Valuation-driven Asset Allocation

Transcription

1 Valuation-driven Asset Allocation Chris Galloway, CFA Managing Director Morningstar Investment Management Asia Limited 2014 Morningstar, Inc. All rights reserved.

2 Outline Valuation-driven investing Historic asset class returns Asset class valuations Advantages of long-term investors Valuation-driven asset allocation simulation Uncertainty and career risk Summary and questions 2

3 Defining Valuation-driven Investing Value Investing From The Greats What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labelled speculation (which is neither illegal, immoral nor - in our view - financially fattening). Warren Buffett All intelligent investing is value investing acquiring more that you are paying for. You must value the business in order to value the stock." Charlie Munger There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. Seth Klarman 3

4 Long-term Equity, Bond and Cash Real Returns Source: Dimson, Marsh and Staunton Global Investment Returns Database. 4

5 Average Long-term Equity, Bond and Cash Real Returns Source: Dimson, Marsh and Staunton Global Investment Returns Database. 5

6 US Cyclically-adjusted Price Earnings Ratio (CAPE) Source: Shiller, Morningstar 6

7 US CAPE and 10-year Real Returns Source: Shiller, Morningstar 7

8 Valuation Has Driven Returns Around the World 8 Source: DataStream, Bloomberg, Morningstar.

9 And Prospective Losses 9 Source: DataStream, Bloomberg, Morningstar.

10 US 10-year Government Bond Yield Source: Shiller, Morningstar 10

11 Bond Yield and 10-year Returns Source: Shiller, Morningstar 11

12 Bond Yields Heavily Impacted By Inflation Bond Yields More Difficult To Estimate Than Equity Yields Little credence can be attached to what anybody has to say about what the real long-term rate of interest should be, has been, or will be in the future over the long run..investors in the bond market, even with 195 years of history to look back on, can make no statement at all about a basic return; they can make no judgments beyond the duration of the particular instrument they happen to be holding at any given moment. Peter Bernstein Source: What Rate of Return Can You Reasonably Expect.. or What Can the Long Run Tell Us about the Short Run?, Bernstein, P

13 Long-term Investing Advantages Key Advantages of Long-term Approach Time invested to benefit from asset class returns Ability to tolerate short-term fluctuations Provider of liquidity during periods of market stress Investment based on fundamentals Profit from deviations between price and fair value 13

14 How To Determine The Neutral Asset Allocation Ben Graham and Harry Markowitz Policy Portfolio? We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums...sound procedure would call for reducing the common-stock component below 50% when in the judgement of the investor the market level has become dangerously high. Ben Graham Instead, I visualized my grief if the stock market went way up and I wasn't in it -- or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities. Harry Markowitz Source: The Intelligent Investor, Ben Graham 4 th Edition, Jason Zweig, Investing Experts Urge 'Do as I Say, Not as I Do' 14

15 CAPE Based Asset Allocation Strategy Asset Allocation Simulation Framework Estimate Price to Fair Value by dividing current CAPE by average CAPE (cumulative) Average trailing 12-month CAPE/Average to smooth signal 50% equities neutral position, remainder invested in US government bonds Equity position determined by 12-month Price to Fair Value multiplied by 50% Equity position ranges of 0% and max 100% No threshold level or weighting scheme No turnover constraint No trading costs included - remember this is a back-test! 15

16 Comparison of Simulations $2,090 $851 Source: Shiller, SBBI Ibbotson, Morningstar 16

17 Simulated Strategy Annual Turnover Source: Shiller, SBBI Ibbotson, Morningstar 17

18 Simulated Asset Allocation Institutional Impossibility? 51 months Source: Shiller, SBBI Ibbotson, Morningstar 18

19 Agency Risk Not A New Phenomenon Career Risk Inhibits Long-term Investing for Institutions Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. John Maynard Keynes Source: J.M. Keynes The General Theory of Employment, Interest and Monday,

20 Extrapolation Can Be Hazardous To Your Wealth Source: Stats Spotting Roger Lowenstein, When Genius Failed

21 Difference Between Risk and Uncertainty Uncertainty Is A Gamble With An Unknown Probability Distribution By, uncertain knowledge, let me explain, I do not mean merely to distinguish what is known for certain what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. John Maynard Keynes Source: J.M. Keynes The General Theory of Employment, Quarterly Journal of Economics

22 Margin Of Safety and Diversification Manage Risk and Uncertainty With Margin Of Safety Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that the future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time. Ben Graham Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. Ben Graham 22

23 Price to Fair Value Drives Returns and Risk Source: Ibbotson. 23

24 Opportunity Set Varies With Valuation, Impacts Concentration Source: Ibbotson. 24

25 Case Study: GFC US Asset Class Opportunity Set Source: Ibbotson, MSCI, S&P, Barclays, Factset. 25

26 Equity Market Valuations Stretched Source: Ibbotson, MSCI, March

27 High Quality Companies Relatively Attractive S&P High vs. Low Quality Indices, Valuation Ratios S&P High Quality Index S&P Low Quality Index P/E 19.8x 20.4x Dividend Yield 2.00% 1.70% EV/EBITDA 11.6x 12.3x EV/Sales 1.75x 2.12x Source: Marathon Asset Management, March 2015 Source: Marathon Asset Management, March

28 Quality Companies Are Driven By Economic Moats Sustainable competitive advantages that allow a company to generate positive economic profits for the benefit of its owners for an extended period of time. There are five sources of economic moats. Intangible Assets Switching Costs Network Effect Cost Advantage Efficient Scale Wide Narrow None 28

29 Valuation-driven Asset Allocation AAA-rated Government Bond Yields Source: S&P, Moody s, Fitch, Factset as at April

30 Summary and Questions Valuation-driven investing is investing in assets trading at less than their estimated fundamental value Asset class returns positive over the long-term, however lower than most expect Beginning valuations strongly impact future returns and adjusting allocations can improve outcomes Long-term investors have a number of advantages agency risk is the key challenge Instead of forecasting and following the crowd, investors can use valuation and a margin of safety Long-term valuation-driven investing can improve risk-adjusted returns and better aligns to objectives A willingness to be different to the crowd is a necessity but it is not easy 30

31