18th February 2013
JP Morgan’s global strategist Dan Morris is warning investors about placing too much emphasis on investing in their home market simply because they are familiar with the companies. For example, global sector forces may be much more important for the majority of firms in Europe as he outlines below.
Home bias describes the phenomenon where investors prefer to invest in their own country’s stocks because they are familiar with the companies that make up the market writes Dan Morris.
Portfolio theory, though, tells us that a broadly diversified portfolio is the key to superior, risk-adjusted returns in the long run. This parochial orientation results in considerable energy expended analysing and forecasting the performance of individual country stock markets, potentially obscuring other, more important factors. The location of the exchange where a stock is listed often has little to do with what drives corporate profits. A good example is Anheuser-Busch InBev (ABI BB), which makes up 56% of the MSCI Belgium Index. Though the stock is listed in Belgium, the company’s profits are derived to a vast degree outside the country, and outside Europe; Western Europe accounted for just 3.6% of net income in 2011.
A lesser emphasis on country factors is particularly appropriate for Europe as it is a region made up of small- to medium-sized, open economies, and most of the companies whose stocks comprise the index compete globally and are affected by broader industry trends. Analysing the performance since 1999 (the launch of the euro) of the 436 companies in the MSCI Europe Index shows that sector factors are more important for stock returns than country factors for nearly half of the companies in the index, while just a quarter are more influenced by the country in which it is listed (see Figure 1). Another quarter of the stocks are affected equally. So it is not enough to just consider the economic outlook for a country when forecasting potential stock market performance. It is also necessary to evaluate the outlook for the sectors which make up the index.
Figure 1: Relative importance of sector and country factors in stock performance
Last data 15 February 2013. Source: IBES, J.P. Morgan Asset Management.
With waning anxiety about the eurozone crisis, which has accentuated country factors over the last few years, sector performance should increasingly drive market returns. Two sectors which we believe will continue to outperform this year are consumer discretionary and financials. Though recent GDP figures suggest domestic demand is weak in Europe, the outlook should nonetheless begin to improve from here and companies will continue to look for growth outside the region. Valuations are still good (about 20% below the sector’s long-run average), and analysts are revising their estimates upward, albeit modestly.
The consumer discretionary sector has a comparatively large weight in the MSCI German Index (see Table 1), which is one of the reasons we still prefer the country despite its exceptional performance last year. There is also more scope in Germany for measures to boost domestic demand than there is in most other parts of the region thanks to strong government finances.
Table 1: Key sectors for countries in Europe
(Percentages after sector show weight in index)
Last data15 February 2013. Source: MSCI, J.P. Morgan Asset Management.
Financial sector stocks have risen more than most during the recent relief rally as financials have been the high beta sector throughout the crisis. But on both a price-to-earnings, and particularly price-to-book, basis they still appear inexpensive. While earnings growth was negative this quarter, in aggregate banks managed to beat expectations. Central banks will continue to provide a backstop to the industry and the regulatory burden appears to be lightening as governments finally realise that continually adding costs and restrictions on the industry ultimately inhibits economic growth.
Financial stocks are among those most influenced by domestic factors, however, and for Italy and Spain local woes will more likely act as a drag on the sector, and hence on the market’s performance, than a boost. The UK and Swedish indices, however, should see their returns aided by the heavy weight of financials in the market.