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© 2016 Morningstar, Inc. All rights reserved.
Daniel Needham
President & Chief Investment Officer
Part 2 – Valuation Driven Asset Allocation
Our Investment PrinciplesValuation Driven Asset Allocation
We strive to
minimise costs.
Outline
gWhat are valuations and why do they matter?
gHow do we respond to changes in valuation?
gHow do valuations, sentiment and fundamentals combine?
gAre our valuation models perfect?
gWhere do we see opportunities and why?
gSummary and questions
What are valuations and why do they matter?The origins of valuation-driven asset allocation
“Earnings in any one year tend to be affected by short-run considerations […]We extend our moving average even further than Graham and Dodd did, on thesupposition that even more smoothing is advantageous, and Graham and Dodddidn't have the data then to make such smoothing possible.”
is what you get
”“Price is what you pay; value
- Warren Buffett, 2008 Letter to Shareholders of Berkshire Hathaway Inc.
- Robert Shiller (1996), following the advice of Graham and Dodd, calculate
the “CyclicallyCyclicallyCyclicallyCyclically----Adjusted PriceAdjusted PriceAdjusted PriceAdjusted Price----totototo----Earnings RatioEarnings RatioEarnings RatioEarnings Ratio”
“”
US Cyclically-adjusted Price Earnings Ratio (CAPE)What are valuations and why do they matter?
Source: Shiller, Morningstar
What are valuations and why do they matter?US CAPE and 10-year Real Returns
Source: Shiller, Morningstar
Price to fair value drives returns and lossesHow do we respond to changes in valuation?
Source: Morningstar
How do we respond to changes in valuation?Australian profit margins were unsustainably high post the resources boom
Source: Ibbotson
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%M
ar-8
5
Dec
-85
Sep-
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-12
Index ex-REIT Average 1985 to 2003 and 2003 to 2012 Average
How do we respond to changes in valuation?In April 2011 our valuation-implied returns were very unattractive
Source: Ibbotson, CFA Institute Presentation May 2011 Daniel Needham
S&P/ASX 200S&P/ASX 200S&P/ASX 200S&P/ASX 200
How do we respond to changes in valuation?Australian equities were used to fund other growth assets with superior risk adjusted returns
0%
10%
20%
30%
40%
50%
60%Ju
n-10
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-14
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-14
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-15
Jun-
15
Sep-
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Dec
-15
European Equities weighting
Japanese Equities weighting
AREITS weighting
Australian Equities Weighting
Source: Ibbotson
How do we respond to changes in valuation?Higher and smoother returns by investing in other growth assets
Source: Ibbotson
++++78%78%78%78%
900
1000
1100
1200
1300
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1500
1600
1700
1800
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Sep-
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-14
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-15
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Dec
-15
Value of $1,000 invested in our mix of growth assets Value of $1,000 invested in the Australian Equities index
+58%+58%+58%+58%
How do we respond to changes in valuation?AREITs were not a ‘busted asset class’ post the GFC
Balance Sheet
Earnings
Payout
Positioning
Sentiment
Valuation
Yield
Recapitalisation/Divestments
Higher Quality
Sustainable
Underweight
Extremely Poor
Cheap!
Attractive
Highly Leveraged
Low Quality
Borrowed
Overweight
Positive
Expensive
Unattractive
2007200720072007 2010201020102010AREITSAREITSAREITSAREITS
0%
5%
10%
15%
20%
25%
30%
Jun-
10
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-10
Mar
-11
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-14
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Sep-
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-14
Mar
-15
Jun-
15
Sep-
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Dec
-15
A-REITs Weighting Australian Equities Weighting
How do we respond to changes in valuation?Change in allocations for Australian equities versus AREITs in the Growth Trust
Source: Ibbotson
AREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocation
How do we respond to changes in valuation?AREITs significantly outperformed Australian equities
Source: Ibbotson
++++109%109%109%109%
800
1000
1200
1400
1600
1800
2000
2200
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
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Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Value of $1,000 invested in Australian Equities index Value of $1,000 invested in A-REITs index
+58%+58%+58%+58%
How do valuations, sentiment and fundamentals combine?Japan emerging from decades de-leveraging
Source: MSCI
How do valuations, sentiment and fundamentals combine?Extract from Internal Presentation 30 September 2012
Source: Ibbotson The Case for Japan – Bianca Rose and Greg Clarke September 2012
How do valuations, sentiment and fundamentals combine?Change in Japanese equities allocations over time
Source: Ibbotson
800
1000
1200
1400
1600
1800
2000
2200
0%
2%
4%
6%
8%
10%
12%
Jun-
10
Sep-
10
Dec
-10
Mar
-11
Jun-
11
Sep-
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Dec
-11
Mar
-12
Jun-
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Dec
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Mar
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Jun-
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Mar
-14
Jun-
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Sep-
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-14
Mar
-15
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-15
Growth Trust weighting for Japanese Equities [RHS] Value of $1,000 invested in the Japanese Equities index [RHS]
Value of $1,000 invested in the Australian Equities index
++++106%106%106%106%
+58%+58%+58%+58%
Are our valuation models perfect?U.S. Profit Margins 1985-2015 – were earnings unsustainably high since 2011?
8.84%
7.09%
0%
2%
4%
6%
8%
10%
12%Ja
n-85
Jan-
86
Jan-
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US profit margins expanded significantly over the last 30 years, moving from 6% to 9%
U.S. PM
Average
Source: MSCI, Ibbotson
Are our valuation models perfect?Change in US equities allocations over time
Source: Ibbotson
800
1000
1200
1400
1600
1800
2000
2200
2400
0%
2%
4%
6%
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12%Ju
n-10
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Growth Trust Weighting Value of $1,000 invested in the index [RHS]Value of $1,000 invested in our mix of growth assets [RHS] +116%+116%+116%+116%
+78%+78%+78%+78%
Are our valuation models perfect?Intellectual honesty and the importance of being humble
Are our valuation models perfect?
But need to account for structural change in corporate payout policy…
Source: MSCI, Ibbotson
Are our valuation models perfect?
S&P 500 buybacks have exceeded dividends in 8 of the 10 past calendar years
Source: MSCI, Ibbotson
Source: MSCI, Ibbotson
Are our valuation models perfect?Total Yields (1871-2014)
Total Payouts have been stable over time
Are our valuation models perfect?Earnings Trend pre- versus post 1980
For illustrative purposes only. Source: Straehl and Ibbotson (2015), The Supply of Stock Returns: Adding Back Buybacks, Working Paper
…leading to a structural increase in earnings per-share growth
$1
$1
$2
$4
$8
$16
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Earnings Pre-1980 Earnings Trend Post-1980 Earnings Trend
Are our valuation models perfect?U.S. profit margins expansion driven by financials and technology
Source: MSCI, Morningstar Inc.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%Jan-85
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Jan-15
Margin expansion in the technology and financial sector largely explain increase in U.S. margins, while margins of the “rest” of the market were largely flat
U.S. PM
Rest PM
FN & Tech
PM
Are our valuation models perfect?U.S. Real EPS vs. Implied Normal EPS – additional fundamentals improves valuations
Source: MSCI, Morningstar Inc.
95.29
92.7692.46
70.98
25.00
50.00
100.00
Dec-74
Jun-76
Dec-77
Jun-79
Dec-80
Jun-82
Dec-83
Jun-85
Dec-86
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Dec-98
Jun-00
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Dec-07
Jun-09
Dec-10
Jun-12
Dec-13
Jun-15
Real EPS
Implied Normal E (ROE)
Implied Normal E (CAPE)
Implied Normal E (Margin)
Log S
cale
Are our valuation models perfect?Enhanced approach for fair values and valuation-implied returns
Valuation-Implied Return = Total Yield + Growth (Adj. for Buybacks) + Change in Valuation
Dividends Dividends Dividends Dividends and and and and
Buyback Buyback Buyback Buyback YieldYieldYieldYield
Trend Fundamental GrowthTrend Fundamental GrowthTrend Fundamental GrowthTrend Fundamental Growth CAPE, ROE and CAPE, ROE and CAPE, ROE and CAPE, ROE and
Profit Margin ModelsProfit Margin ModelsProfit Margin ModelsProfit Margin Models
UK Equities
Australian Equities
Global REITS
European Equities Japanese Equities
US Equities
Korean Equities
Chinese Equities Emerging Market Equities
Taiwanese Equities
Australian REITSDM Infrastructure
US HY Credit EM Local Ccy Sovereigns
EM Hard Ccy Sovereigns
EU Utilities
Australian LinkersGlobal Corporate Credit
EU Energy
Global Aggregate Bonds Australian Gov Bonds
Australian Comp BondsAUD CashRiskier
Assets
Less
Risky
Assets
Where do we see opportunities and why?The opportunity set for an Australian investor
Lower Returning Assets
Higher Returning Assets
Source: Ibbotson
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
20.00
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
U.S. Corporate High Yield
Pan-European High Yield
Source: Reuters/ Morningstar
Where do we see opportunities and why?There are pockets of opportunity outside traditional government bonds
Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)High Yield High Yield High Yield High Yield Credit (%)Credit (%)Credit (%)Credit (%)
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
Brazil Mexico Poland
South Africa Indonesia Malaysia
USA
High Yield indices – option adjusted spreads since 1998 Emerging Markets Local Currency 10 year yields the last 5 years
Where do we see opportunities and why?Cash flows of European energy to benefit from declining capital expenditures (CAPEX)
Source: Deutsche Bank
Where do we see opportunities and why?Need to be selective in Emerging Markets
12.4%
10.4%9.7%
8.3%
7.2% 6.9%6.5%
6.1% 6.1% 6.0%5.2% 5.0%
4.5%3.8% 3.8% 3.8% 3.7%
3.2% 2.8% 2.5%1.9%
1.0% 1.0%0.6%
0.1%
-0.1% -0.2%-2%
0%
2%
4%
6%
8%
10%
12%
14%10-Year Valuation Implied Returns (Real): Emerging Markets (Local Currency)
Source: Ibbotson
Where do we see opportunities and why?High conviction investment positions of different vintages
2010 2012 2014 2016
Œ Increase A-REITS
+ Initiate Japanese Equities
Œ Increase Unhedged Currency
– position for falling AUD
Š Decrease AU Equities
Š Decrease US Equities
Œ Increase EU Equities
Œ Increase Japanese Equities
Œ Increase AU Cash
Œ Increase EM Equities
+ Initiate EU Energy
+ Initiate EM Debt
Œ Increase AU Cash
Š Decrease EU Equities
Š Decrease AREITS
+ Initiate Global Quality Strategy
+ Initiate European Utilities
Œ Increase EU Equities
+ Initiate US HY Credit
Š Decrease Global Infrastructure
2011 2013 2015
Where do we see opportunities and why?Growth Trust allocations
Source: Ibbotson – as at 31 March 2016 -5.0% -2.5% 0.0% 2.5% 5.0%
Japan Equities
Australian REITs
Emerging Market Equities
Cash and Currency
Global Infrastructure
Other Developed Equities
International REITs
Euro Equities
International Bonds
Euro Utilities
Australian Equities
Inflation Linked Bonds
Australian Bonds
Euro Energy
Alternatives
US Equities
Emerging Market Debt
▲ since March 2015
Alternatives14.5%
Cash and Currency21.8%
Inflation Linked Bonds2.1%
International Bonds2.7%
Australian Bonds4.6%
Emerging Market Debt4.8%
International REITs0.2%
Australian REITs6.4%
Global Infrastructure1.7%
US Equities3.6%
Euro Equities12.6%Japan Equities
7.1%
Emerging Market Equities
8.1%
Other Developed Equities
1.1%
Australian Equities8.7%
Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.
- Warren Buffett ”“
Summary
gThere are many investment opportunities other than Australian equities.
gValuations and fundamentals are joined at the hip.
gThere is no point buying something “cheap” if it’s low quality and not in the price – a robust process helps you avoid overpaying.
gIf an asset class doesn’t give you a better opportunity than cash, don’t invest.
gAn active approach to asset allocation leads to a proactive response to changes in valuations.
gBe humble and open minded – ask the question – how could we be wrong and think about ways to improve.
gHolding cash is uncomfortable, but not as uncomfortable as doing something stupid.
gPrice is what you pay; value is what you get.
Questions
Be independent-minded – sometimes the best positions are contrarian, making you feel uncomfortable, because you’re the only one there.
Valuation has driven returns around the world… and prospective losses.
Build portfolios holistically by ensuring that every investment plays its part.
We put investors first by investing their savings in asset classes only when it makes sense to do so.
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