Why international equities are back in favour

Investing in equities offshore has for the past few years been a quick way to add some negatives to a balance sheet, and even the most hardened investors found the going tough. But, as Jason Spits writes, with the edge coming off the local market and the local dollar, international equities are again claiming their place within portfolios. 

Related: Traps for the unwary global equities investor

It has been said that a great strength can easily become a great weakness, and for investors the shining light of the Australian equities story has been both a boon and a distraction. 

While pundits, planners and punters have all reaped the benefits of a strong dollar and the resources boom, many have taken their eye off international equities, scared by talk of fiscal cliffs, austerity measures and political uncertainty. 

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And that may not have been a bad thing. Local equities have indeed done well, but their success has further cemented the home bias of many investors, spurred on by a strong Australian dollar which made it easy to travel overseas but not to invest there. 

However, fund managers working with international equities are actively pushing against that view, trying to remind investors and financial planners that while Australia may be ‘the Lucky Country’, it is not the only country. 

“There are two main drivers behind Australian equities and they are commodities and financials – and they tend to be local, limited and isolated,” Certitude Global Investments chief executive Craig Mowll said. 

“Compare this with the two of the current leading sectors in international equities – technology and healthcare – which are hard to find or buy in Australia, and you can see the risk in not diversifying beyond Australian equities.”

However, Lonsec senior investment analyst Rui Fernandes said the home bias expressed by investors and planners has been entirely natural, given international equity markets in recent years and the purple patch local markets have experienced. 

“Australian equities have done well compared with international equities, and financial planners have found it hard to pitch the story, but in doing so may have forgotten the lesson of Portfolio Construction 101 – diversification,” Fernandes said. 

“The Australian share market represents less than 3 per cent of global equities and its returns were made to look attractive compared to international equities because of the strength of the Australian dollar.” 

At the same time international equity managers have struggled to produce returns which have exceeded local expectations, and they are aware that investors have been burnt by past experiences.

The extent of the burn is such that for many investors it will be some time before they “normalise their views on international equities”, according to Principal Global Investors chief executive Grant Forster. 

“The problem with the mind-shift that has taken place is that many people have stopped thinking about equities as a growth vehicle and have become fixated on yield and forgot the need for growth within their portfolio,” Forster said. 

A larger oversight is that resource stocks have actually lost 18 per cent over the past three years, according to Aberdeen Global Asset Management senior investment specialist Stuart James.

He also pointed out that local banks – which rely on wholesale funding from overseas markets as they can’t source funding locally – are not passing on interest rate cuts as they find the cost of doing business increasing. 

“What has happened in Australian equities over the past few years has been great, and it is part of a larger cycle, but it is not the norm and is unlikely to occur again.

"When examining the best-performing sectors of recent years there are some issues which have yet to play out for local investors,” James said. 

Off the back of this period, international equity managers have also realised that what attracts investors to Australian equities will also attract them to international equities, with Fernandes seeing a shift in how managers are presenting international equities funds. 

“Risk has become the main theme of many presentations, and managers are offering funds which mitigate risk and are talking up the quality of the underlying investments and the active management they offer,” he said. 

This strategy may be the foot in the door international equities managers need to convince planners and their clients that international equities are starting to become attractive once again.

The recently released Lonsec Global Equity Sector Review said this shift was not limited to a few managers but was almost universal, as fund managers emphasise that quality stocks have been less volatile than the index and the economies of the countries in which they are domiciled. 

But while international equities may be cheap in general, these quality stocks still carry a price premium, something which Morningstar had referred to as ‘expensive defensives’. 

These stocks, typically large and mature consumer staples, have been seen as safe for growth and yield and have been priced accordingly, Morningstar research analyst Kathryn Young said. 

“Managers have been flocking to offer more reliable growth and are confident in their ability to deliver returns in these stocks, which often have an exposure to emerging markets as well.  

“However they are unlikely to have significant expansion in price given that much of it has been priced in already – but those managers who have picked them up and used their processes to target growth have benefitted from these types of investments,” Young said. 

Young warns financial planners as also seeing this development as normative with rising valuations making it difficult to double-dip on the rise of the ‘expensive defensives’ as it would require earnings growth beyond what has been priced into market expectations. 

Despite these expensive outliers, Mowll sees renewed interest in international equities, with many investors realising they have missed the start of the revival and looking at re-entering the market very soon. 

“Australian investors were not the only ones sitting on the edge last year waiting for something to happen. People were reluctant to invest in the United States and United Kingdom as well,” Mowll said. 

“No-one questioned the place of cash and fixed interest, but rebalancing is now happening and international equities are being asked to play a role, particularly those that offer exposure to emerging and developing markets.” 

At the same time the perfect storm that drove investors back on to Australian shores is starting to turn, with 5 Oceans Asset Management portfolio manager Piers Watson seeing international equities as a good move from a valuation point of view. 

“At present it is possible to get still get yield as cash comes off, but also get cheap assets overseas that will generate higher returns as the Australian dollar begins to decline.

"People are now thinking again about international equities again, with their main concern about when and how to enter the market again,” Watson said. 

This shift is already reflected in research conducted by Investment Trends, which indicates that allocations to international investments have increased over the past 12 months and that around 40 per cent of investors with investable assets over $100,000 are holding international investments, climbing from a third of investors in 2011. 

Investment Trends senior analyst Recep Peker said that nearly 40 per cent of investors were also spread across multiple regions via access to multi-region funds, but the focus of investments had shifted from Asia and emerging markets towards the United States.

According to Peker, inflows placed by financial planners to international assets are currently at 26 per cent of client inflows – and both client and adviser preferences have swung to North America. 

“The barriers to increased use of international investments predominantly relate to the uncertainty in overseas markets. In addition, clients’ home bias, currency risk, and potential for poor market performance all contribute to hindering the anticipated increase in the use of international,” Peker said. 

“Similar to investors, adviser appetite has swung away from Asian and emerging markets towards the US/North America.

"Among those planning to recommend international investments to their clients, 28 per cent would encourage their clients to invest in the US/North America region in the next 12 months, up from 21 per cent compared to the year prior.” 

What will cause greater shifts into international equities is what drove people out of them – their performance – with Forster stating that improved international equities performance will make the financial planner’s task of discussing any offshore moves much easier. 

“Show clients the top 10 stocks and their performance and then ask the question ‘why would you choose to avoid that?’, and clients will be willing to have a wider discussion about investing offshore and the issues of risk and return that accompany it,” Forster said. 

“Add in a discussion around the Australian dollar and how it will add a performance kicker too, and clients will see the validity of such investments.

"We need to remember that many have a good global view and are not insular, and the global brands they are investing in are known to us here too.”  

While mindsets are returning to consider international equities, in some cases they have a long way to go. With the average self-managed superannuation fund having less than 2 per cent of equity investments offshore, a wider realisation also needs to take place, according to James. 

“Investors see the economic news and relate that back to their investments and are concerned they have made the wrong play – but often there is a poor correlation between the economic return of a country and the market return into which they have invested,” James said. 

“For example many people have avoided Asia but in doing so have missed the growth of Samsung, which has been driven by consumer demand for its assembled products as well as by its component manufacturing for other technology companies, including Apple. 

“A similar situation in Europe is Nestle, which is a global company selling into new and established markets with a product range that includes food, baby products, bottled water and pet food.” 

But will the mighty Australian dollar take the shine off international equity returns, given its historic highs? James doesn’t think this is the case, and instead regards its present place as a further opportunity to invest in international equities. 

“The dollar looks fully valued and the general view is that it will decline from here, and while that translates as negative thing for some, it will enhance returns for those who have unhedged investments in other currencies and locations.” 

Offshore investments and onshore realities 

Overcoming home bias in a client portfolio is easy when it can be demonstrated that clients are both consumers and beneficiaries of the stocks they may be trying to avoid. 

It is the technique used by Lawler Financial Services director and chief executive Philip Moore to encourage his clients to see the scope and potential of investing in international equities. 

“The tendency to home bias is not a uniquely Australian problem, but what is unique is that we are not exposed to the huge markets that exist in overseas growth sectors such as aviation, pharmaceuticals and consumer staples,” Moore said. 

“Yet many clients know and use these products regularly, and their thinking changes when it is pointed out to them that stocks like Google, Johnson and Johnson and Bayer are accessible to them through managed funds.  

“There is a shift from being a consumer to being an investor accessing global companies in use each day, and they realise they are missing out on a huge sector of the equities market.” 

Moore chooses which international equities managers he will use with client portfolios on the same basis, and at present is looking at the theme of growing consumer demand in developed and developing markets. 

“By doing this my clients can invest in companies in the developed world who are working in the developing world, and get exposure to the stability and growth that is on offer through these companies,” Moore said. 

“We are free to choose our own fund managers from an approved product list of 3000 products, so we look for fund managers who are thematic investors and stock pickers.” 

Hub Wealth Management principal David Smith also engages in fund manager examination with his clients so as to benefit from the diversification available in stocks and sectors overseas. 

“When we begin talking about international equities, my clients do ask questions about them and it is an opportunity to discuss risk versus return and how they operate with both Australian and international equities. 

“Very quickly it becomes clear that the local market is limited and concentrated and that we will need to look overseas for diversification in the equities component of their portfolio,” Smith said. 

“Despite some low points the international equities story has been very good, so I try to focus beyond what my clients know – but also demonstrate that we can manage issues around risk and return when investing in international equities.

"Some are more comfortable with this than others but I aim to coach them so they understand.” 

Like Moore, Smith is prepared to look into the actions of international equities managers to ensure each manager brings their own unique benefits to the table. 

“I do look at the sectors in which managers are invested to ensure the portfolio gets the diversification beyond Australia that it needs, but also to avoid a sector skew or index skew that may occur in international equities due to a poor combination of managers,” Smith said. 

Modern research tools have made this kind of examination easier and simpler for financial planners, with Smith using portfolio x-ray tools supplied by his research provider, while Moore said the blending analysis is produced by a third party, and not the adviser. 

Rather, Moore prefers to know what risk will be added to a portfolio when a manager is added, and says that while he understands the science behind the process, his communicating that to the client is where he can best add value. 

“We don’t promote performance to our clients but we do back up our decisions with the information and tools that are available to us.” 

Smith and Moore both recommend clients hold about 20 per cent of their portfolio in international equities, subject to risk profiles and investment goals, and have advised clients not to see international equities as a yield play. 

“Yield has been an issue but the focus has been on total returns and capital preservation where equities provide the growth and other asset classes provide the yield.

"This does mean there are risks involved – but we educate clients about the potential for a downside. We do not predict the future, but rather manage for the best, long-term returns,” Smith said.