International Markets: Why Invest Overseas?
Posted by Larry Brundage on July 18, 2012
For several months now HFM has been discussing the relative value that we see in the domestic large cap equity markets, both when related to historic market prices and when compared to the current level of yields in the bond market. We have also discussed the prudence of diversifying the equities within an account by holding a portion of the equities in non-U.S. equities. Typically we invest about 10% of the equity portion of a portfolio in non-U.S. equities by using a mutual fund. But with the problems we hear about around the globe, is it reasonable to hold international equities in a portfolio?
We believe that the answer is emphatically yes. But you might ask, with so many problems in the world, Europe with its debt problem, Japan with its twenty years of stagnant economic growth and China teetering on a recession, aren’t the risks too high? Not only that, but in 3 out of the last 4 years U.S. equities have outperformed international equities; why would anyone want to invest in an underperforming asset class?
The answer to that is in two parts, the first related to valuations and the second related to the risks. Valuations are the easier part of the answer to address. The equity markets in many other countries are cheap! One of the better analyses of valuation that we have seen is done by J.P. Morgan Asset Management. They use a valuation that combines in equal parts the price to earnings ratio (P/E), the price to book value ratio (P/B), the price to cash flow ratio (P/CF) and the dividend yield. Using that valuation metric, the U.S. market is at the bottom of the range of where it has been over the last 10 years, so is Germany. But Canada, Japan, the United Kingdom, Australia and France are all well below the range in which they have been over the last 10 years (2002-2011.) In fact the entire international index, the MSCI EAFE, is below the range of valuations during the 2002 to 2011 period. Thus relative to their own histories each of these developed markets are cheap. Also the absolute valuation measure for each of those countries is lower than the valuation measure for the United States.
The emerging markets do not present such a clear picture. As a whole they are at the cheap end of the range, but not the absolute bottom. Some, like Russia and China, are very cheap, while others like South Korea and Mexico are in the upper end of their historical ranges. The majority are cheaper than their historical averages but not at bargain basement prices including Brazil, Taiwan, South Africa and India. For these markets, however, it should be noted that the economic improvement over the last 10 years has been dramatic enough to justify higher valuations. Thus historic comparisons are not as good a yardstick. Nevertheless, prices are reasonable.
One of the metrics that we have focused on at HFM has been dividend yield, because in the U.S. the dividend yield on the MSCI U.S. Index is 2.1%, which compares quite favorably to the yield on the 10 year U.S. Treasury bond of 1.64%. Actually, as an aside it is quite amazing to those of us who have been investing over a period of 2-3 decades. Only since 2008 have we seen dividend yields higher than the yield on the 10 year Treasury. Even during this period after the market low in 2009 stock yields have not been consistently above bond yields. Yet for each of the developed markets that were mentioned above the dividend yield is above the dividend yield in the U.S. Foreign dividend yields range from 2.6% in Japan to 5.2% in Australia, with the average for the MSCI EAFE index at 3.9%.
We have to be careful about comparing dividend yields to bond yields. No one has taken the risk out of the stock markets just because the dividend yields are attractive. In fact we expect stocks, both international and domestic, to remain riskier than bonds in the future. But stocks are cheap and historically returns that were achieved by investing in cheap stocks have been significantly better than returns realized on expensive stocks.
Unfortunately the times during which stocks are particularly attractive, as they are now, are times when the investment environment appears to be very ugly. In fact to give the starkest example, the S&P 500 was at 7.42 on April 28, 1942. The market had not been that low since April of 1933 in the early part of the Depression. World War II was in one of its blackest hours. D-Day wouldn’t occur for over 2 years. Yet an investor who bought into the market that day never saw the S&P 500 dip below that day’s level. Yet the risk part of the answer is the most difficult because we don’t have a crystal ball and can not tell you what is going to happen. Without trying to belittle the current level of risk, compared to that day in 1942 the current day couldn’t be rosier. We are, however, talking about a financial crisis that could fundamentally reshape Europe. On the other hand, we have seen the European politicians slowly begin to address their problems. While we would prefer seeing a more rapid solution, they are at least making progress. There is a saying that when politicians are panicking, markets can stop panicking. Often though, we tend to forget that the debt problems in the United States are of a similar magnitude. So should we avoid European stocks just to concentrate in the U.S. only to find out that we are just as bad?
Similarly, Japan and China have problems that are slowly being addressed. When we look at risky scenarios like the ones that currently exist, we tend to forget that one of the best antidotes for risk in the financial markets is to buy low. Certainly markets can get cheaper than they are now over the next several months. But investing in stocks has never been, at least it shouldn’t be, a short term undertaking. Nobody was told on April 28, 1942 that the market was at a low and no one has said or will say anything during this market period. So we can’t sit around waiting for an exact low; in fact it may already be past. But we can measure the value in the markets and we have found them to be very reasonably priced. Consequently, we retain our resolve that international stocks will continue to be a good diversifying and positively contributing part of a well designed portfolio.