Japan has been a laggard a long time, but if you look at the fundamentals, they’re not that dissimilar to other developed countries, and valuations are really cheap. Japan is the only stock market that is trading below its March 2009 trading level.
It is a challenging market. The issue in Japan, longer-term, is demographics. But [company executives] also don’t like giving back money to shareholders, so share buybacks are rare, and dividends are still modest. So you can have a good cash flow-generating company that is a strong franchise, which could do well in the stock market if they gave some money to shareholders.
They do have challenges in front of them, but if you’re a long-term investor, the most important thing is valuation. If you buy things when they are cheap, you have a lot more chance of making money than if you buy when it’s expensive. Japan is one of those markets. It’s been forgotten. But I’ve found it to be a good diversifier in a portfolio because it’s inversely correlated to the rest of the world. They march to their own tune, so in a global context, you can benefit from that as well.
We think most investors have under-exposed themselves to emerging markets over the last decade or so. I think it’s because there’s a natural xenophobia with all investors. Everybody has a home-currency bias. We think they need to set themselves up in their portfolios for more exposure. But more exposure doesn’t immediately mean buy more stocks. We make the argument that if you believe in the long-term fundamentals in these countries, that these governments are going to be running structural surpluses and their economies are going to be growing much faster than the G-7 countries, then [government] debt might be a better way to capture that growth through appreciating currencies and through narrowing credit spreads. If you had a mix of currencies and bonds from emerging markets, you would have gotten roughly the same returns if you had invested in emerging market equities through the same period but with less than half the volatility.
What we’re trying to say is, in small amounts in your portfolio, putting emerging market debt in is going to help increase your returns and your volatility is not going to be that crazy.
North American equities. We did some historical work at Leith Wheeler, where we took the starting valuations of the U.S. market, and you can use, for example, the price-to-earnings [PE] ratio or other measures. Right now, the PE ratio is around 14 times or so.
With that as a starting point, typically 10 years later, at that level you get a high single-digit return on U.S. stocks. That’s one measure that gives us a little bit of hope that, although the market is not expensive, it is a little bit cheaper than average.
The conclusion for us is a balanced portfolio of 60% bonds and 40% stocks, which is typical of pension funds and individuals; if you take a high single-digit return on equities and a lower single-digit return on fixed income, you’re going to be in the zone of a 6% return over the next five years.
