valuation driven asset allocation · the origins of valuation-driven asset allocation “the whole...
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©2017 Morningstar, Inc. All rights reserved.
Daniel Needham, CFA
President & Chief Investment Officer
Valuation Driven Asset Allocation
Outline
Valuation-driven asset allocation
Historic valuation analysis
Asset allocation process
Case study – a full investment cycle
Investment opportunities
Current positioning
Key takeaways and questions
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Valuation-driven asset allocationThe origins of valuation-driven asset allocation
“The whole idea of basing the value upon current earnings seems inherently absurd, since we know that current earnings are constantly changing. […] A conservative valuation of a stock issue must bear a reasonable relation to the average earnings […] which should cover a period of not less than five years, and preferably seven to ten years.”
is what you get
”“ Price is what you pay; value
Warren Buffett, 2008 Letter to Shareholders of Berkshire Hathaway Inc.
Graham and Dodd,1934, Security Analysis (p. 452)“
”34
Valuation-driven asset allocationThe origins of valuation-driven asset allocation
Source: Shiller, Morningstar, Inc. Monthly, as of Dec, 31,2016. For Illustrative purposes only.
0
5
10
15
20
25
30
35
40
45
50
1881 1886 1891 1896 1901 1906 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016
CAPE Price E10 Ratio
35
Valuation-driven asset allocationU.S. CAPE and 10-year real returns
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Q1 Q2 Q3 Q4 Q5
10-y
ear A
nnua
lised
Rea
l Ret
urn
(189
1 to
201
6)
CAPE Quintiles
36
Source: Shiller, Morningstar Investment Management. For illustrative purposes only.
Valuation-driven asset allocationPrice to fair value drives returns and losses
Source: Morningstar. For Illustrative purposes only.
VALUE
TIME
MARGIN OF SAFETY
FAIR VALUEPRICE(MR MARKET)
GREATER POTENTIALFOR RETURNS
LOWER POTENTIALFOR RETURNS
LOWER POTENTIALFOR LOSSES
GREATER POTENTIALFOR LOSSES
37
Historical valuation analysisEmpirical evidence – developed countries shares
gSetup
/Valuation Measure: Cyclically-Adjusted Price-Earnings Ratio (CAPE: 5-Year Average Earnings)
/Universe: 23 Developed Countries - Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United Kingdom, USA
/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)
/Update Frequency: Monthly
/Timeframe: 01/1975 – 03/2016
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Historical valuation analysisDeveloped countries shares (01.1975-03.2016): Growth of $1
$55.0
$18.9
$14.7
$0.5
$1.0
$2.0
$4.0
$8.0
$16.0
$32.0
$64.0
$128.0
1974
1975
1976
1977
1977
1978
1979
1980
1980
1981
1982
1983
1983
1984
1985
1986
1986
1987
1988
1989
1989
1990
1991
1992
1992
1993
1994
1995
1995
1996
1997
1998
1998
1999
2000
2001
2001
2002
2003
2004
2004
2005
2006
2007
2007
2008
2009
2010
2010
2011
2012
2013
2013
2014
2015
2016
High Medium Low
Source: MSCI, IMF, Morningstar Investment Management. Past performance does not guarantee future results.
39
Historical valuation analysisEmpirical evidence – bond markets
gSetup
/Valuation Measure: Current Interest Rate minus 5-Year Average Interest Rate
/Universe: 15 Long-Term Bond Markets - Australia, Austria, Belgium, Canada, Euro Area, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, South Africa, Switzerland, UK, US
/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)
/Update Frequency: Monthly
/Timeframe: 01/1975 – 11/2015
40
Historical valuation analysisLong-term bonds (01.1975-11.2015): Growth of $1
$16.35
$7.58
$4.37
$0.5
$1.0
$2.0
$4.0
$8.0
$16.0
$32.0
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
High Medium Low
Source: IMF, Morningstar Investment Management. Past performance does not guarantee future results.
41
Historical valuation analysisEmpirical evidence – currency markets
gSetup
/Valuation Measure: 5-Year Change in Real PPP Exchange Rate
/Universe: 13 Currency Pairs vs USD - Australia, Canada, France (1975-1998), Germany/Euro, Italy (1975-1998), Japan, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, UK
/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)
/Update Frequency: Monthly
/Timeframe: 01/1975 – 3/2016
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Historical valuation analysis13 currencies (01.1975-03.2016): Growth of $1
$1.72
$0.87
$0.66
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
1974
1975
1976
1976
1977
1978
1978
1979
1980
1980
1981
1982
1982
1983
1984
1984
1985
1986
1986
1987
1988
1988
1989
1990
1990
1991
1992
1992
1993
1994
1994
1995
1996
1996
1997
1998
1998
1999
2000
2000
2001
2002
2002
2003
2004
2004
2005
2006
2006
2007
2008
2008
2009
2010
2010
2011
2012
2012
2013
2014
2014
2015
High Medium Low
Source: MSCI, IMF, Morningstar Investment Management. Past performance does not guarantee future results.
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Asset allocation processOur valuation framework
VALUATION-IMPLIED RETURN
EQUITY
PROPERTY
BONDS
CURRENCY
DividendsBuybacks
Rent
CouponsInterest
FCF GrowthEarnings Growth
Income Growth
Defaults
Inflation
Price/Fair ValueP/CF, P/E
Price/NTA
Yield Spread
Real FX Rate
CASH FLOW YIELD CASH FLOW GROWTH CHANGE IN VALUATION+ +=
Interest Rate Differential
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Depth and quality of our resourcesAsset allocation process
Our fundamental approach to investing helps to form our best thinking about capital markets research and asset classes.
Morningstar’s Investment Management group includes Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., and Morningstar Investment Services LLC, a registered investment adviser and subsidiary Morningstar Investment Management LLC. Globally, other affiliates or subsidiaries of Morningstar, Inc. can provide consulting or investment advisory services in Europe, Africa, Asia, and Australia.
Our fundamental, valuation-driven approach to investing starts with data and analysis from Morningstar, Inc. This judgement-driven approach helps to form our best thinking about asset classes and fund managers.
Our investment professionals collaborate with our global research team to uncover attractive investments around the world.
InvestmentProfessionals
Manager ResearchAnalysts
Equity & CreditAnalysts
110
121203
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Asset allocation processGlobal asset class teams
Asset Allocation
Philip StraehlHead of Capital Markets & Asset Allocation, Americas
Tanguy de LauzonHead of Capital Markets & Asset Allocation, EMEA
James FootHead of Capital Markets & Asset Allocation, Asia-Pac
Global Asset Class Teams
Equity, AmericasMarta Norton
Equity, EMEAClemence Dachicourt
Equity, Asia-PacBryce Anderson
Global SectorsPhilip Straehl
Emerging MarketsNimalan Govender
REITS/InfrastructureBianca Rose
Capital Markets & Asset AllocationRegional Leads
Paul ArnoldCarrie ScherkenbachMichael JuettnerMike StoutNabil SalemRob Miehm
Simon MolicaRichard WhitehallDaniel Vaughn
Vesna PeroskaJoel GrosvenorAndrew Jayne
Dan McNeelaJared WattsRob CaldwellSteve TagarovMatthias Palowski
Cyrique BourbonKyle Cox
Brian HuckstepBryan Platz
Fixed Income, AmericasDario Castagna
Fixed Income, EMEAMark Preskett
Fixed Income, Asia-PacBrad Bugg
GS/Global CreditTanguy de Lauzon
Emerging Market DebtEd Fane
CurrencyJames Foot
Hong ChenJohn McLaughlinJosh CharneyMichelle WardMike KeaveneyShekryar KhanHui Min Chang
Enrico BolzoniEmma Morgan
Ameya HattangadiJames Nairn
Olufemi MadaMarina JelesovaDanielle Rusznyak
John ShelbourneRicky WilliamsonMichael Kruger
Lucian MarinescuMatthew Wu
Equity
Fixed Income
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Asset allocation process
For illustrative purposes only. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive results.
Building multi-asset portfolios
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Case studyA-REITS were very compelling directly after the GFC …however this has been largely played out
How do we respond to changes in valuation?
BALANCE SHEET
2007 2010 2016
Highly Leveraged
Low Quality
Borrowed
Overweight
Positive
Expensive
Unattractive
Recapitalisation/Divestments
Higher Quality
Sustainable
Underweight
Extremely Poor
Cheap!
Attractive
Increasing Leverage
Quality beginningto deteriorate
Becoming stretched
Overweight
Positive
Expensive
Less Attractive
EARNINGS
PAYOUT
MARKET POSITIONING
MARKET SENTIMENT
VALUATION
YIELD
AREITS
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Case studyA-REITS – a valuation-driven opportunity that has undergone a full investment cycle
Source: Morningstar Investment Management.
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$-
$1,000
$2,000
$3,000
$4,000
0.0%
5.0%
10.0%
15.0%
20.0%
AREITs Weight in Portfolio (RHS)
Growth of $1000 in ASX300 Property
Position Increased as AREITs Identified as
UndervaluedStrong Positive
Performance Seen by Sector
Position Tapered Off as Asset Class Approaches
Fair Value
Investment opportunitiesAsset allocation in a low return world
Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.
U.S. Equity Now
U.S. Aggregate Bonds Now
Cash Now
U.S. Equity Fair Return
U.S. Aggregate Bonds Fair Return
Cash Fair Return
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
-16% -14% -12% -10% -8% -6% -4% -2% 0%
Valu
atio
n-Im
plie
d Re
turn
(USD
)
Valuation Conditional Drawdown
Normal
Now
50
Equity and Bond Discount Rates have been in a secular decline, decreasing prospective returns
Investment opportunitiesEquity vs. bond discount rates
Source: MSCI, IMF, Barclays Capital, Morningstar Investment Management. Past performance does not guarantee future results.
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%De
c-74
Oct-7
5
Aug-
76
Jun-
77
Apr-7
8
Feb-
79
Dec-
79
Oct-8
0
Aug-
81
Jun-
82
Apr-8
3
Feb-
84
Dec-
84
Oct-8
5
Aug-
86
Jun-
87
Apr-8
8
Feb-
89
Dec-
89
Oct-9
0
Aug-
91
Jun-
92
Apr-9
3
Feb-
94
Dec-
94
Oct-9
5
Aug-
96
Jun-
97
Apr-9
8
Feb-
99
Dec-
99
Oct-0
0
Aug-
01
Jun-
02
Apr-0
3
Feb-
04
Dec-
04
Oct-0
5
Aug-
06
Jun-
07
Apr-0
8
Feb-
09
Dec-
09
Oct-1
0
Aug-
11
Jun-
12
Apr-1
3
Feb-
14
Dec-
14
Oct-1
5
E Yield (CAPE)
Nom. Interest Rate + IG Credit Spread (OAS)
51
Investment opportunitiesFinding opportunities in fixed income
Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.
U.S. Equity
U.S. Aggregate BondsU.S. Treasury Bonds
Intl. Treasury
U.S. Inflation-linked Bonds
U.S. Credit
U.S. Corporate High Yield
Cash
Hard Currency Emerging Market Debt
Local Currency Emerging Market Debt
0%
1%
2%
3%
4%
5%
6%
7%
-18% -16% -14% -12% -10% -8% -6% -4% -2% 0%
Valu
atio
n-Im
plie
d Re
turn
(USD
)
Valuation Conditional Drawdown
More Attractive
Less Attractive
52
Investment opportunitiesPockets of opportunity outside traditional developed market bonds
Source: Reuters, Morningstar Investment Management. As of 31/08/2016.
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
2011 2012 2013 2014 2015 2016
Emerging Markets Local Currency | 10-year yield
Brazil Mexico Poland South Africa Indonesia Malaysia
53
U.S. Equity
Europe ex UK Equity
Pacific ex Japan Equity
United Kingdom Equity
Emerging Markets Equity
Europe, Australasia and Far East
U.S. Aggregate Bonds Cash
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
-20% -18% -16% -14% -12% -10% -8% -6% -4% -2% 0%
Valu
atio
n-Im
plie
d Re
turn
(USD
)
Valuation Conditional Drawdown
Investment opportunitiesFinding opportunities in equities
Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.
More Attractive
54
Less Attractive
Investment opportunitiesDiverging U.S. and international valuations (CAPE)
0.0
5.0
10.0
15.0
20.0
25.0
30.0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
USA EAFE EM
Source: MSCI, IMF, Morningstar Investment Management. For Illustrative purposes only. Past performance does not guarantee future results.
55
Investment opportunitiesEmerging markets have been very unpopular
Source: BofA Merrill Lynch Global Fund Manager Survey. For illustrative purposes only.
56
Current investment opportunity setAustralia – key asset classes: valuation implied returns (real, local currency)
Source: MSCI, Morningstar Investment Management. As of 31/12/2016. For illustrative purposes only.
6.7%
5.9%
4.8%
3.5%3.0% 2.9%
2.2% 2.2% 2.2%
1.4% 1.1% 0.9% 0.9% 0.9%0.2% 0.1% 0.0%
-0.1%-0.6%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
Kore
a Eq
uitie
s
Taiw
an E
quiti
es
EM E
quiti
es
UK E
quiti
es
Euro
pe E
quiti
es
EM D
ebt -
Loc
al C
cy
EM D
ebt -
Har
d Cc
y
Aus
List
ed P
rope
rty
Japa
n Eq
uitie
s
Infra
stru
ctur
e
US H
igh
Yiel
d
US E
quiti
es
Aus
Infla
tion
Link
ed B
onds
Aus
Equi
ties
Glob
al L
iste
d Pr
oper
ty
US G
ovt B
onds
Aus
Govt
Bon
ds
AUD
Cash
Glob
al A
gg B
onds
Valu
atio
n Im
plie
d Re
turn
(Loc
al C
urre
ncy)
57
Investment opportunitiesHigh conviction investment positions of different vintages
2010 2012 2014 2016
↑ Increase A-REITS↑ Increase Global Credit
+ Initiate Japanese Equities↑ Increase Unhedged Currency – position for falling AUD
↓ Decrease AU Equities↓ Decrease US Equities↑ Increase EU Equities↑ Increase Japanese Equities
↑ Increase Currency Hedging↑ Increase EM Equities+ Initiate EU Energy
+ Initiate EM Debt↓ Decrease EU Equities↓ Decrease AREITS
+ Initiate Global Quality Strategy+ Initiate European Utilities↓ Decrease Global Credit
↑ Increase EU Equities+ Initiate EU Financials+ Initiate US HY Credit↑ Increase Inflation-Linked Bonds↑ Increase EM Debt (LC)↓ Decrease Listed Property↓ Decrease Global Infrastructure
2011 2013 2015
58
Current positioningMorningstar Growth Real Return Fund asset allocations
Source: Morningstar Investment Management. As at 31 December 2016.
Other Developed Equities6.9%
US Equities3.9%
European Equities13.1%
Japanese Equities8.8%
Emerging Market Equities8.2%
Australian Equities7.9%
Global REITs0.9%
Global Infrastructure1.6%
International Bonds1.5%
Emerging Market Debt6.0%
US High Yield1.4%
Inflation Linked Bonds3.8%
Australian Bonds4.1%
Alternatives11.0%
Cash & Currency21.0%
Holdings for Morningstar Growth Real Return Fund Fund as at Dec-16
59
Key takeaways and questions
O Valuation-driven asset allocation is a long-term investment strategy that has the ability to generate significant returns across stocks, bonds, and currencies
O Conversely, an analysis of historical data suggests that holding assets that are overvalued can lead to significant underperformance
O Morningstar’s global investment capabilities, put us in a unique position to identify and harness potential investment opportunities across the globe
O Iterative approach to building multi-asset portfolios, driven by valuations, fundamentals research and a willingness to be different, focused on maximising reward for risk
O Despite lower prospective returns across most major asset classes, we try to find select opportunities in international assets while maintaining defensive aggregate positioning
O Our multi-asset portfolios are biased towards Emerging Markets, Japanese & European equities, and away from developed world government bonds (towards cash, emerging market debt and credit)
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Important information
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