By Corey Hoffstein, Newfound Research
Recently, we’ve witnessed a convergence in views across a number of institutions advocating for investors to take a tactical tilt away from U.S. and towards international equities (both developed and emerging). The crux of the argument is largely valuation-based: international stocks look “cheaper,” typically presented as a relative comparison of price-to-earnings multiples.
Despite having made a nearly identical argument back in our 2016 market outlook, and currently having a significant overweight expressed in The Weird Portfolio, we wanted to write a brief commentary about why this trade – and trades like it – may be a bad idea.
The Case for International Equities
The most common argument we hear today justifying the tilt towards international is that international equities are cheaper than U.S. equities. Whether measured on Shiller’s Cyclically-Averaged P/E or trailing-twelve-month price-to-earnings, price-to-book, and price-to-sales, the U.S. equity market does appear relatively overvalued.
Source: www.starcapital.de. Figures as of 9/30/2017.
We would wager that few other arguments have the power to turn off the critical thinking elements of our brain like “valuation.” Value-based investing is as American as Warren Buffett eating apple pie. It’s one of the few risk premia acknowledged by the quants and academics. And if you argue why a higher valuation might be justified, you should expect to be harangued about the dot-com bubble and bust ad nauseam.
Nevertheless, we’ll risk it and argue why such a valuation-based argument can be dangerous as the basis for a tactical tilt.
Precisely Imprecise Measures
We are sure that if you asked any CEO of a publicly traded company whether price-to-book (or price-to-earnings, price-to-sales, enterprise-value-to-EBITDA, et cetera) accurately captures the full scope of their valuation, they would scoff. Such a simple metric is far too imprecise to capture the nuance of their business.
We would argue that the imprecision is the point. Value metrics are designed to be blunt enough instruments that we can leverage them both across securities and across time. Price-to-book may not give us accurate insight into a specific company, but sorting stocks based upon price-to-book provides a directionally accurate roadmap to relative valuations.
Directionally accurate, but not perfect. For example, many would argue that price-to-book is meaningless for bank stocks. Or that technology firms deserve a higher price-to-earnings ratio because they have a higher expected earnings growth rate.
The simplicity that helps make these measures robust also prevents them from being highly precise.
The same holds true for metrics like the Shiller CAPE. While comparing it against its historical average may give us some direction as to whether markets are currently expensive or cheap, changes in sector composition over time means that today’s reading of 30 may be meaningfully different than a reading of 30 during the dot-com days.
Similarly, when taken and used to compare across countries, Shiller CAPE fails to account for the fact that countries may have dramatically different sector compositions. Is it fair to compare the valuation of a technology-heavy market versus one driven by traditional manufacturing?
To attempt to exploit the signal and minimize the noise created by these imprecise figures, we have to leverage diversification.
The Key Is Diversification
One of the primary ways that quants and discretionary managers differ is in how they seek to manage risk.
A quantitative value investor will try to identify the stocks exhibiting value characteristics (e.g. low P/E, P/B, P/S, et cetera) and then buy a large enough basket of them where the aggregate value signal remains strong, but there is sufficient diversification to limit idiosyncratic risk.
A traditional value manager will try to identify the stocks exhibiting value characteristics and then do a deep dive into them, trying to ascertain, from a qualitative perspective, which are “safe” and which are not.
For regional bets based upon valuation, there is not much to diversify: you’re effectively making one, big single bet. Which, from a quant’s perspective, is highly, highly dangerous. It may be passable for a more traditional manager, but would certainly require a more thorough argument than relative valuations.
“But wait,” you’re saying. “Doesn’t each region represent a big basket of stocks? How is this any different than that traditional value factor where we’re saying low P/B stocks are going to outperform high P/B stocks?”