Diversification and US Exposure

The last 2 years has seen the US exposure in Indian HNI portfolios increase significantly. The number of MF Schemes in India investing in the US has raised a cumulative AUM of INR 20,000 Cr over the same period.

It is important to realize that the US markets have been the best-performing markets over the last 10 years. U.S. equity market performance led the world for the 10 years ending September 30, 2021, which has left the U.S. market trading at a significant valuation premium relative to non-U.S. stocks. Moreover, when you combine this with the depreciation in the INR (which has annualized at 4.1% over the last 10 years), the back-tested data looks extremely attractive to invest in US equities.

While diversification is good as a concept, it’s important to understand the breakdown of the returns in the US, and why we believe at ITUS that US Equities have a significant potential to underperform over the next cycle (This leads us to one of the strong reasons for Indian equities to outperform over the next cycle).

The last decade has seen a significant outperformance in US equities, with the US MSCI Index growing at 16% (in USD terms from Mar 2011 to Mar 2021). Over the same period, non-US Stocks as measured by the MSCI All Country ex-US Index grew at less than half the return of the US (7.5% annualized). It’s important to put this return in the context in the US, as the previous decade in the US was termed as a lost decade in terms of equity returns (In the previous decade, Mar 2001 – March 2011, US Equities generated a return of 2.1% on an annualized basis).

While we all love fundamentals and earnings growth, it’s important to break down the returns of an index into its underlying components – Fundamental return and its change in valuations.

To understand the contribution from fundamental returns, it’s imperative we break down the returns into growth from reinvestment of retained earnings and the second from reinvestment – these two are the long-term drivers of equity performance.

As Fig 1 shows, the difference between the U.S. market experiencing a lost decade from September 2001 to September 2011 and an exceptional decade over the subsequent 10 years is almost entirely attributable to changes in valuations. During the earlier period, valuation declines of 3.9% a year nearly negated the 4.4% fundamental return that companies delivered during that time. In the more recent period, fundamental performance was slightly better at 4.8% annualized, while valuations gained 9.8% a year. So, of the 14.1% improvement in annualized returns delivered by the U.S. market in the most recent decade relative to the decade before, 13.7% came from changes in valuations and only 0.4% came from changes in the returns delivered by the companies comprising the index.

Fig 1: US Fundamental Performance has been lacklustre

The changes in multiples are predominantly the difference between exceptional and the lost decade.

Source: MSCI U.S. Index, GMO

As multiples expanded nearly 10% per year over 10 years, this resulted in valuations causing a doubling in performance. For eg: the index increased from a multiple of 17x 10-year average real earnings on September 30, 2011, to 37x on September 30, 2021. The natural question to ask as a follow-up is, why is the market now willing to pay higher multiples for U.S. companies when the companies themselves look to be delivering fundamental returns that are more or less the same as they delivered in the prior decade?

Lower interest rates are a natural cause, although if low-interest rates were the sole driver of high equity market valuations, one would expect to see much higher valuations in Europe and Japan too. The argument for high U.S. valuations tends to come down to a belief that American companies are special.

The U.S. market has seen platforms and technology companies create immense shareholder wealth over the last 10 years. For example, Apple, Amazon, Microsoft, Google, and Facebook (the “Big Five”) generated annualized fundamental performance of 16.3% over the last 10 years. Companies that can reinvest capital at high rates for long periods of time deserve to trade at higher multiples, and many investors seem to assume that the strong growth of these dominant companies justifies the premium multiple applied to the U.S. market. The problem with that narrative is not that these five companies don’t deserve their valuations. The problem is that when you look at the U.S. market excluding these five names, its fundamental return was only 4.2% annualized over the last decade.

Outside of the Big Five, U.S. equity market investors are paying significantly higher prices (2 standard deviations from the mean) for quite dull fundamental performance.

Valuations mean-revert

History suggests that regions and countries experience mean reversion in their fundamental performance. Economic intuition suggests the same, as competitive capitalism should cause capital to flee areas of low return (thereby improving the prospects for the capital that remains) and seek out areas of high return. That is, the lower a country’s fundamental performance was in one decade, the higher it tended to be in the subsequent decade (the US had its best returns in equities in the decade of the late 90s, and this was followed by its worst decade over the next 10 years. We then saw the US having the best decade in equity performance over the last 10 years. The Indian equity market saw an exact trend reversal having the best decade of equity performance in the first decade of the 2000s followed by the next 10 years where Indian markets had the worst performance).

While the US will continue to be the home to capitalism and innovation, it’s important to understand the odds of success around any capital allocation decision taken. When the odds are in your favour, the results tend to follow. For the first time, we believe that the odds to allocate outside the US in equity portfolios are showing a higher risk-reward and we believe India will be a natural beneficiary of these flows.

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