Before we get too far into the year, we need to get out one more edition of our 2016 Best Bets series. The focus for this update will be internationals, specifically which countries are the most attractive from a fundamental perspective as well as some suggestions for how, and to what degree, you might own them in your portfolio. I’ll finish with a very rare political statement connecting “The Decline and Fall of the Athenian Republic” and Donald Trump’s public appeal. What the?
Most Attractive Internationals
I want to preface this section by making a strong statement. A country, or any investment for that matter, can be attractive for fundamental reasons and yet the trend of that investment can still be down and negative. This is the primary weakness of a pure fundamental approach to investing. One of my professors in business school, Tom Marsico, was a die-hard growth manager (then with Janus) and always held the line on owning companies with strong balance sheets, high free cash and competitive advantage. I watched his growth funds lose nearly 60%, twice in subsequent years. Great companies and great countries can fall in price much further than most investors can tolerate. Anything can lose value as a pure function of an investor's unwillingness to own stock, pushing cheap companies to become even cheaper. As we like to say in our office, zero is also cheap. There are so many examples right now of companies and entire sectors that are incredibly attractive in terms of their valuations and yet every day they fall under selling pressure. So the answer for investors, and the root of our disciplined process, is to understand, recognize and identify value from a fundamental perspective. But ownership should be restricted to periods of time when the price is moving UP. We do this through basic technical analysis of price trends using momentum, breadth and volume to confirm. Enough on that. So which countries are the most attractive from a fundamental, value based perspective?
To answer this question, we looked at each country from several different valuation perspectives including dividend yields, 12 month trailing Price to Earnings ratios, Price to Earnings Growth (PEG ratios). We also looked at trends in share of global GDP asking the very high level question; which countries are increasing their share and which are participating less? We looked at country index performance over the last 3-5 years identifying those that are trading at discounts from previous peaks as of the end of 2015. Are they oversold or overbought on a long term basis? Finally, we looked at demographics and other external factors like currency and political risk. We put all of this information on the table, turn on our brains, have a little quiet moment of reflection using a weight of evidence approach and make our choices. I won't bore you with the data but rather just get to the results, which may surprise you. All things considered, we feel these countries offer investors the most attractive prospects - listing only those that are attractive in order of most attractive first:
United States (barely made the list)
I know, we were sort of surprised to see so much of an orientation to Asia, especially China at the top of the list. China's stock market is obviously in a period of heavy consolidation and correction after gaining 35% in 2014 into the final peak in early 2015. China is still the fastest growing country in the world assuming their reporting is accurate. They have the demographics and the firepower to continue taking more and more share of global GDP at the expense of the developed world, like the US and Europe. Meanwhile, valuations are now almost 40% lower than most of the developed world. Close trading partners like Japan, Taiwan and India are living and benefiting from the growth in China. We see fast growth, attractive values and now a developing buying opportunity into an oversold price condition.
How To Own and How Much To Own
Now we're really going to go out on a limb and suggest what we feel are the best ways to own these countries and propose a simple weighted allocation to the same. Please remember that any recommendations here do NOT factor in any investors' tolerance for risk, time horizon or total portfolio objectives. This is just a very high level suggestion to consider giving you an idea of how WE might split the pie. We would recommend only using international ETFs (exchange traded funds) for this adventure because they are nearly free to own with tiny internal expenses and can be traded freely without hold periods, redemption fees or other mutual fund imposed BS. We would also recommend a TOTAL and maximum allocation of 20% of total portfolio value allocated at this time. These positions should NOT be purchase at one time nor should they be purchased tomorrow. All investors should limit ownership to any of these once they stop falling and develop identifiable up trends in price. At present, not one satisfies that criteria, so we watch and wait but we know where our money is going. Ok?
AAXJ - Asia Pacific ex Japan ETF - 6%
This ETF has the right mix and weightings to Hong Kong, Singapore, Taiwan and Korea. It is really quite perfect. Other Asia funds and ETFs have all sorts of crazy mixes including heavy weightings in Australia (like EPP) or purely China. AAXJ is also on our list of free ETFs for institutional money managers at Fidelity = no transaction fee. We plan to buy this incrementally in pieces and accumulate over time.
IEFA - Europe, Australasia and the Far East - 6%
This is the classic EAFE index which covers our exposure to all of Europe, Australia and Japan. We don't love these countries but they are better looking than the US at present. We need to carry some exposure here and choose to do it in the most broad and diversified way possible. IEFA is also on our list of free ETFs at Fidelity
MCHI – China Index ETF – 3%
Again, this is just to get a toe-hold in China directly, coming off a deep discount. At present the chart pattern for China is very negative so this opportunity may present itself later in 2016 or beyond. But we plan to keep it on the list until the weight of evidence suggests otherwise.
INDY - India ETF - 3%
We want to own India directly and with some conviction as India is the second fastest "gobbler" of global GDP next to China. They have the right demographics, the right valuations, pay one of the highest dividend yields and they are in a position to grow substantially. INDY is still in a downtrend so we’ll wait. This is another free ETF for us at Fidelity.
EWD - Sweden ETF - 2%
We would describe this as our wildcard play. Sweden, just continued to rank highly in our research and we feel there may be a unique opportunity here. We doubled back a few times just to make sure the data was good and without anomalies. It looks good. Typically, we would not choose to get this granular but there are exceptional opportunities like this periodically and we can own it easily through this single ETF.
Note - the rising trend of the US dollar has made international investing a bit of a challenge for investors buying shares in US dollars. This is one reason why we recommend smaller allocations as a percent of total portfolio. Remember that the US dollar has been rising versus all other currencies for almost two years now. The Canadian dollar for instance is trading at nearly $1.40 meaning 40% lower than the US dollar. $1 USD buys you $1.40 worth of Canadian goods and services. Canadian and US currencies have been on par for as long as I can remember - not any more. So, there is a wide gap in currencies now that is likely to become wider. But a lot of the spread is already out there now for most foreign countries. What if internationals starting gaining in price with a flat or declining US dollar? Talk about the Big Bang!
Trump and Athenia ( a rare and personal political opinion – feel free to skip)
In 1776, yes the same year as our Declaration of Independence, a European historian named Alexander Tytler wrote a notable summary about the cycles of empire called, "The Decline and Fall of the Athenian Republic". Bare with me. In that piece, he outlined what he saw as the life stages of all democracies. Since his work was published we have seen these trends and cycles play out over time, mostly in Europe. This was probably his most famous quote along with the sequence of the cycle he outlines.
"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising them the most benefits from the public treasury, with the result that a democracy always collapses over a loss of fiscal responsibility, always followed by a dictatorship. The average of the world's great civilizations before they decline has been 200 years.”
These nations have progressed in this sequence:
From bondage to spiritual faith,
From spiritual faith to great courage,
From courage to liberty,
From liberty to abundance,
From abundance to selfishness,
From selfishness to complacency,
From complacency to apathy,
From apathy to dependency,
From dependency back again to bondage
A little math for you. 2016 - 1776 = 240 years - we're overdue.
Bondage is another word for dictatorship and enslavement. From a European history perspective, the most glaring example of a recent dictator was Hitler and Nazism. Perhaps it's just coincidence and perhaps I am just reading too many books about events leading up to WWII like "The Boys in the Boat" and " All the Light We Cannot See". But, these stories speak of a public psychology that accepted and was almost willing to embrace the rise of a dictator like Hitler. Hitler and Nazism germinated in a fertile environment of discontent and hopelessness associated with a deep depression in Germany. Hitler offered to "Make Germany Great Again". You know where I'm going with this. Hitler declared that certain unappealing members of their culture (Jews and anyone that did not fit his vision of the perfect race) were responsible for Germany's failure. He declared that Germany had become weak in its policies and practices. Germany needed to get tough and tear down the self-serving political and cultural institutions that had brought the country to its knees. Sound familiar? This promise to "Make Germany Great" lead to some very unattractive new social standards which turned Germany to a state of martial law very quickly. A military state ensued and Germany attempted to take over Europe leading eventually to WWII. But the amazing part of this European history lesson was the German people's early acceptance and spirited appeal of a new conservative leader called Adolf Hitler. He just told the people what they wanted to hear without really clarifying the horrors of HOW he planned to do it.
Now circle back to the last line of the progression of democracy. If I had to put a red "you are here" dot, it would be on the last line, where we are sitting with a system that has become fully dependent. Today, we have massive debt spending by governments and quantitative easing that makes us all dependent on low rates and that same spending standard. We have a very large population who are almost completely dependent on social security and Medicare. We have a public pension system that promises unsustainable payments for lifetimes. And we have a very robust welfare state with safety nets like unemployment benefits. I would have to lump in the Affordable Care Act as a new form of heavily subsidized welfare as well. Make no mistake, we are country that has become dependent on government programs. These are products of a democracy that have run amuck for nearly four decades.
Meanwhile, we have a middle class working man that still can't seem to make ends meet. He is angry and frustrated that he works so hard but never has enough while others are getting handouts. He doesn't care if the system fails because the system has already failed him. Now, we have a strong new conservative voice that promises to end it all, to burn down these failing institutions and do things like put up walls against immigrants. Side note - remember that a majority of the greatest companies in the US were founded by first generation immigrants (Google for instance). He promises to "Make America Great" by rooting weakness out of our system (like women, minorities, gays, undesirable politicians, or ineffective business people). After all, Trump did have a reality TV show called "The Apprentice" where he reveled in saying "You're Fired!". So he is the expert and he's the guy who decides! He promises to end dependency and failure. What he doesn't say is that he could/would do so by putting many into "bondage" and ending democracy at the same time. Spend a minute reading through the posts of those who declare allegiance to Trump in the Atlantic.
See if you can find these themes, they are not hard to find with quotes like "I just want it all to burn" or "Trump will tell us how to be great". This is a population that is ready for bondage.
I believe that Trump is The Angel. We cannot blame him for what he is but rather we should blame ourselves for our willingness to even entertain his message. He is appealing to the collective outcry of an angry population and make good on his promises through some form of dictatorship and bondage. I know that sounds paranoid but if you hear his agenda, you must know that many in our country could find themselves at the end of his pointy finger. How safe are any of us? Who is in, who is out? I don’t believe democracy has to fail but it sure feels like Trump could put it to the test if he were elected president. Never in the history of mankind has a population ever been better off under a dictatorship and we would be better served trying everything we can to gradually unwind our state of dependency than to go down this road. As a registered Independent, I will likely vote Republican this election as I feel our country needs to swing back away from a state of dependency. Sanders would certainly push us deeper into that state. But I will not vote for Trump.
I hope the good folks in Iowa can see him for what he really is.