Global equities: The year ahead

The first eleven months of 2014 has been profitable for global investors, and even more so if you were investing in Australian dollars.

In local currency terms the best performing large stock market to date is the US, with the S&P500 gaining 12%. The tech laden NASDAQ is doing even better, up 14%.

If you were an Australian investor fortunate enough to own an S&P500 exchange-traded fund you have a 19% return, turbocharged by a declining Australian dollar.

The US wasn't the only market to do well in 2014. Investors have been rewarded with double-digit returns in the so-called emerging world, with India lifting 35% (43% in Australian dollars), Indonesia climbing 21% (26% in AUD) and Thailand increasing 23% (29% in AUD). Note the power of currency on returns overseas!

China, after a painful and frustrating five-year bear market, saw the CSI300 rally 27% this year. While Japan has been in negative territory for most of 2014, it had a recent rally and has returned 9% so far (but only 2% in AUD due to the weak Yen).

Laggards included most Eurozone markets (up 4%) and the UK's FTSE100 (down .1%). Brazil was essentially flat but in Australian dollar terms is down 3%. Russia somehow managed a 5% return in Rubles but for an AUD investor that market was off by over 30%. Currency is a two-way street. The Australian market also struggled and is down 1.3% so far this year.

In terms of industries, technology and biotechnology provided some market beating returns. Significant laggards were energy, any commodity based industry, gold, and construction/engineering.

The stocks that drove the S&P500 to new highs were mostly the so called “mega caps” from the technology sector: Apple ( 43.6%), Microsoft ( 29.94%), Intel ( 43.22%) and Facebook ( 37.5%). Biotech names like Gilead ( 33.9%) and Amgen ( 45.7%) also contributed.

Exxon Mobil (-9%), Amazon (-17.6%), IBM(-14%), General Electric(-7%), and General Motors(-20%) harmed the S&P500 the most during the year.

In 2014, global portfolio managers had to be significantly overweight the US market in order to outperform as other regions struggled. In fact, the US (particularly large cap stocks) has been the standout performer over the last four years (since the end of 2010) by a large margin. Is this a worry?

In local currency terms and not including dividends, the S&P500 has gained 64% since the end of 2010, while the NASDAQ has surged 80%. Other developed markets with the exception of Japan ( 75% off a very low base) pale in comparison.

The FTSE 100 is up but 13%. A broad index of European stocks has returned a paltry 16% or roughly 4% per annum. The German DAX is an exception with a 44% return. That's decent, but miles behind the US.

To be honest, I think it's probably time to move beyond an extremely heavy concentration in US equities, not only after a huge four-year outperformance but also to diversify. Not that I expect a big market correction or anything like that. I will always be able to find compelling investments in the US.

But rather than having 90 to 100% of their weighting in the US, investors might consider 70 or 80%.

The US market is “fairly” valued at 16 times 2015 earnings per share (EPS). Its economy is doing well and corporate earnings are solid. I expect, all things being equal, more of a normal historical return of 6-7% per annum or so. The AUD has more downside in my opinion, so that return could be conservative.

Europe and Asia are much more modestly valued, especially relative to history. Asia (ex Japan) is trading well below historical averages on price-earnings (P/E) and price-to-book multiples. Europe is at a 20% discount to the US in P/E terms. These markets, having marked time for the past few years, have the potential to finally play “catch up” and are certainly worth a look.

Technology will continue to do well in 2015, both in the US and abroad. While some of your “big tech” names like Microsoft, Cisco, Intel and Oracle have had a pretty good year, that comes after a long period of flat to indifferent relative performance. There may be more upside left. Small and midcap technology companies (where my focus is) will still be a good place for growth investors in 2015.

Some of your other mega-cap names like Google and Amazon (is it a tech stock or a retailer?) have struggled on profitability concerns. Google might be worth a look here as it diversifies into other fascinating but related businesses.

I expect a rebound in oil prices in 2015, so the energy sector – a dog in 2014 due to falling crude prices – could be interesting. I would be accumulating Schlumberger and Whiting Petroleum at these levels.

With Brent below $US70, shale producers may well curtail production while undergoing a cash flow squeeze from lower prices. A growing US economy and low gas prices could well increase demand for petroleum products as motorists take advantage of cheap fuel. Less supply and more demand equals higher prices.

As for risks and headwinds? Well, I think most risks are in the geopolitical arena – not macroeconomic. While the Middle East remains worrisome, with ISIS still active and Palestinian/Israeli tensions escalating, it's Russia and the Ukraine that could be more problematic – particularly if Putin starts to eye other countries that have Russian minorities. A train wreck of an economy may embolden him even more. Do the Russians not remember the 1930s? This is one to watch carefully.

Interest rates will probably rise at some point in 2015 in the US and the UK in order to reverse the extraordinary easing that has taken place and to address an ever improving economic picture at home and abroad. I expect central banks to manage expectations accordingly and markets to take it in their stride.

On balance, then, 2015 should be another positive year for equities and hopefully continue to reward clever stock pickers.

Our focus in 2015

And what can subscribers expect from the international section of Eureka Report in 2015? First and foremost I plan to continue to present investable ideas around the McKinsey “12 Disruptive technologies” and hope to cover all twelve categories. For a growth investor I can't think of a better place to look.

We are also going to spend some time on those “neophyte disrupter” companies like Uber, Airbnb, Lending Club, and Palantir that are primed to go public in 2015 and work out where and why we'd buy them.

As I said, we need to travel farther afield next year and have a good look at investment opportunities in some of the “neglected” (neglected by me anyway) parts of the globe like Europe and Latin America, a region I know well.

We are also going to spend some time looking specifically at some of the high growth economies in Asia such as Indonesia, the Philippines, and Thailand, particularly where retail investors can invest directly. Smaller companies with a consumer focus are interesting here.

China will also be a priority and we'll be analysing both the dually listed “H” shares that trade in Hong Kong and the China “A” shares that investors can buy through the new reciprocal exchange arrangements put in place recently. China looks like its breaking out of its “bear” mode as economic growth shifts to more of a consumption driven model. We'll also be spending some time on Chinese corporate governance when investing in Chinese companies and what to look for. I also plan to do some work on Alibaba.

Another priority I have is to hopefully educate investors in the intricacies of portfolio management, risk controls, and performance attribution in order to “demystify” the whole investment process. I also intend to introduce investors to the science of quantitative investing – using the power of the computer to generate ideas.

All in all it is an ambitious program, but well worth it in my view. Australian investors need to become global investors.