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I want to extend on a note I wrote in mid-May about the power of diversification…
The Australian Dollar has now bounced +25% from its recent low around 55USc. It is now around 70USc and nearly flat for the calendar year.
The AUD bounce is understandable due to Australia’s handling of COVID-19 being outstanding (to this point), while our major export trading partner, China, has re-started its economy well ahead of the rest of the world. Our major Chinese export, iron ore, is also commanding record prices above $100t.
Weakness in the US Dollar itself due to woeful handling of COVID-19, a very dovish Fed, and then a breakdown in law and order has driven a perfect storm of short-covering in the Australian Dollar to what I consider overbought levels.
I see this AUD bounce as a clear opportunity for Australian investors to diversify a little by currency, geography, sector and stock.
To my mind what comes next is highly uncertain with the economic recovery likely to be far more protracted than the V-shaped recovery in equity markets and the AUD itself imply.
There are many potential de-railers of the V-shaped recovery thesis, ranging from a 2nd wave of COVID-19 infections, increase in USA/China trade tensions, continues lawlessness in the USA, and a slow reopening of the global economy and an associated period of high unemployment. Profits downgrades from companies could also be a trigger.
It’s worth remembering we are right in the “morphine” stage right now every very few Australian’s are feeling the pain of the economic reality due to the fast and large–scale actions of the RBA, big four banks, and Federal Government. When the Jobkeeper ends and the banks actually want you to pay your mortgage, this could be a real test for the Australian consumer and Australian economy. This wouldn’t want to be happening alongside increased trade tension with China that could lead to a falling iron ore price.
I see the 2nd half of 2020 being volatile. In fact, with a US Presidential election in November, it has the potential to be very volatile. That is why I encourage you to consider a little diversification while the AUD is giving you a degree of global purchasing power.
I want to reiterate the case for diversification.
The old adage is “don’t have all your eggs in the one basket”. In terms of investing that is sage advice, but even more so in a period of unprecedented global economic turmoil.
I have been banging the drum about the diversification attractions of leading global equities for years. The first slide in my AIM presentation deck is “why global” and it’s never been more pertinent than right now.
Just to remind everyone if you only invest in Australian equities you limit yourself to just 1.9% of the worlds listed equity investment opportunities. You’ve basically turned your back to the other 98.1% of the global listed equity opportunity set. That to me isn’t sensible.
Similarly, if you only invest in Australian equities you limit yourself to a market that is dominated by financials and resource stocks, both of which have unfavourable performance characteristics in a global recession.
However, most importantly, if you only invest in Australian equities you are resigned to the fact your portfolio will not have technology stocks, with information technology and communication services grossly underrepresented in Australian vs. global and US equity benchmarks.
Finally, if you only invest in Australian equities it means the only currency you have exposure to is the Australian Dollar, a commodity currency linked to global growth prospects and Chinese demand for our natural resources.
You don’t have to take high risk to achieve solid positive returns from diversification to world leading technology companies, most of which are listed in the United States. You simply have to own a smattering of the world’s best mega cap technology stocks, while avoiding anything deeply cyclical or financial.
The reason I remain attracted to leading global mega cap technology stocks is unchanged. They produce the best returns on their capital base. I’ve shown you this table before but today I think it’s more relevant than ever. It’s a proprietary AIM table and it shows how much capital a given sector requires to operate and the returns they generate from that capital.
The thin green bar is Information Technology, the big flat fat grey blob is Financials. This return on capital deployed analysis is why we own no financials and have 25% of the fund in IT. Financials simply don’t make an acceptable return on the capital they have deployed. If you’re wondering why NAB shares are the same share price as 25 years ago, refer above. If you’re wondering why NAB needs a bucketload of dilutive equity capital again, refer above.
The other clear attraction of mega cap global technology stocks is balance sheet. There are fortress balance sheets that own between $20b and $150b of cash. In a time of economic crisis those fortress balance sheets are a huge strategic advantage as we explored in last week’s Switzer Report article. It also allows mega cap global technology stocks to continue with large cap stock buyback programs, funded from free cashflow.
I believe you are being given an opportunity via AUD strength to diversify globally. By that I don’t mean selling Australian equities to buy global equities. I always tell people you should be reinvesting your excess Australian dividends in global equities. It’s not like the average SMSF needs more Australian bank shares! They in reality need more exposure to the structural growth sectors of the world such as IT that simply aren’t represented in any meaningful way on the ASX.
Diversifying globally is far easier for Australian investors than it used to be. You can buy direct US equities, buy units in a fund, buy a global LIC, and buy a global ETF to name a few ways. Nowadays the structures are in place for individual Australian investors to easily and cheaply (low transaction costs) gain exposure to global equities. Even the minimum investment levels at most global fund managers have been lowered to around $20,000.
Don’t get me wrong, investing globally isn’t risk free, but you will lower the overall risk of your portfolio by diversification to what are the best companies in the world.
The time to allocate to global equities is when the AUD is relatively strong and global equity markets are offering specific pockets of what I feel will be solid medium-term returns. I believe that is right now and I encourage you think about a degree of global diversification over the next few months.
None of us are certain of what comes next: However, I am certain of having no exposure to 98% of the equity world is not the way to generate the best risk adjusted returns.
Next week I plan to write about the investment case for Berkshire Hathaway, a US company that has all the attributes you should seek in an investment.