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Why you don't need foreign stocks
Plenty of professionals say it's good to have a substantial portion of your assets invested overseas. But Europe and Japan, where many funds turn, offer investors little over the long haul.
By Timothy Middleton
I have never forgotten a joke I heard on the "Ed Sullivan Show" in the late 1950s. It was a minstrels introduction to a fake folk song: In the village from which I come, the people have a legend. They believe it because they are stupid. I believe it, too.
The legend I have long believed, stupidly, is that international investing is so good you ought to put a serious chunk of your assets in Brand X International Fund. I have managed to cling to this textbook notion in spite of the fact that the facts belie this belief.
The facts are, aside from emerging markets and wild rallies of last months sort that took Vanguard European Stock Index Fund (VEURX) up an eye-popping 13.5%, overseas markets are largely a bunch of junk. So are the data that seem to indicate otherwise. Yes, it is true that a company doesnt have to be headquartered in the United States to be the best in the world. But you can count all the ones that are without needing your toes.
The basic argument for international diversification is greatly oversold, says Robert Aliber, professor of international economics and finance at the University of Chicago. The growth argument is mostly empty.
Investing overseas no longer fashionable
Investing in developing countries is a whole nother subject, which I wholeheartedly embrace and recommended last November. Aliber notes that, apart from the United States, rapidly growing companies around the world are mostly headquartered in emerging markets like South Korea.
But as for Europe and Japan, which are where foreign stock funds put between 65% and 90% of their assets, forget it. The latter is in an economic quagmire it thinks is a hot tub. The former mainly consists of a small number of competent but slow-growing behemoths such as Nestl, which makes a better snack than a stock.
Europe and Asia are far behind us, says Kenneth Janke, chairman of the National Association of Investors, a group of investment clubs. For his foreign exposure, he buys American companies such as Pfizer (PFE, news, msgs) that have substantial overseas sales.
Foreign investing became fashionable when U.S. markets were relatively weak, beginning in the 1970s. Between 1976 and 1989, the Europe, Australasia, Far East Index surged more than sixfold, while the S&P 500 ($INX) didnt even quadruple.
Why? The Japanese economic bubble. But then Japan crashed so spectacularly, beginning in 1989, and Europe advanced so slowly, that between 1990 and 2002, that index crept up a miserable 27.1% in toto. In the same period, the S&P galloped ahead about 160%.
When you combine the two periods, that overseas index grew a total of 407% in 26 years, while U.S. stocks raced ahead 789%. That's a New World return nearly twice that found in the Old World.
Not so fast
So much for the conventional wisdom. You could totally write off investing in places like Europe, except ...
These data disguise one big advantage the United States held during much of this period, but doesnt now -- a strong dollar. The euro was launched in 1997 with its value pegged at $1.17. It began to depreciate almost immediately, reaching its nadir at 86 cents four years later.
That 26% drop, along with Japans woes, goes a long way toward explaining why the average foreign-stock fund lost an annual average of 6.4% of its value in the five years ended March 31, while the S&P went down only 3.8%.
Since bottoming, the euro has rebounded to $1.10. Anticipating the rebound, Mutual European Fund (TEMIX), which ordinarily is 100% hedged against currency translations, dropped that to 60% and benefited almost immediately. Last year it beat Morgan Stanley Capital Internationals Europe Index by more than 10 percentage points, and the S&P by more than 14.
The funds co-manager, Matt Haynes, says European equities are so attractive -- and so attractively priced -- that some of the domestic Mutual Series funds have as much as 35% of their assets there. European bourses, insists the value-leaning manager, have been and remain much cheaper than the United States.
The rearview mirror
The recent underperformance of foreign equities also represents, another international fund manager argues, a classic case of driving by looking in the rearview mirror.
A recent trend does not make a rule, says Rudolph-Riad Younes, co-manager of Julius Baer International Equity Fund (BJBIX), which, on average, has made money the last five years, even as the S&P and Europe, Australasia, Far East Index haven't.
He expects U.S. economic growth to be miserable for the foreseeable future. And a climbing current account deficit will hold down the value of the dollar for at least the next three years. At the same time, foreign companies will boost their growth rates, and foreign standards of living will accelerate faster than ours, he says.
These are powerful arguments. They basically explain why I have doggedly insisted on owning a couple of foreign-stock dogs, despite the evidence against them. But that evidence is powerful, too. Whats an investor to do?
Finding a compromise
Dan Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, has found a middle ground between some and none: Very little.
Our foreign weighting (in model portfolios) is about 6%, he says, or about one-third the weighting urged by advocates of foreign diversification. World-class companies exist all over the globe, he says, but there arent that many of them.
I think this is an excellent compromise. A little dollop of developed-markets funds captures that handful of non-American companies worth buying. A further commitment, of 10% or 15%, to emerging-markets equity funds gives exposure to the fastest-growing companies outside our borders.
But any more cash than this is, I think, cheese-eating surrender money. France and other self-satisfied governments will tax too much of it, and inbred corporate managers will fritter away too much of the rest.
What they're buying now
A window of opportunity: Mutual European manager Haynes likes Hunter Douglas (NL:HDG, news, msgs), the Netherlands manufacturer of window coverings. They have north of 90% market share in the premium and luxury ends of the business, which is the higher margin part, he says. But the stock trades at eight times this years expected earnings.
Building bridges: Haynes fund also has more than 10% of its assets in Spanish construction companies such as Acciona (ES:ANA, news, msgs). Spain and the European Union are spending billions of euros to bring Spains bridges, highways and railroads up to the level of everybody elses by 2006. Youve got what historically is a very cyclical sector in large part not succumbing to its historical sensitivity because of this very certain flow of cash, Haynes says.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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