When he made his first investment in 1941, an eleven-year-old Warren Buffett went ‘all in’ on Cities Service, a US energy company that had seen its share price halve over the previous year against a background of regulatory headwinds and war in Europe.
While Buffett went on to be one of the world’s great investors, he started, as most of us do, by investing in companies in his home market.
In the intervening 80 years, Buffet’s portfolio has remained almost exclusively invested in US listed companies. The question is whether other investors should follow Warren Buffet’s approach or diversify their portfolios internationally?
There are two ways to answer this question. The first is from the perspective of the investor and second from the perspective of the investments that are available.
Home bias
From an investors perspective, the inclusion of a ‘home bias’ in a portfolio is an important way to match assets with liabilities.
Unless an investor plans to move overseas or has significant liabilities (such as a mortgage) in another currency, it is important that their assets and liabilities are linked by common economic drivers to ensure that the value of the investors’ liabilities do not grow at a significantly higher rate than the value of their assets.
While this home bias is most important in currency and fixed income holdings, it is also relevant for equity investments.
However, there is a big difference between having a home bias and investing all of ones capital in your home market.
When considering the extent to which we include overseas assets in a portfolio we need to address the question from the perspective of the relative attractiveness of US and overseas equity markets.
This question is especially relevant now, as following a period of high returns from US equities it seems that investors are more reluctant to invest outside.
This reluctance can be illustrated by the US equity exposure of the average fund in the Morningstar US Active Managed 50%-70% which currently stands at 47% equivalent to 80% of the overall equity exposure. This represents a rise of 2% over the last decade.
When considering the attractiveness of any investment, the quality of the asset is the natural starting point.
Buffet’s “wide and long-lasting moat”
It is therefore worth noting that the US equity market has an extraordinary number of high quality companies, illustrated by the fact that 44.7% of the Morningstar US Market index benefit from having a ‘wide moat’ according to our colleagues in Morningstar’s Equity Research team.
The concept of a ‘moat’ is shorthand for a business that has competitive advantages that enable it to deliver superior returns on the capital it invests over the long term.
Such companies are deserving of a higher valuation. The concept was popularized by Warren Buffett who stated in 1995 that when investing “The most important thing [is] trying to find a business with a wide and long-lasting moat around it.”
Yet investors may benefit from higher returns by diversifying their portfolio across global markets.
While the quality of a business is the best indicator of returns over the very long term, Nobel laurate, Robert Shiller has shown that changes in valuation tend to dominate the returns you receive over the next decade.
This is because asset prices are far more volatile than fundamental returns due to the tendency of investors to extrapolate current business conditions into the future.
This extrapolation, combined with investors’ herding behavior can lead asset prices to swing between extremes of pessimism and optimism while the fundamental drivers of the asset remain relatively stable.
While most of us are hoping to invest for longer than a decade, few of us have the fortitude to ignore returns over that period. It is therefore essential that investors consider the quality of a company in the context of the price being paid.
Overpaying for a company with a strong moat may lead to lower returns, or even losses, over the next decade. Equally, a poor quality investment at an excellent price can deliver high returns over 5-10 year periods.
Investment analysis must therefore encompass both the fundamental drivers of return and the appropriate price to pay for those returns.
While the US offers the highest quality companies, this advantage appears to be more than fully reflected in the price and consequently, we are expecting much lower expected returns from US companies than other, lower quality, markets such as the UK, where only 28% of the market capitalization has a wide moat.
Japan and the emerging markets of Asia and Latin America also offer higher expected returns than the US market.
While these markets may not outperform the US over the timescales in which Mr. Buffett tends to think, for those investors concerned about returns over the next decade, it is time to look further afield for returns.
Unless otherwise stated, all data is sourced from Morningstar Direct and is accurate at 28 March 2022.