In his famous 2013 letter to Berkshire Hathaway shareholders, Warren Buffett outlined the directions he made in his will for the money he plans to leave to his wife:
Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
While I think that Buffett is wise to suggest that index funds are a good fit for the average investor, I don’t think the portfolio he is suggesting meets proper diversification thresholds. The S&P 500 is not geographically diverse, nor does it provide any exposure to small or mid cap companies. While Buffett himself has built his wealth through concentrating on a few high conviction names at a time, this is not an advisable strategy for the average retail investor.
In my recent coverage of Vanguard S&P 500 Index ETF (TSX:VFV:CA) “VFV: Outperform The TSX With The S&P 500” I wrote about how important it is for Canadian investors to shake their home bias and look beyond comfortable and familiar stocks. While the S&P 500 is a great starting point for diversification, it doesn’t represent a truly diversified portfolio. Looking deeper into the S&P 500, we will see how ETF’s like VFV:CA, holding 500 stocks, are not as diverse as they might appear.
The S&P 500
The vast majority of the companies that encompass the S&P 500 are large multinational companies that have significant overseas operations. According to Morningstar, 62% of revenues for S&P 500 companies come from the U.S. and as much as 38% are derived from outside the U.S. Europe, the Middle East, and Africa are responsible for approximately 12% of revenues while 9% of sales were sourced from the Asia-Pacific region. An additional 2% are revenues originating in Canada and Mexico combined. Japan accounted for 1% of revenue, while only 2% of revenues came specifically from China, including Hong Kong and Taiwan.
Owning the S&P 500 is not the same as owning a portfolio of 62% US stocks and 38% international stocks. Michelle Gibley of Charles Schwab (SCHW) outlines the importance of investing in foreign firms rather than just U.S. multinationals in 4 Mistakes to Avoid in International Investing. Thank you to SA Contributor David Hunkar for highlighting this in his previous work.
The stocks of U.S. multinational companies tend to move in tandem with other U.S. stocks, and U.S. multinationals typically still derive a large percentage of their profits from the United States. But this misses the point of investing internationally-to diversify into areas that aren’t so highly correlated with the U.S. market.
“Similarly, multinationals have a greater tendency to hedge currency exposure-and one reason to invest internationally is to increase your currency diversification, not reduce it.”
For Canadian investors, holding VFV:CA, (which is comprised entirely of Vanguard S&P 500 ETF (VOO)) offers Canadian investors’ exposure to U.S. currency, as the fund is unhedged. While, this is helpful, more than 40% of global trade is transacted in currencies other than the U.S. dollar.
The U.S. share of the global stock market is declining, so investing in U.S. multinationals means missing out on different opportunities elsewhere. When you look at global GDP, non-U.S. countries dominate, indicating the market share of these countries has room to grow.
In 2020, Goldman Sachs (GS) noted that the share of earnings derived outside of the U.S. for S&P 500 firms had dipped to a 10-year low. In the second quarter of 2022, data compiled by FactSet demonstrated that S&P 500 companies that generated more than 50% of sales inside the U.S. had a blended earnings growth rate of 1.2%. This compared to a blended earnings growth rate of 10.2% for companies that earned more than 50% of sales outside the U.S. So not only is there a shrinking portion of revenue being derived from overseas markets by S&P 500 companies, the companies that aren’t exposed to international markets have lower growth.
- Owning large multinational companies means excluding small cap companies that are more closely tied to the economic conditions in their local markets. International small cap stocks have even lower correlations to U.S. stocks than large cap international stocks.
Small and mid-cap stocks are important to invest in as they are closer to the local consumers, tend to be more domestically focused and have higher than average growth rates. The average market cap of VFV:CA’s 500 constituents is $223B. This compares to a fund with international and cap-size diversification, such as Vanguard Total World Stock ETF (VT) with an average market capitalization of $63B over among its 9,590 holdings.
Holdings and Earnings Concentration
Over the past few years, the concentration of the S&P 500 has reached levels not seen since the dotcom crash. At 15.3% of the index, just three companies, Apple Inc. (AAPL), Alphabet Inc. (GOOG) and Microsoft Corp. (MSFT) have the same weighting as the entire Energy, Utilities, Materials and Real Estate sectors of the index combined. The four largest firms on the S&P 500 have a larger weighting than the smallest four sectors of the 11-sector index. VFV:CA’s top ten holdings account for over a quarter of the funds market weighting.
It’s not just weighting and sector concentration that is a concern here, earnings concentration is also an important consideration. As of Q2, 2022, nearly 50% of the S&P 500’s core earnings were attributable to just 41 companies. These 41 companies represent only 8% of the number of firms in the index, but over 40% of the index’s market capitalization.
This concentration of earnings among U.S. stocks has also pushed up valuations. When compared to Europe, the next largest developed market, the STOXX Europe 600 Index (STOXX) still trades at a significant discount, with a forward P/E ratio of 12 against P/E of about 17 for the S&P 500. This is a historically wide valuation gap, more than twice its historic average.
Global Market Outlook for 2023
It is easy to look back over the past decade and question, why investors need to venture beyond the S&P 500, the U.S. has outperformed international stocks 8 out of the last 9 years, and 10 out of the last 12 years. If we zoom further out, however, this outperformance is far from assured. As recently as 2002-2007, international stocks outperformed the U.S. market for 6 consecutive years. In the 50-year period from 1971 to 2021, U.S. stocks underperformed international stocks 44% of the time.
Based on higher GDP growth expectations and more attractive equity valuations, there is reason to believe that the next decade may be more favorable for international stocks. According to Charles Schwab:
Our current 10-year outlook highlights better opportunities for bonds and a steady outlook for stocks. We continue to project better return opportunities for international stocks.
The bank said in a Friday note that it expects global stocks to handily outperform US equities in 2023 after 15 years of falling behind.
Similar commentary from Fidelity about a rotation to international stocks in 2023:
Fidelity research points to international stocks potentially outperforming US stocks over the next 20 years.
In a recent article in Business Insider, author Matthew Fox explains there are several reasons to be optimistic about the performance of international equities relative to U.S. equities in 2023 and beyond.
According to the Bank of America, “US secular growth stocks substantially outperformed during QE/zero rates”. With interest rates rising around the world, this period of zero and negative yielding debt is now over. Negative yielding debt peaked in 2021 with $18T in circulation across Europe and other developed markets. As a result of interest rate movement, this is now worth $0.
A new 1% tax on share repurchases in the U.S. will create an incentive to deploy capital to longer-term investments including: R&D, manufacturing capacity (domestically and abroad) as well as AI and other technology. The results of these investments will take longer to show up in quarterly results, compared to the next boost in next quarter EPS offered by share buybacks.
China, the world’s second-largest economy, is reopening after almost three years of COVID Restrictions. This year should see a significant increase in consumer spending across China, with pent-up savings being unleashed by the Chinese middle class.
The continued multiple suppression of tech companies driven by regulation and foreign competition will have the most significant impact on the U.S. market. The Tech weighting of the S&P 500 is 26.4% vs 19% in emerging markets, 13% in Japan, 7% in Europe.
U.S. Dollar Strength
In 2022, the U.S. dollar increased in value relative to other currencies to a level not seen since 2001. A strong U.S. dollar could slow exports and weigh on earnings. A high dollar makes the overseas earnings of U.S. domiciled firms less valuable when translated back into dollars. Currency hedging employed by multinationals will mitigate some of this impact.
This headwind has been widely signaled in recent earnings calls, with mentions of foreign exchange at the highest level since 2018. Foreign exchange headwinds resulting from a strong U.S. dollar along with tight labour market challenges were the two most common factors attributed to having a negative impact on earnings, revenues, or profit margins in Q4 2022. Foreign exchange risk especially impactful to the S&P 500 with its 26.4% weighting in technology stocks, as 58% of information technology company sales are sourced from abroad.
Owning a Globally Diversified Portfolio Reduces Volatility
The goal of diversification is to hold a basket of uncorrelated assets. This reduces overall portfolio volatility. This is one of the reasons why a globally diversified portfolio is less volatile than a U.S. only portfolio, or any other single country.
Looking Beyond the S&P 500
VFV:CA is a great core holding, but to counter Buffett, the S&P 500 it is not a sufficiently diversified portfolio. The objective of proper diversification is to own a portfolio of uncorrelated assets. This can only be achieved by owning stocks that are globally diversified by revenue and geographical market.
There are many ways to do this by owning global ETFs, buying ADRs/CDRs (for Canadians) or even by buying foreign stocks directly. Both BlackRock and Vanguard offer a variety of global ETFs and internationally diversified asset allocation portfolios. The Vanguard Total World Stock ETF is a great option for investors looking to hold a U.S. listed fund (ideal for an RRSP). For Canadian investors, asset allocation funds such as iShares Core Equity ETF Portfolio (XEQT:CA) or Vanguard All-Equity ETF Portfolio (VEQT:CA) are great options to ensure proper diversification across markets and company size.
Investors should note there are tax and considerations with holding international stocks directly.