In Ever-Smaller World, Global Diversification Is Proving Less of a Hedge
FOR DECADES, a key rule of investing was to diversify
internationally. The reason was simple. When stocks in some parts
of the world perform poorly, stocks in other parts of the world
perform well. In other words, international markets are not closely
correlated. As a result, owning a strong dose of U.S. stocks has
provided balance for a non-U.S. portfolio, and vice versa.
The bottom line was that, with international diversification,
investors could combine high returns with lower risk.
The statistics were convincing.
A study by Sanford C. Bernstein Co. found that between 1970
and 1995, U.S. stocks significantly outperformed non-U.S. ones
in 12 of the years while non-U.S. equities outperformed U.S. ones
in 12 others; in only two years were returns about the same.
T. Rowe Price, the Baltimore mutual fund house, looked at the 10
major stock markets between 1980 and 1999 and found that the
United States was No. 1 in only one of those years (1982) and
that no country was on top more than twice except Hong Kong.
But something is changing. So far this year (through Thursday), the
U.S. market, as represented by the Standard Poor's 500 index, is
down 12.8 percent. According to Dow Jones Co., the markets of
the rest of the world are also down 12.8 percent! Stocks in the
euro zone are down 12.9 percent; Britain, down 13.1 percent;
France, down 12.9 percent; Germany, down 13 percent; Canada,
down 15.2 percent; and Singapore, down 13 percent. The only
large exception in 2001 is Japan, off just 5.2 percent.
Of course, three months does not a trend make, but last year as
well, world stocks tended to move together. For example, the
average U.S. large-cap growth mutual fund fell 16.3 percent in
2000, while the average international fund fell 15.6 percent.
More important, a recent study by Robin Brooks and Luis Catao
for the International Monetary Fund looked at the performance of
5,500 stocks in 40 markets from 1986 to 2000. The economists
found that the correlation between changes in U.S. and European
stock prices had risen from 0.4 in the mid-1990s to 0.8 last year.
In other words, the movements of U.S. stocks can explain 80
percent of the movement of European stocks, compared with just
40 percent not long ago.
If this pattern holds, it will have two important implications for
investors.
First, geographic diversification will not offer much protection
against volatility. In a year in which U.S. stocks are down sharply,
foreign stocks will likely be down sharply as well. Second, the old
"foreign" and "domestic" categories for companies themselves are
becoming far less meaningful.
After all, how do you characterize a company like Canon Inc.,
which sold $26 billion worth of business machines and cameras
last year? Canon is based in Tokyo, but it sells only 29 percent of
its products in Japan. Thirty-five percent of its business is in
Europe and another 35 percent is in the Americas. Plants are in
Japan, Europe, the United States and Southeast Asia, and foreign
shareholders own 26 percent of Canon's stock.
An even more extreme case is Nokia Oyj. Based in Finland, it
sells cell phones around the world and more than half of its
shareholders are in the United States.
Or consider Unilever NV, the consumer-products company based
in Rotterdam and London, which does business in 90 countries
and is roughly one-fourth owned by U.S. shareholders.
And what about Coca-Cola Co., which earned 68 percent of its
profit last year outside North America?
Mounting international mergers, the tendency of large companies
to list their stocks on several global exchanges, and the
increasingly free flow of capital have meant, as The Economist
magazine recently put it, that "the health of a market's home
economy may matter less than it used to." Then again, the health of
that economy seems more and more tied to the health of other
economies anyway.
In the stock market, it's getting to be one world - for better and
worse.
More and more, managers of worldwide-stock funds do not make
geographic distinctions.
Jean-Marie Eveillard, manager of First Eagle Sogen Global Fund,
whose mandate allows the purchase of stocks and bonds
anywhere on the planet, told me that "the differences between
U.S. and non-U.S. companies are a lot less than they used to be."
Not only are the businesses getting more similar in their global
scope, but European and even Japanese companies are becoming
more transparent for investors and more eager to please
shareholders.
"I started in Paris 40 years ago, and I can tell you," Mr. Eveillard
said, that a "lot of progress has been made - at least for the large
European and Japanese companies, or Asian in general, with
public information."
There have been gains, as well, he said, "in terms of availability of
management to talk strategy with shareholders. With the Philipses
and Unilevers and Bayers and Sonys and Matsushitas of this
world, they are just as available as the General Electrics and
Procter Gambles." EVEN MANAGERS of funds that specialize in
U.S. stocks have been buying more international shares. You can
hardly get more American than a fund called American Funds
Investment Co. of America (the sixth-largest fund in the U.S.), but
among its top 25 holdings are Nokia, Royal Dutch Petroleum Co.
of the Netherlands and AstraZeneca PLC, the global
pharmaceutical house formed in a merger of Swedish and British
companies.
On the other hand, if international diversification matters less, then
why own foreign stocks at all? No longer is it foolish to own an
all-U.S. or all-European portfolio - if domestic companies are
what you know. Except that Japan - not to mention emerging
markets - is another matter. According to T. Rowe Price, Japan's
correlation to the United States over the past 30 years has been
only about half that of Europe.
Still, while chauvinism may now be acceptable in
portfolio-building, a smart investor keeps an open mind about
companies based in other parts of the world.
After all, as Price's research department notes, none of the 10
largest steel companies, electronics companies or appliance
companies is based in the United States. In 1970, U.S. stocks
represented two-thirds of global market capitalization; today, the
figure is just shy of half.
The truth is, you could not be a parochial investor if you wanted to
be. Nearly all the great companies - General Electric Co. and
Siemens AG, Diageo PLC and McDonald's Corp., Microsoft
Corp. and SAP AG - are global in sales, employees and
shareholders.
The only drawback is that, paradoxically, a smaller world for
businesses is a more volatile world for stocks.
(*) James K. Glassman is a fellow at the American Enterprise Institute
and consultant to Folio Investing (www.foliofn.com).
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