If you feel like international equities in your portfolio aren’t holding up their end of the bargain, then you’re not alone. It’s one of the most common concerns we hear today. And the global landscape remains as uncertain as ever. A trade war with China, slowing global growth and Brexit are just a few sources of uncertainty. After a decade of dominance by U.S. stocks, you might be wondering: Why bother investing outside the U.S.?
There have always been reasons not to invest in international stocks. And this article is not a prediction that markets are set to rise in the near term. But for long-term investors, we believe international equities hold great promise, and there are many reasons to stay invested. International investing has changed dramatically in recent years, but one thing that has not changed is its rightful place in a well-diversified portfolio.
International equities have trailed U.S. markets over the past 10 years, but the index-based returns that most investors follow don’t tell the whole story. On a company-by-company basis, the picture is quite different. In fact, it may come as a surprise that the companies with the best annual returns each year have been mostly based outside of the United States.
How have U.S. markets done so much better while a higher percentage of the top stocks each year are non-U.S. companies?
Correlation between global stocks has risen
In some ways, international investing used to be much easier — as simple as dividing your stock portfolio into two buckets, U.S. and non-U.S. The result? Instant diversification. But not anymore. The easy button is gone.
That’s because the correlation between U.S. and non-U.S. markets has more than doubled over the last 25 years.
But why have correlations risen so much? Globalization is partially responsible. Without overlooking the impact of escalating trade tensions in recent years, companies and countries are more integrated than ever. As companies have become more global, the lines between U.S. and non-U.S. indices have started to blur, and correlations between the two have risen. This reduces the diversification benefits of blindly allocating to both areas. As we’ll see, a focus on companies rather than broad indices can help overcome this trend.
If real estate is all about “location, location, location,” investing may be all about “revenue, revenue, revenue.” As the shift toward globalization continues, the address of a company’s headquarters has become less important to its growth prospects than where it makes money.
Consider that a company’s products are often made with parts manufactured in several countries and then sold to customers around the world. This rise of multinational companies means investors should re-evaluate how they think about global stocks. Instead of where a company is based, look at where it earns its revenue.
For example, the 10 largest companies in Europe generate less than a third of their revenue from their home region. Political strife or an economic slowdown can still hinder European stocks, but will affect every business differently. A careful examination of revenue exposure can help identify companies that are less likely to be disturbed by macro headwinds.
The bottom line? Follow the money, not the mail.
Many market leaders are located outside the U.S.
If you were going fishing, would you limit yourself to half the lake, or would you want to seek opportunities wherever they were available? Investing shouldn’t be any different. One of the greatest benefits of global investing is that it allows you to consider the world’s best companies, no matter where they are located.
In certain sectors, European companies are among the world’s most dominant players, including large pharmaceutical companies Novartis, AstraZeneca and Novo Nordisk. The luxury goods industry is another example, centred in France, Italy and Switzerland, with companies such as LVMH, Kering and Richemont.
Outside Europe, the story remains just as valid. Japan is home to many cutting-edge robotics firms, including Murata and FANUC. Some of the world’s most successful technology companies are based in Asia: Samsung, Taiwan Semiconductor, Tencent and Alibaba, to name a few.
To have a well-rounded and robust portfolio of stocks, investors should consider international markets — even if you think the U.S. market in aggregate will continue to do better in the short term.
Greater dividend opportunities overseas
The idea of fishing in a bigger pond may be even more beneficial to income investors. That’s because outside the U.S., more companies have tended to pay dividends, and have done so at higher levels. There were more than six times as many non-U.S. stocks with yields over 3%, as of August 31, 2019.
International dividend investors don’t have to give up growth potential either. For example, semiconductor manufacturers TSMC and Samsung each had dividend yields above 3%. Likewise, pharmaceuticals such as Roche and Novartis are on the cutting edge of cancer research and offer both the potential for capital appreciation and consistent dividend payouts.
At this late stage of the economic cycle, a sharper focus on dividend-paying companies and lower volatility portfolio strategies may be a good idea. But with such a large pool of stocks available, deep fundamental research is key. Indeed, not all dividend-payers are created equal. Many companies appear solid on the surface but carry significant debt burdens and may be on the cusp of losing their investment-grade credit rating. A missed payment or a downgrade could send share prices tumbling, so investors should focus on companies that are most likely to maintain consistent dividend payments.
International stocks are on sale
Valuations matter. There is evidence that stocks trading at a discount average higher long-term returns in future periods than those selling at a premium. But the key phrase here is long term, because there is almost no correlation between valuations and short-term returns.
This may not help those trying to time the market, but it's great news for investors looking to hold onto non-U.S. assets for the long haul. In nearly every sector, there are comparable non-U.S. companies trading at lower valuations than their American-domiciled counterparts. Unicredit and Samsung are just two examples.
Companies overseas often trade at a discount due to political or economic issues in their home countries, even if these factors don’t directly affect the business itself. Over the long term, company fundamentals, not geopolitical turmoil or a company’s address, drive stock returns.
Rob Lovelace is an equity portfolio manager as well as vice chairman of Capital Group and president of Capital Research and Management Company, Inc. He is a portfolio manager of Capital Group Canadian Focused Equity FundTM (Canada). Rob has 33 years of investment experience and is a CFA charterholder.
David Polak is the investment director for Capital Group's global equity services. He has 35 years of investment industry experience. Earlier in his career at Capital, David was a research portfolio coordinator for several global equity portfolios. He holds a bachelor’s in economics from University College London.
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