2017 ANNUAL LETTER
2017 Left Us Shaking Our Heads
R Squared Capital Management celebrated its four year anniversary in May, 2017. As many of you know, our process is based on an international equity strategy that we created back in 1995 while working together at Julius Baer Investment Management. The team at R Squared utilizes both fundamental and macroeconomic analysis in our quest to correctly identify structural tailwinds and headwinds. Over the course of 20+ years, this approach has served us and our investors well.
2017 was certainly an interesting year, although sometimes it left us shaking our heads in disbelief. When we began the year, we proceeded cautiously and positioned the strategy more defensively. The only certainty we could identify seemed to be the uncertainty associated with our newly elected President, the upcoming Brexit negotiations and the actions of global central banks. With the market’s disdain for uncertainty, our expectation was for an environment of elevated volatility. The reality was the exact opposite. International equity markets had a phenomenal year with many posting returns in excess of +20%. The U.S. dollar (USD) declined which relieved some pressure on a number of asset classes. Most surprising, however, was the limited risk premium being demanded by market participants. Volatility, both experienced and forward looking, declined to near all-time lows.
Even with the strong performance over the last year, we continue to maintain that stocks outside the U.S. are very attractive relative to U.S. stocks for two primary reasons:
1. International stock diversification is a very powerful tool.
John Bogle, Vanguard’s former chief, stated recently that he favors a 100% U.S portfolio. While U.S. stocks have outperformed since the end of 1969, Bogle seems to be ignoring the powerful benefits of diversification. Over the 45 year period from 12/31/69 to 12/31/14, despite U.S. stocks outperforming, the maximum return portfolio was 60% U.S. and 40% international. If we enter a period when international stocks actually outperform, benefits from diversification will be enormous. With the current 1 year correlation between MSCI ACWI Ex-US NR and the S&P 500 at -0.26, there is a strong benefit to having international equity exposure within one’s portfolio.
2. International stocks have lagged the U.S. stock market by an enormous margin since the last market peak at the end of 2007.
Consider the table below highlighting the performance comparison between U.S. stocks and the rest of the world; cumulative total returns show the S&P 500 outperforming international stocks by 89-111%. While U.S. economic growth has been a positive, it is hard to justify such a relative outperformance.
We believe international stocks have begun to outperform U.S. stocks. Based on past performance shortfalls and current bargain valuations, we believe that the potential for international stocks to play catch up is very large.
Moving forward, as we head into 2018, our team has positioned the strategy in the following manner. From a thematic perspective, the strategy is designed to harness structural tailwinds at the country, sector and company levels. Simply stated, we look for multi-year structural tailwinds and look to avoid structural headwinds. Currently, our overweight and underweight themes are as follows:
From a regional perspective, we continue to find opportunities within emerging market stocks. Emerging Asia and Latin America look attractive; Japan does as well. We are also underweight Europe relative to the benchmark. This has really been driven by bottom up work – we are finding a lot of attractive stocks in Japan. Both Japan and Europe are attractive relative to the U.S. from both a business cycle standpoint (U.S. is more advanced and housing is beginning to slow), a policy standpoint (monetary policy is easier in Europe and Japan), and a valuation standpoint.
Sector rotation in the market has at times been fast and furious. While the volatility can be a challenge, we are finding some good values. Consumer staple stocks, especially those in Brazil, have looked attractive. Strong economic data from China and Europe has driven industrial metals higher. Notwithstanding seasonal weakness in commodity demand during the winter, robust China demand data should continue to be supportive of the sector. Meanwhile, one clear theme in the U.S. drug industry is the downward pressure on generic drug prices. Given the record number of FDA approvals for generic drugs, and the pricing war between drug wholesalers, we expect the pressure on pharmaceutical companies to continue. Real estate is also being challenged as pockets of over-heating real estate markets across the world have caused governments to implement measures to cool prices, which appear to be working for now.
As we write, global equity markets continue to march higher with many indices setting all-time records. Meanwhile, volatility, both experienced and forward looking, remains stubbornly near all-time lows. Despite the numerous geopolitical events and an overall environment of heightened political risk, many market participants remain enthusiastic about the outlook for future gains. We, however, remain cautious. Valuations appear stretched, and we are cognizant that the current calm, low-volatility environment may have a limited life span.
In conclusion, we want to thank our RIA and institutional investors for the trust they have placed in us. We understand the challenges investors are facing with regards to their asset allocation decisions, and we believe we can help. Our investment process incorporates both rigorous fundamental research and macro perspectives as we seek to identify tailwinds and look to avoid structural headwinds. Additionally, our ability to tactically manage currency exposures should serve us well in the future. The strategy represents our highest conviction ideas and incorporates a risk-managed and diversified approach to international equity investing. We strongly believe that time-tested principles will generate long-term results for our shareholders. Lastly, it is important for you to know that our personal assets are invested alongside yours, and we take the stewardship of that capital very seriously.
We appreciate your continued confidence, and we thank you for being our partners.