Investing compass: How big should your slice of American pie be?
In a listener requested episode we explore whether valuations should impact asset allocation decisions
Shani Jayamanne: Hi, and welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
Mark Lamonica: Okay. So, Shani, right before this thing started, is actively trying to get rid of me.
Lamonica: She told me that I needed to retire.
Jayamanne: I did not say that. I said, have you thought about it, because you had a lot of things, a lot of challenges with work recently. Can we say that?
Lamonica: Yes, and I'm adding you to the list.
Jayamanne: And I said, if I were you, I would just consider retiring.
Lamonica: So, yeah, Shani is trying to get rid of me.
Lamonica: And I said, wouldn't you be upset if you didn't get to see me at work? And she's like, not at all.
Jayamanne: That part of the conversation definitely didn't happen. But anyway…
Lamonica: Anyway. Well, Shani, while I'm still here, we have reached a bit of an inflection point with the podcast. So, we recently doubled the number of voice messages that we have received. And I don't know – I think this is a big accomplishment. Can you believe it?
Jayamanne: I mean, we doubled our voice messages to two, Mark. So, yeah, but two is definitely more than one.
Lamonica: You know, a win is a win, Shani. And after the last couple of weeks we're looking for wins here, right?
Lamonica: So, if we get a third voicemail message, Shani – so, we doubled them, right – if we get a third voicemail message, you know, that is only a 50% increase.
Jayamanne: Yeah, I do know that, Mark.
Lamonica: Yeah. Well, Shani, this is an investing lesson, right? So, this is the power of compounding. Because the absolute amount of the gain is the same, right? One more voicemail. But it took a smaller percentage gain to get there. And that, Shani, is why the first million is the hardest and each subsequent million is easier.
Jayamanne: I'm glad you were able to use (a laughable) show of voicemail messages and turn it into an investing lesson.
Lamonica: Yeah. Well, okay.
Jayamanne: It's a skill.
Lamonica: Yeah, but this is a better introduction than your dog peeing on me.
Jayamanne: Yeah, we've done that twice now, and I think that's twice too many. So, let's steer away from that topic.
Lamonica: Okay. Well, the other place that we're getting an inflection point is we're now getting more recommendations for podcast topics, which of course is nice because we don't have to think of new ideas. So, our second voicemail message was from Will in Brisbane. And once again through the magic of Will's editing we will now play Will's messages – or two Wills – one Will from Brisbane, one Will right here in Sydney. So, we will have our second official guest on Investing Compass.
Will: Hi, Mark and Shani, thanks very much for your podcast. My name is Will from Brisbane. My question is, what role should valuation measures such as the CAPE ratio or P/E ratio play in portfolio construction? So, for example, would it be justified to allocate more to non-U.S. shares on the basis that they appear to be cheaper compared to U.S. shares at the moment?
Jayamanne: Will also followed up his voicemail with an e-mail. He said, I'm interested in the role you think valuation metrics should play in portfolio construction, particularly when choosing shares. I know you both have spoken about valuation a bit, but what role should CAPE or P/E ratios or other valuation metrics play in deciding which shares to allocate to? My interest in this has to do with allocating to broad markets funds rather than individual stock picking. So, for example, many ETFs or managed funds have a large weighting to U.S shares on the basis that they comprise a larger percentage of overall market cap. For example, the Vanguard International Shares Fund has over 70% in U.S. shares, but on CAPE and P/E metrics the U.S. market is much more expensive than non-U.S. markets at present. Would it be justified on this basis to tilt towards non-U.S. shares or to allocate to so-called value stock funds?
Lamonica: Yeah, and I think it's a great question. And I also like that he left a voice message and then sent an e-mail. So, it's like, I don't know if…
Jayamanne: Covering all bases.
Lamonica: …I don't know if he trusted the voicemail message. Like, my mother does that to me, or she used to. I think she is better now. But she would send me an email and then she would send me a WhatsApp message saying did you get my email, like trying to get as many different things through as once.
Anyway. I think it's a great question from Will. There's lots of great points we can talk about. So, let's get started with a couple of observations and then we can get into the meat of the question.
Jayamanne: The first great point is that Will is actually taking the time to understand what is in the ETFs that he is considering. We're huge advocates of this because the name on an ETF is not necessarily indicative of what is in it. For instance, I don't think many people would suspect that an ETF named the Vanguard International Shares ETF with the ticker symbol VGS would contain a 70% allocation to the U.S. The next four largest country exposures of Japan, the U.K., Canada and Switzerland have a close to 20% allocation, which leaves around 10% of the ETF invested in the other 46 countries.
Lamonica: Yes, that does not seem very international. Now, none of this, of course, is Vanguard's fault because they are simply following an index and a very well-known index. But this is another reminder to always check what exposures you were getting with ETFs and funds that you were investing in. But this is also another opportunity to talk about how market cap weighted indexes work.
Jayamanne: A market cap weighted index means that the larger the company, the more they make up of an index. And in this case, the companies in the U.S. are worth 70% of the total value of all companies in the index. And this is where it is important to, again, remind people that when we say largest companies from an investing point of view, we're simply referring to how much the company is worth. It doesn't mean they are the largest in terms of revenue or earnings or employees or any other metric – just worth more.
Lamonica: Now, that's a good point, Shani.
Jayamanne: Yeah. And how much a company is worth is determined by multiplying the number of shares outstanding by the share price, which makes sense, because if you want to buy the whole company, you would simply have to buy all the shares and that is how much you would have to spend.
Lamonica: So, it should seem obvious that if a share price goes up, it makes the company worth more, and if it's worth more, then it makes up a larger part of the index, which incidentally means that anyone buying the index would buy more of that company, which would again make it worth more. So, this cycle continues, Shani.
Jayamanne: And if we go back the last 10 years, the U.S. share market has significantly outperformed other markets, which has increased its share of the overall index. And as Will pointed out in his question, if share prices go up faster than fundamentals, the valuation levels will go up and valuation levels matter when we look at future returns.
Lamonica: And this can cause problems. So, we're going to get a time machine, Shani. So, watch out. We're going back to 1999.
Jayamanne: What were you doing in 1999?
Lamonica: I was in uni. I was in uni in 1999. And yes, Shani, you were six. I get it. This is why you want to send me out to the pasture to retire. But anyway. If we go back to 1999, if you look at the three biggest companies in the world in 1999, it was Microsoft, General Electric and Cisco. Now, of course, this was the dotcom bubble when anything associated with the Internet was doing very well, and that certainly included Microsoft and Cisco. So, we'll skip General Electric for the purposes of this exercise, even though that company has basically imploded since the late 2000s. So, tell me about Microsoft and Cisco, Shani.
Jayamanne: Well, first of all, they are both still very large companies and have overall done well. So, they aren't exactly the Pets.com type of company that is famous for going out of business. But if we dig a bit into their history, we can start to see some problems. Let's start with Cisco. Cisco made US$2.55 billion in profit in 1999. That sounds pretty good. But as the third largest company in the world, it was trading at a market cap of $357 billion. That means the price to earnings ratio was 140 times earnings, which is a lot.
Lamonica: That is a lot, Shani. So, let's look at what happened to Cisco since then. We go back to the last day of 1999 and look at Cisco's returns through early August 2022, so 22 years and more, the share price is down 16%. And incidentally, the share price didn't peak until March of 2000. So, when we're looking at the end of 1999, we're not even at the peak. Now, during that time, 1999 to 2022, earnings grew from US$2.55 billion to US$10.6 billion. And that's pretty good. That's around 6.7% annually, way faster than GDP growth. The problem, of course, is that the valuation level went from roughly 140 times earnings to just under 16 times earnings.
Jayamanne: Let's go quickly through the same exercise with Microsoft. Now, Microsoft has done much better. It's up 380% since the last day of 1999, and that is mostly because of the run it has been on lately. But for a long time, it wasn't doing so hot. In fact, it took until 2015 for Microsoft to match that 1999 high, and that once again is because it was trading for a really high valuation level. The fact that Microsoft was flat when the overall S&P 500 was up 50% in 2015 meant it was a huge drag on the index.
Lamonica: So, the point of this whole exercise is to say valuations matter, and when really large companies or countries make up a huge amount of an index and they do so because of their valuation levels, it can be a drag going forward on the overall index if those valuation levels come back to earth, and we saw this with the S&P 500 during that last decade of the 2000s. The index returned 1.4% over that decade, and that is not per year, that is the whole decade, and a lot of that was because these huge companies with these sky-high valuation levels dragged the index down. If you invested in an equal-weighted S&P 500 index where every company gets an equal amount of money, your return would have been 6.3% a year over that decade. That's a huge difference.
Jayamanne: But the question was, what role should valuation levels play with asset allocation? And we want to introduce two concepts here that will hopefully contribute to Will and everybody else's thinking.
When looking at valuation levels, whether that is the CAPE ratio or the P/E ratio, we need to be cognizant that the number by itself means nothing. We need to compare those valuation levels to something else, and that could be comparing one company to another, one country to another, or one time period to another.
Lamonica: And that is why they are called relative valuation measures. We can make statements like the market is expensive relative to history, or that this country is expensive relative to this country. Now, the kicker here is that we have to assess if that difference is justified, and that is where the tricky part comes in, because ultimately, it's a judgement call. So, normally, I look at Robert Shiller's own data on CAPE ratios for the U.S., which is what I often cite in the podcast. In this case, we need comparison. So, I went to a website that showed CAPE ratios for countries on June 30, 2020. So, it's a little bit dated. The U.S. had the highest at a little more than 29. India was second with a CAPE ratio of 23.29. Now, the question, of course, here is does the U.S. warrant that premium when compared to India?
Jayamanne: And that is for everyone to decide on their own when making decisions about where to allocate their portfolio. And it is complicated. We need to assess the business climate in a particular country, which includes looking at tax levels, capital markets and the ability to raise funding through them, the ability to hire new talent and how the legal system impacts the ability to run a company. What makes this even harder is that we need to do this in a global world where many of the largest companies that make up a meaningful part of these indexes are global in nature and operate all over the world, which exposes them to the legal system, tax, capital markets and local talent in every country they operate.
Lamonica: But I think it's even more important than doing this assessment is the fact that different countries tend to produce different types of companies. So, the exchange the company trades on really doesn't matter if they are large and multinational, and we see this in Australia. So, BHP makes up 10.5% of the ASX 300. Now, BHP sells an insignificant amount of what they mine to Australia. Almost all of their revenue comes from global markets, and 65% of their revenue comes from China. So, while Australia has a lot of natural resources and naturally develops a lot of mining companies and of course, the expertise that goes with it, there really isn't any domestic market for any of the stuff that's mined.
Jayamanne: The other thing that Australia produces a lot of is large banks. But in this case, these large banks are not global leaders, but simply have divided the Australian domestic banking market up between fewer firms than a lot of other countries allowed to happen.
Lamonica: The U.S. produces a lot of tech companies, and the reason that this happens is of course complicated, but likely has to do with a robust venture capital system, world-class universities that focus on technology-related education, a traditional embrace of immigration and an entrepreneurial spirit. If you're an investor in technology, you are going to own U.S. companies and likely be overexposed to U.S. companies. These tech leaders just don't really exist in other parts of the world.
Jayamanne: So, overall, we would say this is complicated and there are a lot of moving parts. When building a global portfolio, you need exposure over the long term to the U.S., and you need a lot of exposure. You need that exposure because the U.S. is still the world's largest economy and because the U.S. has produced leaders in many different industries, but particularly in the technology space.
Lamonica: But if we look right now at where we stay on the U.S. is very expensive. While it has come down slightly in valuation levels this year with the drop, it is still historically expensive. And as we saw in 2000, that can lead to lower future returns. In fact, if you look at Morningstar's estimation of forward returns in global equities, they clock in at 6.75% per year versus 7.9% in Aussie equities. And the reason for that is simple – valuation matters. And the huge run the U.S. has been on when it has outpaced most global markets, that's made it really expensive. And as Will pointed out, when we look at global markets, we are talking mostly about the U.S.
Jayamanne: There is no right answer in investing except when we look at the past. Nobody knows what the future holds. We've tried to make three points during this episode.
The first is that using relative valuation measures means an assessment of why there are differences in valuation and the acceptance that there are always going to be differences in valuation levels. Given that the U.S. indexes are dominated by growth companies like tech, and the Australian indexes are dominated by value companies like banks and miners, the U.S. is probably always going to be trading at a premium. Assessing the relative opportunity is your job as an investor.
Lamonica: The second point we've tried to make is that valuation levels matter and will impact future returns. That is why, given my own personal situation, I've got a good amount in cash. Third point is that some countries are going to develop different homegrown industries even when those companies become multinationals. That is going to lead to concentration in local indexes of certain sectors.
Jayamanne: And everyone's situation is different, but I think a reasonable investor can do the following if taking an active approach to asset allocation. And we should note that many people decide they don't want to do that, given all the complexities we've covered. And that is fine, just buy index. But if you are taking an active approach to asset allocation, there is certainly a case to be made which we make a lot that the U.S. is historically expensive and therefore new money going into the market would be better placed looking for cheaper opportunities.
Lamonica: But to be clear, this is a tilt and not a wholesale shift out of the U.S. As new money going into different markets goes into other countries or cash or different asset classes, your overall asset allocation will naturally look different than the overall market. A global portfolio with a 50% allocation to the U.S. may not feel radical. But that, of course, is a huge difference from the index. We certainly wouldn't advocate avoiding the U.S. completely as that would be missing out on a couple of very important industries and some really globally significant companies.
Jayamanne: As valuation-focused investors we certainly understand where Will is coming from and could not agree more that valuation matters and should play a role in any investment decision you are making. We agree that the way indexes work means that after a long bull run, you're making disproportionate bets on high valuation companies, and that can have lasting impacts. So, we think the strategy makes sense. But like everything else in life, we think it makes sense in moderation and not an extreme interpretation of moving all of his funds away from the U.S.
Lamonica: All right. Well, thank you very much, Will, for sending in our second voicemail message – we'll see if we get a third – and for, of course, following up with an email. It's great for us to get these questions and do episodes on what people want to hear. So, anyway, send in any questions that you may have, call us, leave us a voicemail message, and we love ratings on your podcast app and any comments you may have. And if Shani does not convince me to retire today, we will be back next week for another episode of Investing Compass.