Asset Allocation vs Stock-Picking March 2011
Agenda 1. How important is asset allocation to total returns? 2. Should asset class weights be fixed or dynamic? 3. How should asset allocation be determined? 4. How does bottom-up stock-picking fit into all of this?
How Important is Asset Allocation? Market Timing Share 1.8% Selection 4.6% Other Factors 2.1% Asset Allocation Policy 91.5% 91.5% of the variation in performance results from asset allocation Source: Financial Analysts Journal
Modern Portfolio Theory Source: Fidelity
Problem 1: Volatility as a Measure of Risk 1. Volatility looks at temporary and permanent fluctuations 2. Volatility treats upwards and downward movements equally 3. When volatility is low, risk is not low it s high 4. When volatility is high, opportunities are created
Volatility as a Measure of Risk: South Africa 38000 JSE All Share Index vs SA Volatility Index (SAVI) High risk or opportunity? 60 55 33000 50 45 28000 40 35 23000 30 25 18000 20 13000 Low risk or trouble ahead? 15 10 Source: Bloomberg JSE All Share Index SAVI
Problem 2: Diversification Is Asymmetrical Modern Portfolio Theory relies on diversification to reduce overall risk by combining assets that are not correlated However, the effects of diversification are not symmetrical When markets are going down, correlations change from negative to positive The more extreme the market event, the higher tendency for correlations to converge to 1
Problem 3: Valuation Indifference 25 JSE All Share Index PE Ratio: 1986-2011 EXPENSIVE ENTRY POINTS 20 15 10 5 0 CHEAP ENTRY POINTS Source: Inet Adjusted JSE All Share Index PE Ration Std Dev below Mean Std Dev Above
Valuations Matter Part I: Looking One Year Out Comparison of 1 Year Forward Returns for JSE All Share Index : 1986-2010 90 Max, 80.3 70 EXPENSIVE ENTRY POINTS % Returns 50 30 10 Mean, 32.6 Mean, 11.5 Max, 40.3-10 Min, -5.6-30 -50 CHEAP ENTRY POINTS PE ratio below 1 std dev Min, -30.0 PE ratio above 1 std dev Source: Inet, RE:CM Analyst
Early Losses Can Be Crippling for Returns 180,000 The Cost of Loss 160,000 140,000 Value of R100,000 Investment 120,000 100,000 80,000 60,000 40,000 30% loss in first year 10 years to catch up! 20,000 - Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 30% loss in first year, 10% gain in every year thereafter 5% return every year Source: Intelligent Investor
Valuations Matter Part II: Looking 5 Years Out 50 45 Comparison of 5 Year Forward Returns (annualised) : 1986-2006 CHEAP ENTRY POINTS EXPENSIVE ENTRY POINTS 40 Max, 36.3 35 % Returns (Annualised) 30 25 20 15 Min, 14.3 Mean, 22.0 Max, 15.2 10 Mean, 10.2 5 Min, 3.5 0 PE ratio below 1 std dev PE ratio above 1 std dev Source: Inet, RE:CM Analyst
Valuations Matter Part III: 5 Years Out in Real Terms Comparison of 5 Year Forward Real Returns (annualised): 1986-2006 45 35 CHEAP ENTRY POINTS EXPENSIVE ENTRY POINTS Max, 29.3 25 % Returns 15 Mean, 8.3 Max, 8.1 5-5 Min, -1.0 Mean, -0.2 Min, -8.0-15 PE ratio below 1 std dev PE ratio above 1 std dev Source: Inet, RE:CM Analyst
Valuations Work Across Asset Classes Source: GMO
Problem 4: It Relies on Historical Inputs Annualised Returns Using Historical Performance Depend on Time Period (%) Lehman Period Aggregate S&P 500 MSCI EAFE MSCI EM-Free Five Years 1991-1995 9.2 15.9 10.5 16.3 1996-2000 6.3 18.3 8.2 0.1 Ten Years 1991-2000 7.7 17.1 9.3 8.2 If portfolio managers cannot have faith in the inputs, how is it possible for them to have faith in the outputs? Source: Datastream
Dynamic Asset Allocation From the Top-Down Source: Inet Forecast Economic Growth Forecast Interest Rates Forecast Sectors that will do well Forecast Earnings for Stocks in Sector 70% Probability X 70% Probability X 70% Probability X 70% Probability = 24% chance of getting it right!
GDP Forecasts Track Each Other Closely 7 GDP Forecasts from US Public and Private Sectors 6 5 4 3 2 1 0 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CBO Forecast Blue Chip Forecast White House Source: CBO Economic Forecasting Record
But Are Not Very Good Predictors of GDP 7 Actual GDP versus Forecasts 6 5 4 3 2 1 0 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Actual CBO Forecast Blue Chip Forecast White House Source: CBO Economic Forecasting Record
SA Earnings Forecasts Are Not Much Better 60% SA Earnings Forecasts vs Actual 50% 40% 30% 20% 10% 0% -10% -20% -30% Feb-93 Feb-94 Feb-95 Feb-96 Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 SA MSCI, Consensus 12m Fwd Growth SA MSCI, Realised Source: UBS
The List of Evidence Against Forecasting Goes On Consensus economists have failed to predict any of the last four recessions even while in them! Analysts forecasting company s earnings 2 years prior to the actual event are wrong by 94%. 12 months prior? 45% In 2008, analysts in the US forecasted 24% increase in prices, yet stocks fell by almost 40%. Between 2000 and 2008, analysts didn t even manage to get the direction of change in prices right in 4 out of the 9 years. Source: GMO
100% Forecast Success Rate Luck or Skill? Source: BBC
Top 5 Excuses for Incorrect Forecasts 1. The If only defense 2. The ceteris paribus defense 3. The I was almost right defense 4. The It just hasn t happened yet defense 5. The Single prediction defense Source: Tetlock 2003
The New Normal: Flatter with Fatter Tails THEN NOW Greater uncertainty means forecasting will be even more difficult Source: PIMCO
Bottom-up Approach to Asset Allocation 1. Focus on protecting capital first, then growing it 2. Assess each investment idea on a case-by-case basis 3. Start with the equity market the best generator of real returns 4. Buy undervalued assets and sell overvalued assets 5. Defer to cash in the absence of sufficient ideas deferred alpha
Bottom-up Case Study: Sun International Quality Company Barriers to entry are high Sustainable competitive advantage Has earned excess returns, grown intrinsic value over time Cheap Market price more than 30% less than intrinsic value Replacement cost is double market capitalisation Popularity Under(over)valued when operating margins low(high) Cycle Household credit growth at low 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Sun International Total Return Relative to All Share 1995 1996 1996 1997 1997 1998 1998 1999 1999 2000 2000 2001 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 Household Credit Growth Sun International Total Return Relative to All Share Index Operating Profit Margin vs Popularity Average 60 36.0 3.0 50 32.0 2.5 40 28.0 2.0 30 24.0 1.5 20 20.0 1.0 10 16.0 0.5 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 24 Household Credit Growth 2006 2007 2008 2009 2010 12.0 2000 2001 2002 2003 2004 2004 2005 2006 2007 2008 2009 2010 Operating Profit Margin Popularity: Price / Earnings Relative to FTSE/JSE All Share Index 0.0
Bottom-up Asset Allocation: Does it work? 100.0 RE:CM Global Fund Equity Allocation versus MSCI World Index 150 90.0 130 % Equity Allocation 80.0 70.0 60.0 110 90 70 Total Return of Index 50.0 50 40.0 30 Equity MSCI Index Source: Datastream, RE:CM Analyst
Bottom-up Asset Allocation: Does it work? 340 RE:CM Global Flexible Fund vs All Asset Allocation Unit Trust Index 290 240 190 140 90 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 All Asset Allocation Index RE CM Global Flexible Fund Source: Datastream, RE:CM Analyst
Summary 1. Asset allocation matters a great deal to returns 2. Valuations matter even more 3. Real returns should be maximised, risk of capital loss minimised 4. A bottom-up, value-driven asset allocation process does both well
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