Why bother going global?

Australian Financial Review, September 2008

Last year, Australian equities outperformed global shares. The year before, they did the same. And the year before that. In fact, you have to go back to the start of the decade before you find a year when you were better off in international shares than Aussie ones. It’s possible it will change this year – the S&P/ASX200 was down 22.7% year to date by September 12, compared to 21.9% for the MSCI All Country (AC) World Index, so it’s going to go down to the wire – but even in these noxious times Australia has done better than Europe, China, Hong Kong, India, Singapore, Russia and a host of other nations both emerging and emerged. It’s enough to make you ask: what’s the point of going global?

Mutual fund statistics support the question. Mercer’s data on fund performance for the 2007-8 financial year showed that the median Australian shares fund had dropped 12.3 per cent, and the median international fund 20.9 per cent, putting Aussies more than 8 percentage points clear. Over three years, Aussie funds were up 11.9 per cent a year compared to just 1.5 per cent for global, a more than 10 percentage point outperformance. Five years? Same story: Australians up 16.9 per cent a year, global just five per cent.

Naturally one should take a long term view on these things. But it’s not as if this is a recent development. Paul Taylor, country head of equity investments and portfolio manager for Australian equities at Fidelity Investments, refers to a study conducted by the London Business School last year looking at 107 years of stock market data in 17 developed world nations. “Australia is the best performing market in the world over that very long term,” he says. “The other interesting thing is that the volatility in the Australian market has been a lot lower than other markets. It’s high at the moment, but over prolonged periods not as high as other markets. A market that is relatively stable but giving better returns is an unusual combination.”

Why has this happened? Taylor notes four key themes. One is demographics: a prolonged and healthy level of population growth, both by natural birth and immigration, thus providing a market for goods and services. Another – and this has been particularly pertinent in the last five years or so – is Australia’s abundance of natural resources. A third is that corporate governance and shareholder protection have always been highly regarded in Australia, which in turn has helped GDP growth translate into stock market performance. And finally, Australia has long boasted very high dividend yield and growth. When one considers this last point in tandem with franking credits, which provide such excellent tax efficiency, it’s little surprise that many Australians tend to be a bit domestically focused in their investment decisions.

Andrew Pease, investment strategist at Russell Investment Group, notes two other reasons specific to the last 20 years, leaving aside the currency, while we’ll return to. One is the transition Australia undertook from being a high inflation to a low inflation country between 1987 and 1997. “The interest rate structure came down, and because it did so, the valuation metrics of our share market went up,” he says. Then, from 1997 to 2007, “what drove the market was extraordinarily high profit growth, with earnings per share growth on average over 10% per annum. That was due to deregulation policies in the economy, and the liberalisation of the labour market.”

Others add the impact of superannuation, which puts such huge volumes of capital into the local markets each year that it helps to drive up share prices on its own (though clearly not enough to stop this year’s declines).

The thing is, many of these influences – superannuation contributions, resources, governance, dividends – are still in place, and will be for the foreseeable future. So with all that’s gone before, why venture overseas?

International fund managers argue there’s still good reason to go global. The most obvious is diversification: if the Australian market does ever get into bigger trouble than it already is (a recession in China wiping out resources demand would be an example) then it’s better not to have all your eggs in one basket.

Besides, Australia gives you a lop-sided take on world industry. “The global opportunity set is much larger than Australia,” says Pease. “If all your exposure is in Australia, you’re taking a large allocation to resources and financials.”

Of course, that’s part of the reason Australia has done so well in the last seven years. But both go in cycles and will not last forever. “Australia outperforming for so long has to do with the significant overvaluation in the US leading up to the tech bubble – which needed many years of weaker returns to bring it down to reasonable valuations – while Australia was going through the commodity run and housing boom,” says Chad Padowitz, chief investment officer of Wingate Asset Management. “Those factors are cyclical and mean reverting. There’s nothing that says Australian shares should do better than international ones. Shares are just stakes in companies.”

Padowitz adds: “There’s no inherent difference between a company that’s listed in Australia and one that’s listed elsewhere. There’s no reason a BHP or Rio Tinto should do any better than an Xtrata or Anglo American. There’s no reason ANZ or NAB should do better than HSBC or Barclays.” So the only difference, inherently, is that the world offers more choice. “Limiting yourself to Australia you are denying yourself the depth of choice of different geopolitical, geographical and currency opportunities.” For example, there are many holdings in Wingate’s portfolio that couldn’t be replicated in Australia, such as a stake in a cruise line company, or the premium drink company Diagio. Technology is a sector that can barely be played from Australia, not that that’s always been such a bad thing. “Australia only represents 2% of world markets. If you only invest in that space, by definition, you are impairing yourself to what the world has to offer.”

An example comes with oil shares, which many fund managers remain positive on. Australia does have oil stocks, like Woodside Petroleum, but not many. “We can decide what kind of oil shares we want to buy in terms of reserves, structure, royalty agreements and so on, and choose the company that best meets with our assumptions,” says Padowitz. “If we limited ourselves to Australia we’d only have three to choose from. Internationally we can look at about 100.” One of its biggest holdings is in Petrobras, the Brazilian oil company.

This brings us to a separate point: emerging markets. Comparing the merits of one developed market to another – Australia versus the UK – is one thing, but many people believe the long term biggest growth will come in markets like Asia. Elsewhere in the Fidelity fold, investment director for Asia Pacific Maria Abbonizio understands why Australians wonder about the benefits of going offshore: “We always talk about the diversification benefit, but it doesn’t always seem to work when markets are going down.” But she notes the strong fundamentals in Asia, and the higher growth rates there. “That potential to add extra juice to an Australian investor’s portfolio is definitely there.” That said, some believe a safer way to play markets like China is to buy Australian stocks with a lot of exposure to them, like BHP Billiton.

One of the reasons international shares have lagged local ones is because of the currency. Throughout this decade, and until very recently, the Australian dollar has been strengthening against the US dollar and, to a lesser extent, other major world currencies. That increase in the value of the domestic currency has eroded the returns from international equities for an investor sitting in Australia, making market performance look worse than it actually has been. Over the last few months, that trend has started to reverse, which will begin to enhance the returns from overseas shares. “Ultimately what the currency takes away the currency will eventually give back,” says Pease. “The currency does move in these big cycles and we’ve seen that in the last couple of months.”

The dividend argument is one of the most compelling for Australia: not just the excellent high yield but the tax efficiency of its delivery through franking credits. Padowitz has another take on that, too. “There’s no such thing as a free lunch,” he says. “A company that pays a high dividend is generally taking away from something else: investment opportunities, or perhaps using a high level of gearing. Many of the high yielding instruments designed to suit the Australian [demand for dividends] have caused tremendous pain: we’re very nervous on companies that just pay high dividends because it’s what investors want.” And the tax side is overstated too, he thinks: “Franking credits are a beneficial thing, but I personally think you should never investor in an equity instrument for tax reasons.”

Domestic versus global is not an either-or decision, just a question of allocation, and it’s clear there are opportunities and risks in both approaches. “For the next decade I still think the Australian market is a great place to invest,” says Taylor. “The stock market won’t do 20 per cent a year all the time, that’s not what it does. But the market over the last 107 years has done 7 to 8 per cent a year in real terms over that period, and a nominal return of 12 per cent. If people are looking at the next decade, those are the sort of expectations they should have.” Many, it seems, will still call Australia home.