International Investing: Why now may be a good time to diversify
Riding high on Olympic spirit like me? Watching the Paris Games this summer has been such a fun activity to share with my family. At one point my twelve year old said, during the Opening Ceremonies, “I forgot that so many people live outside the US!”
Living in the United States with so many amazing companies that routinely grab the headlines (think Meta, Tesla, Apple or Google), it’s easy to forget that there are often great companies to invest in outside of the United States. Since these companies are impacted by factors that are different from factors that impact US or domestic companies, adding them to your portfolio allows for the positive effects of diversification.
This blog post will teach you about investing in companies outside the US and why now may be a good time to add this exposure to your retirement or personal brokerage portfolios if you haven’t already done so.
What is Diversification?
“Diversification is an investing strategy used to manage risk. Rather than concentrate money in a single company, industry, sector or asset class, investors diversify their investments across a range of different companies, industries and asset classes.
When you divide your funds across companies large and small, at home and abroad, in both stocks and bonds, you avoid the risk of having all of your eggs in one basket.”
Source: Forbes Advisor, https://www.forbes.com/advisor/investing/what-is-diversification/
Before I get started, here’s a reminder that this is education and not advice! Full Disclosure: Nothing on this website should ever be considered to be advice, research or an invitation to buy or sell any securities. Please see the Disclaimer page for a full disclaimer.
The Basics of International Stock Investing
There are two main international equity asset classes where people invest. The first is called “Developed Markets”, which includes other well-established countries like Germany, France, the United Kingdom and Japan. Some companies you may have heard about from these countries are: SAP (Information Technology), AstraZeneca (Healthcare), Toyota Motor (Industry), Unilever (Consumer Staples) and UBS (Financials).
Just like the S&P 500 is a major index that tracks companies from the United States, the MSCI EAFE Index lists companies from major developed markets outside the United States. What does the EAFE stand for? Europe, Australia, Asia, and the Far East (https://www.ishares.com/us/products/239623/ishares-msci-eafe-etf)
The other type of stock investing outside the US is in countries called “Emerging Markets”. These companies are from countries that are still considered “developing” and therefore have lesser developed economic infrastructure or banking sectors.
It is generally considered riskier to invest in Emerging Markets vs. Developed Markets (including the US) because of various reasons like currency risk and different rule of law, regulations and political systems. However, there is also lots of economic growth opportunity in these countries as their populations have growing middle classes with more discretionary income to spend as consumers.
The top five largest emerging market economics are Brazil, Russia, India, China and South Africa, although there are 24 countries represented here. Some popular companies domiciled in these markets include Samsung, Alibaba, Tencent and Sberbank. The major index that tracks companies in Emerging Markets is called the MSCI Emerging Markets Index.
But isn’t the United States the largest economy in the world with some of the best companies?
You may be asking why even bother going outside the United States if our companies might be considered by some to be “the best”. Why diversify only to have lower quality?
Because the rest of the world’s companies as represented by their stocks are relatively cheap right now.
How can a country’s whole stock market be considered cheap or expensive? Investors are willing to pay different prices for the same companies in different environments.
For example, what’s the price of water? Well, it depends.
Are you paying just pennies to pour it from your tap at home filling your water bottle?
Or, are you instead buying it in a bottle at the supermarket for $2.
Or maybe you are at the basketball arena and have to pay $5 for that same size bottle?
The product is the same, but the price changes based on the environment. The same thing can happen for stocks, and it is called “valuation”.
Generally, after there has been a strong performance in a stock or an index, it will trade at higher valuations and be more “expensive” than it was a year ago.
A company can only produce so much profit and so much earnings growth. But sometimes investors are willing to pay a higher price for those profits and growth in earnings. There is a valuation metric called “Price to Earnings” ratio that takes the price of a security and divides it by the last year’s (or next year’s projected) earnings of the company. Lower P/E ratios means a stock is cheap and higher P/E ratios means it is more expensive.
After the global pandemic market downturn of 2020, the P/E ratio of the United States (dark blue) has really pulled away from the International Developed Markets P/E (red) and the International Emerging Markets P/E ratio (yellow).
In general, the United States has always demanded a “premium” vs. international markets in the form of a higher valuation as measured by the P/E ratio. But what is different is that international markets are trading at a fairly wide valuation discount compared to average. The chart below shows that international P/E ratio discount to US P/E ratio is roughly two standard deviations below the average discount, which theoretically only happens about 95% of the time.
Finally, here is a chart that overlays the expected earnings growth by region of the world with the price-to-earnings ratio of that region. Notice how while the US does have higher expected earnings growth, you have to pay more for those earnings with a higher valuation (black diamond). Meanwhile, Emerging Markets equities have the highest earnings growth of all, but valuations aren’t as high.
With investing, managing risk is more important that trying to earn the highest returns.
Diversification is a risk management tool, not a return-maximizing tool. If you have a portfolio of stocks that is only invested in the S&P 500, then your portfolio is likely more expensive than one that is invested across the world.
Since stock markets are cyclical, swinging over time between being cheap to being expensive, there will likely come a day when the US stock market has another downturn and falls back to being “cheap”. It would be prudent to have a portion of your stock portfolio invested outside the US where things are already cheaper and theoretically have less room to fall in price.
Just like in the Olympics medal count, the US stock market has been “winning” vs. the rest of the world for some time now.
To me, the essence of good portfolio risk management is to consistently pull a little back from your winners and areas that have done really well and reinvest into “cheaper” opportunities who haven’t yet had their time to shine.
I work with my financial planning clients and investment management clients to determine the right portfolio allocations for their situation, and I encourage them to invest across all geographies to be as diversified as possible.
Want to know if you are diversified outside the US? And how you should think about re-orienting your stocks to include more international exposure?
Set up a 30-minute intro call with me here and I can share more about how I can help.
Full Disclosure: Nothing on this website should ever be considered to be advice, research or an invitation to buy or sell any securities. Please see the Disclaimer page for a full disclaimer.
Stacy Dervin, CFA, CFP® provides fee-only financial planning and investment management services in Eugene, Oregon. Tailored Financial Planning (TFP) serves clients as a fiduciary and never earns a commission of any kind. As a financial advisor, Stacy is on a mission to help Gen X and Gen Y be truly proactive about their financial futures.
