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- We’ve read a number of outlooks and commentaries lately from firms arguing for investors to take a tactical tilt away from U.S. equities and towards International equities.
- The logic behind this tilt is largely driven by relative valuations: international equities appear significantly cheaper than U.S. equities based on most valuation metrics.
- In this commentary, we discuss why such a valuation-driven argument can be dangerous as the sole basis for a tactical tilt.
Recently, we’ve witnessed a convergence in views across a number of institutions advocating for investors to take a tactical tilt away from U.S. and towards international equities (both developed and emerging). The crux of the argument is largely valuation-based: international stocks look “cheaper,” typically presented as a relative comparison of price-to-earnings multiples.
Despite having made a nearly identical argument back in our 2016 market outlook, and currently having a significant overweight expressed in The Weird Portfolio, we wanted to write a brief commentary about why this trade – and trades like it – may be a bad idea.
The Case for International Equities
The most common argument we hear today justifying the tilt towards international is that international equities are cheaper than U.S. equities. Whether measured on Shiller’s Cyclically-Averaged P/E or trailing-twelve-month price-to-earnings, price-to-book, and price-to-sales, the U.S. equity market does appear relatively overvalued.
Source: www.starcapital.de. Figures as of 9/30/2017.
We would wager that few other arguments have the power to turn off the critical thinking elements of our brain like “valuation.” Value-based investing is as American as Warren Buffett eating apple pie. It’s one of the few risk premia acknowledged by the quants and academics. And if you argue why a higher valuation might be justified, you should expect to be harangued about the dot-com bubble and bust ad nauseam.
Nevertheless, we’ll risk it and argue why such a valuation-based argument can be dangerous as the basis for a tactical tilt.
Precisely Imprecise Measures
We are sure that if you asked any CEO of a publicly traded company whether price-to-book (or price-to-earnings, price-to-sales, enterprise-value-to-EBITDA, et cetera) accurately captures the full scope of their valuation, they would scoff. Such a simple metric is far too imprecise to capture the nuance of their business.
We would argue that the imprecision is the point. Value metrics are designed to be blunt enough instruments that we can leverage them both across securities and across time. Price-to-book may not give us accurate insight into a specific company, but sorting stocks based upon price-to-book provides a directionally accurate roadmap to relative valuations.
Directionally accurate, but not perfect. For example, many would argue that price-to-book is meaningless for bank stocks. Or that technology firms deserve a higher price-to-earnings ratio because they have a higher expected earnings growth rate.
The simplicity that helps make these measures robust also prevents them from being highly precise.
The same holds true for metrics like the Shiller CAPE. While comparing it against its historical average may give us some direction as to whether markets are currently expensive or cheap, changes in sector composition over time means that today’s reading of 30 may be meaningfully different than a reading of 30 during the dot-com days.
Similarly, when taken and used to compare across countries, Shiller CAPE fails to account for the fact that countries may have dramatically different sector compositions. Is it fair to compare the valuation of a technology-heavy market versus one driven by traditional manufacturing?
To attempt to exploit the signal and minimize the noise created by these imprecise figures, we have to leverage diversification.
The Key Is Diversification
One of the primary ways that quants and discretionary managers differ is in how they seek to manage risk.
A quantitative value investor will try to identify the stocks exhibiting value characteristics (e.g. low P/E, P/B, P/S, et cetera) and then buy a large enough basket of them where the aggregate value signal remains strong, but there is sufficient diversification to limit idiosyncratic risk.
A traditional value manager will try to identify the stocks exhibiting value characteristics and then do a deep dive into them, trying to ascertain, from a qualitative perspective, which are “safe” and which are not.
For regional bets based upon valuation, there is not much to diversify: you’re effectively making one, big single bet. Which, from a quant’s perspective, is highly, highly dangerous. It may be passable for a more traditional manager, but would certainly require a more thorough argument than relative valuations.
“But wait,” you’re saying. “Doesn’t each region represent a big basket of stocks? How is this any different than that traditional value factor where we’re saying low P/B stocks are going to outperform high P/B stocks?”
Great question! We’re glad you asked.
There are two big differences.
First, in the traditional value factor, the dividing line is the characteristic in question: i.e. “cheapness.” All the stocks we buy are, by definition, relatively cheap. In the U.S. versus International case, both sides include both cheap and expensive stocks. We’re trying to express a valuation-driven trade but using very muddied instruments to do it.
Second, we’re using a dividing line that introduces a confounding risk factor. For the value factor, we generally expect both the cheap and the expensive portfolios to share similar characteristics. Both have exposure to U.S.-centric risk factors (e.g. economic growth and inflation). In fact, evidence suggests that if we actively control for unintended bets – e.g. unintentionally overweighting one sector versus another – results are actually enhanced, especially on a risk-adjusted basis.
In the case of U.S. versus International, not only do we not expect the two baskets to share similar characteristics, but the construction of the trade ensures it. This is important because both sides are now exposed to different risk factors that can cause the trade to go off-course. For example, higher relative economic growth in the U.S. may help neutralize a higher relative valuation. Introducing a variety of unintended risk factors means a diluted trade.
If we really wanted to tap into the global value factor, we’d be much better off buying a basket of cheap global stocks (perhaps controlling for country exposure). Or, at the very least, buying a number of country indices with cheap characteristics (and thus diversifying our bet).
This would all be less of a big deal if we could diversify the bet over time. In other words, if we could make this bet 100 times over our investment lifecycle, we could hopefully average out all the extra noise over time. Unfortunately, when it comes to valuations, regimes move very slowly. Consider the Shiller CAPE for U.S. equities:
Source: Multpl.com. Calculations by Newfound Research. Average is calculated as an expanding window average with a minimum period of 30 years.
Over the last 30 years, U.S. equities have been above the average in 29 of the 30 years. Yet if you sat on the sidelines from 1987 to today, you would have missed a 10%+ annualized market return.
Without the ability to exploit cross-sectional or temporal diversification, it’s hard to advocate for an aggressive tilt towards International equities based upon valuations alone.
Earlier this year, in an interview with Bloomberg, AQR’s Cliff Asness said that he now only gets excited when value measures hit their 150th percentile.
While, technically, this is mathematically impossible, we second his wisdom. For all the points we listed above, valuation-driven market timing is really, really hard. Between imprecise measures and an inability to diversify against confounding risk factors, it may not be worth doing at all.
Except – maybe – in the case where we’re seeing historically absurd, never-before-seen measures. When simple metrics give exceptionally weird readings, it helps limit the odds that the result is due to some unaccounted-for oversimplification. Today’s relative valuations may indeed be justified.