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Nicholas Coppola, CFA
October 2, 2019
Your team at Kays Financial recently reduced positions in the Invesco S&P SmallCap Low Volatility ETF (XSLV) and added emerging market exposure through the Vanguard Emerging Markets Select Stock Fund (VMMSX). Certain investors also saw the sale of the Industrial Select Sector SPDR Fund (XLI) and additional allocations to the iShares S&P 500 Growth ETF (IVW) and SPDR Portfolio S&P 500 Value ETF (SPYV).
These transactions were strategic in nature and based on a number of considerations. First, while we don’t claim any particular insight into short-term emerging market performance, we are decidedly long-term bullish. Notably, looking at fund characteristics (i.e., weighted average metrics based on holdings in the fund), VMMSX simultaneously offers stronger expected long-term growth and a lower price to earnings ratio than XSLV. In addition to offering attractive geographic diversification, emerging markets also have faster population growth, with particularly strong growth expected in the middle class. It’s often been said that ‘demography is destiny,’ and with emerging market populations enjoying higher incomes and consuming more goods and services, we think emerging market companies stand to gain over a long period of time.
Upon considering this basic rationale for investing in emerging markets, many investors will next ask, “well, what about the US-China trade war?” While trade uncertainty may continue to drive volatility over the short-to-intermediate term, we expect at least a partial resolution over the next several years at most, which in our view, is also more relevant given our longer-than-average investment horizon. At a high level, we also believe that many investors are overly focused on trade as they consider emerging market allocations. As we look at VMMSX, greater than 70% of market cap weighted holdings are domiciled outside of China. And to the extent that supply chains are re-organized and manufacturing capacity is re-located from China to other developing countries, other parts of the portfolio may benefit.
As always, ‘the price you pay’ matters a lot in investment decision making, and we look at valuation a number of different ways. In comparing emerging market stocks to domestic stocks, emerging markets are trading at a lower multiple of earnings on an absolute basis as well as relative to each region’s history. The same holds true as we look at 10-year ‘cyclically adjusted’ price-to-earnings and price-to-net asset value. Thematically, we often see attractive investments at bargain prices in periods where headlines are negative and pessimism is elevated. Alternatively, where optimism abounds, prices in a geography or sector can rise to unsustainable levels and potentially sets up for less attractive returns. In our view, a ‘wall of worry’ regarding the Chinese economy and recent trade frictions have contributed to an attractive entry point for long-term investors.
So why Vanguard Emerging Markets Select? First, for a variety of reasons, we view emerging markets as an attractive asset class for active management. In our view, ‘emerging markets’ are far from homogenous and analysts with differing styles can create value as they distinguish between risks and opportunities across the world. Note that this strategy has a multi-manager structure containing four sleeves, managed by Baillie Gifford, Oaktree, Pzena, and Wellington. These strategies range from ‘deep value’ to ‘growth’, and it’s our expectation that each strategy will have a chance to shine across a market cycle, thus potentially providing attractive long-term returns in addition to a smoother ride. As always, we are also fee sensitive, and in addition to providing access to world class investment managers, VMMSX has an expense ratio well below the category average.
In regards to our sale of XLI, industrials tends to be a more cyclical sector, and we are taking this opportunity to reallocate to low cost large cap ETFs. And in regards to our other sector specific investments, we continue to be more bullish on the Technology Select Sector SPDR Fund (XLK) based on our outlook for secular long-term growth in technology (i.e., growth that’s independent of the economic cycle).
We thank you for your continued trust and please let us know if you have any questions regarding recent trades or your broader portfolio.
Nicholas Coppola, CFA
Senior Portfolio Manager