Where Are The Opportunities?
IN PRINT ARCHIVE CIR Summer 1999
|Where Are The Opportunities?|
|Is it too Late to Invest in Europe, and too Soon for Japan?|
|The world is seemingly full of investment opportunities, but these are constantly changing. Some of these changes come from geopolitical events: the European Union has changed many of the investment features of Europe. In other cases, the markets themselves have changed opportunities. Europe has had a great run, but can it continue? Japan and Asia have been beaten up for so long that it may be time for a rebound. And what about the elder statesman in the game--the United States? Are there still opportunities there? Several speakers address these issues in the pages that follow.|
|Peter Rathjens, chief investment officer, PanAgora Asset Management, Boston.|
For the last several years, many investors have viewed Europe as the promised land of equity investing. This was motivated by several factors: perceived efficiencies from the introduction of the EMU, the coming benefits from corporate restructuring, low inflation, and the unsustainable valuation measures in the United States and much of the rest of North America.
Since these issues are widely known, do the current prices of European equities already reflect them? Are European equities overvalued relative to other developed world regions? As fabulous a performer as Europe has been--returns have gone up almost fourfold in a decade--this is still a far cry from the kind of bubble that some people are concerned we are seeing in the U.S. where cumulative returns are up almost sixfold.
On a valuation basis, Europe has clearly become more expensive but it's nothing like what we see in the U.S. There are lots of good reasons why the U.S. have become so much more expensive. One can make a good case that there has been a lot more successful corporate restructuring in the U.S. than there has been in Europe. Nonetheless, the really expensive asset on a relative basis appears to be the U.S., although clearly Europe is much more expensive than it was a decade ago.
If you do want to invest in Europe, there is a fundamental question that all plan sponsors ask themselves--should I do so on an active or a passive basis? Portfolios should be actively managed if managers have some legitimate ability to forecast asset returns, but if they have no insights into the future at all, you want to be passive and just minimize transactions costs and management fees.
One basis for forecasting returns is informational. This is still the predominant approach, and most firms which are actively managing assets in Europe or in most markets do so with an informational approach. They are on the ground collecting information and hopefully finding interesting opportunities on the basis of that information. However, this is hazardous insofar as you have to understand where you are in the food chain of information. Informational inefficiencies were identified by academics almost 20 years ago, but what they pointed out was that there should be opportunities. They did not suggest that these opportunities would be easy to identify. There is a very rich literature to suggest that asset prices do a better job of forecasting macroeconomic events than macroeconomic events do of forecasting asset prices. One example of an informational inefficiency is inside information. An academic many years ago identified that insiders appear to have better information than the rest of us, and appear to be very successful traders. That is probably not a surprise to anybody. It fits every criteria you would have for when an informational approach works--it is proprietary information and it is hard to arbitrage away. The problem is that it is illegal to do so, so there's always a catch in every great story. And once it becomes public, what is to keep it from being arbitraged away? Informational inefficiencies are notoriously easy to arbitrage away.
The analytical approach is less common. They attempt to exploit the systematic behavioural mistakes that individuals make. We are all humans; we all make systematic mistakes that we can identify after the fact but which are hard to arbitrage away because human behaviour evolves very slowly. The most common and most well understood analytical inefficiency is probably value investing. It is very well understood. It was identified in the 1930s and yet it has never really been arbitraged away. Every time people think it's now finally been arbitraged away, it roars back with a vengeance and it's been doing so for over 60 years and that's the good news. The bad news is that they are hard to exploit. For example, it is very hard to buy Japan or Korea at the bottom. Value plays are intrinsically uncomfortable because you're typically selling winners and buying losers. Even if your intellect tells you it is the right thing to do, it's hard not to have your heart rule your head. You end up wanting to wait until there is a little indication that Korea is in fact a good investment. Of course, by the time you finally came to the conclusion that it's on the road to recovery.
How have some of the behavioural or analytical tilts done in Europe? Valuation was an outperformer. If you had tilted your portfolio (without even picking stocks) towards countries with high dividend yields and away from countries with low dividend yields, you would have outperformed. If you look at price-to-book and momentum you see similar results.
You can combine many of these relationships together for added results. I think a disciplined multi-factor approach is the key to adding value on a consistent basis. A low correlation suggests that when you have the luxury of exploiting both tilts, individual stock and country tilts, you will do better than doing one or the other.
|Rupert Tate, senior fund manager, Merrill Lynch Mercury Asset Management, London.|
Where are we with the European Monetary Union? The exchange rates between participating countries have now been irrevocably fixed. The Euro is no longer the dream of minority visionary Europeans. It is now a reality. The EU as an economic block is slightly larger than the United States. But if you look at the size of the capital markets Europe is still pretty immature. They have got quite a way to go before they catch up with the United States. In stock market terms, the EU is about 50% below the level of the U.S. stock market and in terms of the corporate debt market, it has a very long way to go. There is a lot of scope for that to develop in the years ahead.
In terms of the economic impact, quite a lot of this has happened already. We've now got public sector deficits which are very much lower. We've got lower inflation than anybody can remember. We've got an independent and disciplined central bank which is running European monetary policy which does not report to any European body.
But there are clearly risks to what is going on at the moment. Participating countries have surrendered control of monetary policy. At the same time, they have also given up a lot of fiscal flexibility. In order to reflate their economy, they can only take their public sector deficit to 3% of GDP but at the same time these economies are structurally still quite different.
There are three investment implications. The first is the growth in mergers and acquisitions activity within Europe. The pressure is no longer just to achieve critical mass within your national frontiers but to position yourself to compete right across Europe. There were 21 deals over a billion dollars in 1997. That went up to 30 in 1998.
The second implication is the deflationary impacts of monetary union. There is going to be pressure on margins to bring down their prices to the final consumer. It will put the pressure back on companies to look at their cost lines again and try and bring down the price of the final good so that they can compete effectively.
The third is the role of liquidity in supporting the markets. There have been strong inflows into equity mutual funds in the last few years. What has been driving this is the reduction in interest rates in Europe which has changed fundamentally the risk/reward relationship between bonds and equities. This trend has got quite a bit further to go.
You cannot underestimate the importance of what is happening in Europe. In financial terms it is the most important event since the Second World War. It has already fundamentally altered the behaviour of companies, investors, and consumers.
|Bruno Gerard, assistant professor of finance, Marshall School of Business, University of Southern California, Los Angeles.|
The EMU is really a very significant event. Its advocates describe the introduction of the Euro not as a major currency reform, but rather as a currency changeover that will simplify international transactions and increase market liquidity. In turn, this should provide a boost to international investments. But will the adoption of the single currency really have an effect on the international investor?
Currency risk is an important component of the overall risk of any financial asset. Exchange rate volatility induces systematic fluctuations in security returns, and the currency risk component commands an economically significant reward or premium in the market. For international portfolio managers, it is crucial to consider all sources of currency risk in devising an investment strategy.
To the extent that exposure to EMU currency risk is systematic, asset return volatility is likely to decrease, both for European and non-European equity markets. It is clear that the adoption of the single currency will reduce the risk exposure of international investors. It is usually assumed that a decline in risk is desirable, but the issue is really complex. It depends on whether the risk that will be eliminated is fully diversifiable and, to the extent that it is not diversifiable, on the reward investors receive for bearing it. For example, if EMU currency risk is fully diversifiable, then the adoption of a single currency will have limited benefits for international portfolio investors.
We have found that, for both European and non-European investors, the major component of currency risk was related to the exchange rate volatility of the currencies of the countries outside the European circle, and not the currencies within the EMU. The non-EMU currency risk premium is consistently negative and is much larger, in absolute value, than its EMU counterpart. In terms of portfolio strategies, most of the benefits of currency risk management accrue from managing non-EMU risk.
This suggests that the adoption of a single currency is likely to have a limited impact on international asset prices, risk and expected returns. By itself, the Euro will not change much in the risk/return trade-off faced by investors in the international market. In fact, for the last six or seven years, most European countries already have closely aligned their exchange rates with the Deutschmark.
But there will be impacts. Investors will be able to invest without performing multiple currency translations. The single currency will result in more price transparency. Improved transparency and decreased transaction costs will likely increase market liquidity. And there is the larger issue of how the adoption of the Euro will affect the role of the U.S. dollar in the world economy.
|The United States|
|Ian Ainsworth, vice-president and portfolio manager, equities, Altamira, Toronto.|
The U.S. market is the largest market in the world and the driver of global markets today. In fact, the correlation between markets has really shrunk. We've got high correlation even within sectors. The banking sectors around the world seem to move together. The technology sectors move together. It has really become a homogeneous market and I think the U.S. is leading that evolution.
Obviously the S&P has been the best performing marketplace for the last 10 years. When you look at it you could say that there has been a big catch-up going on. We had, on an inflation adjusted basis, pretty mediocre markets through the 1980s. The United States was in a very difficult situation in the 1980s where its capital base was highly unproductive.
The major theme in the United States and around the world is the impact of globalization. Obviously, globalization has a lot of repercussions. First it means that you can source labour around the world; you can access new markets that open up for growth opportunities that you didn't have in your domestic market. You can achieve higher return investment in these foreign markets than you can in your domestic markets, so some of the big brand name companies like Coca-Cola, McDonald's and others are experiencing a rebirth because of this opportunity.
In order to compete in a global market, you've also got to take steps to be a competitor as a country. You've got to restructure your economy. The United States has led the deregulatory move along with the U.K. for the last 15 years in telecommunications, healthcare, defence, banking and more recently, utilities and other sectors. Another big impact is technology change. We are now in a universe where we share everything. We are learning about our customers through the Internet. We are sharing information that is critical for more efficient use of inventory, more efficient use of human resources, and more efficient allocation of our resources to target our customers very effectively.
The e-business models of today, like Amazon and Yahoo, are taking advantage of this network-based technology. It means that you can come closer to your customer--you can interact with them for the first time on a real time basis. You can do market surveys or conduct promotions instantaneously. You can do the same thing with suppliers--you can allow them into your systems, and you can get into their systems, so that you actually create virtual corporations. These virtual corporations, which can include companies like General Motors, outsource all of those skill-sets where they have no value-added benefit, and instead focus on their own expertise. Another example is Magna, which can create product on time and under budget more effectively than they can be produced within Ford. Cisco Systems is another example, and brings in about 60% of its revenue from the Internet. The Internet has created a relationship between Cisco and its suppliers, and between Cisco and its customers, that is very deep.
Technology still has a great future. We are going into a new business model environment that will have a major impact on productivity in the United States and around the world. The United States leads in that effort to bring these models to fruition. It is said that the Internet will improve productivity at rate of .6% per year in the U.S. over the next five to 10 years, which is a significant improvement in productivity. Stock markets tend to correlate highly with productivity. The Japanese were the most productive market and productive economy in the 1980s and their markets took off. If you can lead in the application of new business models, your stock market should benefit.
There are many industries that are going to be affected. I think the task is to find investment opportunities in those spaces that are unrecognized that will take advantage of this major change that's going on. And, as investors in general, to take advantage of the productivity gains that are going to be experienced in the U.S. market and around the world from the adoption of new technologies.
|James Clunie, chief investment officer, Murray Johnstone, Glasgow, Scotland.|
I think that many people are prejudiced against Japan right now, but there are some things worth noting. A 20-year chart (above), which plots Japan against the world index, shows that the bubble of the stock market has now been erased. So Japan is now actually lower than it was 20 years ago, despite that bubble and including the market falls we've seen recently. Now the short-term. In quarter four of last year, the Japanese market was actually one of the best markets worldwide, up about 26% in dollar terms. So far this year Japan is up 10%. Germany, by contrast, is down 12% year-to-date in dollar terms. If we had two investors, investor A and investor B who had invested equal amounts of money in Germany and Japan at the start of this year, investor B in Japan would now have 25% more money than investor A with his German investments. That's how dramatic the moves have been already. So to ignore Japan based on short-term performance or long-term performance, may be a risky strategy.
What are we actually buying when we talk about Japan? Banking is still an important sector, as well as a lot of heavy industries. It is comprised of a lot of large cap, well known companies, some of them with technological leads and good market shares, others in uninteresting industries that some investors may choose to ignore for one reason or another.
Here are some value measures. The price-to-book value of the Canadian markets at the moment is about 2.1 times. Japan trades at about 1.7 times book value. Both of those figures seem quite reasonable in terms of long-term ranges. The U.S., by contrast, is 5.1 times. You pay $5.12 for a dollar's worth of assets. With price to cashflow multiple: Canada is 10.2 times; Japan is 10 times; the U.S. 18 times. We've been telling ourselves for years that the Japanese market is expensive, but in terms of cashflow Japan trades on a price to cash multiple of 10 times. This is about 40% less than the U.S. market.
There are a huge number of opportunities and risks, as you would expect in such a market condition. Cash savings point in one direction. There are enormous figures being quoted for how much money there is in Japan. The last figure I heard was cash savings of $10 trillion yen. Divided by the population of Japan and then converted equals $150,000 Canadian per man, woman and child. This is an astounding sum of money. Just imagine if that went to work in the markets or in the shops. The money hasn't been going anywhere, but maybe one day it will.
However, the state of the economy is dismal. There is as yet no hard data that leads me to suggest the Japanese economy is recovering. The yen is also a risk. If the yen collapses, should it all be good for Japanese exporters? Perhaps, but just think of the turmoil that will cause in the global financial system. Think of what it will do to Korea, or what it will do to the U.S. trade and current account situation.
Are Japanese companies really restructuring? Inax Manufacturing has been cutting its workforce by 11% last year. Sony has cut 10% of the workforce and 21% of manufacturing facilities are to be cut by 2003. Sunitomo Bank has actually rationalized in line with the banking sector. Japan is beginning to restructure and companies like Sony are admired in Japan. They are Japan Inc. They will lead the way and others, we believe, will follow.
Japan is actually an ideal stock pickers market right now. Identify companies that have a leading global market position and are relatively cheap.
|Bill Ziemba, alumni professor of management science, Faculty of Commerce, University of British Columbia, Vancouver.|
There has been an enormous loss of paper assets in Japan in this decade. This has been estimated to be at least US$5 trillion in Japanese land and US$5 trillion in Japanese stocks. At the peak of the economic expansion which lasted from 1949-to 1988, Japanese stocks represented over 40% of the world's capitalization. During this decade, this sank to only about 15% of world cap.
There are some resulting social and political changes. Keritsu and long-term employment systems have deteriorated. Unemployment is high, slowing growth. Currently, the unemployment rate is estimated to be at 4.4%. If it is measured as it is in the United States, the rate rises to well over 6%. For Japan, and indeed any country, this is quite substantial.
There is a tremendous resilience to spend, which means that savings are high. The Japanese people save for a variety of reasons. They don't have good pensions; they can get kicked out of their jobs at age 60. They actually save because they're afraid.
Now they are petrified to invest in the stock market because they simply feel that they are going to lose. But if this market ever takes off, and institutional investors will move in, and then the retail investor, you will have a huge move. This extra saving power will further any positive stock market movement. At some stage there will be a rebound, fuelled by overseas investors. There is a tremendous feeling from many managers around the world that they don't want to miss Japan the next time it starts to move.
|Comments From The Floor|
Bob Kay, senior vice-president, investments, Ontario Pension Board, Toronto.
To the outside observer, the advent of the Euro appeared seamless and well orchestrated but what of the aftermath? Will the Euro challenge the U.S. dollar's place as a global currency?
At this stage in the life of the Euro, the answer is that it won't as it is presently constituted. So why would the U.K. want to join in a monetary union with diverse countries which have spent the past 300 years at odds with each other.
Rupert Tate, Senior fund manager, Merrill Lynch Mercury Asset Management, London.
You've got to ask why these countries, which have been fighting and arguing with each other, are getting together in the first place? I think the answer to that is that they're trying to change the way things will be in the next 50 years. That is a very strong motivation for the politicians who have got behind this and made it a reality. The politicians are taking a long view but actually, companies and businesses are moving faster. Many are pricing their goods in Euros. U.K. companies want to get access to capital in the same way that European competitors will. If they are not in, arguably, they are at a disadvantage. So I think businesses will push it on.
Johnny Quigley, Pension fund controller, city of Montreal.
Is it valid to focus on controlling our risk through a passive approach, where we would take a large cap approach on each country weighted pretty well in function of the index we want to beat, and then add small to mid cap in an attempt to add value?
Peter Rathjens, Chief investment officer, Pan Agora Asset Management, Boston.
Clearly you want a process which is dynamic and which evolves to reflect changes, but there are ongoing market inefficiencies that one should try to exploit to some degree. The degree of activity is a wide open issue. In terms of the index, I think the important distinction is whether it is a truly passive index which doesn't require rebalancing or an index which is truly an active portfolio with a simple active role like rebalanced equal weights.
Janet Greenwood, Director, investment services, Aurion Capital Management, Toronto.
Given the growth of the equity culture in Europe by both investors and issuers, what is the potential for dominance of EMU and the equity markets to actually outpace the returns of the U.S. ?
There is a lot of ambiguity about whether the EMU will ultimately work. I suspect it will, but there will be pressures against it. There is probably a risk factor which may have implications for returns. I think you see in part the huge historical run up of the Euro countries in the last few years reflecting anticipations that Euro will work.
You should look beyond monetary union to try and decide whether you want to be in Europe or whether you want to overweight Europe rather than the U.S. I think there are things going on in Europe, which are independent of monetary union, which make Europe a compelling story. You could argue that Europe is where the U.S. was about 15 years ago. What is driving management and the bottom line is how well their share price performs. In the past, management has gauged its success by the size of the balance sheet or by sales or they may have been aiming for local employment targets. The shift towards realizing shareholder value is very strong.
Jimmy Fortin, Financial analyst, Caisse de Dépôt et Placement du Québec.
Let's say in two years there are two or three countries in Europe in a severe recession. At the same time you also have a few other countries with a GDP growth rate of 5%. What will be the reaction of the Central Bank?
I think the scenario that you're outlining is pretty unlikely. The charter of the Central Bank is very clear. Their priority is price stability and we've seen so far that they won't pander to the politicians. One of the reasons I think the Euro has been quite weak so far is because market perception was that the German finance minister was trying to bend the arm of the Central Bank and that he lost. I think that the stimulus will not come from the Central Bank, but rather from the politicians. What you will probably see is some kind of variation of the stability pact. They might decide that things have become so acute that it was necessary, or appropriate, to increase deficits or fiscal stimulus could take place in the countries which were seeing economic hardship.
Bruno Gerard, Assistant professor of finance, Marshall School of Business, University of Southern California, Los Angeles.
There will be some stress in the near future especially since it's been quite hard on most of the countries and on the citizens. The governments in most of Europe are becoming more socialist or new type socialist, so they will tend to be less inclined to adhere to drastic fiscal policy that might be required by those kind of scenarios.
Reynald Harpin, Chief Pension Investment Officer, Alcan Aluminum, Montreal.
Can corporate Japan improve the return on capital which is to me a true condition of recovery?
James Clunie, Chief Investment Officer, Murray Johnstone, Glasgow, Scotland.
This is actually a critical stage for Japan in terms of market trend momentum. What other Japanese companies do will be critical. If you see a flurry of announcements following on the back of the Sony layoff announcement--that is a very clear signal that things will get better.
Ian Ainsworth, Vice-President and Portfolio Manager, Equities, Altamira, Toronto.
When you start comparing markets like they were commodities, it is unfair because there are major structural differences in the economies of Japan and the United States that might make it difficult for them to restructure. For example, the small business community in the United States, generally representing more GDP than all of Japan, has been the absorption area for all these layoffs in the restructuring that's going on in the United States. You just don't have that sector in Japan. So these layoffs are going to be a little more difficult to achieve.
Bob Bertram, Senior Vice-President, Investments, Ontario Teachers' Pension Plan Board, Toronto.
What has been said here, in some cases, is that even though a certain benchmark might be seen as overvalued, for example, there are still plenty of opportunities in the U.S. market. So do the standard benchmarks still work ?
In the U.S., people are obsessed with benchmarking because so many active managers have underperformed. In Japan, it is not too big an issue. In Japan we think that the index will do relatively little in the year ahead. Individual stocks should actually excel.
Raman Uppal, Associatae Professor, Faculty of Commerce and Business Administration, University of British Columbia, Vancouver.
In the early 1990s the U.S. looked very much like Japan looks today. It was in recession; the unemployment rate was high and it had been following a strict monetary policy. The solution to these problems was to expand monetary policy and let the interest rates drop, and the market took off from that point onwards. So the question from a macro perspective is can we use the same policies to fix the problems in Japan? The difference between the Japanese situation and the U.S. situation was that in 1982, the U.S. nominal interest rate was very large and therefore there was a potential of lowering the interest rate through an expansionary monetary policy. In Japan today the interest rate is close to zero. If you talk to one extreme group of people, they've argued that the interest rate is negative. Structural reform is also very difficult and fiscal expansionary policy is also very difficult to implement given that the budget deficits are already very low. So the question is, given the problems that we see today and given the political and macro environment in Japan, what do we expect for the next year? I agree that in the long-term Japan might look very attractive but for the purposes of our investment gain, where you have a lot more at stake, how many of you would like to pull out money from Europe and the U.S. and put it in Japan?
Bill Ziemba, Alumni Professor of Management Science, Faculty of Commerce, University of British Columbia, Vancouver.
It takes guts to sell Microsoft and invest in some Japanese junk. But, if you're a long-term investor, it's very hard to time the market.
It takes real discipline to buy low and sell high.