For American investors, one of the thorniest questions is how many foreign stocks to own. All investors are unilateralists at heart, biased toward the homeland, and most economists think that's a mistake.
I plead guilty to this crime myself. I own only one foreign-stock fund, T. Rowe Price International Stock (PRITX), and it represents less than 2 percent of my total financial assets. (By the way, this is not a recommendation; it's a decent fund with low fees, and I have owned it for a long time, but there may be better.) I do own foreign stocks in other ways -- through a few closed-end funds that concentrate on individual developing markets and through mega-U.S. funds that also own foreign shares. For instance, among the top 20 holdings of Fidelity Contrafund (FCNTX), which I consider the best of the large-cap funds, are EnCana Corp. (ECA), a Canadian oil and gas company; Ryanair Holdings PLC (RYAAY), a Dublin-based European discount airline; Samsung Electronics, the Korean high-tech giant; and Rio Tinto PLC (RTP), a London-based mining company.
Why own pieces of companies based in other countries?
One reason is that "investing globally conveys a mighty benefit simply in terms of added opportunity," as a recent report by Sanford C. Bernstein & Co., a New York investment firm, put it. Today, U.S. stocks represent only about half the total value of global markets, down from two-thirds in 1970. T. Rowe Price's research department recently pointed out that none of the 10 largest companies that make steel, electronics or appliances is based in the United States. Listed on the 21 major markets outside the country are 1,005 substantial public corporations. Why ignore them?
But a more important reason to invest in foreign stocks is that, historically, markets have tended to move independently; when one is up, the other may be down, and vice versa. In technical terms, such markets are said to lack correlation. A good portfolio should balance off uncorrelated assets. That way, you get a smoother ride with roughly the same returns.
A study by Bernstein found that between 1970 and 1995, U.S. stocks significantly outperformed non-U.S. stocks in 12 calendar-year periods while non-U.S. outperformed U.S. in 12 years as well; in only two years were returns about the same.
But that study, you'll notice, ended in the mid-1990s. Immediately afterward, something seemed to change. Markets, especially in the developed world (North America, Europe and Japan), became more and more correlated. In 2000, for example, the average U.S. large-cap growth fund fell 16.3 percent while the average international fund fell 15.6 percent.
A study by Robin Brooks and Luis Catao for the International Monetary Fund looked at the performance of 5,500 stocks in 40 markets over the period 1986-2000. The researchers found that the correlation between returns in American and European stock prices rose from 0.4 in the mid-1990s to 0.8 in 2000. In other words, the movements of U.S. stocks could explain 80 percent of the movement of European stocks, compared with just 40 percent a few years earlier.
If shares of large U.S. and foreign companies move roughly in tandem, then, obviously, you won't benefit from a lack of correlation. Instead, you may as well own the best companies in the world, wherever they may be, without any special urgency to hold foreign stocks in your portfolio.
It's unclear, however, whether the late 1990s were an aberration or the vanguard of a brave new correlated world. Over the past 12 months (ended Wednesday), for instance, the Dow Jones World Index (which does not include U.S. stocks) returned 28 percent while the Standard & Poor's 500-stock index, the U.S. benchmark, returned only 16 percent. In 2002 and 2003, foreign stocks rose a total of 17 percent while U.S. stocks were practically flat (up 0.2 percent). On the other hand, so far in 2004 (again through Wednesday), the MSCI World Index has risen 1.7 percent while the S&P has risen 2.9 percent -- awfully close.
Bernard R. Horn Jr., a talented money manager who has concentrated on foreign markets for about a quarter-century, believes that the post-1995 period was a fluke. Horn is president and portfolio manager of Polaris Capital Management, a Boston firm that handles $262 million for institutions and wealthy individuals and runs a public mutual fund called Polaris Global Value (PGVFX), on which Morningstar Mutual Funds bestows its top rating, five stars.
"You have to look at correlations over long periods of time. Fifty or 60 years," Horn told me last week. "We have good data since 1970." That history was summarized recently in an excellent Bernstein study released in April titled "Fortune & Misfortune." Between 1970 and 2003, if you owned a portfolio composed of 30 percent foreign stocks and 70 percent U.S. stocks, you would have received roughly the same returns as with an all-U.S. portfolio -- but, for the mixed portfolio, the volatility, or risk, was lower.
In other words, your returns, year after year, were less dramatic -- both up and down -- which means that you were more apt to enjoy the ride. It wouldn't disturb your sleep, and you wouldn't be inclined to bail out at the wrong time.
Horn said that the apparent correlation between foreign and U.S. stocks in the late 1990s and early 2000s was the result of the run-up in a single sector: telecommunications, media and technology. High-tech stocks all over the world rose so much that they distorted the broader country indexes, which are weighted by the market caps of the companies they comprise. "Nortel became one-third of the Canadian market," said Horn. "Nokia became one-half of the Finnish market. So, the rise in the sector made the indexes look more correlated. Is that a reason to throw international investing out the door? No."
Horn concedes that "the world is more integrated than in the past," but, even though multinational firms do business worldwide, there remain considerable differences in the pace of growth in different countries.
For instance, Horn said that Americans should take advantage of booming Asia. Over the next few decades, Asian competition may hold down U.S. wages, so why not profit from the growth of Asian capitalism in your retirement and make up for any relative loss in your pay?
He points, for example, to ASM Pacific Technology Ltd., the world's largest supplier of assembly and packaging equipment for the semiconductor industry. The company is based in Hong Kong and listed on its exchange. A majority of the shares are owned by ASM International NV, which is listed as ASMI on the Nasdaq Stock Market and headquartered in Holland.
This company is not the sort you're going to stumble on yourself -- which is why international investing is usually done best through mutual funds. "ASMPT gained market share during the down cycle against its competitors," said Horn. Shares of the parent are up by about one-third over the past 12 months, and the stock trades at a price-to-earnings ratio, based on expected 2004 earnings, of just 12 and a PEG ratio (P/E to earnings growth) of just 0.7, according to Yahoo Financial. Any PEG ratio under 1.0 typically indicates a bargain.
Horn is a bottom-up investor who buys and holds (he keeps his average stock about three years, compared with just one year for the typical fund manager). He looks for companies first, countries second. For example, his fourth-largest holding at last report (April 30) is a Finnish elevator manufacturer called KONE. "This is a good R&D and production-innovation story," said Horn. "They have reinvented the elevator," putting a motor on the side, which takes up less space than conventional cables.
He also owns CRH PLC (trading in the United States as American depositary receipts under the symbol CRHCY), a Dublin-based construction-materials company that sells aggregates and asphalt all over the world. Most U.S. companies in this business are small, but CRH last year grossed $13 billion. "You have to go to Ireland to invest in American infrastructure," said Horn.
CRH also appears to be a bargain. Its forward P/E ratio, according to Yahoo's calculations, is just 10 and its PEG ratio is 0.9. It's typical of the values to be found outside the United States right now. "What we see is that American companies are priced to perfection, priced very high," Horn said.
Horn uses the ratio of a company's price to its "cash earnings" -- that is, official net earnings with depreciation and amortization and special reserves added back in -- as a key valuation indicator. Right now, U.S. companies carry an average P/CE ratio of 12.9 while companies outside the United States have a ratio of 8.8. "That's a big difference," he said.
Yes, and capitalizing on the difference has produced impressive returns for Polaris Global Value, which was up 47 percent last year and has returned 6 percent so far in 2004. And talk about lack of correlation! Between 2000 and 2002, Polaris broke even while the U.S. benchmark was losing a total of one-third of its value.
Horn runs a global fund, which means that he holds U.S. stocks as well as non-U.S. (in financial jargon, an "international" fund owns only non-U.S. stocks). Right now, his exposure to U.S. companies is on the low side -- 44 percent of total assets -- because he thinks stocks abroad are cheaper. He follows companies in 40 nations, and the fund is well diversified. About one-eighth of his assets are in British firms, but after that no country's stock represents more than 6 percent of assets.
Horn holds 70 stocks in all, and each represents about 1.5 percent of his total fund. Among them: Continental Corp., the German tire company; Tokyo Electric Power Co.; and Imerys, the French minerals company. He's especially high on firms that are immune to competition from China, such as British home builders Persimmon PLC and George Wimpey PLC.
While I am persuaded by Horn's argument that correlation is a passing fad, I still worry about the future of European and Japanese companies, especially. Although many of them do business globally, they are still burdened with their governments' economic policies, which have not proven very successful in recent years.
Between 1992 and 2003, for example, the gross domestic product of the United States grew by an average of 3.2 percent annually after inflation; Europe grew just 1.7 percent; Japan, 0.9 percent. The United States grew less than 2 percent in only a single year (2001, when we were attacked by terrorists) while Europe grew less than 2 percent in six of the 12 years and Japan in nine of the 12.
On the other hand, one would expect that this sluggish growth is reflected in lower foreign share prices. But recognize that a bet on Europe and Japan is a bet on substantial change -- both in government policies and in corporate management. Will it happen? I think so, but the revolution isn't tomorrow.
Still, my advice is to own foreign stocks -- through funds like Polaris Global Value or others I have mentioned in the past, including Thornburg International Value (TGVAX) and Julius Baer International Equity (BJBIX), both of which have been awarded five stars; Oakmark International (OAKIX); and Forward Hansberger International Growth (FFINX).
What proportion of your portfolio should be foreign? More than mine.
Somewhere between 10 and 20 percent sounds about right, and there is nothing wrong with making a global fund such as Polaris a core holding, even though slightly less than 50 percent of its holdings are American. If you like the companies, multilateralism is a perfectly sound policy.
James K. Glassman is a resident fellow at the American Enterprise Institute, a Washington think tank, and host of TechCentralStation, a Web site focused on issues of technology and public policy that is sponsored by various corporations and trade associations. He is also a member of Intel Corp.'s policy advisory board. Of the mutual funds mentioned in this article, he owns T. Rowe Price International Stock and Fidelity Contrafund. His e-mail address is email@example.com.