Smart Money: Catching a falling knife

Australian Financial Review, Smart Money, August 2011

“Buying now,” says Shane Oliver, “would be like trying to catch a falling knife.”

AMP Capital Investors’ head of investment strategy and chief economist was speaking to the AFR on August 2, as the US debt crisis rolled towards an ugly conclusion. The subsequent three weeks, with a US sovereign debt downgrade, renewed problems in Europe, and dramatic plunges in stock markets worldwide, proved him right. And it’s not as if the dust has settled since: buying now is still like trying to catch a falling knife.

No matter where you look in the world, there is uncertainty. Arguments over America’s debt ceiling, and then the historic downgrade from AAA status by Standard & Poor’s, are actually not the point: beneath the surface there are real worries about the ability of the US economy to rejuvenate itself. “The debt ceiling issue having been resolved, the focus will come back to the US economy,” notes Scott Thiel, chief investment officer at international fund manager BlackRock. “You really have to think that if the US economy stalls, that has implications for the European economy, for the Asian economy – for economies globally.”

And then there is the European sovereign debt crisis: what we used to call the Greek crisis, until it rolled into Ireland, and Portugal, and Spain, and Italy. The future viability of the European Union and its currency are at stake here, and for every new pact and agreement and rollover negotiated among European governments and creditors, you won’t find a single economist or analyst who believes the problem is fixed yet.

A look at the strident performance of the yen – 77 to the US dollar at the time of writing, compared to the 100 most visitors tend to use as a rule of thumb – would lead you to believe that Japan is the new safe haven in the developed world. But that’s quite a surprise to the Japanese. Their economy is still attempting to recover from the devastating earthquake of March 11; their level of national debt stands at 200% of GDP, which would make even the Americans wince; their political situation is deadlocked (a prime minister who has promised to resign but given no indication of when); and a very likely downgrade to single A status at some point in the near future, which will affect the cost of borrowing internationally.

Even Asia, the bold new hope for global growth, faces major challenges. In China, the discussion is about whether the country will face a hard or soft landing – either way, a decline in growth. And booming economies like Indonesia, India and Vietnam risk being undermined by runaway inflation – which is no joke when you have much of your population hovering on the poverty line. Inflation annoys us when it puts the cost of our petrol up. When it increases the cost of rice beyond what your family can afford, that’s not annoying; that’s a prompt for desperate social unrest.

So should we all stay at home in Australia’s relatively robust economy? The prospects here are pretty good.

And yet, and yet. Think back to 2009. The people who made real money – you probably know a few of them – were those who put money into the share markets when things seemed darkest. They caught the bottom – or close enough to it – and then shared in the rebound. This is how contrarian investors think. Given that your Australian dollar today buys more overseas shares than it ever has before, should we be looking to position ourselves for an improvement in world markets?

Bruno Lee, who heads regional wealth management for Asia Pacific at HSBC, sees some reasons to be positive. “As the global economy recovers, stock markets still have further upside, although continued volatility may discourage investors,” he says. “Undemanding valuations, strong liquidity and reasonable earnings growth forecasts provide a favourable backdrop for equities.” In a market like this, he suggests high dividend stocks to provide regular income in uncertain times. “The important thing about stock market investing is to buy low, sell high,” he says. “However, many investors simply follow the herd and get into the market when prices are on the high, or nearing the highs.”

As ever, it’s a question of timing. “Global shares are already cheap, but thanks to all the uncertainties in Europe, the US and China, I think the next few months will remain weak and volatile,” says Oliver. “The September quarter is normally poor and this year is proving no different.

“However, by year end, global shares are likely to have rebounded on the back of attractive valuations and probably another round of quantitative easing in the US.” In his view, greater certainty that China will avoid a hard landing, and that global growth will remain positive, “albeit fragile and sub-par”, should also help underpin markets later this year.

So where’s best? “The key point for investors is that it’s likely to remain volatile and messy even though the broad trend may remain up,” says Oliver. “I find it hard to get excited about any of the major advanced countries, but would prefer Japan (on valuation grounds) and the US (because the Fed will do whatever it takes to keep the recovery going) over Europe (where policy makers are in denial about the size of the problem).”

It’s always instructive to see what the global private banks are telling their clients to do at a time like this. Citi Private Bank, for example, is telling its clients to be overweight Japanese equities and – this seems surprising – has upgraded its suggested holding in European and US bank stocks from zero to neutral. “Financials have been too smashed up for now to be comfortable having none,” the bank told clients in August.  But the overall message is one of volatility and uncertainty. “Is it any wonder that investors have decided to sit on the sidelines until the return to the market of conviction, consensus and clarity?” asks John Woods, chief investment strategist for Asia at Citi Private Bank.

Increasingly, though, fund managers are sensing that the declines in developed markets add further reason to rebalance towards Asia. “The financial crisis showed the weakness in the leveraged economies of the developed markets,” says Kerry Series, chief investment officer of 8 Investment Partners, which specialises in Asian equities (but was excluded from the accompanying Morningstar screen because its track record is less than three years). “And it showed the strength of the capital surplus countries, of which Asian countries remains at the forefront. Investors globally are quite nervous about investing in equities, but as they become less nervous, Asia will get a larger share [than it usually does] because of the fundamental strength of Asian economies.”

One problem with Asian equities is that no matter how robust their economies look, international capital tends to flee their markets when there’s a global macro problem, which means Asian markets fall regardless even when it’s illogical for that to happen. This is because Asia Pacific is equivalent to just 6% of the MSCI Developed World Index. “When investors change their attitude to risk, it’s going to be marginal stock markets that perform better or worse,” Series says. “Asia is only now developing the institutional investment structures that underpin long term investment in markets.” So an investor in Asia faces volatility, though arguably a better long-term outcome. Series, incidentally, focuses on two themes in particular: Asian consumption growth, best reflected in consumer stocks; and fixed asset investment as a consequence of urbanisation, which benefits resource stocks.

For his part, Oliver says Asia is “vulnerable to any further falls globally over the next few months coming out of Europe or the US, and has its own problems with inflation.” But he adds: “fundamentally, Asia is in far better shape and it should be favoured on a medium term view.”

Any investor contemplating international shares ought to keep in mind the currency. The Australian dollar is exceptionally strong against the US dollar now, despite a recent fall-back amid global volatility, and has also risen against more or less every major world currency, though generally to a lesser degree. This is relevant to international investment in two ways. One is that you get more for your money now. But the other is that what happens to the currency next is crucial to your investment. If the Aussie dollar falls again, then your overseas investments will improve in value. If it carries on climbing, the reverse will happen and any gains will be negated – as any investor in gold in the last year will know. Many investors may prefer to buy a product that is either hedged (neutralising the impact of the currency) or actively managed (meaning that the fund manager positions itself to benefit from currency movements, just as it positions itself to benefit from share movements).

Not everyone has the stomach to invest in such uncertain markets, and not everyone should. But as sure as night follows day, someone will be making money out of all this.

SIDEBARS – Five International Funds Worth a Look

We asked the fund researcher Morningstar to look through its database of international equity funds and select five worth further study. Rather than basing heavily on traditional metrics of past performance, Morningstar opted for funds in which its analysts have the highest conviction – that is, highly recommended or recommended. That’s a verdict based on style, staff, process and performance. We also asked for a range of styles from thematic to quantitative, global to Asian. Here’s what they come up with.

MFS Global Equity

What is it?

A global equities fund with a growth leaning. As of April 30 it put 46.26% into the US, 36.12% into developed Europe, a further 10.39% into the UK, 4.49% into Japan and 1.32% into developed Asia.

Who runs it?

David Mannheim founded MFS in 1992 and now runs the fund alongside Roger Morley. It’s an admirable level of consistency but Morningstar foes get worried about key man risk.

What’s the approach?

Fundamental research looks for companies with competitive edges such as proprietary products, pricing power, management quality and financial strength; also industries with barriers to entry. If those stocks also sell at a discount to MFS’s assessment of potential earnings growth, they will be considered. The portfolio holds 80 to 100 stocks and are not subject to any benchmark requirements by sector or country. Top holding on April 30 was Linde, followed by Nestle and Heineken.

How’s it doing?

5.45% one-year return (to June 30) doesn’t look like shooting the lights out, but that’s actually 6^th out of nearly 100 large-cap growth-style international equity funds in the Morningstar database. 1.22% over three years doesn’t look so amazing either – but ranks fourth. Remember that most of these funds are also having to compete with a soaring Aussie dollar.

What does it cost?

0.77% ongoing fee (0.8% for hedged version) plus platform fees.

What does Morningstar say?

“Retains its allure courtesy of a time-tested and esteemed leader who’s upheld a consistent process and supported by a deep bench of analysts. Easily among the upper echelon of core global equities managers.”

Platinum International Global Equities

What is it?

Famed Australia-based global equities fund – one of the very biggest in the market. Split on May 31 was 28.76% North America, 26.8% Europe developed, 18.89% Japan (Platinum is noted for its Japan enthusiasms and has a successful Japan equities fund), 10.77% emerging Asia, 6.74% developed Asia.

Who runs it?

Kerr Neilsen founded Platinum Asset Management and is one of the biggest names in international equities in Australia. Two other key portfolio managers from the Platinum stable, Andrew Clifford and Jacob Mitchell, are also closely involved in stock selection.

What’s the approach?

Looks for undervalued stocks (quantitative analysis is part of the process) with good growth prospects, combining its findings with thematic and trend techniques. If an analyst finds a stock, one creates a detailed investment report, and at least one portfolio manager and two analysts have to be part of any decision to invest in a new company. Morningstar calls it a ‘blend’ approach with both growth and value characteristics. Notably, the fund can take short positions; on June 30 it was 18% short.

How’s it doing?

Over the long term, outstanding: since its 1995 inception it is up 591.7% (to June 30) compared to 86.9% for the MSCI AC World index. Has had a bad year, down 7.32% to June 30, but is still up 7.03% a year over three years, among the best in the market.

What does it cost?

1.54% per year.

What does Morningstar say?

“An outstanding portfolio manager and roster of talented investors mean that Platinum International continues to set the standard for global equities managers. We expect this to continue to be a standout core strategy for years to come.”

DWS Global Equity Thematic

What is it?

A global equities fund based on thematic investment ideas. On May 31 34.25% of it was in North America, 23.76% developed Europe, 11.09% Latin America, 7.79% emerging Asia and 6.31% Japan.

Who runs it?

The fund is run by Oliver Kratz, who actually left DWS with his time in 2010 to establish Global Thematic Partners – which DWS then appointed as adviser.

What’s the approach?

The idea of the fund is to use top-down themes to define investment ideas, and then look for attractively valued stocks that fit within them. There are three broad categories: Growth, which includes themes like supply chain dominance (dominant players in their industries); insurance and protection, whose themes include private/public partnerships; and Mispricing and non-Correlation, which includes the theme of disequilibria, looking for opportunities in unstable industries. Other examples include personalised medicine (based on preventative healthcare) and the Indian Ocean. All told, the fund holds 80 to 140 stocks at any one time.

How’s it doing?

Pretty flat this year (1.27% in the year to June 30) and in negative territory over three and five years. Its results are wrecked by a shocking 2008 – lagging the index, which did bad enough in its own right, by 7.85% – but its recovery since then has been strong.

What does it cost?

0.96% unhedged and 1.12% hedged – those are wholesale figures so you’ll access them through a platform, which will have its own fees.

What does Morningstar say?

“Doesn’t follow the typical path of global equities investing, but we think the journey’s worth serious consideration.”

Treasury New Asia

What is it?

An Asia equities fund. Invests in both developed and developing Asian stock markets.

Who runs it?

Treasury Asia Asset Management and its two key portfolio managers, Peter Sartori and Eng-Teck Tan, both ex-Credit Suisse. Its investment team is split between Singapore and Sydney.

What’s the approach?

Classic bottom-up approach predicated on getting out there and kicking the tyres with company visits. It screens across quantitatively driven factors such as earnings and profitability, then makes a more fundamental assessment of shortlisted stocks. Typically holds 40-60 individual stocks. Morningstar considers it a value manager.

How’s it doing?

Has delivered 1.69% a year over five years – which, while nothing to get excited about, is the middle of the pack. Having a tough year though: down 6.07% in the year to June 30, well below the index.

What does it cost?

1.025% plus a 10.25% performance fee.

What does Morningstar say?

“A more than suitable vehicle for investing in the fast-growing Asian region. We’ve no difficulty suggesting it for use as a supporting player in an international equities portfolio.”

Walter Scott Global Equity

What is it?

Growth-styled global equity fund, sold in Australia through the Macquarie Professional series. In May 31 had 45.62% in North America, 18.21% Japan, 13.88% developed Europe (plus 11.23% UK) and 4.73% Asia.

Who runs it?

Walter Scott is a fund manager based in Edinburgh.

What’s the approach?

Looks for stocks capable of delivering 20% annual growth. Then takes a buy and hold approach. Screens for earnings per share growth and return on equity, then looks at competitive position, industry, profitability, financial model and quality of management, ideally interviewing them. Portfolio usually 40 to 60 stocks.

How’s it doing?

Down 1.14% in the year to June 30 – but a hedged version, sold by Perpetual, is up over 21%, demonstrating the impact of the currency on returns.

What does it cost?

1.28%, plus any additional fees charged by the platform through which you get access.

What does Morningstar say?

“Has many great qualities, but composure, conviction and consistency are what make this a distinguished offering.”