By Jayson Forrest
Adding global equities to a multi-asset portfolio provides investors with significantly greater opportunities to access a range of sectors and regions that are difficult to buy locally.
Tim Richardson (Pengana), Hugh MacNally (Private Portfolio Managers), and James Harwood (Russell Investments) discuss the opportunities and risks when allocating to global equities
In Australia, it’s no secret that investors have traditionally had a healthy appetite for Australian equities, with a significant weighting to banks and mining companies dominating many investment portfolios. But considering Australia represents less than 2 per cent of the global share market, this local bias can be detrimental for investors, who are missing out on many other opportunities in other parts of the world.
Tim Richardson, CFA — Investment Specialist, Global Equities at Pengana — believes it’s time to shift the dial on equity investing by better educating investors about the advantages of allocating to global equities. This can provide investors with the ability to tap into greater opportunities globally, particularly in sectors like technology, industrials and pharmaceuticals, which in comparison to the local market, are very limited.
Hugh MacNally
Private Portfolio Managers
James Harwood
Russell Investments
Tim Richardson, CFA
Pengana Capital
Will Dougall
Pengana Capital
In the current environment, where interest rates are starting to fall globally but valuations remain relatively expensive despite market volatility, Tim believes there are three key factors impacting global equities that investors should be aware of. They are:
- Interest rates. Rates have been falling across the major developed economies.
- Innovation. There has been a wave of innovation, particularly in artificial intelligence (AI). This innovation will help drive productivity growth in the global economy.
- Consumer spending. Predictions of consumer spending “falling off a cliff” has not eventuated.
Addressing the topic of global equities at the 2024 IMAP Independent Thought Conference, Tim says when you put these three factors together, they suggest that earnings growth is going to continue, which will support global equity prices.
Being neutrally weighted with global equities in a multi-asset portfolio is probably where you currently need to be. And while the S&P 500 could be at 6,000 points by year end, I still believe it’s a brave call to be heavily overweight global equities
Opportunities and risks
Against this backdrop, when allocating to global equities, Tim believes investors should be looking for companies that have an enduring competitive advantage and are able to grow their earnings sustainably over the long-term. He says investors should focus on companies with strong balance sheets, innovative business models, and which are aligned to long-term secular growth trends.
He believes an example of a company that fits the bill is Costco — an American multinational corporation that operates a chain of membership-only big-box warehouse club retail stores.
“By keeping their margins really low, Costco has been able to grow revenue by becoming attractive to a wider and more affluent demographic that recognises value and convenience. These customers are prepared to pay a significant annual membership fee, which has the effect of driving repeat business,” he says. “It’s a great business model.”
When putting together a global equities portfolio, Private Portfolio Managers (PPM) looks for stocks with high returns on capital, while also accepting that returns are not static, with very high returns often reverting to the mean average. Therefore, for Hugh MacNally — Founder and Director at Private Portfolio Managers — the best approach, when building portfolios, is not to pay “very high prices for very high returns”.
PPM uses operational data over a long period of time, particularly over the tenure of a chief executive officer, to better understand how the company is deploying its capital and how that will affect the return on that capital. It also doesn’t rely on the use of economic forecasts when picking stocks, believing these types of forecasts are too broad and unreliable to use.
While PPM doesn’t specifically focus on sectors, country exposures and currencies, it does currently see attractive opportunities in the industrial services sector in the United States. A company Hugh likes is United Rentals — an American heavy equipment rental company, which owns one of the largest rental fleets in the world. This company has a long history of high returns on capital, and it’s been able to invest a high proportion of its operating cashflow at high rates of return.
“We believe there are quite a number of companies operating in the industrials space that are very attractive from an investment perspective, despite market volatility over the last couple of years,” says Hugh.
As a thematic, Tim likes AI, adding that the AI revolution is transforming the global economy. He says opportunities across the AI value chain, like software businesses using AI to develop applications that will help grow productivity, are likely to see earnings growth.
He also believes that smaller companies are attractively priced. So, as interest rates come down and the market experiences a soft landing, these companies will be well-positioned to outperform.
However, even though the global economy may be heading towards a soft landing, Tim says that doesn’t mean the economy has slowed down. This has significant implications for cyclical businesses, particularly those that are sensitive to consumer spending.
“That perhaps implies long-term global equity investors should be thinking about big long-term secular growth trends, like AI, the ageing population, and the onshoring of industrial capacity,” he says.
With ongoing geopolitical issues, investors need to be careful. There are risks out there and the markets aren’t cheap. Although interest rates are coming down, it’s really important to know where the neutral rate settles in terms of the earnings growth of companies
Building global equity portfolios
Russell Investments is also bullish on global equities. It takes a multi-manager style approach to global equity investing, where it blends factors, like growth and value. According to James Harwood — Director, Senior Portfolio Manager at Russell Investments — Russell’s approach aims to find best-of-breed managers.
“On the multi-asset side, we have started taking some views at a sector level, and often that’s about addressing some risks in underlying equity funds. For example, a lot of equity managers don’t own a lot of REITs, because for some time, REITs have been an awful investment, primarily due to the U.S. office market, which has been in a downward trend. So, we want to address some of the risk there,” he says.
“We’ve also seen the outperformance of the ‘Magnificent Seven’ (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla) stop this quarter (third quarter 2024), and we’re starting to see small caps and equally weighted indexes starting to outperform those market cap indexes.
So, we think there is some relative value with small caps and we’re starting to see earnings forecast grow with REITs, which tells us this sector is close to bottoming out.”
James believes when it comes to positioning global equities within a multi-asset portfolio, investors should take a diversified approach to the equity styles they invest in. He says using a multi-manager approach should help them through market cycles.
“Being neutrally weighted with global equities in a multi-asset portfolio is probably where you currently need to be,” says James. “And while the S&P 500 could be at 6,000 points by year end, I still believe it’s a brave call to be heavily overweight global equities.”
We believe the rates of return on capital in the U.S. is substantially higher compared to most other markets. Whilst we agree that a 60 per cent dominance in capitalisation of the world’s stock market is very high, we still think the economics of U.S. corporations is superior to that of other developed markets
Beware the risks
Although global equities provide a range of opportunities for investors, Tim acknowledges there are also risks, particularly in relation to geopolitics and the effect these have on markets. Some examples he points to include the 2024 U.S. Presidential elections, ongoing trade issues with China, the Ukraine/Russia conflict, and burgeoning issues in the Middle East, particularly between Israel and Iran.
“With ongoing geopolitical issues, investors need to be careful,” Tim cautions. “There are risks out there and the markets aren’t cheap. Although interest rates are coming down, it’s really important to know where the neutral rate settles in terms of the earnings growth of companies.
“That means investors should be thinking about balance sheets. They want to look at companies that are able to refinance their debt and are able to raise finance to invest in new projects, regardless of where we are in the credit cycle.”
In terms of where this leaves global equity investors, Tim believes it could be a “bumpy landing” for investors, who need to be prepared to weather some market volatility. However, he doesn’t believe that should be a problem for investors who take a long-term view and are properly advised on this asset class.
“Growth is becoming scarcer and much more concentrated,” he says. “Value is not being spread evenly across the market or economy, which presents an opportunity for active management.”
When considering China, I think it’s important to look at it from a stock level, rather than a macro level. Investors should be very clear that the company they are investing in is involved in things that align with the priorities of Beijing. If the companies are engaged in areas that don’t align with the government’s priorities, that becomes a political risk that is hard to price, so you have to be particularly careful
A bias to the U.S. market
Over the last 15 years, the U.S. market has grown from 40 per cent to 60 per cent in terms of capitalisation of the world’s stock market, with the ‘Magnificent Seven’ (Mag 7) alone accounting for almost 20 per cent of the MSCI World Index. James acknowledges the dominance of the U.S. market is something that’s hard to avoid when constructing portfolios with an allocation to global equities. However, he says active managers are usually underweight in stocks like the Mag 7, preferring to look for better opportunities outside highly valued mega cap stocks in the market. “This means we do suffer some performance by being underweight with some of those stocks. However, we look to hedge some of the risks. You often find global equity managers, particularly in the relative value space, will be underweight the U.S. and overweight Europe. We look to manage some of those exposure through using futures. Going long with S&L 500 futures is the obvious way to address some of those risks from being underweight the U.S. and the Mag 7.” However, James believes there are encouraging signs emerging in the market for fundamental stock pickers, which will see a broadening of stock opportunities outside of the Mag 7. These opportunities will be good for active managers, he says. Looking at the Mag 7, PPM divides these stocks into two groups. It considers the first group (Microsoft, Amazon, Alphabet, and Meta Platforms) to be reasonably — “although not outrageously” — expensive, whilst the second group (NVIDIA, Apple, and Tesla) is very expensive, and well outside PPM’s comfort zone to invest in them. “We actually think the return on capital for two of these stocks — NVIDIA and Apple — is so high, we think they are very unlikely to be maintained over the long-term,” says Hugh. “So, we think there is a fair bit of downside in both of these stocks. And Tesla is far too expensive for what is a reasonably modest return on capital, which looking at its decline in margins, is an indication that even that return is perhaps not maintainable.” However, putting aside the Mag 7, PPM does have a more optimistic view of the overall U.S. market. “We believe the rates of return on capital in the U.S. is substantially higher compared to most other markets. Whilst we agree that a 60 per cent dominance in capitalisation of the world’s stock market is very high, we still think the economics of U.S. corporations is superior to that of other developed markets,” says Hugh. Tim points to technology companies as being the cause for the “big shift” towards a concentration in U.S. stocks over recent years. He says listed companies in information technology and communication services are disproportionally located in the United States, while adding that it’s likely the U.S. will adopt AI more rapidly and effectively compared to many other countries, which will spur growth in U.S. domiciled AI companies.
Don’t discount China
Given recent geopolitical developments with China — including tensions in the South China Sea, along with declining consumer confidence, lagging growth, and the potential risk of tariffs being imposed on it from the U.S. and Europe — James remains cautiously optimistic about China as an investment opportunity. However, he accepts that the lack of political and economic reform coming out of Beijing has been disappointing.
Despite these issues, Russell still believes China is investible, with much of this belief being reflected in the price of Chinese stocks, which are still very cheap compared to other emerging markets.
“The earnings of these companies are not too bad,” says James. “We’ve started to see some of the big Chinese tech companies engage in buy-backs, so there are some ‘green shoots’ coming out of China. We believe there are strong reasons why you shouldn’t dismiss China.”
While James is reasonably optimistic about China, he still believes this market needs a catalyst to get investors excited. One potential catalyst could be growing social unrest, which could lead to a policy response from the government. He warns that to have no China exposure is a risk, because having just one positive policy response could see the Chinese market outperform quickly.
Tim agrees that China has some “massive headwinds” to contend with, including an ageing population, the collapse of its property market, and countries moving to diversify their supply chains away from it.
Not withstanding these challenges, Tim acknowledges there are some high quality companies in China. He says the overall size of the Chinese market does make it hard to ignore from an investment perspective.
“When considering China, I think it’s important to look at it from a stock level, rather than a macro level,” he says. “Investors should be very clear that the company they are investing in is involved in things that align with the priorities of Beijing — like AI, electric vehicles, cybersecurity, and clean energy. If the companies are engaged in areas that don’t align with the government’s priorities, that becomes a political risk that is hard to price, so you have to be particularly careful.
“You also have to be careful about investing in companies that depend on exports to the U.S., as well as the import of sensitive components from the broader West, and companies that depend on finance from the U.S. markets.”
About
Tim Richardson, CFA is Investment Specialist, Global Equities at Pengana;
Hugh MacNally is Founder and Director at Private Portfolio Managers; and
James Harwood is Director, Senior Portfolio Manager at Russell Investments.
They were part of a panel discussion on Global Equities at the 2024 IMAP Independent Thought Conference in Sydney.
The session was moderated by Will Dougall — Business Development Associate at Pengana.