Equity portfolio construction: some food for thought from history

CIO Insights 1Q2017

If you pursue a pure bottom-up, company-by-company approach to investment selection, as we do, the overall portfolio could be expected to look very different from that of an investor who uses a top-down, macro-driven allocation method. Our funds clearly meet that expectation. For example, on a geographic basis, the current portfolio rather unconventionally maintains the bulk of its capital allocation in companies from Japan, Italy, and Brazil. This exposure stands in stark contrast to a market-cap-weighted perspective of the world, which of course is dominated by the US: as per the end of 2016, its share alone made up comfortably more than half of the total global stock market capitalization.

In this context, it will be interesting to consider a historical perspective by looking at the vast database compiled by professors Dimson, Marsh, and Staunton (DMS) as published in the Credit Suisse Global Investment Returns Yearbook 2017. Their data starts at the end of 1899. At that time, world market capitalization was led by the UK (25%), followed by the US (15%), Germany (13%), France (11.5%), Russia (6.1%) and Austria-Hungary (5.2%). Now, if you invest according to a typical market-cap-weighted, index driven approach – representing the default strategy for the majority of investors these days – some obvious questions arise. For example, let’s say you had used this top-down approach to capital allocation back in the early twentieth century. Even when allowing for the fact that the initial 15% of the portfolio invested in the US would have resulted in a highly favorable contribution to the overall performance over the course of the ensuing century, such an asset allocation would certainly be judged negatively on an ex-post basis, given what we now know about the trajectory that the then-prominent capital markets were about to take during the subsequent decades.

A second striking observation from the same database concerns industrial sectors. If you had taken a similar top-down, index-driven view as assumed above and had used the US as a representative benchmark at the end of 1899, the portfolio’s asset allocation would have been concentrated in railroads, financial services, and heavy industrials such as iron, coal and steel. We obviously know that the US economy looks very different today, dominated by technology and health care. In fact, only a few essential sectors such as financial services and certain consumer staples have managed to maintain their relative importance until present times. In their study, DMS state that “in stock market terms, railroads were the ultimate declining industry in the USA in the period since 1900.” More intriguingly, however, their data further reveal that “[y]et over the last 117 years, railroad stocks have beaten the US stock market, and outperformed both trucking stocks and airlines since these industries emerged in the 1920s and 1930s.” As a possible explanation, the authors propose that “investors may have placed too high an initial value on new technologies, overvaluing the new, and undervaluing the old.”

This phenomenon is exactly what we try to exploit in dedicating ourselves to a deep-value investment approach. To illustrate this, the fund is predominantly exposed to the industrials, materials, and consumer discretionary sectors (the latter mostly comprising traditional media such as newspapers, books, TV and music). Today, these areas are commonly considered to be part of what is known as the “old economy.” They are often dismissed as too boring and low growth by the overall investment community. However, it is precisely because of their unfashionable status that they tend to become heavily undervalued at times.

In sum, we take away the following two insights from the study cited above: First, in a rearview mirror perspective, country allocation practiced with a top-down, market-cap-weighted, index-driven method may be fraught with peril as nations’ economic welfare sometimes develops in wholly unexpected ways. And second, on an industry level, value seems to trump simple aggregate growth considerations over time if the objective is to generate solid returns; the chief reason being that high growth in itself can be a great detriment to investment results if you overpay for it. We are convinced that on both counts our strict bottom-up perspective of the investment universe is highly effective in avoiding some of these potential shortcomings.

Sincerely,