Slicing the market cake

We all know, instinctively, that there’s a right and a wrong way to slice a cake. Square cuts out of a round cake? Horrible. Diagonal slice off a corner of a square cake? Disgusting. Take a chunk out of the middle? Possibly an actual crime.

There are countless ways to slice the investment cake. And unlike real cake, there’s no clear “right” and “wrong” way.

But. In my opinion, national borders aren’t the best slice.

You see, the investment world is obsessed with geography. “UK stocks” and “US equities” and “Chinese markets”, etc, etc..

In the 1600s, it made sense. The public companies listed in Amsterdam and London raised capital from local investors to fund projects in the country. Banks and insurers. Utilities. Railroads. Factories for new industries. Breweries ¹

And to be fair, you can still see that today in countries in the early stages of capital market development. Look at the listings on the stock exchanges in Nigeria or Cambodia or Peru (all classed as “frontier” or early-stage market economies) and you’ll see cement companies and dairies, paint producers and ports, banks and breweries. Firms that do most of their business where they’re based.

If you invest in one of these countries, typically the fortunes of the businesses you own depend on what’s going on locally – so fair enough.

Outside of the developing countries, though, the link between companies and their country of listing has been almost completely lost. Both their investors and their business models are now global.

Where large companies choose to list their shares often has very little to do with their business models, or where they make their money. Instead, the decision typically tends to be a matter of tax optimisation, prestige and availability of global investors (or simply tradition and legacy!).

Looking at the UK’s most famous (?) stock market, the FTSE 100, it includes many companies that started small and local. But now, the likes of BP, Diageo and Unilever have more interest in the habits of Chinese or American consumers than they do in what’s going on in British high streets. Even the London Stock Exchange Group itself only generates around half of its money in the UK!

But because everyone gets geography, because we understand countries, as investors, we can end up making the wrong connections.² It feels rational to connect a country’s prospects to that of the businesses listed there; but that’s just not reality. I spend a load of time telling people that the FSTE 100 doesn’t represent the UK economy, but every time I switch on the business news, there’s a journalist implying that exact link!

Typically, the differences in performance between countries’ stock markets come down to sector exposures – NOT the underlying economy. Whether as a result of historical accident, or different listing rules, or tax treatments, every country’s stock market is different, tending to be dominated by one or two large sectors. Technology in the US. Healthcare and energy in the UK. Banks and mining in Australia.

Ok, so as an investment analyst maybe you start to get to know these significant sectors a little in order to try and get a handle on what’s driving a certain market.

And once you do that… lightbulb.

Sectors are lovely! They’re nice and stable - they work by classifying a company by what it does rather than where it is. Vocation, not location. A national stock index can change behaviour as the big stocks change – the FTSE 100 was basically a banking index in 2007, for example, yet now it’s nothing like that. An analyst who was grappling with Lloyds’ balance sheet 10 years ago is now having to have a view on Rolls Royce.

Whereas if a company is an energy company, it is very unlikely it will suddenly end up in the healthcare space. Sector behaviour remains similar, regardless of which particular company or industry is flavour of the month.

Lightbulb again. If we need to have a view on a sector to help us invest in a country’s stock market… why not just invest in (or avoid) that sector itself! Perhaps three years ago, there wasn’t the product available to invest in. No point having a crystal-clear theory about utilities if you can’t actually go and buy the utilities sector. You just couldn’t slice the cake that way. But that’s now changed.

And so will investment strategies in the future. We’ve been building processes and models based on sector analysis for a few years, and we’ve been increasingly able to implement them in our portfolios.

I’d be very surprised if investing was still being done solely on a regional basis in five years. Why would anyone limit themselves to geographic borders when the rest of the world has moved past them?!

Investing in sectors, you might say… is a piece of cake.

¹ The exception is the trading companies (British and Dutch East India, most famously), but even these, the profits made by those companies were quite literally shipped back home and pumped into the domestic economies.
² Nowhere more so than “Emerging Markets”. South Korea is in the Emerging Market index, but ask anyone who’s been to South Korea and they’ll tell you that’s not the case. It has the same GDP per capita as the UK!