Of the world’s 500 largest companies, how many do you think are domiciled outside of the U.S.? Would finding out the answer is 368 – almost 75% of the total – surprise you? Or answer this: how much do you think the U.S. contributes to the world’s output, its global gross domestic product? Most Americans would be surprised to learn that it’s now less than 20%. These statistics aren’t intended to minimize the contribution the U.S. makes to the global economy. In many ways, we’re still the envy of the world, with a productive, highly skilled workforce and a legal system that supports property rights and encourages investment. But what’s lost on many U.S. investors is the sheer size and quality of the world’s other markets, and the opportunities those markets hold for investors willing to take a look at them.
So why don’t U.S. investors know more about investing in international markets? Actually, it’s due in part to human nature. The way we’re wired causes us to focus more on things in close proximity to us than on things that are far away. Things closer to us constantly bombard our senses and rightfully get a lot of our attention. So how does this trait manifest itself in the investing world? Investors can tend to focus more on investment options close to home, to the exclusion of viable options elsewhere. This behavior is known as “home country bias”. Honestly, it makes sense that most of us have a home country bias. After all, it’s just easier to “buy what you know”. The best method of overcoming this bias is to begin learning more about foreign markets so you’ll feel more comfortable investing in them.
Many U.S. investors haven’t noticed that international market conditions have improved recently. Because these improvements have gone unnoticed, most U.S. investors remain significantly under-allocated to foreign stocks, which account for half of the world’s total stock market value. U.S. stocks comprise only 49% of global equity market cap, but represent 74% of U.S. investors’ portfolios. This is unfortunate because foreign markets offer a number of attractive features to U.S. investors. Foreign stocks currently trade below their historical averages and below their pre-recession highs, despite improving economic fundamentals and stronger balance sheets. Valuations in specific markets, countries and industries may present attractive opportunities as economic conditions improve from the depths of the financial crisis of 2008–09. Developed international stocks (Europe, Australasia and Far East, or EAFE) and emerging market stocks may thus have more room to grow over the long term as conditions continue to improve.
Investing internationally also contributes to diversification. Most investors know they’re supposed to diversify, but they often can’t tell you what that really means or why it’s needed. Diversification is simply adding variety, which can reduce risk. Investing in a stock portfolio concentrated in one country — even one as big as the U.S. — can lead to a bumpy ride. Diversifying across several countries can help lower portfolio volatility because stock markets in different places don’t usually move in tandem. Diversification can also provide access to larger markets and therefore broader opportunities. Owning foreign stocks can help an investor diversity a portfolio and can also provide enhanced dividend income, as international stocks tend to offer higher yields than their U.S. counterparts. In France and the U.K. for example, the equity yield has been nearly twice that of U.S. stocks.
Another reason foreign markets seem attractive is that many companies domiciled abroad are positioned for growth, especially in Europe. The headlines may be telling us that Europe’s economy is in a slow recovery mode and may have a long road ahead, but many companies there have really improved their financial positions since 2008. Just as their U.S. counterparts did, in the wake of the financial crisis, prudent European companies aggressively cut back, paid off debt, raised cash, and have put themselves in a position to take on new debt (re-leverage) at historically low rates to fund future growth initiatives and potentially increasing cash returned to shareholders in the form of dividends.
Emerging markets also offer upside. The International Monetary Fund expects that more than half of global growth over the next four years will come from emerging markets. This stands in contrast to most developed markets, including the U.S., who still face low economic growth. This disproportionate growth from emerging markets bodes well for many European companies that have heavily invested in those markets outside Europe. Like many U.S. firms, many firms with headquarters in Europe are now generating significant revenue from outside the continent. In fact, European companies now pull in about one-third of their revenue from emerging markets, on average. For many firms, that ratio is much higher. Despite recent volatility in emerging markets, urbanization and demographics will continue to drive growth there. As emerging market residents continue moving to the cities, demand for infrastructure — roads, apartments, offices and public transportation — will continue to increase. Investing in companies poised to meet this demand is just one opportunity. Also, urban workers are more productive than agricultural workers, which allows city dwellers to produce more goods and therefore to generate higher wages. These higher wages, in turn, increase the demand for all sorts of goods and services. The impact of these changes is amplified in markets with younger populations where more people are proportionally of working age. Economic growth, continued development and increased consumer spending, in turn, require more energy, more raw materials, an expansion of the banking sector and rapid changes in technology. This “virtuous circle” of economic growth presents opportunities for companies exposed to emerging markets, regardless of where they are domiciled. And consider that emerging market urbanization is only in its infancy. Six billion people – about 85% of the world’s population – reside in what is considered emerging markets, and these markets are in the earliest stages of urbanization.
The attractiveness of investing in international markets is likely to manifest itself in improved rankings versus domestic investments in the future. So don’t be surprised if an investment you’ve never noticed before ranks near the top of the funds we track in your plans.