't really explain the nuances of emerging markets investing without highlighting the data... Nonetheless, here's the simple version of the following section about emerging markets investing:
(1) The emerging markets can add valuable diversification to a stock portfolio and (2) the role that emerging economies serve in our global economy is ever-increasing. A serious look at these holdings is warranted.
Okay, now that you have the above "simple version of the next several paragraphs you can skip the next section unless you're a real nerd like me.
... If you made it this far, then it looks like you're still with me and want the elaborate reasons why I think emerging markets makes sense in a globally diversified stock portfolio. Thanks for sticking around.
The world is a big place, but stock market investors often ignore a lot of it. Although only about 55% of the investable stock market is in the US, investors will often concentrate much more of their portfolio in US stocks than just 55%.
There's nothing wrong with having some home bias (i.e. disproportionately investing in your home country), but there's a lot of opportunity in foreign markets as well. Particularly if you're concerned about geopolitical issues in the US.
In this segment, I'd like to specifically address Emerging Markets.
I believe this is an important part of a well-diversified global equity portfolio. But recent history reminds us that they can be volatile and can perform differently than US markets. Below is a longer term, historical perspective on the performance of emerging markets and the countries that constitute them.
Recent Performance in Perspective
In recent years, the returns of emerging markets have lagged behind those of developed markets. As shown in the right side of the graph below, over the past 10 years (2010–2019) the MSCI Emerging Markets Index (net div.) had an annualized compound return of 3.7%, compared to 5.3% for the MSCI World ex USA Index (net div.) and 13.6% for the S&P 500 Index. While recent returns have been disappointing, it is not uncommon to see extended periods when emerging markets perform differently than developed markets.
For example, just looking back to the prior decade (2000–2009... or the left side of the graph), emerging markets strongly outperformed developed markets, with the MSCI Emerging Markets Index (net div.) posting an annualized compound return of 9.8%, compared to 1.6% for the MSCI World ex USA Index and –0.95% for the S&P 500 Index. That's right, a whole decade of S&P 500 performance where the annualized return was negative 0.95%!
In this segment of the market, the return differences from year-to-year can be large. For example, relative to the US, the biggest underperformance (or lag) in the past 10 years was in 2013, when emerging markets underperformed by over 34 percentage points. The chart below helps to put this difference into historical context: between 1988 and 2019, emerging markets outperformed US stocks by 34 percentage points or more per year four times (1993, 1999, 2007, and 2009) and underperformed US stocks by that same magnitude four times (1995, 1997, 1998, and 2013).
Over the entire period from 1988 to 2019, investors with a consistent allocation to emerging markets were rewarded. The MSCI Emerging Markets Index (gross div.) had an annualized return of 10.7% over this period. That exceeded the 5.9% annualized return for the MSCI World ex USA Index (gross div.) and was similar to the 10.8% average annualized return for the S&P 500, even when including the recent decade of strong performance of the US equity market. However, emerging markets returns were also more volatile. Looking at the same indices, the annualized standard deviation was higher for emerging markets: 22.4% vs. 14.1% for the US and 16.4% for developed markets outside the US.
This higher volatility, as well as the potentially sizable performance deviation from developed markets, underscores the importance of patience, discipline, and an appropriate allocation that investors can stick with when considering investing in emerging markets.
A Closer Look at Emerging Markets Country Performance
Diversification across emerging markets countries can improve the reliability of investment outcomes, as dispersion among country returns can be wide. As you might expect, the things happening in India are much different in a given year than, say, Egypt. The table below displays the best and worst performing countries in the emerging markets during each of the last 20 years.
Focusing on the countries at the top and bottom of the columns for each year reveals substantial differences in returns between the best-performing and worst-performing market. The chart above shows that, over the past two decades, the annual return difference between the best- and worst-performing emerging markets has ranged from 39 percentage points in 2013 to 159 percentage points in 2005. On average, that difference has been approximately 80 percentage points per year. Perhaps somewhat counterintuitively, the extreme performers were not necessarily dominated by a handful of countries or by the smaller countries. In fact, 13 different countries were the worst annual performers, and similarly, 13 different countries were the best annual performers. These data illustrate the extreme outcomes that investors may be exposed to by concentrating in a few countries. There is no compelling evidence that investors can reliably add value through dynamic country allocation.1 By holding a broadly diversified portfolio, investors are instead well positioned to capture returns wherever they occur.. It's extraordinarily difficult to know which countries are poised to perform well in advance, so I don't even recommend that even try to make these kinds of guesses.
Evolving Emerging Markets
As a group, emerging markets represent a meaningful opportunity for investors. The size and composition of the investible universe of emerging markets have steadily evolved since the late 1980s, when most comprehensive data sets and benchmarks for emerging markets begin. Over the years, major geopolitical, economic, and demographic changes have contributed to shifting weights for individual countries and companies within emerging markets, but in aggregate they have continued to grow.
As of the end of 2019, the total free-float adjusted market capitalization (i.e. the total value of the companies in these countries) of Dimensional’s emerging markets universe was $7.8 trillion and included 24 countries and over 7,000 securities. As shown in Panel A of the graphic below, emerging markets represented 12.5% of global markets’ free-float adjusted market capitalization. Measured by gross domestic product (GDP), emerging markets’ share increases to 38.0% (Panel B), reflecting the fact that emerging markets typically have smaller market capitalizations compared to GDP than most developed markets.
To interpret that more simply: the segment of the global market that represents 38% of GDP represents only 12.5% of the investable universe.
Regardless of the metric, emerging markets represent a significant component of global markets.
Panel A of the chart below examines the country composition of Dimensional’s emerging markets universe. The top five countries in terms of market capitalization—Brazil, China, India, Korea, and Taiwan—represented 73.2% at the end of 2019, slightly higher than at the beginning of the decade, when these same five countries represented 68.8% of the universe. A more significant development over the past decade has been the rise in the weight of China, from 17.2% of the universe at the end of 2009 to 31.4% at the end of 2019. This increase has been driven primarily by new equity issuance and new avenues for foreign investors to gain exposure to Chinese companies, including securities listed on the local Shanghai and Shenzhen stock exchanges through Hong Kong stock connect programs.
The growing size of China in the emerging markets has prompted many questions from investors on issues such as benchmarking and concerns about potential reliance on that single country. While these issues are complex, it is often helpful to consider China’s weight from a global perspective. Panel B of chart above shows the weights of the top five countries in the global universe as of the same date. Compared to its 31.4% weight in the emerging markets universe, China’s weight was 3.9% in the global market, making it the fourth-largest country after the US, Japan, and the UK.
In addition to changes in size and country composition, emerging markets have undergone important improvements in their market mechanisms and microstructures over the past decade. Generally, emerging markets have become more open to foreign investors with fewer constraints on capital mobility. Evidence of these developments includes fewer instances of market closings, capital lockups, and trading suspensions of individual stocks in many markets. Finally, emerging markets have broadly adopted international accounting and reporting practices over the last decade. Our analysis suggests more than 90% of the firms in most emerging markets now report their annual financial statements according to International Financial Reporting Standards (IFRS) or US Generally Accepted Accounting Practices (GAAP). In countries like China, India, and Taiwan, the national standards have substantially converged with IFRS. This has helped improve the reliability and transparency of financial data in emerging markets.
In sum, emerging markets represent a meaningful opportunity set within global markets. They continue to evolve in their structures, market mechanisms, and accessibility. Investors in emerging markets can benefit from a long-term perspective, expertise and flexibility in navigating these changing markets, and an approach that emphasizes diversification and discipline.
*Special thanks to Dimensional for the breadth and data behind this piece.
That's all for this newsletter, thanks for reading!
If you have any comments, questions, or would like to discuss any of this, be sure to send me an email or call anytime.
Three Things: Investing Basics, A Widening Rift, and Emerging Markets
September 21, 2020