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Thursday, January 13, 2011

Globetrotters

Written by: Ben Atwater and Matt Malick

Most investment strategies today include at least a modest allocation to foreign equity markets.

While specific percentage recommendations will vary among advisors, a logical starting point is the fact that the United States currently represents about 40% of the global stock market. This rationale would lead to 60% of a portfolio’s equity exposure devoted to international markets, perhaps a bit too bold for most investors.

For a more realistic proxy of how managers allocate their clients’ portfolios, Morningstar reports that the typical target date mutual fund allocates somewhere between 20% and 45% of its total equity holdings outside the U.S.

Why do so many investors look overseas?

For starters, many point to the potential diversification benefits from allocating capital to all corners of the globe. Theoretically, economies and stock markets around the world should not flourish or decline in tandem.

Furthermore, international investing has exploded simply because that is where the growth has been. While United States gross domestic product (GDP) contracted at a 2.6% rate in 2009, India expanded at a 7.4% clip and China grew by an impressive 9.1%.

As a result, emerging market mutual funds are now enormously popular, a contrarian indicator. According to Bloomberg News, “Individual investors are pouring money into emerging-market stocks at the fastest pace since 2007. The last time investors were this bullish, the MSCI Emerging Markets Index sank 11 percent in three months, data compiled by EPFR Global and Bloomberg show.”

Overall we would not quibble with the notion that international diversification is favorable when constructing a portfolio. We do take issue, however, with the method by which most financial advisors seek access to global markets.

Readers of our past market commentaries are familiar with our distaste for “outsourced” investment management, i.e. financial products such as mutual funds, due to limited transparency, high fees and tax inefficiency. Yet in our experience, most portfolios rely heavily on international and emerging market mutual funds for exposure to companies that trade directly on foreign stock exchanges.

Drawing a distinction between domestic and foreign equity investing is hardly as black and white as one might think. According to the below chart from Ned Davis Research, of companies in the S&P 500 that report foreign earnings, 30.9% of their revenue and 54.4% of their profits were derived from overseas in 2009, a significant rise from 2000. Moreover, 507 non-U.S.-domiciled multinational companies currently trade on the New York Stock Exchange, as well as many thousands of American multinationals. In today’s integrated world economy, an investor can strategically seek international diversification through individual companies.


MetLife (MET), for example, recently closed a $15.5 billion acquisition of Alico from the beleaguered insurance giant, American International Group (AIG). AIG sold Alico, an otherwise healthy business, to help repay its taxpayer-funded bailout. The deal allows MET, already the largest U.S. life insurer, to significantly expand its presence in Asia, Europe and Latin America. Nearly all of Alico’s business is outside the United States. The company recently predicted that operating results would rise as much as 45% next year, helped by the acquisition.

A recent Bloomberg Businessweek article profiled Coca-Cola (KO), and its attempt to expand its African beverage business. “Coke has been in Africa since 1929 and is now in all of its countries; it is the continent’s largest employer, with 65,000 employees and 160 plants. In 2000 about 59 million African households earned at least $5,000, which is the point when families begin to spend half their income on nonfood items, according to a recent McKinsey report. The study suggests that number could reach 106 million households by 2014. Coke plans to spend $12 billion in the continent during the next 10 years, more than twice as much as in the previous decade,” according to Bloomberg Businessweek.

For Diageo (DEO), the British spirits maker, Africa was among its fastest growing regions last year, growing 10 percent and representing 13 percent of total sales. At a time when Diageo is shuttering factories in Ireland and Scotland as a meager European economy takes its toll, they intend to invest 100 million pounds ($158 million) to expand in Africa next year.

We have more confidence in Coke and Diageo’s ability to uncover opportunity in Africa than we do in an emerging market mutual fund manager sitting at a desk in Minneapolis.

Among our portfolio of companies, perhaps Procter & Gamble (PG) maintains the most ambitious plan for international expansion. P&G has articulated a growth strategy of, “touching and improving the lives of more consumers in more parts of the world, more completely.” Put in more measurable terms, P&G would like to sell its products to 5 billion consumers by 2015 and achieve $175 billion in sales by 2025. And the 173-year-old company appears to be on the right track, increasing its global household penetration – the percentage of households using at least one P&G product – nearly two percentage points in its most recent quarter, to 61%.

A significant contributor to international investment returns is often currency exchange rates. For example, let us consider an American investor who purchases shares of a mutual fund that invests in Mitsubishi UFJ Financial Group, the largest bank in Japan. In times when the U.S. dollar drops relative to the Japanese yen, this investor should prosper as the profits Mitsubishi UFJ earns in yen are repatriated to U.S. dollars. Obviously, the opposite holds true as a strong dollar hinders returns.

Yet by investing in individual companies that do business overseas, we benefit or suffer from the very same currency effects. For instance, Coach (COH), the New York-based maker of handbags and leather goods, booked 22% of its fiscal 2009 sales in Japan. In its most recent quarter, Coach’s Japanese sales rose 13.8% to $173.1 million, which included a 10.6% positive impact from currency translation.

The most compelling argument in favor of multi-national American companies may be their track record for allocating capital overseas before most Wall Street strategists see an opportunity. For instance, Procter & Gamble began marketing its brands in China in 1988, long before emerging markets became en vogue among asset allocators. Today, P&G is the largest consumer products company in China, with about $5 billion in annual sales and a strong record of profit growth.

By owning individual businesses rather than investment products, an investor can essentially cut out the middle man and the commensurate extra layer of management fees. Individual, multinational companies offer the geographic and currency diversification that come from foreign investing, along with the transparency, tax efficiency and control that are so often lost in investment products.

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