Morningstar Investment Management Adviser Roadshow€¦ · gCurrent investment opportunities gWhere...

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Morningstar Investment Management Adviser Roadshow

Daniel Needham, CFAPresident and Global Chief Investment Officer,Investment Management group, Morningstar

Finding Investment Opportunities in an Uncertain Investing World

Agenda

gValuation-driven investinggWhy we need to be contrarian investorsgInvestment opportunity setgCurrent investment opportunitiesgWhere have we been and how are we investing?gKey takeaways and questions

3

The value of any stock, bond, or business today is determined by the

cash inflows and outflows—discounted at an appropriate interest rate—

that can be expected to occur during the remaining life of the asset.

Warren Buffett, Berkshire Hathaway’s 1992 Annual Report

How value is determined

“

”4

In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:

Price 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

5

Source: DataStream, Bloomberg, FactSet & Morningstar Investment Management as at 31/12/2017. For illustrative purposes only.

Valuation and average returns

-5%

0%

5%

10%

15%

Q1 Q2 Q3 Q4

Aver

age

Real

5 y

ear R

etur

n (p

.a.)

Valuation Quartile

US

UK

Europe

Japan

Australia

Average

6

Our valuation framework for asset classes, regions & sectors

VALUATION-IMPLIED RETURN

EQUITY

PROPERTY

BONDS

CURRENCY

DividendsBuybacks

Distributions

CouponsInterest

FCF GrowthEarnings Growth

FCF GrowthEarnings Growth

Defaults

Inflation

Price/Fair ValueP/CF, P/E

P/E, P/CF, P/FFO

Yield Spread

Real FX Rate

CASH FLOW YIELD CASH FLOW GROWTH CHANGE IN VALUATION+ +=

Interest Rate Differential

7

Agenda


8

“The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone is agreed about its merit, the investment is inevitably too dear and therefore unattractive.”

What it means to be a contrarian

John Maynard Keynes, Letter to Jasper Ridley, 1944

9

Two theories – key contrasting arguments

Efficient Market Theory

g Investors are assumed to be rational and hence value securities rationally

g Irrational investor trades are random and cancel each other out

g Irrational trades not cancelling out are met by rational arbitrageurs

Behavioural Finance Theory

g Investors regularly violate rational postulates, with biased decisions and preferences

g Investors don’t deviate from rationality randomly, most deviate the same way

g In contrast to efficient markets theory, real-world arbitrage is risky and limited

Source: Inefficient Markets: An Introduction to Behavioural Finance Andrei Shleifer

10

Warren Buffett’s folksy rhyme to the rescue

Warren Buffett outlined this well in in his 1988 letter to Berkshire Hathaway shareholders:

“…Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day…”

11

Source: Inefficient Markets: An Introduction to Behavioural Finance Andrei Shleifer

The Jellybean Experiment

Wisdom of the crowd

g Jack Treynor’s jelly bean experiment

gMichael Mauboussin (2007) –73 Columbia Business School students:

/Guesses: 250 – 4,100

/Average error: 700 (62%)

/Actual number: 1,116

/Average guess: 1,151 – just 3% off

12

Source: Mauboussin, M.J and Page S

Wisdom of the collective

According to the Diversity Prediction Theorem:

Collective wisdom breaks down when: Insufficient diversity causes individual errors to correlate

Individual error (ability of the individual) minusPrediction diversity (difference of individuals)

Collective error =

Source: Mauboussin, M.J and Page S

13

Interdependence and independence

Bees use collective intelligence to select new hive sites

Waggle dance is used to indicate potential bee hive sites. Each scouting bee makes an independentevaluation - and the new hive is only established once a quorum is reached. Source: Collective Intelligence in social insects, NR Franks / Modified from an illustration of nectar foraging by honeybees in Seeley (1985)

Waggle dancePossible hive site

14

Music downloads and social influence on decisions

Source: Experimental Study of Inequality and Unpredictability in an Artificial Cultural Market, M. J. Salganik, P. S.. Dodds and D. J. Watts.Science 2016

15

Illustrating noise versus signalShort-term oriented observers may see the first 20 coin tosses and conclude that it is a “tails-biased coin”.….

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Source: Mauboussin

20 Trials


16

Source: Mauboussin

100 Trials


16

Source: Mauboussin

Loss of difference and narrowing breadth

Well functioning markets have diverse participantsIndependent participants e.g. value/growth, short-term/long-term, institutional/retail, fundamental/technical

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A breakdown of diversity leads to fewer investor typesRemaining investors follow similar strategies, more correlated

17




Contrarians tend to be lonely –especially at extremesContrarians tend to be concentrated on the short and long side of market extremes

17




Agents of negative feedback are critical for marketsValue, contrarians, long-term, re-balancers, volatility sellers

Contrarians tend to be lonely –especially at extremesContrarians tend to be concentrated on the short and long side of market extremes

17

Contrarian investors checklist

Are most investors underweight and is ownership concentrated in more contrarian investors?

Are earnings expectations low relative to history and other assets?

Is sentiment negative as gauged by investor surveys? Is trading volume or turnover low? Is realised and implied volatility high and rising? Are there low valuation ratios relative to history and

similar assets?

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Critical condition – buying dollar bills for 50 cents

19

“Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety”—room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.“Seth Klarman – Introduction to the 6th edition of Security Analysis, Graham and Dodd

Critical condition – buying dollar bills for 50 cents

19

20

Agenda


4.0%3.4% 3.3%

2.5% 2.5% 2.4%2.1%

1.8%1.1% 1.0% 0.8% 0.5% 0.5% 0.2%

0.0% 0.0% -0.1% -0.2% -0.4% -0.5%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Glob

al T

elec

oms

Euro

Ene

rgy

UK E

quiti

es

EM D

ebt -

Loc

al C

cy

EM E

quiti

es

Euro

Fin

anci

als

Japa

n Eq

uitie

s

Euro

pe E

quiti

es

Aus

List

ed P

rope

rty

Paci

fic x

JP

Equi

ties

Infra

stru

ctur

e

Aus

Infla

tion

Link

ed

Aus

Equi

ties

Aus

Com

p Bo

nds

Aus

Govt

Bon

ds

Glob

al L

inke

rs

AUD

Cash

Glob

al L

iste

d Pr

oper

ty

US E

quiti

es

Glob

al B

onds

↑4 ↓1 ↑1 ↑3 ↓3 ↓3 ↑1 ↓2 ↑2 ↓1 ↓1 - ↑1 ↑1 ↑2 ↑2 ↑2 ↓2 ↓6 -

Valu

atio

n Im

plie

d Re

turn

(Loc

al C

urre

ncy) Dec'17 Change vs Dec'16

Source: Morningstar, data as of 31/12/2017

Current valuation-implied return opportunity set

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Aus EquitiesNow

Aus Comp BondsNow

AUD CashNow

Aus EquitiesFair Return

Aus Comp BondsFair Return

AUD CashFair Return

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

-70% -60% -50% -40% -30% -20% -10% 0%

Valu

atio

n Im

plie

d Re

turn

(AU

D)

Valuation Conditional Drawdown

Asset allocation in a low return world

Source: Morningstar Investment Management Estimates. For illustrative purposes only.

22

Global Telecoms

UK Equities

EM EquitiesEuro FinancialsJapan Equities

Europe Equities

Pacific x JP EquitiesInfrastructure

Aus EquitiesAus Comp Bonds

AUD CashGlobal Listed PropertyUS Equities

-1%

0%

1%

2%

3%

4%

5%

-80% -70% -60% -50% -40% -30% -20% -10% 0%

Valu

atio

n Im

plie

d Re

turn

(Loc

al C

urre

ncy)


Equities vs Key Australian Assets


Finding opportunities in equities

More Attractive

Less Attractive

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EM Debt - Local Ccy

EM Debt - Hard Ccy

US High Yield Aus Inflation LinkedAus EquitiesAus Comp Bonds

Aus Govt Bonds

Global LinkersAUD Cash

Global Bonds

-1%

0%

1%

2%

3%

-70% -60% -50% -40% -30% -20% -10% 0%

Valu

atio

n Im

plie

d Re

turn

(Loc

al C

urre

ncy)


Fixed Income vs Key Australian Assets


Finding opportunities in fixed income

More Attractive

Less Attractive

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25

Agenda


Source: JPX Tokyo Stock Exchange

Japanese companies are showing improved corporate governance

12.9% 15.0% 16.7% 18.0%21.5%

48.4%

79.7%

88.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

2010 2011 2012 2013 2014 2015 2016 2017

% o

f com

pani

esPercentage of 1st section companies with two or more indpendent directors

26

Source: Morningstar Investment Management calculation to 31/12/17

Japanese dividend payout ratios have also increased …

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

World USA Europe ex UK Japan Asia ex Japan Emerging Markets

Divi

dend

s / E

arni

ngs

20-year average dividend payout Current dividend payout

27

Source: Morningstar Investment Management calculation to 31/12/17

Return-on-equity will be a key metric to watch for Japan…

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1974

1976

1977

1979

1980

1982

1983

1984

1986

1987

1989

1990

1991

1993

1994

1996

1997

1999

2000

2001

2003

2004

2006

2007

2008

2010

2011

2013

2014

2016

2017

Retu

rn-o

n-eq

uity

%Japan ROE World ROE

28

Source: MSCI, IMF, Morningstar Investment Management. For Illustrative purposes only. Past performance does not guarantee future results.

Emerging markets equities

0

5

10

15

20

25

30

35

40

45

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cycl

ical

ly A

djus

ted

Pric

e to

Ear

ning

s (1

0yr) Diverging U.S. and International Valuations (CAPE)

USA MSCI World ex US EM

29

0

2

4

6

8

10

12

14

16

18

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18

Historic 10yr Bond Yields

South Africa 10yr Poland 10yr Mexico10yr Brazil 10yr Indonesia 10yr Australia 10yr United States 10yr

Source: MSCI, IMF, Morningstar Investment Management. For Illustrative purposes only. Past performance does not guarantee future results.

Emerging markets debt

30

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Telecoms Health Care Financials Cons. Stap. Energy Materials Industrials Info Tech Cons. Disc.

Global Sector Valuation Implied Returns Over 10yrs

World EM USA Euro Aus

Source: Morningstar, data as of 31/12/2017

At a sector level, selective opportunities are more apparent

31

Source: Morningstar. Data as of 30/11/2017

Global telecoms standout on relative valuation

32

Bank of America Merrill Lynch Fund Manager Survey – October 2017

Source: Bank of America Merill Lynch Fund Manager Survey

Global Sector Sentiment (% saying overweight - % saying underweight)

Pessimistic investor sentiment towards global telcos

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Agenda


2010 2012 2014 2016

Œ Increase A-REITSŒ Increase Global Credit

Œ Increase Japanese EquitiesŒ Increase Unhedged Currency – position for falling AUD

Š Decrease AU EquitiesŠ Decrease US EquitiesŒ Increase EU EquitiesŒ Increase Japanese Equities

Œ Increase Currency HedgingŒ Increase EM Equities+ Initiate EU Energy

+ Initiate EM DebtŠ Decrease EU EquitiesŠ Decrease AREITS

+ Initiate Global Quality Strategy+ Initiate European UtilitiesŠ Decrease Global Credit

Œ Increase EU Equities+ Initiate EU FinancialsŒ Increase EM Debt (LC)Š Decrease Listed PropertyŠ Decrease Global Infrastructure

2011 2013 2015

+ Added Healthcare+ Added TelcosŠ Reduced High Yield and IG Credit

2017

High conviction investment positioning of different vintages

35

-8% -4% 0% 4% 8%

Cash & Currency

EM Equities

Global Property

Currency Overlay

Alternatives

Listed Infrastructure

Inflation Linked Bonds

Australian Bonds

Other European Equities

Australian Real Estate

Australian Equities

European Financials

Global Bonds

Japanese Equities

North American Equity

European Energy

EM Debt

12m Position Changes

Source: Morningstar. As at December 2018.

Cash & Currency28.60%

EM Equities11.82%

Alternatives11.24%

Japanese Equities8.48%

Australian Equities6.81%

European Energy4.30%

EM Debt4.26%

US Health Care3.64%

Inflation Linked Bonds3.46%

Australian Bonds3.41%

European Telecoms2.35%

Other European Equities2.32%

European Financials1.88%

Listed Infrastructure1.72%

North America Equity(ex US HC)

1.72%

Global Property1.54%

EM Credit1.06%

Pacific ex JP Equity0.72%

Global Bonds0.69%

Taiwan2.51%

Korea2.28%

Russia2.18%

South Africa0.79%

China0.67%Other EM

3.35%

36

Morningstar Growth Real Return Fund – Dec 2017

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Key takeaways and summary

gValuation-driven asset allocation is a long-term investment approach that can generate significant returns across asset classes

gHolding overvalued assets can lead to significant underperformance

gCollective wisdom breaks down when there is insufficient diversity and investor errors correlate, creating opportunities for long-term contrarian investors

gWe believe an iterative approach that is driven by valuations, fundamental research and a willingness to be different will help maximise reward for risk in this environment

gWe favour Emerging Markets, Japanese and European shares; cash; and emerging markets debt, avoidingg developed world government bonds)

gWe continue to look for select opportunities in international sharemarkets – e.g. European Telecoms and US Healthcare

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Key takeaways and summary

“To buy when others are despondently sellingand to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” – Sir John Templeton

Disclaimer

This document is issued by Morningstar Investment Management Australia Limited (ABN 54 071 808 501, AFS Licence No. 228986) (‘Morningstar’). Morningstar is the Responsible Entity and issuer of interests in the Morningstar investment funds referred to in this report.

© Copyright of this document is owned by Morningstar and any related bodies corporate that are involved in the document’s creation. As such the document, or any part of it, should not be copied, reproduced, scanned or embodied in any other document or distributed to another party without the prior written consent of Morningstar. The information provided is for general use only.

In compiling this document, Morningstar has relied on information and data supplied by third parties including information providers (such as Standard and Poor’s, MSCI, Barclays, FTSE). Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third parties accept responsibility for any inaccuracy or for investment decisions or any other actions taken by any person on the basis or context of the information included.

Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment or the return of capital. Morningstar warns that (a) Morningstar has not considered any individual person’s objectives, financial situation or particular needs, and (b) individuals should seek advice and consider whether the advice is appropriate in light of their goals, objectives and current situation. Before making any decision about whether to invest in a financial product, individuals should obtain and consider the disclosure document. For a copy of the relevant disclosure document, please contact our Adviser Distribution Team on 02 9276 4550.

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