Investment Insights: Why International Securities?
By: J. Reed Murphy, CIO
Contributions by: Rob Young, CFA
Bias. As the famous author, Malcolm Gladwell, has so eloquently illustrated in many of his writings, perhaps none so profoundly as Blink: The Power of Thinking Without Thinking, humans are prone to biases. Gladwell has an insightful way of illustrating how the mind works psychologically in cultural, social and economic settings. His insights are a practical and broader application of what several Nobel Laureates have illustrated in behavioral economics and finance. People have biases and it impacts our decisions.
This paper highlights one of the more popular biases in behavioral economics – Familiarity Bias. The avoidance of investments that we either don’t understand or are less familiar with is a classic form of familiarity or home bias. It exists within all humans and in all countries.
We’d like to dispel this thought process and highlight that, for a number of reasons, most investors should carry a core position in international securities. In this paper, we will answer the following key questions:
- How does the U.S equity market compare to the rest of the world?
- Why a binary comparision of domestic stocks vs. all other international stocks--as a group--is flawed and misleading?
- How should investors approach international investing?
How Does the U.S. Equity Market Compare to the Rest of the World?
There are several factors to consider before making a decision to include or avoid international equities. To begin, focusing on demographics and certain fundamentals provides a broader context for decision making. Consider the following. The U.S. represents:
4% of world’s population,
10% of the world’s publicly traded companies,
24% of world’s economy and
56% of its total stock market (market cap basis).
However, as shown in Exhibit 1 U.S. investors allocate a disproportionate 74% of their overall equity allocation to the U.S. By avoiding international investment opportunities categorically, investors could be dramatically reducing their opportunity set for successful investing.
Why is Comparing a Group of U.S. Stocks to a Group of “All Other” International Stocks Misleading?
The most common pitfall investors make is comparing the U.S. equity market as a group to all other international stocks as their own group. In making this binary comparison, one is generally comparing the S&P 500 (index comprised of 500 companies) to the Morgan Stanley Capital International (MSCI) EAFE index, comprised of 900 developed market companies or the MSCI Emerging Markets (EM) index, comprised of over 1,100 companies. This comparison is fraught with shortcomings, some of which we will explore. Let’s start by dissecting these shortcomings from a top-down perspective, starting with countries, sectors and individual companies.
REASON 1: Country Performance Gets Lost In Index Performance
The MSCI EAFE (developed countries) index consists of 21 countries and the MSCI EM (emerging markets) Index consists of 26 countries. Each index has unique performance and volatility drivers. As we previously noted, the S&P 500 is representing just one country. In Exhibit 2, we use the S&P 500 as a proxy for United States security performance and compare it to other countries within the MSCI EAFE and EM indexes--in general, since 1990, the U.S. tends to fall near the middle of international country performance. Said another way, an investor that solely uses domestic securities for their equity allocation, misses several international country standouts on an annual basis.
REASON 2: Sector Weighting Differences Are Significant
When comparing the sector weightings of the U.S. in a global stock market context, the S&P 500 has greater exposure to Information Technology, Healthcare and Communication Services, which over the last decade has seen the strongest performance. International indices tend to be heavier weighted to the material, financial and energy sectors, which have seen poorer relative performance (Exhibit 3) in recent years. Making a decision to invest without this perspective leads to less informed decisions.
As we also evaluate the actual performance of economic sectors within a global context, we note that the actual performance differences can be significant. Over the last 20 years (ending November 2019), the average annual sector performance dispersion was meaningful. The Consumer Staples and Materials sectors were fairly tight, but the performance difference within Energy, Financials and Technology was significant (Exhibit 4).
REASON 3: Some of the Best Performing Companies are Not in the U.S.
To further drive the point, according to The World Bank, as of 2018 only 10% of globally available public companies are based in the U.S. Not opening one’s tool box to international companies significantly restricts one’s exposure to some of the best companies and business models in the world. For example (Exhibit 5), Royal Dutch Shell, based in the Netherlands, is the 3rd largest company in the world based on 2018 revenues. Volkswagen, the largest global auto company, is nearly 2x the size of General Motors. Alibaba, a technology and commerce giant, is a Chinese company. Over the last three years Alibaba has grown its revenue at a 55% CAGR versus a ~30% CAGR for Amazon. Nestle is a Swiss company that is nearly 10x the size of Hershey. According to Bloomberg, Novartis represents an uncorrelated option for pharmaceutical investors and while BNP isn’t as large as J.P. Morgan by market cap, its dividend yield is nearly twice as large.
From a stock performance perspective, the top 50 performing companies on an annual basis have generally been foreign companies. On average only 25% of the top 50 stocks annually since 2009 were U.S. based (Exhibit 6). As a result, if an investor was U.S. based only, they missed some of the best companies and investment opportunities in the world.
How Should One Approach International Investing?
Investing should not be commoditized down to a game of winning or losing. That begs the question – winning or losing relative to what? The decision to include non-U.S. companies should be based on fundamentals and one’s goals.
Goals-based Investing Supports More Tools in the Toolbox
Investing should be client-centered. That is, investing should be goals-based. Considering international equities as part of one’s allocations simply brings more tools into the tool box to help one achieve a desired behavior and outcome. After all, one would not expect a carpenter to only use a hammer and nails to build a home. As we have demonstrated, considering international investments theoretically adds 90% of global companies back into the toolbox.
Active or Passive Considerations
While investible indexes are not available for all asset classes, they do exist for broad international markets. Actual investments in international companies can be obtained through passive (i.e., index) approaches or through active management (i.e., picking specific companies). International markets are certainly less efficient than the domestic large cap market, which further reinforces the point that deciding to invest in U.S. vs. non-U.S. markets should not be based on a binary comparison of stock indices.
Moreover, when indexing, you are set to achieve the same returns (ex-fees), same level of volatility and the same yield as a given index. Not all investors want or need these same behaviors. For those that desire a higher level of yield, investing in international markets (even through an index) can provide higher dividend yield levels than in the U.S. (S&P 500 index). Furthermore, as exhibit 7 illustrates there are far more foreign companies that have dividend yields greater than 3%. As of November 30th, 2019, there were 1,022 companies with dividend yields of 3% or more – 87% of those came from foreign companies. In a low interest rate environment, this is an important additional perspective.
While there are several other factors to consider when investing in international equity markets, the bigger picture suggests there are more opportunities outside of the United States. Considering the allocation to international markets is not only a client-centric decision, but it should also be based on economic and market outlooks.
Being that the international universe is so large, comparing the U.S. to one index representing the entire international market is misleading. Some of the best international managers are picking from among the best countries, sectors and individual companies – all of which is lost when making a binary comparison of the S&P 500 to an international index.