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 guide 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.
This guide will cover 10 things you need to know to help navigate the challenging investing environment outside the U.S:
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?
We’ll explore both ideas in greater detail, but first let’s dig into how non-U.S. markets have changed in recent years, and why investors need to rethink their approach to international investing.
4 ways international investing has changed
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. indexes 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 indexes 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.
With company locations becoming less significant and correlations on the rise, where should investors look for returns? It comes down to company fundamentals.
A study by Empirical Research Partners shows that in 1992 most of an emerging market company’s return could be explained by its sector or region, and only 36% was accounted for by the business itself. That was at a time when investing in emerging markets (EM) was a relatively new concept, and the macro environment drove returns. In many portfolios they were grouped together as a basket of higher growth but riskier assets.
Today that relationship has flipped. As EM companies have become more established on the global stage, 64% of their stock returns can be explained by company fundamentals. This is the same proportion found in developed markets. So no matter where you invest, company fundamentals matter most.
Sector and country-specific issues will still influence business profits, but the best companies are often led by strong management teams able to overcome external factors. This is where bottom-up research becomes essential — and can be the difference between investing in a company that succumbs to macro headwinds, or one that becomes the next big growth story.
There are many reasons for lackluster non-U.S. returns over the last decade: a strong U.S. dollar, political turmoil and trade tariffs — just to name a few. But another factor is the way in which we typically measure international markets.
International indexes generally have a greater concentration of value-oriented stocks in “old economy” sectors such as materials, financials and energy. Contrast that with the U.S., where technology, health care and consumer tech dominate local indexes. That alone accounts for much of the decade-long return disparity between U.S. and non-U.S. stocks.
That’s not to say that growth can’t be found in international markets. It just requires more work to uncover promising companies that may be hidden within indexes. And that’s where company-by-company analysis becomes so critical. The average stock in Europe may be growing slower than one in the U.S., but growth can still be found by those who look past index averages and examine each opportunity based on its individual characteristics.
3 reasons to consider international today
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, centered 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.
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.
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.
2 portfolio construction decisions
When markets are uncertain, it can be good to have some flexibility in your portfolio. Deciding on the right balance between traditional regional funds and more flexible global funds is one of the first asset allocation decisions investors need to make.
A regional approach is the most traditional, typically including three dedicated geographic segments: U.S., developed international and emerging markets. This allows portfolios to be constructed with specific geographic allocations in mind.
On the opposite end of the spectrum, a more flexible approach would include global funds. These mandates typically allow portfolio managers to dynamically shift their holdings and choose companies that they find most attractive from anywhere in the world.
Both approaches have their merits, and investors may want to consider combining dedicated international funds with a more flexible global strategy.
Much of this article has emphasized fundamental research of individual companies as one way to overcome international investing headwinds. But at a time when index investing has become increasingly popular and non-U.S. equities have lagged, is it worth the effort? Or would all investors be better served investing in a passive U.S.-only index fund?
The truth is, the average active mutual fund may not offer an advantage over the index, and passive funds only seek to replicate rather than beat their benchmarks. But there’s no need to settle for average. Not when you consider that the top quartile of active funds outpaced the indexes by a wide margin in the 20 years ending December 31, 2018.
Global fund managers have shined the brightest, outpacing the MSCI ACWI by 4.9% per year. These funds also handily beat top quartile U.S.-only funds in a period when U.S. indexes dominated. One explanation is that these global managers were most successful in benefiting from flexible mandates that allowed them to choose from the best companies, no matter where they were located.
When selecting non-U.S. and global fund managers, remember that it’s impossible to cover the entire world from New York. Consider partnering with investment managers whose research teams travel the globe and have access to company management.
1 answer to a key asset allocation question
When it comes to answering this question, the simple answer may be, “More.” Whether it’s due to a home bias or a lack of rebalancing during the long U.S. bull market, many investors may find themselves underexposed to non-U.S. equities.
At Capital Group we don’t make top-down asset allocation decisions based on geography, and we don’t believe there is a magic number to target. But as a rule of thumb, having about a third of your equity allocation within non-U.S. stocks may be appropriate. For a standard 60/40 portfolio, that would be 40% U.S. equity, 20% non-U.S. and 40% fixed income. Our objective-based model portfolios and target date series may also provide good starting points for discussions around international exposure levels for various risk profiles and life stages.
Digging one step deeper, the type of equity should vary depending on an investor’s risk tolerance. In the current late-cycle environment, investors may want to consider more conservative portfolios, which generally include more dividend-paying equities with a history of lower volatility. Outside of equity, investors can seek additional diversification by allocating a portion of their fixed income portfolio to international bond funds.
Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries.
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