Thursday, December 23, 2010

Do your portfolio really need exposure to international equities?

Everybody’s mother wants to participate in the growth of emerging markets. And considering that the  average stock should only grow about as fast as the GDP growth in its country, a strong case can be made for having significant exposure to international stocks.

But before making a decision of whether or not to invest in stocks from a particular country, we need to  look at whether or not the country observes the rule of law, and also look at the political condition of that country to determine if the country is a stable place to invest our money. I don’t think I would ever invest in a country run by dictators (even if stocks in that country are trading at a P/E ratio of 2) who could seize the assets of the private sector whenever they feel like it. We should also take the time to look at inflation, budget deficit, national debt, and some other macroeconomic factors just to make sure things won't go out of control anytime soon.  

Foreign stocks and domestic stocks are in essence stocks. And like any other stock, the price you pay plays a huge part in whether or not your investment will turn out to be a success. Yes, we have to pay more for a company with a good long-term growth rate, but if we pay too much, then the company needs to keep growing without any hiccups for a very long time before its intrinsic value catches up to the price we paid for it. Usually things don’t always go so smoothly, and there usually will be hiccups which can cause the price of the stock to crash back down to reality leaving the investors who paid too much with significant paper losses for what could be a very long time. 

One of the main reasons for investing internationally is to get better returns, and the price we pay plays a very significant role in the kind of returns we get. So, by paying too much for a foreign stock, we are defeating one of the main purposes of investing in foreign stocks. I will pick a domestic stock with decent growth and solid fundamentals trading at a discount to intrinsic value over an overpriced foreign stock any day.

There are also companies based in the US that do a significant amount of business outside the US, but might not trade at a premium, as they are not based in a “hot” country. If you invest in these companies at sensible prices, you could potentially enjoy better returns than the average US stock due to the companies you invested in having higher growth rates from their international business units. You also could potentially earn much better returns than if you were to invest in overvalued foreign stocks which could very well produce dismal returns or even heavy losses.

Even if a company only has operations in the US, doesn’t necessarily mean it’s a bad thing. The US is still the largest economy in the world, and it’s a huge market for any company to expand and grow healthily in (especially for small-cap and medium-cap companies which might only have operations in a few states or maybe even a city).

While it’s always foolish to bet against the US, the fact is that it’s prudent to try and diversify your portfolio to have some international exposure. Emerging markets will probably continue to be the big story for a long time to come, and while emerging market stocks can be overvalued at times, there are also times when fast growing, good quality emerging market stocks trade at a discount or trade at a fair price (just remember that a company really needs to have excellent fundamentals for you not to need a margin of safety when investing in it), and this kind of opportunities if acted upon can potentially result in really spectacular returns for investors.

I personally believe that the best way to go about things is to, of course, invest in equities that you believe will produce good risk-adjusted returns regardless of where those companies are based, but also try to pick up  some domestic stocks with international exposure and good quality emerging market stocks when the opportunities present themselves.
Another strategy to get international exposure that I like and might consider using in the future is to allocate a certain amount of money every month or so to dollar-cost average into a few country ETFs or maybe even just one country ETF if you really like equities in that country. I talked about why I like ETFs to get exposure to foreign stocks in this article here. I would just like to say that it might be wise to avoid countries which stocks might be too overvalued as the risks can be too great even with dollar-cost averaging.       

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a great holiday!