The Foreign Investor's Advantage
If we start investing like foreigners then good things are cooking elsewhere. Grab a free diversification lunch and more interesting investment menus. (PBL #4 2022)
In this PiggyBack Letter (PBL) we piggyback global portfolio diversification. Mostly by pointing to data and common sense. Global investing pioneer John Templeton is briefly introduced as a role model.
From August PBL is back.
When ready, we will launch PiggyBack's premium, actionable, equity research paid edition. PiggyBack Letter readers will get samples and ongoing, selected insights from this upgrade. For free.
Look forward to this!
Johan Eklund, CFA
The Foreign Investor's Advantage
“Sweden accounts for approximately 1 percent of the world economy. A rational investor in the United States or Japan would invest about 1 percent of his assets in Swedish stocks. Can it make sense for Swedish investors to invest 48 times more?”
— Richard H. Thaler and Cass R. Sunstein in Nudge: Improving Decisions About Health, Wealth, and Happiness (2009, p.153)
Thaler and Sunstein’s question above is on how Swedes* chose their equity allocation when offered to make an active choice of mutual funds. The takeaway? An extreme home bias effect, at least initially. Investors who make active choices tend to over-allocate equities in their “home” market.
This experiment constituted a small part of Sweden's state-run pension system. Most Swedes of working age have at least some allocation. The pension system default, non-choice “nudge” is more globally diversified. For good reason, as we will learn.
In its defense, Swedish equity indices contain a handful of multinational industrial champions. But still: whether investing in passive products or buying insignificant active stakes one should not put half of one's stocks in such a small "home" market. Equities are a too major asset class with good global access not to diversify.
A similar critique, but less extreme would be Americans putting most of their wealth in the S&P 500 Index. Despite this Large/Mega cap index having a good share of multinational U.S. companies.
Some readers might protest. The U.S. currently makes up almost 60% of global equities market capitalization. In the MSCI ACWI + Frontier Markets All Cap Index, covering 99% of world capitalization. But any investor, including those whose "home" markets dominate the global market cap, can have a too narrow universe. Let us piggyback on global diversification.
(* Sweden is PiggyBack’s home country. A small, open economy in the Northernmost EU. Easy to confuse with our non-EU Switzerland friends down in the Alps.)
The Global Free Lunch
A lot of portfolio theory rests on the assumption of market cap-weighting. This means we accept the market as efficient, at all times (and not just most of the time).
Want the market average risk-adjusted return (minus low fees and taxation)? Then be a passive investor by just buying cheap, well-executed market index products. This let-markets-do-their-dance has historically beaten the average, active investor in the same universe. This "wisdom of the crowd" is well-known by most investors nowadays.
An important aspect is often missed in practice. This market portfolio should be global to capture all diversification benefits. In the 2019 report, Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated, the hedge fund manager Bridgewater provides an excellent summary of 20th and early 21st-century support for global diversification. The charts are great (and copyrighted) so please go to the above link to study the report. Our highlights:
1900–early 2019 Excess Returns*
* Excess return = return above cash risk-free interest rates in this report.
Individual country excess returns
Bridgewater looks at passive, buy-and-hold investing in equities of the big five powers at the start of the 20th century. Germany, France, Russia, the U.K., and the U.S.
Most of us know that the 1900- period that followed was the best for U.S. stocks. The U.S. won great success with its economic model and capital markets. Plus its domestic economy was better isolated from two world wars.
Public equity investors in Russia were wiped out in the revolution.
German equity investors lost decades around the two world wars. Interestingly, German post-war capitalism has been very successful. So successful that German excess returns including the wars have already surpassed France’s and almost caught up with the U.K.’s. Both were on the “winning” side in both world wars that Germany lost. (Some argue that war has no real winners.)
“Global” excess returns
Bridgewater compares with a passive, equal-weighted “global” strategy of 20% each in Germany, France, Russia, the U.K., and the U.S. Bridgewater rebalanced this allocation every year. This means selling down the previous year’s winning countries to buy more of the losers.
This simple mechanical strategy showed excess returns of almost as much as the U.S. from 1900. Despite allocating 20% to Russia and 20% to Germany.
1900-early 2019 Draw-downs
As long-term fundamental investors, a risk we care about is permanent loss of capital. The first step to permanent loss is experiencing long-lasting and deep portfolio-level draw-downs. A draw-down is just a period of cumulative negative returns. More concretely, a percentage loss from a portfolio's peak value to its following trough.
Individual country versus global draw-downs
Here Bridgewater’s comparison gets even more interesting.
The equal-weight five-country “global” portfolio’s worst excess return draw-down? -66% in USD, during the 1929–1932 global Great Depression. Within 13 years this was recovered and the global strategy advanced higher (post-WWII).
The big five 1900 countries all did worse, in terms of worst draw-down:
Russia of course lost all. A terminal -100%.
Germany from WWI lost -99% during a draw-down that lasted for 47 years(!).
The U.S. lost -85% during the Great Depression, which took 16 years to recover. So compared to the global strategy’s worst drawdown, U.S.-only investors would see their equities drop an extra more than half. Compared to an allocation with both WWI & WWII Germany and the Russian revolution.
France’s worst -83% started towards the end of WWII. Recovery took 15 years.
The U.K. fared “best” and still lost -72% during the 1970s inflation.
Bridgewater then expands the data by including more major country stock markets, as they become available for each decade.
Since 1900 no single major stock market has yet shown a milder worst drawn down than the global equal-weight portfolio. Switzerland, with data from 1966, was closest with a 51% draw-down during the 2007–2009 Global Financial crisis. The global strategy’s worst was -49% during the same period.
Stock markets are conduits for allocating capital and public investment access. This was true in very different times and places during the 20th and early 21st centuries.
Bridgewater’s study highlights how national stock markets see very different fates. Some geographic economic and political outlooks are reasonably predictable near term. Most are very unpredictable far out into the future. By diversifying across regions and countries, investors reduce the impact of macro uncertainties. Without sacrificing much, if anything, in long-term expected returns.
An extreme, yet not uncommon example would be major wars or political revolutions:
Around such events, some investor groups risk getting labeled “enemies”. Of a state, the revolution, or some other political interest group. Right or wrong, this opens up asset confiscation.
The practical reality is that someone’s investment can be withheld or handed over to someone else permanently. Then stock index averages no longer reflect that first investor’s experience. By diversifying, we reduce this and other binary “terminal zero” risks down the road. However unlikely they may seem today.
We should not assume our future in the 21st century as an extrapolation of the last decades, or the 20th century. History is full of civilizations once successful in trade, science, innovation, or politics. Most eventually lose track and waste their advantages.
One-way bets on a single dominant or emerging world power at the start of the 20th century had a foolish risk-reward. The same is true today.
To balance, diversifying to every geography might be infeasible or inadvisable. Most investors have constraints on where they are allowed, or willing, to invest:
Some constraints are self-imposed. We may reason that we lack enough insight into regional, national, or local affairs. Or that we believe to understand an unattractive risk-reward of a specific market. For example, a lack of accounting transparency, weak minority protection, widespread insider graft, or politically controlled companies. Investors’ personal beliefs against political regimes can put whole stock markets out of the question. (With merit some would argue.)
In other cases, we lack access to invest at reasonable terms. This could be due to a lack of resources or regulatory hurdles. For example, foreign controls or punitive taxation make international investing impractical or unattractive. Such issues may involve both the investment destination if we are foreigners. But also our home country, if we are unlucky.
Managing the money of others usually comes with formal mandate restrictions.
Investing under constraints is like fishing in a smaller pond. Nothing wrong with this, since we should know “our” pond better for the time being. But we should be aware that we are missing out on the free lunch of global diversification.
The Global Stock-Picker
OK, so we should diversify globally within our constraints if investing passively. What does that have to do with active value investing? (For primer see Value Investing 101.)
As active investors, we by definition tilt away from our benchmark. We think that we are smarter than “lazy” passive market cap-weights (which is harder in practice than it sounds). Smarter than the discussed simple trick of equal-weights (even harder).
So we start picking the best stocks using our fundamental value-investing methods. Wouldn’t we then want to explore the widest possible universe of investable stocks? One that we could at least partly understand if we are willing to study a little?
One investor who did just that was the U.S.-born British mutual fund manager John Templeton (1912–2008). His specific methodologies we have to return to, as they cover several case studies. In meantime, see this overview by Broken Leg Investing.
For this article, we will only showcase Templeton as an early pioneer in using his mutual funds to explore equity markets far outside any U.S. home bias. He invested in some at the time very exotic equity markets. Like post-war Japan in the 1950s. Imagine investing in one of your home country’s top war enemies within a decade or so. Takes some forward-looking perspective.
So Templeton had this contrarian, exploratory global investing streak. But he went even more contrarian in adding the value-investing mindset that we are piggybacking.
Skilled in both stock picking and portfolio management this contrarian global value style allowed Templeton Growth Fund (ticker TEPLX) to widely outpace the “home” U.S. market. When Templeton managed this fund from 1954 to 1992 he compounded investor returns at more than 15% after fees. An exceptional, long track record.
Within our investment constraints, we may search for attractive opportunities in new waters. With an open mind we may ask ourselves:
After hearing just a little about some “exotic” investment, does it make common sense to us?
Can we understand and accept the practical reality of the terms under which we invest? (Which may be very different from what we are used to “at home”.)
Does valuation support the idea? We may compensate for our limited geographical knowledge by requiring a larger margin of safety. (Deeper discount between entry price and valuation, or more conservative assumptions.)
The result may be good risk-reward investments where we learn more about the world. Seemingly “scary” macro may sometimes be more a function of our bias, prejudice, and lack of knowledge, than a reflection of reality. And even correctly judged macro risks will, to some extent, cancel out if the countries and regions selected are not tightly connected.
It takes experience to learn new rules of the game. So start. Opportunities await.
As always, thanks for reading PiggyBack! If it is the first time feel very free to join us for free:
Disclaimer: This publication and related communications are for informational and educational purposes only. All readers are assumed to accept the full version of this disclaimer, see the following link.
Your Analyst sincerely hopes all readers enjoy and get some inspiration and ideas for value investing from PiggyBack. If so, please consider sharing and discussing PiggyBack with friends and colleagues interested in investing:
Spreading the word really helps(!) in growing PiggyBack’s readership. Working together, this publication can reach a sustainable scale for free, independent insights.
Many thanks to all PiggyBackers!
Johan Eklund, CFA
PS: Feel very free to (1) follow us and (2) discuss and share/tag our content, with us and with others in relevant threads/groups/hashtags, on the following platforms:
Commonstock @piggyback (New investing & trading community platform)