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Global Investment Strategy and Asset Allocation For Financial Professional Use Only
Long-Term Analysis Conquers Wrong Turn Paralysis
Morningstar Investment Management
Europe Ltd
February 2017
Note from the CIO
As the world attempts to understand the motives of Donald Trump and his circle of followers, it is
worthwhile acknowledging that we have been here before.
Contents
2 Key Convictions
3 Equity Market
7 Fixed Income
11 Currency
14 Fundamental Considerations & Risk
21 Investor Behaviour
24 Summary
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of
foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the
season of darkness, it was the spring of hope, it was the winter of despair, we had everything before us,
we had nothing before us”.
-
Charles Dickens 1859 writing in ‘A Tale of 2 Cities’
Dickens was talking about the French that were becoming demoralised in the years leading up to the
1789 French revolution. There are parallels that can be drawn to the situation today, and one can’t help
but ponder what Dickens would be saying about the emergence of Donald Trump if he was alive today.
Investing in 2017 is undoubtedly challenging as we live in a world dominated by political headlines and
stretched valuations. We find economic optimism that is cyclically robust but structurally challenged,
causing us to further consider the implications of downside risks, inflationary shocks and ‘quality’
factors.
Dan Kemp
Chief Investment Officer EMEA
With the above in mind, we are pleased to share some insights into the following themes:
× Does the size premium explain the long-term mid-cap outperformance? Nobel prize winning
research by Fama and French created a logic to support small-caps as superior investments. We look
under the hood and find that it is not as conclusive in the U.K. as many expect.
× Inflation and European politics: what does a long-term investor do? We explore fixed income
markets under the lens of rising inflation and European instability.
× Can Trump talk down the US dollar? And will it act as a store of value if the share-market
How to Use this Report
This report is intended to showcase the
investment philosophy used by
Morningstar Investment Management
Europe Limited when we run our
managed portfolios. Within this
document, the reader will find many
references to valuation-implied returns,
which encompasses our extensive
proprietary research into capital markets.
We invite professional readers to
generate ideas and challenge the content
herein.
crashes? Donald Trump has made his opinion clear that the US dollar is “too strong” for his liking.
We explore the validity of the US dollar as a recipient of any ‘flight to safety’ and find that it may not
always have the protective properties we have come to expect.
× How should a valuation-driven investor rebalance? As markets move and portfolios diverge from
the desired exposures, one must consider the optimal method of rebalancing. We believe that autorebalancing has inherent weaknesses, and tie in our knowledge of value traps into our methodology.
× What happens to equity markets in conflict? Data from the World Wars and the French revolution
show that equity markets are resilient through conflict, but capable of painful drawdowns.
× Lessons from neuroscience: which parts of the brain are the best for investors? Training our
brain to ‘focus on focus’ could help overcome the long list of behavioral deficiencies we deal with.
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Key Convictions
Long-term outlook of the global asset allocation team
Exhibit 1 The global asset allocation outlook shows pockets of danger and opportunity.
Overall
Conviction
Notes
United States
Low
We remain focused on valuation pressures, which pose downside risk
in the long-term.
Europe ex-U.K.
Medium
The European landscape offers both risk and opportunity. Selected
exposure appears warranted.
U.K.
Medium
U.K. equities are being influenced by currency shifts. From a valuation
perspective, there is moderate appeal.
Japan
Medium
Japanese equities are falling in fundamental appeal, but are similarly
influenced by currency.
Low
Unlike other parts of developed Asia, Australian equities offer a poor
long-term outlook.
Emerging Markets
Medium to High
Emerging markets remain segmented, however in aggregate we see
broad opportunity.
U.S. Treasuries
Low to Medium
Valuation-implied returns are improving from very low levels.
U.S. TIPS
Low to Medium
One of very few defensive assets offering decent prospects (albeit still
low in absolute terms).
U.S. Credit
Low to Medium
Similar to Treasuries, the prospects are improving from low levels.
Asset Class
EQUITIES
Australia
FIXED INCOME
Euro Treasuries
Low
European bond yields remain low in absolute and relative terms. This
asset still looks unfavourable in a long-term context.
European Credit
Low
Face similar valuation constraints and with heightened credit quality
risks.
U.K. Gilts
Low
U.K. gilts retain a low conviction despite the recent rise in yields.
Australian Treasuries
Australian treasuries offer a relatively attractive return by fixed
income standards.
High Yield
Low to Medium
We have seen our high yield conviction tapered as spreads tighten.
Emerging Market Debt
Medium to High
Remains attractive on a relative basis. The composition of currency
exposure remains important for risk purposes.
Low
Offers an attractive yield but outlook requires caution. REIT’s offer
poor return prospects in both relative and absolute terms.
Real Estate
SPECIAL
MENTIONS
Medium
European Financials
Medium to High
The valuation backdrop remains appealing, even on a risk-adjusted
basis. Although we note some of this value has now been captured.
Pound sterling
Medium to High
Sterling still appears undervalued in fundamental terms despite the
implications of Hard-Brexit.
Source: Morningstar Investment Management, conviction levels confirmed at 31/1/17.
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Equity Market Valuations
Quality and size offers an interesting angle
Exhibit 2 The evolution of our long-term expectations remains segmented by sector (10-year valuation-implied
returns, real % per year).
6.0%
Sector return expectations continue to show
divergence, which is creating opportunities.
We can see a recent deterioration in many sectors,
which dampens our conviction going forward
5.0%
Telecommunications
7.0%
4.0%
% Return
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3.0%
2.0%
Energy
Healthcare
Financials
Utilities
Consumer Staples
1.0%
0.0%
Materials
Info Technology
Industrials
-1.0%
Consumer Discretionary
-2.0%
Source: Morningstar Investment Management calculation, at 31/1/17
As investors attempt to make sense of lofty valuations and political uncertainty, the question of ‘quality’
has become increasingly prominent. Debates around quality are framed in several ways, but more
recently the discussion has concentrated on the apparent decoupling of large stocks and their smaller
counterparts. This phenomenon is best illustrated in the U.K. where mid-caps (as defined by the FTSE
250 index) have outperformed the large-caps (FTSE 100) by more than 100% over the past 15 years.
Many have concluded that a size premium genuinely exists in the U.K. because the companies
underlying the FTSE 250 index grow earnings at a superior rate to large companies. But to conform to
this theory, it is worth re-iterating what is meant by the size premium and to investigate the underlying
composition of the index.
Why it is useful to question the size premium as a blanket solution
The size premium was described by Nobel laureate Eugene Fama and his fellow researcher Kenneth
French who identified the fact that smaller companies consistently provided higher returns than large
companies over long periods of time. This insight has become one of the most widely used inputs into
the asset allocation process and accounts for the fact that most equity funds have a structural bias
towards smaller companies.
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While we respect the foundations and logic that underpin this body of research, as investors, it is
important to note that not all performance is attributable to a ‘single factor’. Just as French and Fama
have since found that there are at least five factors that influence performance (size, value, market risk,
profitability, investment, and possibly a sixth as Cliff Asness - Fama’s student - wants the momentum
effect included), we can’t explain all the performance by any one factor.
Equally, as investors, we need to look beyond simple mathematical relationships and understand the
fundamental drivers of these results. This understanding is embedded in Morningstar’s ‘building blocks’
approach to estimating returns. Rather than simply estimating a total return of an asset class, we divide
asset returns into the key fundamental drivers and scrutinize each of these individually. By doing this,
we believe that we gain a better estimate of the overall return of the asset class and are less dependent
on historical relationships and heuristics. It is this approach that causes us to question the superior
performance of mid-cap on the basis of size alone.
Where our analysis of the FTSE 100 versus FTSE 250 performance gets interesting
We find that the outperformance of mid-caps in the past decade (especially in the U.K. but also in
Europe and to a lesser extent the U.S.) has been mostly attributable to the difference in earnings.
Exhibit 3 The earnings trend has seen a remarkable difference between mid-caps and large-caps. The question is
whether this is a sustainable advantage.
Is the
outperformance
due to mid-cap
strength or
large-cap
weakness?
Source: Morningstar Investment Management calculation at 31/12/16
When we think about the drivers of earnings, it is necessary to go beyond the headlines and look at
whether the profitability is being driven by revenue growth or profit margins, as the latter tends to have
a tighter baseline and is harder to sustain as a competitive advantage. What we find is that the
attribution in the U.K over the past 15 years weighs heavily in favour of profit margins, which have
diverged dramatically relative to revenue growth.
Exhibit 4 Underlying earnings have been driven by profit margin expansion. This is seen to be a mean reverting
series so caution may be required.
A large portion of the earnings
advantage is explained by profit margins
rather than revenues
Source: Morningstar Investment Management calculation at 31/12/16
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Perhaps due to this profit margin growth, we have also witnessed valuation measures such as the
cyclically-adjusted price-earnings ratio and price to sales ratio increase at a faster rate than their large
counterparts as investors increasingly price in a continuation of this trend into the current price.
Exhibit 5 A valuation premium exists for mid-caps. This typically exists due to a perceived ‘quality’ advantage,
although it is not clear this exists in the U.K.
FTSE 250 xIT
22.50
A value premium also
exists, although it is not
clear if this is justified
20.00
17.50
15.00
12.50
10.00
May/2009
Aug/2009
Nov/2009
Feb/2010
May/2010
Aug/2010
Nov/2010
Feb/2011
May/2011
Aug/2011
Nov/2011
Feb/2012
May/2012
Aug/2012
Nov/2012
Feb/2013
May/2013
Aug/2013
Nov/2013
Feb/2014
May/2014
Aug/2014
Nov/2014
Feb/2015
May/2015
Aug/2015
Nov/2015
Feb/2016
May/2016
Aug/2016
Cyclically-adjusted Price-Earnings Ratio
FTSE 100
25.00
Source: Morningstar Investment Management calculation at 31/12/16
In order to justify these higher prices, we would typically expect the underlying companies to have a
superior business model and consequently be of higher ‘quality’ than its peers. This is something value
investors need to be mindful of, as a bias towards low margins could lead unaccustomed value investors
to favour poorer quality companies. In an ideal world, we want to be informed by quality, with the
assessment of ‘fair value’ acting as a hurdle rate and accounting for the greater stability of cash-flows.
Bringing this back to the mid-cap versus large-cap debate
Knowing that we should adjust for quality, it may be possible to explain the mid-cap superior earnings
growth by looking at the sector exposures of the FTSE 250 and comparing this to the FTSE 100. If the
mid-cap superiority would be explained in this chart, we would see a clear bias in sector exposure
towards ‘higher quality’ industries. However, as we can see below this is only marginally the case.
Exhibit 6 A break-down of the ‘quality’ by sector shows mixed results within mid-caps. We see a slight ‘quality’
advantage in aggregate, although this is mostly attributable to high industrials exposure.
FTSE 250 versus FTSE 100
Overall quality
differential slightly
favours mid-caps
Total 'Higher Quality' Exposure
Total 'Lower Quality' Exposure
Financials
Energy
Utilities
Materials
Telecommunications
‘Lower quality’ mid-cap
exposure is concentrated
in financials
Consumer Discretionary
Industrials
Healthcare
Consumer Staples
Information Technology
-15.0%
-10.0%
-5.0%
0.0%
5.0%
% Sector Exposure vs FTSE 250
Source: Morningstar Investment Management calculation at 31/1/17
‘Higher quality’ mid-cap
exposure is concentrated in
industrials
10.0%
15.0%
20.0%
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Looking forwards, not backwards
The question in a forward-looking context is whether the FTSE 250 could be expected to deliver superior
performance going forward.
What we find is a situation that is not so clear cut. While the FTSE 250 has delivered superior earnings
growth over the past 15 years, the fact a large portion of this has been derived by stretching profit
margins is of some concern (especially given the ‘quality’ element is not particularly convincing based
on our initial findings). We also have the issue about Brexit, especially as the pound sterling experiences
abnormal volatility and influences bottom-line earnings.
As only 25-30% of large-cap revenue is derived onshore, a rebound in sterling would hurt the FTSE 100
far more than the FTSE 250, which obtains approximately 50% of its revenue domestically.1 Of course,
the same applies in reverse. In addition, there are concentration issues that must be understood by
investors. As one such example, the top 10 holdings in the FTSE 100 account for approximately 43 per
cent of the exposure versus just 11 per cent for the FTSE 250. Therefore, mid-caps provide greater
diversification benefits at a stock selection level. 2
What lessons can be applied?
To make the analysis simple to absorb, we can boil any outperformance advantage to a few key
variables in a forward-looking context. In order for the FTSE 250 outperformance to be repeatable and
the apparent size premium to be maintained, we would need to see:
a)
Profit margins continue to expand (highly unlikely);
b)
The pound sterling to rebound (potentially likely, albeit with further drawdown risk);
c)
Cyclically-adjusted price-earnings multiples to further expand (unlikely); or
d)
An alternative ‘factor’ influence pricing.
It is worth disclaiming that our team are undertaking further fundamental digging at a sub-industry
group level (for example, mid-cap financials are very different to a large-cap bank), as well as the
continued work around pound sterling valuations amid Brexit. Withstanding the above, the early
evidence is unconvincing that the mid-cap space will continue to act as a superior investment on the
basis of size alone.
1
2
Source: FT Adviser on 16/2/17
Source: FTSE Russell factsheet at 31/1/17
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Fixed Income Valuations
European instability and why inflation is important
Exhibit 7 Valuation-Implied Returns over the next 10-Years (% per year in real terms after inflation). We have
watched the evolution of our return expectations decline markedly in 2016 before improving in recent months.
0.5%
0.0%
U.S.
Treasury
-0.5%
Australian
Treasury
-1.0%
Euro
Treasury
-1.5%
Japan
Treasury
-2.0%
Sterling
Gilts
-2.5%
Return expectations remain negative
across the majority of the
government bond universe, despite
the recent improvement in yields.
-3.0%
-3.5%
Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17
Source: Morningstar Investment Management calculation, at 31/12/16
Regular readers will know that Morningstar have had ongoing concerns about the durability of fixed
income returns for a considerable period, especially among developed world government debt (including
treasuries, gilts, bunds, and so on). Our basis for this has been the rapid deterioration of yields and the
recognition that the downward trajectory was simply unsustainable in a long-term context. We knew it
would require patience, but as long-term valuation-driven investors it was a luxury we could afford to
persist with.
The question that remained among pundits was the catalyst that would be required for a long-term
reversal. For an extended period, we had deflationary threats, continued monetary stimulus and record
low cash rates. These were all conducive to the ‘lower for longer’ rhetoric and kept bonds in favour
among many investors.
Yet, with inflation expectations having shifted and bond yields spiking higher last November/December,
we have witnessed an interesting dynamic that requires global thought.
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So, what can we expect from here? As contrarian investors, is it time to add to government bond
exposures? And if so, which part of the market offers the best prospects?
Any assessment of fixed income markets in a forward-looking context require a knowledge of the likely
moves in inflation, cash rates, yield curve changes and default risks. These components of returns are
fundamental to our thinking.
When viewed in this way it is clear that the key risk to fixed income returns are a normalisation of real
interest rates (after inflation) rather than a sustainable rise in inflation. It is therefore somewhat
surprising that the threat of inflation is garnering more attention in the media and among pundits than
real interest rates. While it is possible that this reflects a lack of fundamental rigor among market
participants, it is more likely to be caused by the ‘availability bias’ - a well-known tendency to focus on
the most discussed drivers of returns and ignore other determinants.
In this case, it is far easier to debate the possibility of a rise in inflation rather than become embroiled in
the rather arcane study of bond mathematics. However, investors must armor themselves against this
bias in order to avoid the trap of forecasting something that is unknowable in nature.
Therefore, a key message is that investors need to focus on empirical data and understand the
components that make up a government bond yield both now and into the future. While sparing readers
of the complexity that underlies our approach to these building blocks, below we depict the net outcome
of our long-term expectations for U.S. treasuries. This acts as a potentially useful proxy for our broad
global government bond assessment, especially given the fact U.S. treasuries make up 35% of the world
government bond index. It also goes some way to explaining our dire return expectations from
developed world government bonds.
Exhibit 8 The evolution of yields have played to the ‘lower for longer’ rhetoric. Looking forward, our analysis shows
the long-term yield could expand (this is subject to ongoing review and may change as our analysis evolves).
16.00
14.00
Our assessment is for bond yields
to rise further from current levels.
This means we continue to lack
conviction in this space.
12.00
10.00
8.00
6.00
4.00
2.00
Source: Morningstar Investment Management calculation at 31/1/17
Jan/2038
Jan/2035
Jan/2032
Jan/2029
Jan/2026
Jan/2023
Jan/2020
Jan/2017
Jan/2014
Jan/2011
Jan/2008
Jan/2005
Jan/2002
Jan/1999
Jan/1996
Jan/1993
Jan/1990
Jan/1987
Jan/1984
Jan/1981
Jan/1978
Jan/1975
Jan/1972
Jan/1969
Jan/1966
Jan/1963
0.00
Jan/1960
% 10-Year Government Bond Yield
18.00
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European political risk and its impact on markets
The United States is not the only market facing political risk. All eyes are now turning to Europe and the
impact of European instability on bond markets. As European markets make up approximately 31% of
the global bond market (37% if we include the U.K.) it is little wonder investors are nervous.3
With Greek debt remarkably high and the relationship with the IMF in flux, the media are having a field
day. There are also key elections in Holland, France and Germany in the coming year (Italy may also
have a general election), all of which is placing the European Union under a considerable amount of
scrutiny. Given this anxiety and a wide range of potential scenarios over the next decade, we believe it
is prudent to maintain an element of conservatism in our calculations. At present, we find a fair yield for
U.S. treasuries is approximately 3.6% in real terms and we have been actively engaging in fundamental
research to determine what the European ‘fair yield’ should be.
What can an investor do to make a risk-adjusted view?
To start this analysis, it is important to reiterate we are not interested in predicting the exact series of
events that would lead to a black swan scenario in Europe. However, we are very interested in what any
trigger event would mean to our fair value calculation and any impairment that could take place.
An example would be Marine Le Pen winning the French elections. What would happen to French bond
yields? Would a credit rating agency downgrade France and other countries in the block? Is the high
existing debt level sustainable under such a scenario? Could we expect inflation to increase further and
would bailouts be required?
These are the types of questions we want to comprehend, and as a means of structuring such analysis
we maintain a fundamental risk scorecard that retains a long-term perspective. The central idea is to
obtain an impartial view of the developments. We do this by actively scoring our fundamental analysis
on both the level and rate of change of factors such as growth, fiscal policy, external accounts, debt
levels, inflation, socioeconomics and other financial vulnerabilities.
This also includes analysis of the country ratings assigned by the prominent rating agencies. Our job is
to avoid the temptation of front-running the rating agencies and instead to comprehend the relationship
between the rating they assign and the spread.
Exhibit 9 Ratings agencies have aggressively reduced the credit outlook among some European exposures in recent
years, especially for Spain, Italy and Greece.
Country Ratings
Standard & Poors
United States
AA+
Stable
Aaa
Stable
AAA
Stable
AA
Negative
Aa1
Negative
AA
Negative
BBB+
Stable
Baa2
Stable
BBB+
Stable
AAA
Stable
Aaa
Stable
AAA
Stable
United Kingdom
Spain
Germany
France
Italy
Greece
Fitch
AA
Stable
Aa2
Stable
AA
Stable
BBB-
Stable
Baa2
Negative
BBB+
Negative
B-
Stable
Caa3
Stable
CCC
N/A
Source: Trading Economics at 31/1/17
3
Moody's
World Government Bond Index factsheet, at 31/1/17
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We find that the ratings assigned at a country level are a useful measure of yield spreads, which help
guide our view on a regional basis. Of interest, we can see the rating for France is considerably higher
than that of Italy and Spain, despite the impending political risks. This feeds our analysis, as we
determine the spreads between these countries and the higher rated sovereigns of the U.S. and
Germany.
As you’ll see in the chart below, there is some dispersion, but generally, there is a good relationship
between credit quality and spread – even when comparing corporates to sovereigns. One point to note
is that this analysis does not consider the difference in maturities of those indexes, which could explain
some of the dispersion.
% Spread
Exhibit 10 The relationship between the credit rating of a country and the spread can be powerful information
when determining the fundamental risk being priced into bond markets.
Ratings and spreads
are closely aligned
across the universe
Source: Morningstar Investment Management calculation at 16/2/17
Where are we putting our fixed income exposure?
To bring it all together, we do not proclaim to have inside or expert knowledge on the longevity of the
European project. We can have personal opinions like everyone else, but these are immaterial to our
thinking at an asset allocation level.
To get around this temptation, we adopt a common language to determine conviction levels on asset
classes. Below are the four pillars we use and our stance between U.S. and European debt:
 Absolute Valuation: Compare valuation-implied return to unconditional fair return – U.S. treasuries
with a low-to-medium conviction versus European treasuries with a low conviction.
 Relative Valuation: Compare valuation-implied returns of an asset class with the opportunity set –
U.S. treasuries with a medium conviction versus European treasuries with a low conviction.
 Contrarian Indicators: Investor positioning, expectations and sentiment – U.S. treasuries with a
low-to-medium conviction versus European Treasuries with a low conviction.
 Fundamental Risk: The monitoring of risk is not designed to be precise or reliant on one particular
metric. We have higher conviction in undervalued assets that should have a limited drawdown
potential – U.S. treasuries and European Treasuries are both mildly concerning and we generally
lack conviction in either market helping to reduce the risk of a permanent loss of capital.
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Currency Valuations
Trump and the US dollar: Where will it go?
Exhibit 11 Valuation-implied returns over the next 10-Years (%per year in real terms after inflation) shows the US
dollar remains expensive.
4.00%
3.00%
US dollar overvalued
2.00%
1.00%
0.00%
-1.00%
-2.00%
US dollar undervalued
-3.00%
South Africa
China
Mexico
Norway
Sweden
Taiwan
Turkey
Malaysia
United Kingdom
Romania
Japan
India
Poland
Colombia
Denmark
Korea
Canada
Hungary
Eurozone
Russia
Czech Republic
Chile
Singapore
Hong Kong SAR
Switzerland
Thailand
Brazil
Peru
Philippines
Australia
Israel
New Zealand
Indonesia
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Source: Morningstar Investment Management calculation, at 31/12/16
Currency markets are incredibly complex at a day-to-day level, although they make far more sense over
long time horizons. The US dollar is an interesting case in point, where Donald Trump is seemingly
having a tantrum about the strength of the US dollar against global peers.
While this short-term noise should be largely ignored (such sentiment comes in waves and will revert to
fundamentals in the long-term) we find Donald Trump’s view of the US dollar opens up a fascinating
conversation around whether it offers protective elements to a portfolio.
Why the US dollar is overvalued
Currency is influenced by countless amounts of factors, but most center on one premise: the purchasing
power differential between one country and another. For this reason, we use a process that analyses
inflation deflators and purchasing price parity (PPP), where we can understand currency valuations in a
long-term context.
We find that on this basis, the US dollar is currently overvalued in a long-term context against 23 of the
33 currencies we measure. This includes the majors such as the pound sterling, euro and the yen. On
face value, this would lead a rational investor to avoid US dollar exposure in many instances.
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Yet, there are two important elements that require further thought. First, a large margin of safety is
required in currency analysis, especially over shorter time periods. Our analysis has found that
drawdown risks tend to be high regardless of the valuation backdrop, which differs greatly from markets
such as equities. The second component, which is far more comprehensible, is the concept of a ‘flight to
safety’. We want to know whether US dollar exposure may help deliver diversification benefits at a
portfolio level, especially if equity markets turn sour.
While these long-term valuation measures (along with the home bias of the investor) are the primary
driver of currency exposure in the portfolios, it is also worth considering the role that currency can play
as a ‘safe haven’ asset during periods of high volatility.
How protective is the US dollar to a portfolio?
Below we look at the 10 worst stock-market crashes over the past 50 years and across three key markets
– European equities, U.K. equities and U.S. equities. The analysis includes the 2008 financial crisis, the
2000 tech wreck, the 1987 flash crash, the 1974 oil embargo and other key events. We can see the
broad reaction from a currency perspective, showing any protection available to an investor.
Exhibit 12 Protection for U.K. investors may be available by holding Swiss francs or US dollars.
1974
2003
2009
1987
1981
1990
1994
1978
2015
1998
80.00%
Currency protection
is inconsistent
% Return (peak to trough)
60.00%
40.00%
20.00%
0.00%
-20.00%
-13.96%
-12.72%
-10.15%
-9.18%
-8.02%
-7.76%
-27.27%
-40.00%
-39.77%
-38.44%
-60.00%
-80.00%
-65.95%
MSCI United Kingdom NR
US Dollar
Swiss Franc
Yen
Euro
Source: Morningstar Direct, Morningstar Investment Management calculation at 31/12/16
Exhibit 13 Protection for European investors is often limited and inconsistent in practice.
2003
2009
1974
1988
1990
1998
1995
2016
40%
Same inconsistency
applies in Europe
30%
% Return (peak to trough)
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
MSCI Europe Ex UK GR USD
US Dollar
Swiss Franc
Source: Morningstar Direct, Morningstar Investment Management calculation at 31/12/16
Yen
Pound Sterling
1997
1981
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Exhibit 14 Protection for U.S. investors is very difficult as currency volatility can be rampant.
2009
2002
1974
1987
1982
1998
1990
1978
1980
1978
40%
30%
% Return (peak to trough)
20%
10%
0%
-10%
-20%
-30%
Currency protection is a
difficult consideration for
U.S. investors
-40%
-50%
-60%
S&P 500 TR USD
Swiss Franc
Japanese Yen
Euro
Pound Sterling
Source: Morningstar Direct, Morningstar Investment Management calculation at 31/12/16
What can an investor do with this information?
From a portfolio construction perspective, it is important to know your currency exposures. This requires
a fine balance between any conviction in your long-term currency valuation and the protective
properties that the currency may provide.
Based on historical crises, we can see the Swiss franc has been an effective diversifier in most
instances, however the US dollar is less convincing.
How this transpires into the future will be interesting to see. We have the so-called trifecta of a strong
economy, strong stimulus and strong corporate earnings – all lifting sentiment for U.S. denominated
assets and the US dollar. However, these factors may well prove to be cyclical, meaning we could see a
rapid reversal of both the positive sentiment towards both the US dollar and potentially even U.S.
equities. This current short-term positioning is noted below, and is worthwhile monitoring as a
contrarian indicator.
Exhibit 15 Currency sentiment of the majors vs US dollar. From a sentiment perspective, we can see the US dollar
has a net long position in place, while the positioning against the euro intensifies.
Currency Sentiment: Majors vs USD
EUR
JPY
GBP
CHF
CAD
AUD
MXN
NZD
USD
European euro
Japanese yen
British pound sterling
Swiss frank
Canadian dollar
Australian dollar
Mexican peso
New Zealand dollar
US dollar
Long Positions
Short Positions
Percentile
Percentile
($Bil)
($Bil)
16.9
89.0
22.9
31.6
2.9
25.1
9.0
49.0
3.0
6.4
8.0
78.7
0.9
10.9
2.7
58.0
3.5
89.0
2.8
26.4
5.1
75.4
3.8
40.6
0.8
38.0
2.2
58.7
2.5
98.0
2.4
92.2
53.9
40.6
35.5
58.0
Source: Commitment of Traders Report, Goldman Sachs, at 10/02/17
There is positive sentiment
towards the US dollar
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Fundamental Considerations
Rebalancing and value traps: care is required
Even if an investor has the perfect valuation-driven asset allocation model, there is still scope for error
when it comes to execution. One of the key elements that any investor must consider when managing a
portfolio is when and how frequently to ‘re-balance’ back to ‘target’ weights. While this subject is both
important and hotly debated, we have found no academic work to support the view that there is an
optimum rebalancing period. Therefore, while we remain open to the discovery of a reliable systematic
approach to rebalancing, we believe that rebalancing requires significant thought and a best execution
policy should be open to change.
Rebalancing principles and Warren Buffett
The key element of a diversified portfolio is the fact that asset prices move in different directions,
especially when allocating between negatively correlated assets such as equities and bonds. This aspect
of capital markets can help reduce the volatility of a portfolio that is broadly spread across asset classes,
although does reduce our exposure to our best ideas. By virtue, this can lead to a misalignment between
the desired asset allocation and reality.
Rebalancing is therefore an essential part of a valuation-driven philosophy. Left unchecked, our
exposures will not resemble our best ideas. Yet, executed too aggressively or regularly and we expose
the portfolio to unnecessary turnover (taxes and fees) and the potential for drag. We have witnessed
this in practice, with Warren Buffett a master but countless others failing miserably as they seek to topup positions that are in structural decline.
Exhibit 16 The relationship between price and fair value is the principle that guides valuation-driven investing.
However, it does open potential issues regarding value traps.
Source: Morningstar Investment Management
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‘Averaging down’ is simple but not easy
The subject of averaging down is one of the biggest challenges for valuation-driven investors to tackle.
In essence, it is the art of obtaining the lowest cost base possible. For example, say an investor buys an
asset today and it falls by 40% tomorrow. Should they buy more of it?
For value investors, the general wisdom is that you should definitely buy more so long as their conviction
in the long-term fair value of the asset remains. It was this exact concept that Warren Buffett referred to
when he famously said, “Whether we're talking about socks or stocks, I like buying quality merchandise
when it is marked down”.4
If you must be early, make sure it is right
The key challenge is that ‘early’ and ‘wrong’ are often indistinguishable in the initial stages of a
valuation-driven investment. An investor who is ‘early’ should increase their capital commitment as the
probability-adjusted gain increases (much like a poker player should). However, if that investment is
‘wrong’, they should accept their losses and move on. This is what we tend to call value traps and are
the nemesis of an auto-rebalancing policy.
At this point, it is worthwhile reminding that as a valuation-driven investor, you conform to the basic
principle that you might be early to the party. After all, you are buying an investment today because it is
cheap and no one else wants it (yet). By undertaking this exercise, there are no guarantees someone
will want it next week, month or even year. Hence the reason value investors often emphasise the word
‘patience’.
Value traps are dangerous but potentially identifiable
As an example of a rebalancing policy gone wrong, many investors in the 1990’s never anticipated the
progression of digital cameras, nor that Kodak would be left behind in that progression. By buying into
Kodak in 1997, 1999 or 2001, they would have experienced a value trap first hand.
Exhibit 17 A classic value trap was Kodak. After an extended period of price gains, it famously collapsed as the
industry evolved.
Value traps are dangerous
when rebalancing
Stock Price (US dollars)
Source: Google Finance
The problem is that Kodak was in structural decline, but very few understood that at the time, and a
fixed rebalancing policy would have led investors to continually bid up this exposure only to find it halve,
halve and halve again. In the case of Kodak, an auto-rebalancing policy would be a terrible idea.
4
Source: Berkshire Hathaway 2008 Shareholder letter
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What can an investor do to avoid value-traps?
The process of identifying these value traps is beset with behavioural challenges and something every
value investor can do better. They tend to cluster under the following situations:
 Leveraged businesses that succumb to debt constraints. Every time the investment falls in price,
the debt as a percentage of the investment rises. This can cause a perfectly good business to be a
value trap based on a poor capital structure alone.
 Business with poor cashflow management. Fundamental analysis should usually help an investor
avoid such a circumstance, however if a Board decides to undertake a monumental capital
expenditure program when they don’t have the cashflow to support it, they risk destroying the
value of the business.
 Situations undergoing structural change. This is the most common at an asset class level, which
can evolve via comprehendible means (an ageing population or industry in structural decline) or
via rapid disruption that is less probable (wiped out via technological advancements).
Of the major behavioural deficiencies we experience, the most important for value trap identification are
likely to be the endowment effect and overconfidence. Specifically, investors tend to overvalue what
they already have and this often skews their assessment of the resulting news flow. This is often due to
over-confidence in the original buying decision and therefore less likely to change our assessment of fair
value as it evolves. Said simply, we seek confirmatory evidence to support our view that something is
cheap.
However, we must also be aware of the availability bias that tends to lead humans to extrapolate
current trends. The more an asset price falls, the more likely we are to sell. Therefore, the worst
situations occur when an impatient investor aggressively adds to a position in the early stages of a
decline and then loses confidence at the lowest point, maximising the permanent loss of capital.
Said simply, the endowment effect can be damaging as we view fair value, while the availability bias
causes us to ignore any fair value calculation. Both biases must be controlled if an investor wants to
successfully and consistently identify value traps.
Bringing this into a rebalancing policy
The major lesson from the above is that an auto-rebalance policy can be a potentially dangerous policy.
It is what we would consider ‘lazy’ portfolio management as it leaves end-investors open to significant
transaction costs as well as value traps.
Therefore, given these weaknesses, we believe portfolios should not be subject to rebalance schedule
as such. Instead, portfolio managers should be provided with the tools and accountability to monitor
portfolios continuously and have any rebalancing decisions formally challenged by a Portfolio
Committee.
This review should include both quantitative and qualitative assessments of the portfolio to make sure it
continues to reflect the best thinking and avoid unnecessary turnover. Investing is all about harnessing
the long-term power of compounding.
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To bring this to life, we consider rebalancing using the following considerations:
 Look at performance through the lens of fundamentally expected returns rather than recent past
performance. Consequently, a price fall appears as an improvement. This engenders a probabilistic
approach to capital allocation and encourages averaging down.
 Actively seek contrarian positions by treating an asset class and its popularity as a negative
relationship.
 Undertake deep fundamental research in an attempt to identify potential value traps and avoid
them.
 Peer review all convictions and investment decisions to try to avoid confirmatory bias. A Portfolio
Committee, in particular, is designed to pick holes in a proposal rather than provide a balanced
assessment.
 Focus on long term performance to reduce any focus on short term returns and consequently
enable patience as one can hold positions that are moving against them.
 Have formal and informal limits on the maximum amount of capital one can commit to positions in
order to reduce the impact of errors.
 Undertake quarterly portfolio reviews to identify instances of the endowment effect.
 Mock those that make forecasts.
Portfolio Alignment in a Managed Portfolio Context
The final point we would make on rebalancing is in a managed portfolio context. As visibility of
underlying clients’ actual portfolios can often be unknown, drift must be measured at the model
portfolio level.
The drawback of this approach is that it is grounded on the assumption that all investors were invested
at the last rebalancing point. In reality, new clients are regularly joining the portfolio management
service and consequently the actual drift they experience may be different from the model. This is
especially true when clients join the service during periods of high asset price volatility.
In order to address this misalignment, we believe the entirety of a portfolio should undergo rebalancing
when portfolio changes are made, whilst maintaining an ambition to keep costs as low as possible. We
believe that this balances the interests of both new and existing investors with the underlying objective
of the portfolio.
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Fundamental Risk
What happens to markets during a War?
As a part of our structured learning program, Morningstar have a monthly book club that explores topics
that both support and challenge our asset allocation thinking. For February, the book was ‘Common
Stocks and Uncommon Profits’, written in 1958 by Phil Fisher, which is a classic among qualitative and
quality-focused investors. One question that arose in our review of the book was the concept of conflict
(such as wars) and how markets react under the prevailing uncertainty.
While we are not in the business of predicting macro events, we appreciate that many investors are
concerned about the rising geopolitical conflict and would like to understand what this might mean to
equity markets.
While it is practically impossible to determine in a forward-looking context, we can explore what
historically occurred in the U.S. during the two World Wars (highlighting changes to dividends, earnings
and market prices) as well as U.K. equity performance during the French revolution.
World War One
World War One
S&P 500
Dividends
Earnings
Bond Yields
Inflation
3%
28%
75%
7%
65%
Change from 1914 - 1918
Exhibit 18 World War One experienced a strong wave of earnings growth followed by a reversal as the war
progressed. Overall, the market saw a subtle gain despite an 11% drawdown in 1917.
S&P 500
Dividend
Earnings
3.00
2.50
Normalised at 1
2.00
1.50
1.00
0.50
11% maximum drawdown
Source: Morningstar Investment Management calculation at 31/12/16
Sep/18
Jun/18
Mar/18
Dec/17
Sep/17
Jun/17
Mar/17
Dec/16
Sep/16
Jun/16
Mar/16
Dec/15
Sep/15
Jun/15
Mar/15
Dec/14
0.00
Sep/14
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World War Two
World War Two
S&P 500
Dividends
Earnings
Bond Yields
Inflation
29%
19%
25%
0%
31%
Change from 1939 - 1945
Exhibit 19 World War Two saw a rather significant 32% drawdown between 1939 and 1942. However, as the war
progressed, prices rebounded strongly.
S&P 500
Dividend
Earnings
1.70
Normalised at 1
1.50
1.30
1.10
0.90
0.70
32% maximum drawdown
Jun/45
Dec/44
Mar/45
Jun/44
Sep/44
Mar/44
Sep/43
Dec/43
Jun/43
Dec/42
Mar/43
Jun/42
Sep/42
Mar/42
Sep/41
Dec/41
Jun/41
Dec/40
Mar/41
Jun/40
Sep/40
Mar/40
Sep/39
Dec/39
0.50
Source: Morningstar Investment Management calculation at 31/12/16
French Revolution – 1789 to 1799 (U.K. equities)
Exhibit 20 The French revolution carried strong market momentum, before experiencing a significant 40%
drawdown between 1792 and 1798. However, a strong recovery helped pull the market back into positive territory.
4.0
French Revolution
commencement
Index level £
3.5
3.0
40% maximum drawdown
2.5
2.0
Sep/99
Dec/98
Mar/98
Jun/97
Sep/96
Dec/95
Mar/95
Jun/94
Sep/93
Dec/92
Jun/91
Mar/92
Sep/90
Dec/89
Jun/88
Source: Morningstar Investment Management calculation at 31/12/16
Mar/89
Sep/87
Dec/86
Mar/86
Jun/85
Sep/84
Dec/83
Mar/83
Jun/82
Sep/81
Dec/80
Mar/80
1.5
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Lessons from conflict periods
We are reluctant to draw too many conclusions from the analysis; however, one clear insight is that
equity markets do not automatically crash as many would assume. In fact, in all three periods, equities
actually rose modestly through the entirety of the period, despite large drawdowns occurring at some
point through the conflict.
There appear to be valuation considerations at play in this analysis too, which could have an effect. For
instance, during world war one the cyclically-adjusted price-earnings ratio (CAPE10) was 10.5x and
ended at 6.3x (normal P/E went from 13.8x to 8.0x), which would be considered a bargain by today’s
standards. During world war two, we saw a similar development as the CAPE went from 15.1x to finish
at 12.9x (normal P/E went from 14.6x to 14.8x), again very low by today’s standard.5
Therefore, the key takeaway is to ignore the temptation to forecast and instead focus on the
fundamentals of underlying investments. While we have seen large drawdowns in each of the major
historical conflicts, the net result is that markets eventually follow the fundamental drivers.
5
Source: Robert Shiller’s publicly available data via Yale University portal
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Investor Behaviour
Focus on focus: activating the prefrontal cortex
Quite possibly the most famous quote of the past 15 years on investing is “be fearful when others are
greedy and greedy only when others are fearful”6. Of course, this was written by Warren Buffett as a
way of demonstrating his contrarian behavioural philosophy, yet most investors can attest to the
difficulty of implementing his wisdom.
In the ups and downs of life, people are often required to face complex financial decisions – whether
they should save, spend or invest at a simplistic level - and the final decision is heavily influenced by
risk, probability, prior experience and social interactions. This often leads to gut reactions and the ‘F’
word (‘feeling’), which are common emotional responses among individuals trying to understand the
best way forward. The question we pose is whether it is right to trust your gut? What can we do to
make better decisions? For this, we can draw on some lessons from high performance training and
neuroscience.
High Performance Training is Teaching us the Wrong Things
We are usually taught that the learning cycle follows a simple trajectory, whereby time and performance
are positively correlated.
Exhibit 21 The relationship between time and performance is generally seen to be positive. However, for investors,
there is a subtlety that should make us favour ‘conscious competence’ as opposed to ‘unconscious competence’.
Unconscious
Competence
Conscious
Competence
Performance
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Conscious
Incompetence
An investors sweet spot
Unconscious
Incompetence
Time
Source: Morningstar interpretation of work initially developed by Gordon Training International
6
Source: Berkshire Hathaway 2004 Shareholder letter
An athletes sweet spot
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The typical example is a tennis player. Roger Federer can hit a backhand winner without really thinking
about what he is doing, and this unconscious competence is said to be the elite mode of thinking,
forming the key to peak performance. However, in the investing world, unconscious competence opens
us up to a long list of behavioural deficiencies that can become counterproductive if left uncontrolled. To
understand this further, we explore four sections of the brain, the first two of which are generally good
for investing and the latter two mischievous.
1.
The Rational and Reflective: Prefrontal Cortex
The prefrontal cortex is the most reliable part of our brain and the area we want to reinforce most of our
analytical output – it is known as the brain’s boardroom. It is what helps people think, communicate,
restrain actions, learn from mistakes, control memory and ultimately make rational decisions. It is also
known as the ‘reflective brain’. It has many strengths and has a distinct ability to identify fair offers and
to reject unfair offers.
However, it is not without weaknesses. The prefrontal cortex has a limited capacity, meaning it can only
process a certain amount of information at any one time (recall when you forget someone’s name just
after meeting them). It is also known to prefer instant rewards over future rewards, and is known to
react to fear and greed, albeit in a more controlled manner than in our automated areas of the brain.
2.
The Long-Term Memory: The Hippocampus
We all have a relative or friend that has an exceptional long-term memory. But while their trivia skills
may be the show, it can also help them collect the dough. Successful investing and experience are
considered to be highly correlated, and a strong long-term memory helps provide perspective during the
market cycles and inevitable setbacks. It is also known to change in size depending on how often it is
exercised, so teaching our mind to focus on long-term analysis can potentially help investment
performance.
3.
Irrational Fears: The Amygdala
This section of the brain is responsible for irrational fears such as arachnophobia and can easily
influence illogical decision making. It is the area of the brain that makes contrarian investing so difficult
in practice, even when we know it works in theory. In an investors case, this is usually triggered among
a crisis, creating an overwhelming sense of fear that leads an investor to stray from their preferred
investment style.
4.
Greed is Good: The Nuclei Accumbens
The brain’s reward center is a powerful phenomenon, but tends to have an irrational impact on
investment decision-making. It is the reason the rich want to get richer, even if they have enough money
to comfortably meet their long-term needs. The reason this reward center is so powerful and hard to
control is that it is responsible for feelings of happiness.
Creating a roadmap for behavioural performance
The question is whether a roadmap is possible on the best way to turn on our brains in the right areas
and dull out the prohibitive ones.
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This focus on the conscious makes a lot of sense, and is backed by a healthy and growing amount of
scientific grounding. In this regard, there are a few techniques that can be used effectively, and while
this list is not exhaustive and somewhat theoretical, it should help to identify potential areas to improve
our behavioural biases. As you read this list, we encourage you to think about your behaviour during the
financial crisis and whether you remained disciplined in your analytical thinking throughout.
Lesson 1 – Lifelong learning – London cab drivers are said to have a larger hippocampus (long-term
memory) than an ordinary person, and the size of the hippocampus is highly correlated to the amount of
experience they have. Therefore, if one wants to build on their investment strength, learn as much as
you can about financial market history and the long-term drivers of returns.
Lesson 2 – Make investment decisions when calm – there are many problems with stress and its
impact on performance. Firstly, it is important to minimise unnecessary exposure to fear-related
anxieties via the amygdala. Even in the prefrontal cortex, stress can reduce working memory
performance. Sleep is incredibly important in this regard.
Lesson 3 – Enjoy the process – positive thinking is known to increase activity in the prefrontal cortex.
Therefore, typical exercises such as laughing, expressing gratitude and focusing on positive stories can
supposedly help create the ideal mindset before making investment decisions.
Lesson 4 – Turn on the mind – there are multiple ways to increase dopamine in the prefrontal cortex,
including caffeine. This is known to significantly reduce impulsivity and may help performance.
However, excessive amounts of dopamine are said to destroy blood flow to the prefrontal cortex and can
also create in imbalance in our reward systems.
Lesson 5 – Put yourself in the future – by taking your perspective to a different place, you are forcing
your mind to be reflective. A great question to tackle is something akin to “in 5 years’ time, what would
cause me to sell this investment?”. Once again, this activates the prefrontal cortex.
Lesson 6 – Avoid the drama – gossip and confrontation fire up the amygdala and sends the prefrontal
cortex off course. If it is possible, any negative feedback loops should be held off until the investment
proposal is structured.
Lesson 7 – Write your synopsis on paper and present it - writing words and reading aloud are both
shown to be effective ways to activate the prefrontal cortex, which can promote rational decision
making. A portfolio committee can help manifest this into a sound investment process.
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Summary
Finding purpose in a challenging market
We certainly live in interesting times. While the world order appears to be potentially in jeopardy, equity
markets continue their upward trail. If only the fundamentals were supportive of such strong moves. As
we reflect on the state of markets, we advocate that investors decouple their thoughts about the state
of the U.S. political/economic landscape and instead direct more of their attention on portfolio
fundamentals.
We continue to believe many of the global markets are overvalued relative to their long-term fair value,
although selective pockets of opportunity endure.
By understanding our behavioural idiosyncrasies as well as the relationship between the underlying
exposures of equities, fixed income and currency, it is our hope we can preserve capital when we need
to most while maximising the risk-adjusted return. It is this adherence to a pragmatic process that will
help us navigate any macroeconomic setbacks on the horizon and meet the needs of our end-investors.
"The noblest question in the world is ‘What good may I do in it’?"
-
7
Benjamin Franklin7
Memoirs of the life and writings of Benjamin Franklin, written by himself in 1818
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About Morningstar Investment Management Europe
Drawing on our core capabilities in asset allocation, manager research and portfolio construction,
Morningstar Investment Management Europe Limited creates customised investment solutions to help
financial institutions meet investor needs. We have both a global point of view and local market
expertise, delivered through an international network of experienced investment professionals who
specialise in serving regional markets.
When building investment offerings, we benefit from access to quality information from one of the
largest investment databases, as well as patented methodologies, intuitive technologies and decades of
ground breaking research. Our independence and strong investor focus allow us to develop solutions
that help clients stand out within their markets. Our clients include many of the top wealth management
firms, insurance companies, banks, asset managers, and retirement plan providers.
Our investment processes incorporate the rich heritage of Ibbotson Associates, a leading independent
asset allocation provider offering investment advisory services, retirement advice programs, and
customised research. Ibbotson applies academic research to create real-world solutions for financial
institutions. Ibbotson was founded in 1977 and is a Morningstar company.
Disclosures
The information contained in this document is the proprietary material of Morningstar Investment
Management. Reproduction, transcription, or other use, by any means, in whole or in part, without the
prior written consent of Morningstar Investment Management, is prohibited.
The information, data, analyses and opinions presented herein do not constitute investment advice; are
provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are
not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and
are subject to change without notice. Except as otherwise required by law, Morningstar Investment
Management shall not be responsible for any trading decisions, damages or other losses resulting from,
or related to, the information, data, analyses or opinions or their use. This document contains certain
forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”,
“forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking
statements involve known and unknown risks, uncertainties and other factors which may cause the actual
results to differ materially and/or substantially from any future results, performance or achievements
expressed or implied by those projected in the forward-looking statements for any reason. Past
performance does not guarantee future results. The value of investments can go down as well as up and
an investor may not get back the amount invested.
Feedback
This report is the collective effort of numerous contributors among the Morningstar Investment
Management global team. Below are the personnel that are available for comment:
Scott Dixon
Dan Kemp
Investment Communications EMEA
Chief Investment Officer EMEA
[email protected]
[email protected]
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