For many years investors have looked to a company’s location as an avenue for investing in a particular market. Paul Hennessy argues why this basis of investment is no longer prudent.
Geography is a key building block for investors, whether they are individuals buying index funds or professional money managers thinking about asset allocation or building investment portfolios. Unfortunately, investors may be undermining their results by making decisions based on a simple, historically accurate assumption that is becoming less relevant every day.
Without much debate, we have always used a company’s locale as a good proxy for where it does business and thus its prospects. Today, though, basing an investment decision on where a company gets its post delivered tells us little about its potential for success and consequent growth in its share price. This is an issue facing all investment managers, but it is especially acute for investment vehicles based on geography, including many of today’s most popular index funds.
Capital Group created the Capital International indices, known today as the Morgan Stanley Capital International (MSCI) indices, in the late 1960s from data we gathered while doing global research on individual companies. Back then, there were only 18 countries available for investing and five of them accounted for 90 per cent of the opportunities. Where those companies were based was very much the same as where they did business.
The world has changed dramatically since then. Average tariffs have declined from 26 per cent in 1986 to 8 per cent in 2010. Global trade has exploded, accounting for nearly a third of all global gross domestic product. Today, where a company is located may have little to do with where it generates its revenues or profits and tells investors almost nothing about the company’s prospects.
Even the companies in the indexes don’t always give you a clear picture. Most investors consider the Standard & Poor’s 500 Composite Index an American index because all 500 companies in it are domiciled in the United States. But that isn’t the whole story. Those 500 US-based companies generate 39 per cent of their revenue outside the US.
In Australia, investors in a portfolio that replicates the S&P/ASX 200 might not get the Australian concentration they’re seeking, given around 43 per cent of revenues generated by companies represented in the S&P/ASX 200 come from outside Australia.
To give you a sense of how significant an issue this has become it is helpful to look at the MSCI ACWI through the revenue versus domicile lens. The index – the broadest global equity index, comprising 2500 companies – shows us that while emerging markets represent only 11 per cent by market capitalisation, they account for a whopping 34 per cent by economic exposure, or more than a third of all global demand. At the same time, the US accounts for 46 per cent of the MSCI ACWI Index, but only 27 per cent of demand.
Investors in a portfolio modelled on the S&P/ASX 200 might not get the Australian concentration they’re seeking and MSCI ACWI investors might not get the global diversification they want. In either case, though, investors who rely on one of these geography-based indexes would be missing the opportunity to focus their attention on those companies that are generating the most revenues and profits.
We believe there is a better approach, referred to as ‘the new geography of investing’ – looking past where a company is headquartered to where it generates its revenues and by extension its profits. Consider these examples.
Burberry is based in the United Kingdom but derives the largest share (33 per cent) of its income from China and other emerging market nations. In Australia, it’s well-known James Hardie Industries has significant operations in the US. In fact, its economic exposure to the US market is about 70 per cent and 10 per cent to the rest of the world ex-Australia. Is Burberry a European company? Is James Hardie effectively a US company?
How can investors use the new geography to focus investments on those companies that offer the best opportunities? Firstly, investors will need to rethink how they define a company’s geography. A switch to using revenue measures will mean a company is no longer from one place.
Secondly, investors need to be clear about what they want to achieve. Whether it is growth, growth of income, a steady dividend stream or financial quality of companies, an investor’s objective will be the new organising principle rather than country of domicile.
The old geography has served investors well for more than 40 years. It remains a very useful tool and should not necessarily be abandoned overnight. But we need to begin using a better approach to stock selection other than country of domicile. Rather, we should focus our attention on the companies with the brightest prospects, no matter where they’re headquartered or domiciled.
More than ever, active research and security selection is crucial to navigating the investment world. To help people reach their individual objectives, we need to align our decision-making with that rather than only being confined by a geographic index. Indexes can still be useful in judging an investment manager’s results, but investors need to be aware of their limitations when it comes to asset allocation and security selection.