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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
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
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…”
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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”.….
16
Source: Mauboussin
20 Trials
Illustrating noise versus signalShort-term oriented observers may see the first 20 coin tosses and conclude that it is a “tails-biased coin”.….
16
Source: Mauboussin
100 Trials
Illustrating noise versus signalShort-term oriented observers may see the first 20 coin tosses and conclude that it is a “tails-biased coin”.….
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
17
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
A breakdown of diversity leads to fewer investor typesRemaining investors follow similar strategies, more correlated
17
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
A breakdown of diversity leads to fewer investor typesRemaining investors follow similar strategies, more correlated
Contrarians tend to be lonely –especially at extremesContrarians tend to be concentrated on the short and long side of market extremes
17
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
A breakdown of diversity leads to fewer investor typesRemaining investors follow similar strategies, more correlated
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
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
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
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
21
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)
Valuation Conditional Drawdown
Equities vs Key Australian Assets
Source: Morningstar Investment Management Estimates. For illustrative purposes only.
Finding opportunities in equities
More Attractive
Less Attractive
23
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)
Valuation Conditional Drawdown
Fixed Income vs Key Australian Assets
Source: Morningstar Investment Management Estimates. For illustrative purposes only.
Finding opportunities in fixed income
More Attractive
Less Attractive
24
25
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
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
33
34
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
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
37
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
37
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
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