high relative to fundamentals. In fact, over time many firms and even industriesare alternately characterized as “value” or “growth” as their marketprice fluctuates.
EXPLANATIONS OF SIZE AND VALUATION EFFECTSThere have been many attempts to explain the size and valuation factorsin the data. Fama and French had hypothesized that there might be unusual financial stresses in value stocks that only appear during periods
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of extreme crisis, and that investors demand a premium to hold valuestocks in case those circumstances arise. Indeed, value stocks did underperform growth stocks during the Great Depression and the stock market crash of 1929 through 1932. But since then, value stocks have actuallydone better than growth stocks during both bear markets and economicrecessions, so it is doubtful this is the answer.26Another possible reason why value stocks outperform growthstocks is that the use of beta to summarize the risk of a stock is too narrow. Beta is derived from the capital asset pricing theory, a static pricingmodel that depends on an unchanged set of investment opportunities.In a dynamic economy, real interest rates proxy changes in the opportunity set for investors, and stock prices will respond not only to earningsprospects but also to changes in interest rates.In an article entitled “Good Beta, Bad Beta,” John Campbell separates the beta related to interest rate fluctuations (which he called “goodbeta”) from the beta related to business cycles (which he called “badbeta”)27 based on historical evidence. But recent data are not supportiveof this theory as growth stocks rose from 1997 to 2000 when real interestrates were rising and fell subsequently as real interest rates dropped.Another theory about why growth stocks have underperformedvalue stocks is behavioral: investors get overexcited about the growthprospects of firms with rapidly rising earnings and bid them up excessively. “Story stocks” such as Intel or Microsoft, which in the past provided fantastic returns, capture the fancy of investors, while those firmsproviding solid earnings with unexciting growth rates are neglected.28
The Noisy Market HypothesisA more general theory for the outperformance of value stocks is that stockprices are constantly being impacted by buying and selling that is unrelated to the fundamental value of the firm. These buyers and sellers arecalled “liquidity” or “noise” traders in the academic literature. Their transactions may be motivated by taxes, fiduciary responsibilities, rebalancingof their portfolio, or other personal reasons. In order to explain the value26
John Y. Campbell (with Jens Hilscher and Jan Szilagyi), “In Search of Distress Risk,” revision ofNational Bureau of Economic Research (NBER) Working Paper No. 12362, Cambridge, Mass.,March 2007.27John Y. Campbell and Tuomo Vuolteenaho, “Bad Beta, Good Beta,” American Economic Review, vol.94, no. 5 (December 2004), pp. 1249–1275.28Behavioral finance is the topic of Chapter 19.
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and size effects we see in the historical data, another assumption needs tobe added: that price movements caused by these liquidity traders are notimmediately reversed by those trading on fundamental information.This assumption is a deviation from the efficient markets hypothesisthat claims that at all times the price of a security is the best unbiased estimate of the underlying value of the enterprise. I have called the alternativeassumption the “noisy market hypothesis” because the actions of noise orliquidity traders often obscure the fundamental value of the firm.29The noisy market hypothesis can provide an explanation for thesize and value effects.30 A positive liquidity shock raises the price of thestock above its fundamental value and makes that stock more likely tobe classified as a “large” or “growth” stock. When this positive shockdisappears, these large growth stocks decline in price and thus havelower returns. On the other hand, a negative liquidity shock lowers theprice and makes it more likely a stock will belong to the “small” or“value” category, which is likely to be underpriced relative to its fundamentals. When the negative shock disappears, these value stocks havehigher returns.
CONCLUSIONHistorical research shows that investors can achieve higher long-termreturns without taking on increased risk by focusing on the factors relating to the size and valuation of companies. Dividend yield has been onesuch factor and the price-to-earnings ratio has been another. Over time,portfolios of stocks with higher dividend yields and lower P-E ratioshave outperformed the market more than would be predicted by the efficient markets hypothesis or the capital asset pricing model.Nevertheless, investors should be aware that there is no strategythat will outperform the market all the time. Small stocks exhibit periodic surges that have enabled their long-term performance to beat thatof large stocks, but most of the time their performance has fallen behindlarge stocks. Furthermore, value stocks have tended to do very well inbear markets, but often underperform growth stocks in the latter stagesof bull markets. This means that investors must exercise patience if theydecide to pursue these return-enhancing strategies.
29
See Jeremy Siegel, “The Noisy Market Hypothesis,” Wall Street Journal, June 14, 2006.See Robert Arnott, Jason Hsu, Jun Liu, and Harry Markowitz, “Does Noise Create the Size andValue Effects?” unpublished manuscript, September 2006.30
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10
CHAPTER
GLOBAL INVESTING AND THERISE OF CHINA, INDIA, ANDTHE EMERGING MARKETSToday let’s talk about a growth industry. Because investing worldwide is a growth industry. The great growth industry is internationalportfolio investing.JOHN TEMPLETON, 19841
Chapter 1 demonstrated that the superior long-term returns of stockswere not unique to the United States. Investors in many other countrieshave accumulated substantial wealth in equities. Until the late 1980s,however, foreign markets were almost exclusively the domains of nativeinvestors and were considered too remote or risky to be entertained byoutsiders.But no longer. The globalization of financial markets is not just a prediction for the future; it is a fact right now. The United States, once theunchallenged giant of capital markets, is today only one of many coun1
Transcript of address delivered to the Annual Conference of the Financial Analysts Federation,May 2, 1984.161
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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tries in which investors can accumulate wealth. At the end of World WarII, U.S. stocks comprised almost 90 percent of the world’s equity capitalization; in 1970, they still comprised two-thirds. But today, the U.S. market constitutes considerably less than half of the world’s stock value, andthat fraction is shrinking. To invest only in the United States is to ignorethe majority of the world’s equity capital.
THE WORLD’S POPULATION, PRODUCTION, AND EQUITY CAPITALDespite the growth abroad, the equity markets are still heavily represented by the developed countries in the world.2 The lopsidedness of theworld economy is illustrated in Figures 10-1a through 10-1c. The developed world contains less than 15 percent of the world’s population. Yetit produces over 50 percent of the world’s goods and headquarters over93 percent of the world’s equity capital.32North America (the United States and Canada); Western Europe; Japan; Australia and NewZealand; Singapore, South Korea, and Taiwan; and Hong Kong.3The equity capital is based on the free float shares, and for China only those shares issued in HongKong.
FIGURE
10–1a
The 2005 World Population
FIGURE
10–1b
The 2006 World GDP
FIGURE
10–1c
The 2007 World Equity
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But this very unequal distribution of output and capital will not last.The emerging nations’ share of output and equity capital has been risingrapidly and will continue to do so. As we shall see, the forces unleashedby the communications revolution and market capitalism will pushcountries such as China and India to the forefront of the world economy.Nevertheless, investors should not become too enchanted with economic growth. We learned in Chapter 8 that growth does not guaranteegood returns. A look at history shows that there have been many timeswhen investor hopes of superior returns were dashed by subsequentevents.
CYCLES IN FOREIGN MARKETSIn the past, strong U.S. markets were often coupled with weak foreignmarkets and vice versa. In the 1970s and 1980s, U.S. stock returns laggedbehind both Europe and Japan, then surged to the head of the pack inthe 1990s, only to lag behind again this decade, as shown in Table 10-1.TABLE
10–1
Compound Annual Dollar Returns in World Stock Markets, 1970 through December 2006 (StandardDeviations in Parentheses)Country orRegion
World*EAFE†
USA
Europe
Japan
19702006
19701979
19801989
19901999
20002006
10.81%
6.96%
19.92%
11.96%
4.65%
(17.07)
(18.09)
(14.59)
(13.94)
(20.76)
11.57%
10.09%
22.77%
7.33%
7.08%
(21.93)
(22.77)
(23.28)
(16.93)
(23.85)
10.84%
4.61%
17.13%
19.01%
2.45%
(17.10)
(19.01)
(12.52)
(14.39)
(18.35)
12.27%
8.57%
18.49%
14.50%
7.34%
(20.95)
(20.97)
(25.89)
(12.71)
(24.33)
11.47%
17.37%
28.66%
-0.69%
4.28%
(34.69)
(45.41)
(28.57)
(28.90)
(25.71)
*World = Morgan Stanley Capital International (MSCI) Value-Weighted World Index.†EAFE is the MSCI index for Europe, Australasia, and the Far East.
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These differences in returns emphasize the importance of maintaining awell-diversified world portfolio.
The Japanese Market BubbleThe 1980 bull market in Japan stands as one of the most remarkable bubbles in world stock market history. In the 1970s and 1980s, Japanesestock returns averaged more than 10 percentage points per year aboveU.S. returns and surpassed those from every other country. The bullmarket in Japan was so dramatic that by the end of 1989, for the firsttime since the early 1900s, the market value of the American stock market was no longer the world’s largest. Japan, a country whose economicbase was totally destroyed in World War II and had only half the population and 4 percent of the land mass of the United States, became thehome to the world’s most highly valued stock market.The superior returns in the Japanese market attracted billions ofdollars of foreign investment. By the end of the 1980s, valuations onmany Japanese stocks reached stratospheric levels. Nippon Telephoneand Telegraph, or NTT, the Japanese version of America’s former telephone monopoly AT&T, was priced at a P-E ratio above 300. This company alone had a market valuation of hundreds of billions of dollars,dwarfing the aggregate stock values of all but a handful of countries.Valuations reached and in some cases exceeded those attained in thegreat technology bubble of 2000 and were far above anything known inthe U.S. or European markets.During his travels to Japan in 1987, Leo Melamed, president of theChicago Mercantile Exchange, asked his hosts how such remarkablyhigh valuations could be warranted. “You don’t understand,” they responded. “We’ve moved to an entirely new way of valuing stocks herein Japan.” And that is when Melamed knew Japanese stocks weredoomed, for it is when investors cast aside the lessons of history thatthose lessons come back to haunt them.4The Nikkei Dow Jones, which had surpassed 39,000 in December1989, fell to nearly 14,000 by August 1992 and below 8,000 in 2002—a decline worse than any experienced by the U.S. or European stock marketssince the great 1929 to 1932 crash. The shares of NTT fell from 3.2 millionyen to under 500,000. The mystique of the Japanese market was broken.
4
Martin Mayer, Markets, New York: Norton, 1988, p. 60.
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The Emerging Market BubbleThe collapse of the Japanese market shifted the emphasis of global enthusiasts to emerging markets—markets in developing countries. Investors had already witnessed the stock booms of Taiwan, South Korea,and Thailand. Now India, Indonesia, and even China were set to join theclub.And Asian countries were not the only markets put into play. LatinAmerica, long a backwater of authoritarian, anti-free-market regimes (ofboth the right and left) had turned full circle and aggressively soughtforeign investment. Equity gains were impressive in such countries asArgentina, Brazil, and Mexico.Even China, the last major country ruled by communist leaders, developed stock markets. The opening of the first Chinese stock market inShenzhen in 1998 was met with a riot as thousands stood days in lineswaiting to be allocated shares in firms in the world’s most populatedcountry. And who would have imagined that investors in Hong Kongwould beat those in the United States during the last decade, despite thefact that the island nation was handed over to communist China, oncethe sworn enemy of capitalism?The term emerging markets evokes the image of a beautiful butterfly rising from its chrysalis, ready to soar to the heavens. But a moreaccurate name might have been “submerging markets.” The enthusiasm that greeted these markets far exceeded their performance. Just asbirds eat most butterflies soon after they take wing, the bears devoured many of these newly emerging markets soon after investorsrushed in.The year 1997 marked the beginning of the worst collapse in thehistory of emerging markets. The emergent Asian economies, idolizedby many investors who had sent their shares skyward, saw their currencies and equity prices plummet. In 1998, the bearish contagionspread beyond the Pacific Basin to Latin America, Eastern Europe, andRussia.In that two-year period, virtually no emerging market was safe.Most, if not all, of the countries’ stock markets fell by at least 50 percentin dollar terms, and many fell much more. Measured in U.S. dollars, theIndonesian, Thai, and Russian markets fell more than 90 percent, andthose in the Philippines and South Korea fell more than 80 percent. Evenstocks in the strongest and most advanced of these developing countries, Singapore and Hong Kong, fell 70 percent.
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The collapse of these economies dimmed investors’ enthusiasm forforeign investing. But troubles were also brewing for U.S. investors seeking gains in the developed markets. As the U.S. stock market and theU.S. dollar soared, the dollar returns in European and Japanese marketsfell behind the United States. The advantage that U.S. investors hadgained through many years of investing abroad vanished, leaving manyquestioning the wisdom of international investing.
The New Millennium and the Technology BubbleThe last three years of the twentieth century, marked by the emergenceof a huge technology bubble, saw strong gains in all of the world stockmarkets, with the European and American markets surging to all-timehighs. But this was not to last.A few months into the new millennium, the technology bubbleburst and stocks fell into a severe bear market. All of the developedcountries’ markets fell by at least 50 percent: from March 2000 throughOctober 2002, the U.S. market fell by one-half, matching its recordpost-Depression decline in the ferocious 1972 to 1974 bear market,while European and Japanese markets, which suffered declines of 60and 63 percent, respectively, bottomed in March 2003—five monthsafter the U.S. market bottomed and just prior to the U.S.-led invasionof Iraq.As the world economy recovered from the 9/11 terrorist attacksand the recession, stocks in the United States and Europe pushed upward, and by 2007 they hit new all-time highs. But the dollar changed direction sharply. After appreciating strongly from 1995 through 2001, thegreenback sank precipitously, falling by one-third of its value throughthe end of 2004. As a result, dollar-based investors saw their international stocks far outperform their domestic holdings in a reversal of thepattern set in the previous decade.Emerging stock markets, which usually fare far worse than developed markets in downturns, held up surprisingly well in the 2000 to2002 bear market, a good portent for future performance. Indeed, whenthe world economy had recovered, emerging markets soared once again,surpassing their highs of a decade earlier.What have these market cycles taught us about internationalstocks? No single market is always dominant, and the globalization ofthe world markets affords investors more opportunities for spreadingtheir risk than are available in the domestic markets.
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DIVERSIFICATION IN WORLD MARKETSPrinciples of DiversificationIt might surprise investors that the principal motivation for investing inforeign stocks is not that foreign countries are growing faster and therefore will provide investors with better returns. We learned in Chapter 8that faster growth in no way guarantees superior returns.Rather, the reason for investing internationally is to diversify yourportfolio and reduce risk.5 Foreign investing provides diversification inthe same way that investing in different sectors of the domestic economyprovides diversification. It would not be good investment policy to pinyour hopes on just one stock or one sector of the economy. Similarly it isnot a good policy to buy the stocks only in your own country, especiallywhen developed economies are becoming an ever smaller part of theworld’s market.International diversification reduces risk because the stock pricesof one country often rise at the same time those of another country fall,and this asynchronous movement of returns dampens the volatility ofthe portfolio. However, in recent years, world markets have movedmore in sync with each other, particularly in the short run, which I willdiscuss later in this chapter.An asset with a low correlation with the rest of the market providesbetter diversification than an asset with a high correlation. The correlation of returns between stocks or portfolios of stocks is measured by thecorrelation coefficient. A good case for investors is if there is no correlationbetween the stock returns of two countries, and the correlation coefficient is equal to zero. In this case, an investor who allocates his or herportfolio equally between each country can reduce his or her risk by almost one-third, compared to investing in a single country. As the correlation coefficient increases, the gains from diversification dwindle, and ifthere is perfect synchronization of returns, the correlation coefficientequals 1 and there is no gain (but no loss) from diversification.
“Efficient” Portfolios: Formal AnalysisHow do you determine how much should be invested at home andabroad? As the above analysis suggests, the amount invested in eachcountry can be derived from one’s assessment of the expected risk and5
Risk here is defined as the standard deviation of the returns on the portfolio.
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expected return in each country and the expected correlation betweenreturns of the U.S. market and these emerging countries. One way of estimating these expected returns, risks, and correlations is by analyzingthe historical return data. Once these expectations have been determined, the “best” or most “efficient” risk-return portfolio can be determined by mathematical techniques of formal portfolio analysis.The historical risks and returns for U.S. and foreign markets areshown in Table 10-2. One can see that from 1970 through 2006, the dollarreturns on Morgan Stanley’s EAFE Index, an index of the developedworld stocks,6 actually surpassed that of the United States, offering dollar-based investors compound annual returns of 11.57 versus 10.84 percent in U.S. stocks.Although the return was higher in foreign stocks, the risk was alsohigher. The risk of these returns to dollar investors in foreign markets iscomposed of two sources: fluctuations in foreign stock markets themselves, called local risk, and fluctuations in the exchange rate that translates foreign returns back to dollars, or exchange-rate risk.It is very important to note that the total risk of holding foreign equities is substantially less than the sum of the local and exchange-rate6The countries in the EAFE portfolio are Australia, Austria, Belgium, Denmark, Finland, France,Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
TABLE
10–2
Dollar Returns and Risks in Stocks, January 1970 through December 2006
Country orRegion
U.S. $ ReturnsCompound Arithmetic
DomesticRisk
ExchangeTotal RiskRisk
CorrelationCoefficient*
World
10.81%
12.17%
16.57%
5.07%
17.07%
84.27%
EAFE
11.57%
13.64%
19.30%
10.25%
21.93%
57.42%
USA
10.84%
12.21%
17.10%
——
17.10%
100.00%
Europe
12.27%
14.10%
20.18%
11.27%
20.95%
70.57%
Japan
11.47%
16.05%
28.34%
12.71%
34.69%
29.90%
*Correlation between U.S. dollar returns and foreign market U.S. dollar returns.
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risks. This is because these variables are not perfectly correlated, somovements in the exchange rate and the local stock market frequentlyoffset each other.The standard deviation of dollar returns in foreign markets is nearly22 percent, about 5 percentage points higher than found in the U.S. market. The historical correlation between the annual returns in U.S. andnon-U.S. markets has been about 57 percent, which means that 57 percentof the variation in non-U.S. markets is also seen in U.S. stock returns.Using these historical data allows us to construct Figure 10-2,which shows the risk-return trade-off (called the efficient frontier) for dollar-based investors depending on varying the proportions that are invested in foreign markets (measured by the EAFE Index) and U.S.markets. The minimum risk for this world portfolio occurs when 22.5percent is allocated to EAFE stocks and thus 77.5 percent to U.S. stocks.But the “best” risk-return portfolio, called the efficient portfolio, isnot the one with the lowest risk but the one that optimally balances riskand return. This “best” portfolio is found at a much higher 37.8 percentforeign stock allocation.7 For comparison, in July 2007 the EAFE stocksFIGURE
10–2
Portfolio Allocation between U.S. and EAFE Stocks13.80%
Risk-free rate is 5.0%
0% U.S., 100% EAFE
13.60%
10% U.S., 90% EAFE20% U.S., 80% EAFE
13.40%
Return
13.20%
30% U.S., 70% EAFE40% U.S., 60% EAFE
13.00%
50% U.S., 50% EAFE
12.80%12.60%
60% U.S., 40% EAFE70% U.S., 30% EAFE80% U.S., 20% EAFE
12.40%
90% U.S., 10% EAFE
12.20%12.00%16%
U.S. PortfolioEAFE PortfolioMinimum RiskEfficient Portfolio
Risk17.100%21.928%16.585%16.825%
Return12.207%13.641%12.529%12.749%
% U.S.100.0%0.0%77.5%62.2%
% EAFE0.0%100.0%22.5%37.8%
100% U.S., 0% EAFE
17%
18%
19%
20%Risk
21%
22%
23%
CHAPTER 10 Global Investing and the Rise of China, India, and the Emerging Markets
171
represented about 57 percent, and the U.S. stocks represented 43 percentof this world portfolio based on market values.The estimation of the best combination of U.S. and foreign stocks isvery dependent on the risk and return assumptions. For example, if foreign exchange risk is ignored, as might be justified for an investor or institution that buys goods in many different countries, so that translationback to dollars is not necessary, the optimal foreign portfolio rises to 52.6percent, just slightly short of the 2007 market value weight.The impact of changes in the risk and return assumptions on theallocation between U.S. and foreign stocks is shown in Table 10-3. Forevery increase of 100 basis points in U.S. expected returns—or fall in expected returns in the EAFE Index—there is about an 11.1 percentagepoint rise in the allocation to U.S. stocks. For every percentage point increase in the expected risk of U.S. returns or decrease in the expected riskof EAFE returns, the U.S. allocation falls 6.5 percentage points. And a 0.10increase in the correlation coefficient between EAFE and U.S. returns willlower the EAFE allocation by just over 2 percentage points.87
Readers who wish to understand risk-return analysis can go to Richard A. Brealey, Stewart C.Myers, and Franklin Allen, Principles of Corporate Finance,” 8th ed., New York: McGraw-Hill, 2006.8The impact of a change in the correlation coefficient is highly nonlinear. If the correlation rises to0.77, the U.S. allocation will rise over 6 percentage points; if it rises to 0.87, the U.S. share will riseby over 17 percentage points.
TABLE
10–3
Efficient Portfolio for Varying Assumptions
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This last result is of particular note. Using historical data, an increase in correlation between U.S. and EAFE returns lowers the attractiveness of foreign investing. And there is evidence that the short-runcorrelations between U.S. and foreign markets have been increasing. Atwo-year moving average of the correlation coefficient between theUnited States and the EAFE is shown in Figure 10-3. The correlation rosedramatically in the early 2000s, and it has dropped a bit since. Critics offoreign investing often cite high correlations as a reason to keep foreignstock exposure low.But this is not necessarily so. The impact of increased correlation onthe allocation can be reversed with only a slight change in assumptions.If EAFE returns are expected to be only 60 basis points higher than theirhistorical average, or the expected risk of foreign stocks slightly lower,then an increased correlation will actually raise your foreign allocation.This occurs because under these altered assumptions, investors wouldbe receiving a better risk-return trade-off in foreign stocks than they receive in U.S. stocks. Hence, the more correlated foreign and U.S. markets, the less attractive U.S. stocks are.
FIGURE
10–3
The Correlation between U.S. and EAFE Stock Returns
1.00.80.60.40.20.02006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
-0.21972
Correlation Coefficient
Two-Year Correlation Windows
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173
Should You Hedge Foreign Exchange Risk?Since foreign exchange risk does add to the dollar risk of holding foreignsecurities, it could be desirable for an investor in foreign markets tohedge against currency movements. Currency hedging means enteringinto a currency contract that offsets unexpected changes in the price offoreign currency relative to the dollar.Although currency hedging seems like an attractive way to offsetexchange risk, in the long run it is often unnecessary and could be detrimental. This is because the cost of hedging depends on the difference between the interest rate in the foreign country and the domestic country,and that could be high.For example, the British pound depreciated from $4.80 to about$2.00 over the past century. But since British interest rates were, on average, substantially higher than interest rates in the United States, the costof hedging exceeded the depreciation in the pound. Thus investors’ dollar returns were higher if they owned British stocks without hedgingthem than their dollar returns if they owned British stocks and paid tohedge them.Furthermore, for investors with long-term horizons, hedging currency risk in foreign stock markets is not important. In fact, there is someevidence that in the long run, currency hedges might actually increasethe volatility of dollar returns.9 In the long run, exchange-rate movements are determined primarily by differences in inflation betweencountries, a phenomenon called purchasing power parity.