Money managers have been tripping over each other during the 1990s to offer American investors a chance to invest abroad. One after another, managers have rolled out foreign stock mutual funds or other vehicles to channel your cash overseas. They have been aided and abetted by advisers who told clients that non-U.S. companies offered better diversification and higher potential returns.
Oops. When you really think about it, the stampede to invest abroad may have been based on some assumptions that are outdated or flat-out wrong. It also is questionable whether any U.S. investor, including the big-league money managers, actually knows the foreign exposure of his or her portfolio.
Let’s start at the beginning. During the 1980s a consensus emerged that U.S. investors are better off holding some percentage of non-U.S. stocks. At that time few portfolios included any significant component of non-U.S. companies, because foreign stocks were difficult to analyze, obtain and trade through U.S. sources.
Why did we conclude that investors ought to look overseas? Advisers came to believe:
- Foreign companies and the stock markets where their shares traded were growing faster than their U.S. counterparts, thus becoming a larger component of the global equity market. To take advantage of the opportunities these shares offered, our focus had to broaden to include overseas stocks.
- The U.S. economy, though still the world’s largest, was expanding more slowly than those of many other countries, especially in the Far East and Latin America.
- Foreign business cycles are not in sync with our own. Therefore, foreign companies could still experience economic expansion at times when American companies were facing recession.
- Foreign stock markets move independently of ours. A weak stock market in the U.S. could be offset by a strong market overseas, assuming a portfolio contained shares trading in both places.
I believe all of these points are valid. The problem is that we made a leap of faith to go from these observations to the conclusion that the U.S. investor should, as a matter of policy, maintain a certain percentage of portfolio investments in the shares of foreign companies. To make this leap we had to accept a number of unspoken and questionable assumptions. These included:
- Money managers can capitalize on foreign stock opportunities just as easily as they can take advantage of U.S. opportunities. This requires that we assume the financial and business information about foreign companies, and the economic data for those companies’ home economy, is as good as the information available here.
- Foreign stock markets, including those in fast-growing developing countries, operate as efficiently as our markets. The advantages to be had by trading in those markets would not be dissipated by factors such as insider trading, market manipulation, government intervention, or economic and monetary crises.
- U.S. companies participate only in the U.S. economy, and foreign companies participate only in their local economies. To take advantage of faster-growing foreign economies, one had to buy foreign stocks.
- Currency movements could be safely disregarded in the investment mix, either because they do not matter over the long term or because they could be economically hedged away. If currency swings mattered, we would not be so sure that the varying movements of U.S. and foreign markets would counteract each other and make investor portfolios less volatile.
If these assumptions sound as dubious to you as they do to me, we have to question whether we would ever want to add a group of companies to our portfolios merely because they happen to be based abroad. It’s one thing to be aware of opportunities globally; it’s quite a different matter to tilt the investment playing field in favor of a certain set of those opportunities.
As always, we advisers have used historical statistics to back-test our hypothesis that foreign investments make our portfolios better. The problem with this is that the world of international trade has been changing rapidly. It was probably true two or three decades ago that American companies did not take advantage of overseas markets, but this is no longer the case.
Any decently diversified portfolio of U.S. stocks today is going to have a substantial overseas exposure. Unfortunately, we do not know how to track and measure this exposure. We typically look at a meaningless fact where the companies in the portfolio are domiciled or traded rather than the more significant factors such as where the companies derive their sales or profits, produce their products, or maintain their employees.
Consider the Fidelity Magellan mutual fund. At March 31, 1995, Magellan’s top five holdings were IBM, Motorola, General Motors, Oracle and Intel. All are U.S. companies. Yet these companies recently reported foreign sales, as a percentage of total sales, as follows: IBM, 63%; Motorola, 44%; GM, 21%; Oracle, 58%; Intel, 50%.
These are just the top five holdings in a $39 billion fund that has more than 500 stocks in its portfolio. And this is just a simple analysis of sales; no attempt is made here to weight the percentages according to the size of the company, or to evaluate the locales where output and profits are generated. It is a safe bet that even Magellan’s talented portfolio manager, Jeff Vinik, does not know how much of his fund’s performance is actually derived overseas.
This, oddly enough, is probably the way it should be. In a world where companies span the globe in their operations as well as their markets, the distinctions between U.S. and foreign stocks ought to disappear. What you ultimately want your portfolio manager to do is buy shares in the best companies, regardless of where they happen to be headquartered or traded. The management of these companies, in turn, is best equipped to analyze the business risks and opportunities overseas.
Ask yourself which is the better way to participate in China’s fast-growing economy. Do you want to buy shares of a Chinese company you have never heard of, or would you prefer to buy shares of Procter & Gamble, which has products that hundreds of millions of Chinese can afford and which has positioned those products as a nationwide market leader? I’ll take old reliable P&G, thank you.