Asking the right question: What is the business, not where is the business
The investment world has lots of strange traditions and conventions that can seem out of place in the twenty-first century. COVID-19 has challenged a number of them already.
For example, until March this year, traders on the floor of the London Metal Exchange (LME) had to have their leg touching a central sofa in order for a trade to be valid. While entertaining to observe, the practice didn’t survive social distancing, and the LME is now embracing electronic trading.
Another convention, though, is far more widely embraced than an idiosyncratic commodity trading floor. It’s the idea that a country and its main stock market are meaningfully connected. That’s just not the case and, as we come to terms with COVID-19, is worth thinking about more carefully.
The older companies have outgrown their domestic roots, while many newer businesses ignore geography altogether.
A historical habit
The investment industry has a bad habit of talking about ‘UK stocks’ or ‘US equities.’ Like many bad habits, it started for understandable reasons.
When public companies first came into existence – in Amsterdam in the early 1600s, in London in the 1690s and in New York a century later – they did so to raise money from local investors, in order to carry out their business. Stock exchanges sprang up as convenient places for these investors to trade their shares, and for companies to issue new ones.
The point, in the pre-information age, was to have an agreed place to carry out financial transactions. People wanted to know where to go to buy shares, and companies wanted to know where the pool of willing investors were. In London, that was in the coffee houses in the streets behind the Royal Exchange. In America, it was said to be under a particular buttonwood tree on Wall Street.
Up until the early twentieth century, the link between the stock markets and economies made sense. Local businesses raised capital from local investors. While these companies’ commercial activities were often global, the profits came back to the home country – where they were spent, or taxed, or reinvested. If the shareholders were doing well, so was the economy (most of the time).
For most major benchmarks, that is no longer the case. The link between geography and economy has been almost completely severed.
Today, stock markets look very different, for two main reasons. The older companies have outgrown their domestic roots, while many newer businesses ignore geography altogether.
The FTSE 100, for example, includes lots of companies that started small and local, but for which the UK is now just a handy place to keep a head office. Drinks brand Diageo makes roughly 5% of its revenue from the UK. AstraZeneca and GlaxoSmithKline rely on the UK for less than 10% of their sales. Royal Dutch Shell and BP make far more money from Asia than from the UK – as does HSBC. Even the London Stock Exchange Group makes only about half of its money in the UK!
And for newer large companies, the country or city where they choose to list their shares often has nothing to do with their business models, or where they make their money. It tends to be largely a matter of tax optimisation, prestige and availability of global investors.
Take Aramco, the huge Saudi Arabian state oil company, which was at one point looking to list in either New York, London or Hong Kong. Or Alibaba – the all-conquering Chinese consumer/technology company which is listed in New York, alongside three others in the list of the largest ten Chinese businesses.
Focus on sector exposures
Many investors are making the wrong connections. They focus on the prospects for a certain economy, and then talk about whether to invest or not in its market. They suggest that Japanese equities might do well thanks to a new prime minister, or the inflation outlook, or fiscal policy.
We believe that’s wrong. The differences in performance between countries’ equity markets largely comes down to sector exposures. Whether as a result of historical accident, different listing rules, or tax treatments, every equity market is different, tending to be dominated by one or two large sectors.
The US, for example, is dominated by technology stocks, due to the magnetic draw of Silicon Valley and the promise of easy financing. But those companies – Apple, Facebook, Google and so on – have a reach that far exceeds the US. To like the US market you have to like the prospects for technology companies.
In Japan, over one fifth of the benchmark is industrial companies, so to have a view on Japan’s market, you need to have a view on the global demand for manufactured goods. But Japan has no real energy companies to speak of, so the oil price shouldn’t really enter the equation.
Likewise, the UK is global banks and global oil companies, with no technology worth mentioning. Emerging markets have lots of financial sector exposure alongside a large consumer sector, but precious little in the way of industrials or healthcare.
The financial industry is still working with outdated tools. Investors aren’t looking at sectors, so providers don’t create products. BlackRock has $50 billion in its US equity market ETF, and less than $5 billion across all twelve of its US sector ETFs. No UK iShares sector product even exists.
When we build our asset allocations, we take these limitations into account. We know about our tools – the regional indices, and their various biases. Our strategic asset allocation process implicitly and explicitly considers sectoral exposures as well as regional ones. We end up with portfolios which are structurally distributed across global sectors, which feeds into our tactical decision-making.
We can invest in specific sectors – healthcare for example. Or we can tilt our portfolios towards regions with sectoral exposures that we believe are appropriate, such as our ‘COVID recovery’ basket which tilts portfolios towards the cyclical sectors in Europe and Japan.
At 7IM we don’t think our clients’ capital should be run in particular ways just because convention says so. Instead, we look for a robust and repeatable process that sees the world for what it is rather than in terms of outdated traditions and tools.