This is MoneyClub

Stocks for the Long Run
Part 2: Valuation, Style Investing, and Global Markets.

Chapter 10 Chapter Guide

The World’s Population, Production, and Equity Capital

CYCLES IN FOREIGN MARKETS

• The Japanese Market Bubble
• The Emerging Market Bubble
• The New Millenium and the Tech Bubble

DIVERSIFICATION IN WORLD MARKETS

• Principles of Diversification
• “Efficient” Portfolios: Formal Analysis
• Should You Hedge Foreign Exchange Risk?
• Sector Diversification
• Sector Allocation around the World
• Private and Public Capital

THE WORLD IN 2050

CONCLUSION

APPENDIX: The Largest Non US-Based Companies

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Chapter 10 Chapter Takeaways

The World’s Population, Production, and Equity Capital
-The Developed world contains less than 15% of the world’s population but it produces over 50% of the world’s goods and headquarters over 93% of the world’s equity capital. For now.

CYCLES IN FOREIGN MARKETS
-In the past (70’s to date), Strong US markets were often coupled with weak foreign markets, vice versa. So a well-diversified world portfolio is important.

• The Japanese Market Bubble
  -Japanese stocks averaged >10% p.a. above US returns over the 1970’s and 80’s. by the end of 1989, the American stock market was no longer the world’s largest. Japanese investors justified PE ratios above 300 by coming up with entirely new ways of valuing stocks. The Nikkei went from 39,000 in Dec 1989 to below 8,000 in 2002.
• The Emerging Market Bubble
  -Emphasis shifted to booms in India, Indonesia, and China, as Taiwan, South Korea, and Thailand had put up ogod performances. Latin America also was impressive in Argentina, Brazil, and Mexico. However the 1997 collapse saw contagion spreading beyond the Pacific Basin to Latin America, Eastern Europe, and Russia. Indonesian, Thai, Russian, Phiippines, and South Korea markets fell more than 80%. Singapore and HK fell 70%. (in USD terms). This indicated that it made more sense to invest back in the US.
• The New Millenium and the Tech Bubble
  -The last 3 years of the 20th century saw strong gains in all stock markets. Yet a few months into 2000 all of the developed countries markets fell by at least 50% (for US, from March 2000 to Oct 2002). European and Jap had 60% and 63% declines respectively. Following 9/11, stocks in US and EU again hit all time highs, yet dollar based investors saw their international stocks far outperform their domestic holdings because the USD fell 33% from 2001 to 2004. (in a reversal of the Emerging Mkt Bubble)

DIVERSIFICATION IN WORLD MARKETS

• Principles of Diversification
  -We do not invest in emerging countries because they are growing faster and therefore will provide beter returns. Chapter 8’s research disproved that. The reason of doing so is to diversify the portfolio and reduce risk. If two countries have zero correlation, a 50-50 allocation will reduce risk by 1/3 compared to the risk of investing in a single country. However countries have become increasingly correlated over time.
• “Efficient” Portfolios: Formal Analysis
  -We identify two forms of risk: local risk, fluctuations in local stock markets themselves, and exchange-rate risk: fluctuations in exchange rates. Table shows Domestic risk ranging from 16-28% and Exchange risk ranging from 5-12.7%.
  -Based on historical data, the best portfolio has a 37.8% foreign stock allocation. Ignoring foreign exchange risk, which is justified for an institution, the optimal portfolio allocation rises to 52.6%.
  -The more correlated foreign and US markets are, the less attractive US stocks are.
• Should You Hedge Foreign Exchange Risk?
  -using Currency hedging (entering into a currency contract that offests unexpected changes in the price of foreign currency relative to the dollar). But for investors with long-term horizons, hedging currency risk in foreign stock markets is not important. Currency hedges may actually increase the volatility of dollar returns as real assets typically adjust to compensate long-term investors for exchange rate risks.
• Sector Diversification
  -However, the returns betwen internationl industrial sectors are becoming less correlated. This is because the business cycle has become moderated, so shifts in sector demands rather than changes in the overall economy become the primary sources of changes in the firm’s profitability.
  -Siegel believes a sector approach to international investing will eventually supplant a country approach, envisioning a future of international incorporations where firms have no headquarter countries.
• Sector Allocation around the World
  -The financial sector is the largest sector in every region of the world. Banks are critical to economic growth.
  -In consumer discretionary sector, Japan has the highest weight because of Toyota Motors, Sony, Honda, and Matsushita. DaimlerChrysler in Europe. Comcast, Time Warner, HD in the US.
  -Consumer staples: US largest, with Europe a close second. P&G, Altria, WalMart. Nestle, Unilever, British Am. Tobacco. Japan has virtually no presence.
  -Energy: large everywhere but Japan which has little energy resources. XOM, Chevron, ConocoPhillips, BP Total, ENI. PetroChina, GazProm.
  -Healthcare: largest share of US firms, smallest share in emerging mkts: Pfizer, J&J, Merck. Europe: GSK, AstraZeneca, ROche, Novartis. Japan: Takeda Pharma.
  -Industrial: largest in Japan, smallest in emerging mkts. Japan: Mitsubishi/Mitsui, Europe: Siemens. US: GE.
  -IT: largest in emerging mkts, cos of Samsung and Taiwan Semicon. Excluding S. Korea and Taiwan, India has 80% of remaining mkt value led by Infosys and Wipro.
  -Telecom: Largest in emerging mkts: Chunghwa Telecom of Taiwan, American Movil of Mexico, and China Mobile. Vodafone in Europe. ATT and Verizon in the US.
  -Utility: 3.5% of US market share led by Exelon Corp, to 7% in europe led by Enel of Italy and Electricite de France.
• Private and Public Capital
  -XOM may be the largest company by market value and largest reserve of oil and gas in the world but it is only the 14th largest if one includes govt-owned companies. Aramco and Iran’s NIOC have far more and have been valued at about $1 trillion each. Much wealth is still owned by governments around the world, especially in land, natural resources, roads, dams, schools, and parks. Growth of the world’s capital stock will come partialy from the privatization of many government owned assets.

THE WORLD IN 2050
-The US’ share of world output will shrink from 19 to 12 percent
-West Europe: 19 to 9%.
-Japan: 6 to 2%
-China will have 23%.
-India: 15%.
-But China’s population is projected to be about 3.5x that of the US, and per capita income 0.5 our level.
-This brings Chinese and Indian output back to historical averages in the 17th and 18th centuries.
-The developed world has over 90% of world stock market value now -> will shrink to slightly more than 1/3.

CONCLUSION
-The inexorable trend toward integration of the world’s economies and markets will certainly continue in this new millennium. No country will be able to dominate every market, and industry leaders are apt to emerge from any place on the globe. The globalization of the world conomy means that the strength of management, product lines, and marketing will be far more important fctors in achieving success than where the firm is domiciled. Sticking only to US equities is a risky strategy for investors, in part because US market share will shrink to less than 18%  of the world market by 2050.

APPENDIX: The Largest Non US-Based Companies

1. PetroChina
2. OAO Gazprom
3. Royal Dutch SHell
4. BP
5. China Mobile
6. Toyota Motor Corporation
7. Industrial and Commercial Bank of China
8. HSBC
9. Total
10. Electricite de France