Insights

“The essence of investment management is the management of risks, not the management of returns.” – Benjamin Graham

The Russia-Ukraine conflict has brought to fore an important risk that investors have to contend with – loss of legal claims driven by geopolitical events. Specifically, in the case of Russian assets, the unprecedented sanctions rendered the value of Russian investments traded on western exchanges to nearly zero. On the other hand, while the local securities continue to trade on the Moscow Exchange, the ability of foreign investors to trade in and out of such securities is nearly non-existent currently.

We believe it is an important risk that investors have to contend with. So, how do we manage/reduce that risk? We believe that the right approach to managing this risk is to diversify. Diversify across businesses and diversify across geographies, both in terms of the country of domicile of the company and the place of the business’s operations.

High Geographic Concentration

Home country bias. As against diversifying geographically, most investors have a very high concentration in their home countries. The chart below shows the allocation to domestic equities by country. As is seen, Indian investors have one of the highest concentrations in domestic equities.

Figure 1: Country-wise Concentration in Domestic Equities

Problems with high country concentration. High geographic concentrations pose multiple risks to investment portfolios. We discuss some of them below.

Business models. In a world where businesses operate globally, limiting oneself to any one country results in portfolios that do not have exposure to different business models. For example, we identify Shimano as one of the better businesses with globally dominant positions in bicycle gears and fishing tackles. However, an investor concentrated in Indian or U.S. equities does not have a way of getting exposure to Shimano’s business.

Sector exposures. Most country portfolios do not allow for the kind of sectoral exposures that is afforded by global portfolios. For example, a Brazilian portfolio is likely to be highly concentrated in financials, energy, and materials resulting in excessive exposure to the vagaries of commodity price cycles. Similarly, an Indian high-quality portfolio likely ends up with concentrations in the financials and consumer staples sectors.

Geopolitical events. Country concentrations expose the portfolio to undue risks during periods of geopolitical turbulence. While investors have been conditioned to buy on the sound of canons[1], it doesn’t always work. It depends on which side of the warring parties the country is on. As the experience of Japan and Germany show, the losing country’s stock markets tend to lose nearly all of their market value.

Figure 2: Investment Returns and Geopolitical Events

Does global diversification work? One of the criticisms of global diversification is that during periods of stress/panic, correlation coefficients across markets rise towards one. Indeed, we do not believe that globally diversified portfolios offer protection against periods of crashes like the one we experienced in March 2020.

What they offer protection against are extended periods of drawn-out bear markets. Most families and investors have investment horizons that extend in decades. Such long-term and multi-generational portfolios are much more concerned with deep bear markets that lead to permanent losses of capital. For such investors, global diversification provides meaningful benefits[2].

Problems in Portfolio Construction: High Concentration

While we are of the view that portfolios need to be more diversified and not less, portfolios today have become ever more concentrated. As we have highlighted previously via our letters as well in our conversations with investors, we believe that one of the significant risks that portfolios face is that of very high concentration driven by the skewed profile of benchmarks. It is especially true of passive portfolios.

MSCI ACWI – All Country World Index or US-focused Index. The U.S. accounts for about 25% of the global GDP. However, it accounts for just about 16% of the global GDP when looked at on a purchasing power parity (PPP) basis. In relation to its share of the global GDP, the U.S. has a disproportionately higher representation in the financial market, accounting for 60% of the MSCI All Country World Index. As is seen, that representation has increased substantially over the past decade.

Figure 3: All Country Index has a very high concentration in the U.S.

Concentration within U.S. Indices. A handful of large-cap stocks account for a much larger proportion of the total within the U.S. markets. Whereas the S&P 500 index gives one the sense of a widely diversified, in reality, the largest ten companies account for nearly 30% of the total index. This is the highest such concentration in data going back to the last two decades; higher even than the tech bubble.

Notably, the index concentration has precipitously increased from just about 18% in 2015. In fact, the increase in concentration has been even steeper since the Coronavirus pandemic’s impact on financial markets took over, with the concentration rising from about 25% in February 2020 to 30% in August 2020.

Figure 4: Top-10 Companies within the S&P 500

Problems in Portfolio Construction: Overvaluation of U.S. Equities

In our previous writings, we have repeatedly highlighted the overvaluation of U.S. equities. As we wrote in our earlier article, “valuation multiple assigned to corporate cash flows, tends to have high variability. The variability is primarily a matter of investor sentiment, the willingness or the lack of it, to pay for those cash flows…. We are currently experiencing a period of investor euphoria, which has driven valuations to extreme territories…. The current expected returns of U.S. equities are their worst levels of the past seven decades.”

The chart below takes a look at the valuation of the S&P 500 in terms of traditional valuation multiples[3]. The multiples plotted here are median multiples of the 500 companies within the index. As is seen, U.S. equities are currently trading at the highest multiples of the last two decades.

Figure 5: Median Multiples for S&P 500 Components

Constructing Sensible Portfolios: Diversification and De-emphasizing U.S.

Having a maximum concentrated exposure makes sense if one has perfect foresight. However, as uncertainties around potential outcomes increase, it makes sense to diversify. As things stand currently, we seem to be shifting from a benign investment to a turbulent one. The investment environment we are moving towards is likely to be characterized by a wider range of outcomes and much fatter tails.

In such an environment, diversification is an essential tool that investors should employ. We recommend investors diversify their portfolios across businesses, sectors, geographies, and asset classes,though still taking cognizance of the quality of earnings, quality of the business model and corporate governance.

 Indeed, this is how we have structured the portfolios we manage. For our non-US investors who have invested in both the Global Moats Fund and the Global Select Value Fund at our recommended 33:67 mix, the combined portfolio’s U.S. exposures amounted to about 27%. That combined portfolio was diversified across moats, infrastructure assets, businesses structured as toll collectors, and commodity companies. It was diversified across the valuation spectrum with exposure to deep value as well as growth equities, i.e., both short duration and long duration assets. Importantly, it results in a 10% plus exposure to gold bullion and gold miners.

We currently only offer our long-only equity product for our U.S. investors, the Global Moats Investments. To ensure that they achieve appropriate diversification herein, we limit our U.S. exposures to 25% while ensuring that the Fund is diversified across business models, sectors, and countries.

One of the rules we subscribe to is to share the information we would like if our roles were reversed. Keeping with that philosophy, we maintain full transparency in our management of our portfolio and detail all significant actions implemented. This approach is in sharp contrast to the black box approach of the typical hedge fund. We believe that by sharing our actions in a transparent manner, we allow our investors to appropriately assess our actions and understand the risks embedded in each one of the line items of our portfolios.

As is true with anything in life, it is crucial to understand what we don’t do. We don’t construct portfolios that are designed for benign environments, i.e., fragile portfolios. Sure, such portfolios generate higher returns when the going is good. However, when the operating environment truly shifts, the fragility of such portfolios is exposed, resulting in permanent losses of capital. That is an enterprise we have no interest in.

[1] For the purposes of this analysis, we have constructed an index that approximates the S&P 500. With a tracking error of just about 1%, this is a very good approximation of the S&P 500.

[2] Refer the Note titled Global Diversification: Highly Desirable for Long Horizon Portfolios

[3] “Buy to the sound of cannons, sell to the sound of trumpets.” – attributed to Nathan Mayer Rothschild