KEY ELEMENTS OF OUR INVESTMENT APPROACH /
Global Investing: Expanding Opportunities in an Integrated World
Peter Lynch made a name for himself as a “stock-picker”—someone with a knack for uncovering great companies with equally great (or greater) investment opportunity. The strategy Lynch found most successful became popularized as “buy what you know”: investing in Taco Bell because he enjoyed their burritos, or in Hanes because his wife had a strong preference for L’eggs hosiery. Lynch did the detailed analytical work, too, but he believed that many individual investors had the ability to pick great stocks, simply by buying what was right in front of them.
While Peloton’s management approach incorporates stock-picking, today we manage diversified global investment portfolios for clients. Years ago we might even have been partially characterized as a “buy what you know” manager, primarily focused on large-cap U.S. stocks. However, the investing landscape has changed dramatically since the mid-1980s when Peloton was founded and when Lynch penned his straightforward investing views. Information and communication technology has progressed to the point that data and voice transmissions travel instantaneously and cheaply around the globe. Shipping and logistics networks now connect almost every part of the planet, and national borders have opened to allow much freer flows of labor, capital, raw materials, and finished goods. Central economic planning has yielded to free enterprise. Countries rich only in natural resources three decades ago now have millions of citizens with discretionary income. The world has become accessible to all but the smallest companies, and the number of viable investment opportunities has exploded. Investment opportunities have ballooned, and the process of evaluating these opportunities requires new disciplines and tools.
“Investing in foreign markets is no longer an allocation choice; it’s inescapable.”
Investing in foreign markets is no longer an allocation choice; it’s inescapable. That is, virtually every company of a certain size sells some proportion of its products in countries away from home. Success depends on having the appropriate tools and disciplines. Peloton’s investment discipline has evolved over time to reflect this new reality. In this paper we briefly trace the changes in tools, information, and practices which have allowed Peloton to become a global investor. Finally, we conclude by highlighting our view of the future of global investing and what those changes mean for investors.
The Times They Are A-Changin’
Access to foreign securities has changed dramatically over the last 30 years, and the growth in the number of American Depositary Shares (ADS) is the largest single contributing factor to this phenomenon. ADS are securities which trade in U.S. capital markets—mainly the New York Stock Exchange and the NASDAQ market system. The first ADS was introduced in 1927 for UK retail store Selfridges and, until recently, virtually all ADS represented large companies from developed countries. Now fully one third of all ADS represent companies from emerging market nations.1 Each ADS represents a direct ownership interest in a foreign-traded company’s share(s), akin to owning the common stock of an American company. In years past, U.S. investors who wanted to purchase foreign securities needed to first hack through a jungle of administrative barriers: establishing an account with a capable and trustworthy broker in the foreign country where the shares traded; converting dollars to the home currency; transferring the cash to the foreign account; and, finally, communicating with the foreign sales representative who might neither have spoken English nor been available during usual business hours in the West. These weren’t insurmountable obstacles, but if the investor only wanted to buy the securities of one company in a particular country, the required effort was hardly worthwhile.
These difficulties even pushed many professional investors toward mutual funds, in order to gain international exposure. Large, co-mingled funds could more effectively establish foreign brokerage accounts and manage the associated administrative hassles. But, as we have written elsewhere, subcontracting to a mutual fund can be expensive for clients of investment advisors. The internal expense ratio for many international funds remains well above 1.50%, producing a typical “all-in” fee in excess of 2.50% annually. Thus, the cost of investing in foreign companies via funds is ultimately shouldered by the investor.
“Successful global investing also requires the right disciplines and information sources, and it begins by asking the right question.”
The rapid growth in the number of ADS to which Peloton has access—and the ease with which we are able to analyze and invest in these securities—means that our universe of investable securities has more than doubled since our founding. Investing fruitfully abroad requires more than just access to foreign markets, however. Successful global investing also requires the right disciplines and information sources, and it begins by asking the right question.
The Right Question
Posing the question “Why should someone invest internationally?” is likely to elicit the same response from most investors: diversification. Investors frequently attempt to mitigate risk by diversifying. But diversification works because certain types of securities bear enduring economic dissimilarities from other securities.2 Before globalization took root, the stocks of two identical companies operating in different countries might have performed very differently from one another. Today, the companies’ actual locations (i.e., countries of domicile) impact performance far less than the industries and markets in which they operate. Put differently, owning the stock of two large banks— a U.S. bank and a German bank, for example—provides a far weaker prospect for diversification than owning the stock of a U.S. industrial equipment manufacturer and a U.S. food producer. Simply investing “internationally” may no longer yield the type of diversification it did years ago.3
The beneficial aspect of a globalized market is that the number of investment alternatives available to individual investors across industries has increased tremendously. The right investment question is no longer: “Should I invest in the U.S. or in Japan?” for example, but “Which markets are most attractive for investment, and which companies provide the best access to those opportunities?”
The electric utility industry offers a helpful illustration. In a mature market like the U.S., the demand for electricity increases very slowly—between 1% and 2% per year, typically. However, demand for electricity in emerging markets may increase 5%-7% or more per year. Consider the stark contrast: an old, slow-moving industry in the U.S. may actually be a growth industry in foreign markets. Mobile phones offer a similar comparison: most Americans already have cell phones, so future growth opportunities in the U.S. are limited; but, in Africa, Asia, and parts of Latin America, large majorities of consumers just now have enough discretionary income to afford a mobile phone.
The Best Means Of Access
The “Buy America” push of the 1970s and 1980s ran into an interesting speed bump when it came to automobile manufacturers. If the Japanese company Honda manufactured cars in one of its U.S. plants, using U.S. made parts, with exclusively U.S. labor, and sold those cars to U.S. consumers, is the end product really still foreign somehow? In the same way today, is a U.S. domiciled company that sells most of its goods to foreign consumers really a U.S. company? From an investment perspective, does it really matter where the company is domiciled?
“If we can gain access to growing emerging markets through a U.S. company, we are happy to make this “international” investment because we know that the figures reported in financial statements are reliable.”
In our global investment discipline, we are less focused on where the company is headquartered than we are on whether the company is accessing the right (growing) markets and whether sound and stable corporate governance is present. If we can gain access to growing emerging markets through a U.S. company, we are happy to make this “international” investment because we know that the figures reported in financial statements are reliable.
Likewise, we’re eager to invest in the ADS of foreign companies when we’ve grown comfortable with the stringency of their financial reporting requirements, political climates, and other macroeconomic considerations. We are indifferent to whether a company is domiciled in the U.S. or in another country which has a stable political system and good governance. Our ultimate focus is on accessing the most attractive markets.
Falling Barriers
Language has been another barrier to global investing, but this, too, is changing rapidly. Most investor relations web pages now offer versions in multiple languages. As well, investor relations personnel are very commonly fluent in English, further facilitating our research. An annual report from Spain today may read very similarly to one published in the U.S.
Communications from companies are now primarily electronic and thus instantaneous. And since the enactment of Regulation Fair Disclosure in 2000, the importance of having analysts with special access to corporate managers has vanished. We receive dozens of updates daily directly from company managements all around the globe via e-mail and RSS feeds. Being located in a different continent than the companies in which we invest no longer inhibits us from receiving the information we need to make timely investment decisions.
Finally, the majority of the ADS in which we invest are “listed,” meaning they trade on U.S. exchanges and are thus required to file annual financial reports with the SEC. The most common form filed by foreign firms with ADS in the U.S. is known as a 20-F. The Form 20-F contains the same essential information that a domestic company’s 10-K would include. From that perspective, we’re minding both our “Ks & Fs.”
Global Investing In The Future
The magnitude and rate of change for investing in a global market are only increasing. As the globe becomes ever more integrated, we expect to contend with at least three major developments:
1. FINANCIAL SYSTEM COORDINATION. Since the 1988 Basel Accord, central banks from the “G-10” (the largest 10 economies) countries have coordinated minimum bank capital requirements and other financial system standards. The first update to the original Basel Accord, Basel II, was negotiated in 2004. The global financial crisis of 2008-2009 resulted in another update, Basel III, the terms of which were agreed to by the U.S. Federal Reserve and other nations’ central banks during the fourth quarter of 2011. We expect the pace and intensity of international bank coordination to continue.
On a parallel track, the U.S. Financial Accounting Standards Board (FASB) is working with the International Accounting Standards Board (IASB) to consolidate standards into a single body of regulations. This convergence will further facilitate the analysis and comparison of financial statements from countries around the globe.
2. CURRENCY CONSOLIDATION. We expect the benefits of coordinated monetary systems to continue to appeal to large and small exporters alike, the Euro’s struggles notwithstanding. Certain states in West Africa have utilized a common currency in the past and the possibility of a Pan-Arab currency remains strong. Alongside common currencies, we expect the Chinese Yuan to trade freely internationally, becoming one of a few global reserve currencies. In a world with fewer currencies, the impact of foreign exchange on reported financials lessens, making the jobs of global investment analysts easier as a result.
3. CAPITAL MARKET CONVERGENCE. The first decade of the 21st century saw numerous stock and derivative exchanges combine to form global trading platforms. We expect this trend to continue and, as it does, we believe there will be positive results: better pricing of securities and easier relative value comparisons among similar companies in an industry.
“Diversification has become much more a function of where a company’s sales occur than where headquarters are located.”
As global investment markets become more accessible, the requisite analytical tools and conventional wisdom are changing. This results in changing purposes and goals for investing internationally. Diversification has become much more a function of where a company’s sales occur than where headquarters are located. We believe that, as the tools and access change, our opportunities to make attractive investments will continue to increase. As professional investors, we welcome these changes as they will provide us with greater opportunities, access, and tools to construct portfolios for our clients.
1 www.adr.com, DR Search. Of the 2,434 ADS on the NYSE, NASDAQ, or OTC, 1,628 are from developed Europe or Asia, with the balance from Emerging Asia, Emerging Europe, Latin America, or the Middle East / Africa. 2 Peloton Wealth Strategists, How Diversification Works, p. 2. 3 Bruno Solnik and Dennis McLeavy, International Investments (Boston: Pearson Addison Wesley, 2004), p. 484.