Introduction to International Diversification

In the ever-evolving landscape of global investing, the allure of the U.S. stock market has been undeniable, driven partly by the meteoric rise of large-cap technology stocks. These stocks have commanded eye-watering valuations, prompting investors to increase their exposure to U.S. equities significantly. While this strategy has borne fruit in recent years, it presents considerable risks, chief among them being overvaluation and market concentration. Such risks underscore the importance of international diversification—a strategy that allocates investments across various global markets to mitigate reliance on any single economy or currency.

Historical Perspective and Current Trends

Historically, the dominance of the U.S. stock market is not a constant. For example, during the 1970s, 1980s, and 2000s, U.S. equities generally underperformed compared to their international counterparts. This variance in performance across decades highlights the cyclical nature of market leadership and the benefits of a diversified investment portfolio that can capitalize on different regional dynamics over time.

The Prevalence of Overvaluation and Bankruptcy Risks

Before delving deeper into the specifics of market valuations, it is imperative to address the two predominant risks in equity markets: overvaluation and bankruptcy. Overvaluation occurs when stock prices exceed their intrinsic values, a scenario often propelled by excessive investor optimism and speculative trading. Bankruptcy risk, on the other hand, pertains to the potential for companies to fail financially, which can lead to considerable investor losses. Both risks highlight the critical need for a diverse investment portfolio that not only spreads out economic and financial exposure but also mitigates the impact of adverse movements in any single market or stock.

The U.S. Valuation Problem

The impressive performance of the U.S. market since the 1990s can largely be attributed to expanding valuation multiples rather than fundamentally superior growth. Between 1990 and 2022, U.S. stocks outperformed the MSCI EAFE Index by an average of 4.6% annually, primarily driven by rising valuations. Initially valued at half the level of their EAFE peers in 1990, by 2022, U.S. stocks commanded valuations 1.5 times higher. When adjusted for these valuation disparities, the apparent outperformance diminishes significantly, suggesting that the U.S. market’s returns were largely fueled by increased investor willingness to pay higher prices for stocks, an inherently unsustainable trend.

Graph Analysis: Valuation Disparities Between Markets

As illustrated in the graph below, using the CAPE Ratio (the CAPE ratio is a p/e ratio that uses 10-year average earnings) for a valuation metric there is a stark contrast in valuation trends between the U.S. and other major markets such as Europe, Hong Kong, and Singapore. Over the past few decades, we can observe periods where the U.S. market valuation significantly outstrips those of other regions, particularly during the recent tech-driven market rally. However, the graph also shows periods where these markets have either outperformed or provided better value compared to the U.S., highlighting the cyclical nature of market valuations and the potential for international diversification to capitalize on these disparities.

Source: Shiller CAPE data,  12/31/1981 to 6/28/2024

Opportunities in Emerging and International Markets

With U.S. markets currently sporting high valuations, it is an excellent time to be looking at emerging and international markets that offer compelling investment opportunities. These markets often boast more attractive valuations and the potential for significant returns, especially when global markets experience corrections or when U.S. valuations revert to more historical norms. Countries in Southeast Asia, Europe, and Latin America, in particular, present promising prospects due to their favorable demographics, growing economies, and expanding consumer bases.

Risks of Overweighting U.S. Stocks

Investors heavily concentrated in U.S. stocks face significant exposure to a downturn, particularly within the technology sector, which has disproportionately driven recent market gains. Such concentration heightens the risk of substantial losses in the event of a tech-sector correction or broader economic downturn. Additionally, the U.S. economy itself faces numerous challenges, including structurally higher inflation, geopolitical tensions, and potential recessions, which could undermine the sustained performance of its stock market.

Conclusion: The Strategic Necessity of Global Diversification

While the U.S. stock market has provided robust returns in recent years, its elevated valuations and sectoral concentrations pose substantial risks. A strategically diversified investment approach is not merely optional but essential in today’s complex global financial landscape. By broadening investment horizons beyond U.S. borders, investors can enhance their potential for risk-adjusted returns and safeguard against market volatility and economic downturns. In essence, HCM believes it is unwise to anticipate a continuation of the U.S.’s triumph over the last 15 years, which was largely driven by escalating multiples, and now is a particularly poor moment to misinterpret historical lessons.

Introduction

In an era marked by rapid changes in economic conditions and monetary policies, understanding the true strength of the stock market has become more complex. Traditional metrics often obscure the underlying economic realities, making it necessary to delve deeper into value and performance. Analyzing the S&P 500 in terms of a timeless asset like gold provides a precise measure of value and truth amid fluctuating currencies and inflation.

Unveiling the Real Market Value: The S&P 500 Measured in Gold

The log scale graph above vividly illustrates the S&P 500 index in gold terms from January 1950 to June 2024, highlighting the market’s performance adjusted for fundamental economic influences. This metric, which divides the index value by the price of gold per ounce, reveals not just nominal market trends but the real purchasing power and intrinsic value of stock market gains over time.

Key Insights from the Ratio Analysis

1. Understanding Real Purchasing Power

The graph shows that the S&P 500, when measured in gold, has experienced fluctuations that highlight the importance of considering real purchasing power. While nominal stock market returns have been strong, evaluating these returns against the price of gold provides a deeper understanding of their true value. This perspective encourages investors to be mindful of the real economic gains versus nominal increases.

2. Gold’s Role as a Hedge

Gold’s performance during periods of economic turbulence reaffirms its status as a safe haven. The recent subdued S&P 500-to-gold ratio reflects ongoing economic uncertainties and investor skepticism about future stability. When gold appreciates, it often signals a flight to safety, highlighting concerns about the broader economic and financial environment.

3. Monetary Policy Impact

The extensive use of monetary tools like low interest rates and quantitative easing has inflated asset prices without necessarily enhancing their actual value. The lagging S&P 500-to-gold ratio suggests that such policies may boost stock valuations nominally while diluting their real value, necessitating a cautious interpretation of market gains.

Reflecting on Recent Economic Dynamics

The past two decades, marked by the 2008 financial crisis, the tech boom, and the COVID-19 pandemic, have created a complex market landscape. These events have influenced investor behavior, monetary policy, and market dynamics, affecting how assets are valued against gold. The rise of technology giants and pandemic-induced market volatility have underscored the divergence between market optimism and economic reality.

A Call for Prudence and Strategic Diversification

The discrepancy between the S&P 500’s nominal and gold-adjusted values serves as a crucial warning: nominal gains do not necessarily equate to real economic growth or wealth creation. For investors, particularly those adhering to value investing principles, these insights suggest a diversified strategy that includes assets like gold as a hedge against inflation and market volatility.

At Hoover Capital Management (HCM), we’ve always championed the principles of value investing. Our commitment is rooted in the belief that focusing on fundamentally strong companies with undervalued assets leads to sustainable long-term growth. This belief is further reinforced by a recent analysis of the French High Minus Low (HML) factor, which highlights the historical performance of value versus growth stocks, as shown below:

The data, spanning an impressive 97 years from July 1926 to December 2023, presents a compelling case for value investing. The cumulative return of value stocks has eclipsed that of growth stocks by an astounding 3,000%. To put it into perspective, value investing has delivered 30 times the return of growth investing over this period.

This remarkable outperformance underscores the resilience and potential of value investing. It serves as a reminder that while market trends may fluctuate, the fundamentals of value investing remain a cornerstone for building wealth. As we navigate the complexities of today’s global markets, the lessons from the past century continue to guide our investment strategy at HCM.

We believe that this historical perspective reinforces our commitment to value investing. It highlights the importance of patience, discipline, and a focus on fundamentals in achieving long-term investment success. As always, we remain dedicated to helping our clients unlock global investment opportunities through a disciplined and informed approach to value investing.

A Return to Dominance: The Magnificent 7’s Influence in 2023

In 2023, the financial markets witnessed a striking phenomenon. The S&P 500 and MSCI ACWI reported robust returns of 26.2% and 22.2%, respectively, signaling a buoyant year for investors. However, these headline figures mask a deeper, more intricate narrative of market concentration and disparity.

The Disparity Behind the Headlines

While the market-weighted S&P 500 and MSCI ACWI indices soared, their equal-weighted counterparts told a different story, lagging with returns of 14.0% and 10.2%. This divergence underscores the significant impact of market-weighted movements, where a handful of dominant stocks disproportionately influence overall index performance.

The Rise of the Magnificent 7

Central to this narrative is a group of technology and growth-oriented stocks, aptly dubbed the Magnificent 7 — Apple, Microsoft, Amazon, Nvidia, Google, Tesla, and Meta. These titans not only dominated the market but also accounted for a staggering 62% of the S&P 500’s annual return. Their dominance favored stocks with high valuation metrics, such as price-to-earnings (P/E), price-to-sales, and price-to-book ratios, while traditionally value-based stocks lagged behind.

The Shift in Market Dynamics

Our 2023 market outlook speculated a shift away from the hegemony of American mega-cap/tech companies. However, 2023 saw these very entities, particularly the Magnificent 7, soar anew, largely driven by the burgeoning AI industry. This pivot to AI rekindled investor enthusiasm, cementing these companies as the must-own stocks and leaving the rest trailing.

The Spectacle of Passive Investment and the Echoes of History

Today, the investment landscape is increasingly characterized by momentum-chasing. Approximately two-thirds of global passive investments flow into U.S. stocks, with a significant portion directed towards the Magnificent 7, often irrespective of their valuations. This trend is echoed in the behavior of large active money managers and hedge funds, reminiscent of historical market patterns that have often led to dramatic corrections.

Historical Parallels: Lessons from the Past

The 1960s Conglomerate Bubble

The 1960s saw conglomerates like ITT and LTV expand aggressively, driven by favorable conditions and accounting practices. However, this bubble burst due to rising interest rates and regulatory shifts, leading to a steep decline in shareholder equity.

The Nifty-Fifty Bubble of the 1970s

The Nifty Fifty era was defined by the meteoric rise of fifty large-cap stocks. However, their inflated valuations couldn’t sustain the momentum, resulting in significant losses during the 1973-1974 market crash.

The 2000 TMT/Tech Bubble

The late 1990s were marked by rampant speculation in tech stocks, culminating in a dramatic burst in 2000. Companies like Qualcomm and Cisco Systems, once market darlings, experienced severe declines, offering a stark reminder of the risks of overvaluation.

The Future: Caution and Perspective

The current market dynamics, heavily influenced by the Magnificent 7, raise important questions about the sustainability of such concentration. Are we on the brink of a scenario akin to the late 1960s, 1973, or 1999-2000? Only time will tell. Investors should be wary of the potential for a low single-digit return decade for the S&P 500, a scenario reminiscent of past market corrections.

In conclusion, while the current market performance, led by the Magnificent 7, might seem enticing, it’s crucial for investors to heed the lessons of history. Diversification and a keen eye on valuation remain key tenets of prudent investing, especially in an era marked by such significant market concentration.

In the world of investing, there are few names as revered as Sir John Templeton. A pioneer of global investing and the founder of the Templeton Growth Fund, Templeton’s investment philosophy has stood the test of time, consistently delivering value to investors. His approach to investing, which emphasizes value and contrarian thinking, resonates strongly with our philosophy here at Hoover Capital Management.

One of Templeton’s most famous quotes encapsulates his approach to investing:

“The ordinary investor will hear that X corporation has a good outlook, and he rushes in to buy the stock. Nine chances out of ten, that’s a mistake because if obviously it has a good outlook, the price already reflects that. And then if there should be any change in its outlook, the price will go down. So he’s basing his investment selection on something that is misleading him nine times out of ten. So you have to buy those things that other people are selling. Otherwise, you will never get a bargain. Don’t ask yourself, does this company have a good outlook? Ask yourself, how cheap is it? How unpopular is it? If you find that you’ve found a stock that investors say, oh that’s terrible, I wouldn’t buy that. That’s the one to buy.”

This quote underscores the essence of value investing – the pursuit of stocks that are undervalued by the market. This philosophy is at the heart of our approach at Hoover Capital Management. But how do we apply this philosophy in today’s complex and fast-paced market environment? Let’s break it down.

1. Look Beyond the Obvious

Just like Templeton, we at Hoover Capital Management caution against the herd mentality. Just because a company has a good outlook doesn’t mean it’s a good investment. The market has likely already priced in this positive outlook. The key is to look beyond the obvious, to find value where others may not see it.

2. Embrace Unpopularity

Templeton advises investors to buy what others are selling. This contrarian approach, which is a cornerstone of our investment strategy at Hoover Capital, can be challenging, as it often means going against prevailing market sentiment. However, it is in these unpopular stocks that one can often find the greatest bargains.

3. Focus on Value, Not Outlook

Rather than asking if a company has a good outlook, Templeton suggests asking how cheap and unpopular it is. This shift in perspective, which is integral to our approach at Hoover Capital, can help investors identify undervalued stocks that have the potential for significant price appreciation when the market corrects its undervaluation.

4. Don’t Shy Away from ‘Terrible’ Stocks

Finally, Templeton suggests that the stocks that investors are most averse to may be the ones worth buying. This doesn’t mean buying into companies with poor fundamentals or unsustainable business models. Instead, it means identifying companies that are temporarily out of favor but have strong underlying value. This is a principle we adhere to at Hoover Capital, as we seek to uncover value where others may not see it.

In conclusion, Templeton’s investment philosophy encourages a contrarian, value-focused approach. It’s about finding hidden gems in the rough, those stocks that are overlooked or shunned by the majority of investors but hold significant potential for value appreciation. At Hoover Capital Management, we resonate with this philosophy and strive to apply these timeless principles in our investment strategy. As we navigate the complexities of today’s global markets, the wisdom of Sir John Templeton serves as a guiding light, reminding us of the timeless principles of value investing.

Value investing, a strategy that involves buying securities that appear underpriced by some form of fundamental analysis, has historically shown to outperform other investment strategies for several reasons:

1. Market inefficiencies: Despite efficient market theory, which states that all available information is already factored into a security’s price, markets can often misprice securities. This can be due to cognitive biases, overreaction to news, or simply neglect. Value investors seek to exploit these inefficiencies by purchasing stocks that they believe are underpriced.
2. Margin of safety: The margin of safety is a principle of value investing where investors only buy stocks when the market price is significantly below its intrinsic value. This not only increases the potential for profits but also minimizes the downside risk if the assessment of the intrinsic value was wrong.
3. Long-term approach: Value investing usually requires a long-term investment horizon. This is because it often takes time for the market to recognize a company’s true intrinsic value. In the long run, this can lead to significant gains.
4. Focus on fundamentals: Value investing involves detailed analysis of company fundamentals, such as earnings, dividends, book value, and cash flow. This thorough analysis can lead to a more accurate understanding of a company’s true value and less reliance on speculative factors.
5. Contrarian nature: Value investing often involves going against the grain of popular market trends. This contrarian strategy can be beneficial because it avoids buying into overhyped stocks that may be overvalued.
6. Dividend yield: Value stocks often pay consistent dividends, which can provide a steady income stream and contribute to total return.

While value investing has historically been successful, it’s also important to note that it requires a great deal of skill, research, and patience, and it may underperform in some market conditions. During certain periods, like during the tech boom of the late 1990s or in other growth-focused markets, value investing may not perform as well as other strategies.

The Art of Value Investing: Unlocking Hidden Gems in the Stock Market

Have you ever wondered how some investors seem to have a magic touch when it comes to picking winning stocks? They don’t rely on luck or gut feelings; instead, they follow a strategic approach called value investing. Value investing is a time-tested investment strategy that focuses on identifying undervalued stocks and holding them for the long term. In this blog post, we will explore the principles of value investing, its benefits, and how you can get started on your own journey to becoming a successful value investor.

Unveiling the Essence of Value Investing

Discovering Hidden Value

At its core, value investing is all about buying stocks that are priced lower than their intrinsic value. In other words, value investors seek out companies that have strong fundamentals but are currently undervalued by the market. They believe that over time, the market will recognize the true worth of these stocks and their prices will rise accordingly. This approach allows investors to capitalize on market inefficiencies and profit from the long-term growth potential of undervalued companies.

The Power of Patience

Patience is a key virtue for value investors. Unlike short-term traders who are constantly chasing quick profits, value investors take a long-term view of their investments. They understand that it takes time for the market to recognize the hidden value in a stock, and they are willing to wait patiently for this to happen. By avoiding the temptation of frequent trading, value investors can benefit from compounding returns and minimize transaction costs.

Embracing Margin of Safety

One of the fundamental principles of value investing is the concept of a margin of safety. This refers to the difference between the intrinsic value of a stock and its market price. Value investors always seek stocks that have a significant margin of safety, as this provides a cushion against any unforeseen market fluctuations or company-specific risks. By buying stocks at a discount to their intrinsic value, value investors minimize their downside risk and increase their potential for higher returns.

Getting Started with Value Investing

Do Your Homework

Successful value investing requires thorough research and analysis. Start by identifying companies with strong fundamentals, such as a robust balance sheet, consistent earnings growth, and a competitive advantage in their industry. Look for stocks that have been overlooked or undervalued by the market due to temporary setbacks or negative sentiment. Dig deep into financial statements, industry trends, and company news to gain a comprehensive understanding of the potential investment.  You can learn more about how an investment process is set up to do this, refer to our website,  hcmvalue.com/investment-process/

Develop a Disciplined Approach

Value investing is not about making impulsive decisions based on short-term market movements. It is a disciplined approach that requires sticking to a well-defined investment strategy. Create a set of criteria for identifying undervalued stocks, and stick to it religiously. This will help you avoid emotional decision-making and stay focused on the long-term value of your investments.

Learn from the Masters

Value investing has a rich history, with legendary investors like Warren Buffett, Benjamin Graham, David Dreman, and John Neff,  paving the way for future generations. Study their investment philosophies and learn from their successes and failures. Reading books, attending seminars, and following value investing blogs can provide valuable insights and guidance for your own investment journey. For example, you can read ‘The Intelligent Investor‘ by Benjamin Graham, which is considered a classic in the field of value investing. Another insightful read is ‘Contrarian Investment Strategies: The Psychological Edge‘ by David Dreman. These books provide a wealth of knowledge for anyone looking to delve deeper into the world of value investing.

The Rewards of Value Investing

Long-Term Wealth Creation

Value investing has proven to be a highly effective strategy for long-term wealth creation. By buying undervalued stocks and holding them for the long term, investors can benefit from the compounding returns and the growth potential of these companies. Over time, the market tends to recognize the true value of these stocks, leading to significant capital appreciation and wealth accumulation.

Risk Mitigation

Value investing inherently incorporates a margin of safety, which helps mitigate risks associated with investing in the stock market. By buying stocks at a discount to their intrinsic value, value investors reduce the downside risk and increase the probability of favorable investment outcomes. This approach provides a level of protection against market volatility and unexpected events.

Focus on Fundamentals

Value investing forces investors to focus on the fundamentals of a company rather than short-term market fluctuations. This approach allows investors to make informed decisions based on the underlying strength and potential of a business, rather than being swayed by market hype or sentiment. By focusing on fundamentals, value investors can avoid the pitfalls of market speculation and make rational investment choices.

Conclusion

Value investing is a time-tested investment strategy that offers the potential for long-term wealth creation and risk mitigation. By identifying undervalued stocks, practicing patience, and maintaining a disciplined approach, investors can uncover hidden gems in the stock market. While value investing requires thorough research and analysis, the rewards can be substantial. So, if you are ready to take a thoughtful and strategic approach to investing, value investing may be the key to unlocking your financial goals.