Monday, August 22, 2016

Global Investing Based on Valuation

Avoiding Home (or Continent) Country Bias

On an earlier post, I wrote about one of principles being global diversification.  As a Canadian, I know a lot of investors who either invest primarily in the Canadian stock market, or a blend of Canada and the U.S.

I also used to be that way.

However, research made me very aware of the problem with doing this.  The issue is that by investing in only Canada and the U.S., I was missing out on approximately 44% of the stock markets around the world.  This pie chart from the document references earlier, shows the breakdown of country stock market size.

There are a number of other great stock markets around the world that can provide opportunities for increasing my wealth, and I wanted to make sure I took advantage of that.

Arguements FOR Global Diversification

There are a number of solid reasons I decided to invest outside of the U.S. and Canada.  The first was mentioned above:

  • Opportunity to invest in the remaining 44% of the world's markets, outside of the U.S. and Canada

In addition, there are a number of other reasons that highlighted to me that global diversification was a good idea:
  • Less than Perfect Correlation with U.S. Markets.  As the chart from Vanguard highlights below, "...investors should realize a diversification benefit from investing globally because the equity markets of other developed economies are  less-than-perfectly correlated with the U.S. equity market."

  • Adding global diversification has reduced the volatility of a portfolio.  The benefit of this is that I can get better gains, with less volatility.  In other words, better returns with less wild swings in my portfolio value (which can lead to stupid emotional decisions).  This chart from Vanguard gain, show that by adding non-U.S. stocks to a portfolio volatility is reduced.

Arguements AGAINST Global Diversification

The primary argument against investing globally for U.S. and Canadian investors is that by investing in products like the S&P 500 you are essentially owning massive multi-national organizations that give you more than enough exposure to the global markets.

Fair argument, however there are a couple of problems with this line of thinking:
  1. No exposure to companies that are based in other countries.  You miss on huge companies like Samsung, Nestle, or even Alibaba.
  2. Less diversification across industries; focusing on just the U.S. means you are limiting yourself to the sectors that make up a large part of the U.S. markets (like technology or biotech).  Going global allows you to diversify yourself better across global sectors.

So How Much Global Diversification?

Personally, I have 40% of my portfolio allocated to global markets, with the rest in the U.S. and Canada.

The reason it is not higher, is that there is a point where there is no additional diversification benefits from going over a certain percentage in my portfolio. 

Specifically, research has shown that the approximate "right" number is around 30% dedicated to non U.S. equities.  Have a look at this chart, again from Vanguard, which presents the research backing this up:

My 40% allocation is higher, however I am comfortable with the added risk as my chosen investment strategy hos shown to provide solid returns over long periods of time (and my investment horizon is 20+ years).

My Chosen Global Investment Strategy - Countries with the Lowest Valuation 

There are a lot of different ways to invest in global markets.   The easiest, and probably best option for most people, is to head over to Vanguard and buy the Vanguard FTSE All-World ex-US ETF (VEU). 

VEU seeks to track the performance of the FTSE All-World ex US Index and gets you broad exposure across developed and emerging non-U.S. equity markets around the world.

I however take a different tact.  My method is systematic, and is once again based on solid research done by folks like Meb Faber, Alpha Architects,  and Research Affiliates.

It is based on buying countries that exhibit low CAPE ratios.  What is the CAPE ratio you ask.  For a detailed description read this and this.  Here is a quick summary for the purposes of this article:
... it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns. It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events. Source

When applied to global markets, research done by Star Capital has shown that: the “All Countries” group based on 4889 observation periods, attractive  CAPE  levels  of  below  10  were  followed  by average capital growth of 11.7% p.a. over the following 10 to 15 years....The majority of the subsequent returns ranged  from  9.9%  to  13.9%, and even  in  the  least favourable  case  (Canada)  real  subsequent  returns  of 4.9% p.a. were measured. Source
In simple terms: buy countries that are cheap relative to their historical CAPE ratios and hold them.

My application of this strategy was outline in Meb Faber's Global Asset Allocation book.  In a nutshell, here it is:
  1. Identify the world's cheapest stock markets based on the Shiller P/E, or CAPE ratio.  These ratios can easily be identified here and here.
  2. Sort the list from lowest to largest CAPE ratio, or expected return.
  3. Buy the 10 cheapest countries using ETFs that track the associated country.
  4. Hold for one year, rinse and repeat.
As of today, my portfolio is holding the following countries (index ETFs in brackets):
  • Russia (ERUS)
  • Poland (EPOL)
  • Brazil (EWZ)
  • Italy (EWI)
  • Turkey (TUR)
  • Spain (EWP)
  • China (MCHI)
  • South Korea (EWY)
  • UK (EWU)
  • France (EWQ) 
I started this portfolio a few weeks ago and will update its progress over the years to come.  If the results turn out like the research, then it should perform well.  It is going to be volatile for sure (I own Russia and Turkey for fucks sake!)

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