Over long term investment horizons, valuations can be a valuable guide for portfolio allocation. Most recently, we here at AlphaClone have been struck by the current valuation divergence across global equity markets.
We believe, long-term investors should be looking to increase their allocations to International equities in their portfolios.
Why? In a word, price.
The case for favoring international equities over U.S. domestic equities all comes down to price. This table, sums up the current situation.
Whether it is developed market central banking policies, or other economic factors that have led to developed markets being richly valued, the bottom line is that equity markets in the U.S. and other western markets are historically expensive.
As you can see in the table above, United States equities trade for 24x their cyclically adjusted price-to-Earnings ratio or CAPE ratio. The historic average for U.S. equities has been a CAPE of around 16x.
If U.S. equities regress all the way back to their historic average of 16x CAPE over the next 10 years, then investors would be looking at a -4% per year headwind. As price multiples contract, earnings have to grow that much faster to maintain the same price growth levels. Even if we only go only halfway back to a 20x CAPE ratio, that would represent a -2% per year headwind for U.S. investors. All of these headwinds would predict anywhere from a positive 1% to potentially negative -2% real return for U.S. equities over the next 10 years. That is a lot of headwind, for the investor who invests solely in the US!
In the international markets and emerging markets in particular, their average CAPE is just 13x. What’s more, if you focus in on just value stocks within emerging markets, you can find an average CAPE of 8.5x for those stocks. These markets have been hammered over the last three years but now they may offer compelling value to the patient long term investor.
This opportunity means investors can get almost 2-3x times as much value for their invested dollar through investing in stocks internationally as they can from buying the U.S. broad market indices.
If you’ve invested Internationally, you’ve lived this growing valuation divergence.
Through November 4, 2015, Morningstar’s Foreign Large Blend equity fund category is -4.8% in the past three months compared with their U.S. Large Blend equity fund category -0.6%. This foreign category is dominated mostly by actively managed funds. Annualized returns for longer periods can be seen below.
Is the time right for foreign equities to start outperforming U.S. domestic equities Timing is always difficult, but we believe that this is the area where patient long term investors should be looking for value, to increase their international equity portfolio allocations, and taking advantage of the discount they represent.
How should you do it?
Even if you are convinced of the opportunity that exists internationally, how should an investor best do it?
International investing brings with it a host of additional challenges for investors including:
- which countries to choose
- which sectors to pick
- which securities to select
- foreign currencies issues
- when to enter/exit trades
- tax implications
- what visibility do you have
But probably the most important question is which managers should you trust to help you navigate the above obstacles over the long-term. If the table above shows you anything, it shows you how difficult it’s been historically for active managers to beat the broader, cap-weighted market benchmarks.
A New Way…
To help investors navigate the opportunities and challenges that exist in international markets, we have developed the AlphaClone International Downside-Hedged Index (ALFIIX). This index is a systematically-managed index of American Depository Receipts (ADRs) favored by hedge funds and institutional investors. The ALFIIX index employs the time-tested methodologies employed in our SMA’s (Separately Managed Accounts) for more than five years, and seeks to solve many of the problems that face international investors. Investors who invest according to this index will benefit by having:
- Built-in manager selection based on our Clone Score approach
- High conviction ADR holdings from managers with highest scores
- Risk minded rules-based portfolio construction
- Built in dynamic hedging to protect capital in bear markets
- Quarterly rebalancing and new position adjustments
International markets are attractively valued and offer potential returns far above U.S. equities as the global economy improves. On top of the overall discount available in foreign markets, our ALFIIX index will be able to focus in on company-specific opportunities, that the broad market averages will not capture as well.
Please visit www.alphaclone.com to find out more about this new index (ALFIIX) and how it can help long term investors looking to take advantage of the better value offered in international equities.
AlphaClone® is a registered trademark of AlphaClone, Inc. All investment strategies have the potential for profit or loss. Historical performance is not a guarantee of future returns. Information presented is for educational purposes only and is not intended as an offer or solicitation for the sale or purchase of any specific securities, investments or investment strategies, nor shall it be construed to be the provision of investment advice. Investments involve risk and unless otherwise stated, are not insured or guaranteed. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It is not possible to invest directly in an index.