Sunday, October 2

Week 13 - Foreign Stocks and Bonds

Situation: The ending of the Cold War in 1989 and the widespread use of the internet  launched the “global village” in earnest. The US economy now contributes only 25% of the world’s GDP.
Goal: Explain the benefits received when half of an investor’s assets are deployed outside the United States.
In an earlier blog, we defined the ITR Goldilocks Allocation which recommended 1/6th of an investors stock holdings be in foreign investments. A contributing point of fact is that 50% of sales made by S&P 500 companies occur outside the 50 states. Therefore, 2/3rds of recommended stock holdings are drawing part of their revenue from outside the US. Why not recommend an allocation that equals the 75% of world GDP found outside the US? There are 3 key reasons:
   (1) expenses are higher for the international mutual funds that must buy and sell stocks on foreign exchanges and hedge the currency risk
   (2) there is more political uncertainty
   (3) there is less transparency because of less stringent accounting and reporting rules

And then there is this remarkable statistic: several studies report that the coefficient of correlation of international stock indices with the S&P 500 Index is ~0.80. What this means is that economies around the world are strongly tied to the US economy and will move in sync with the US economy. Therefore, there is little risk that the companies on our Master List will fail to benefit from a strong bull market occurring in any country where they sell goods and/or services. Ownership of stock in high quality multinational companies that are based in the US is an indirect means of investing in foreign markets. Many of the Master List companies are heavily invested in Brazil, Russia, India, and China (known by the acronym BRIC), which are large countries that dominate “emerging market” growth.
Broadly diversified bond funds like PRCIX now include some bonds issued by foreign governments and corporations; such funds compose half of the ITR recommended bond allocation. When added to our 1/3rd recommendation for international bond funds like RPIBX, almost 40% of ITR’s recommended bond holdings are outside the US. Why not recommend 75%? Here, the argument is less rational. High quality foreign bonds outperform high quality US bonds by 1-2% because the value of the US dollar has been falling for the past decade. That means you will have to form an opinion about the future value of the US dollar before deciding how much to invest offshore. Recently, the fiscal and monetary policies of the US were redirected to clean up balance sheets at the US Treasury and Federal Reserve. This means the value of the dollar may gradually rise relative to a trade-weighted basket of other currencies. Here at ITR, we are concerned with retirement income and recommend sticking with “the devil we know”, namely, mutual funds and stocks denominated in US dollars - the currency we’ll be spending in retirement.  The type of international bond fund that we are recommending does little investing in emerging markets because such bonds typically carry a high level of risk. But on the stock side of the ITR asset allocation model it is important to capture growth, which is best accomplished by investing in emerging markets.
You may have counted the 1/6ths and noticed that we haven’t yet recommended a safe place to park the last 1/6th of stock holdings targeted to countries where growth is happening. That’s because almost all of the diversified international mutual funds lost more than the S&P 500 Index during the last big downturn, and weren’t beating it by much even before that downturn. Over the past 5 yrs, the S&P 500 Index is more than 1%/yr ahead of foreign indices. And, here at ITR we have only been able to identify two foreign companies that appear to meet ITR’s investment criteria (see Mission & Goals): Total SA (France’s integrated oil company) and BHP Billiton (the Australian mining company).
A generic solution to this problem is to recommend that you resort to a “flexible portfolio” mutual fund, one that can invest in anything anywhere. Few such funds have a long track record but those that do have weathered the recent unpleasantness better than any other category of stock funds. An ITR assessment finds that the flexible portfolio fund with the best track record over the past 15 yrs is Blackrock Global Allocation (MDLOX). It lost only 22% during the “bear market” between 10/9/07 and 3/9/09 vs. the spectacular 43% loss for the S&P 500 Index. As of 9/29/11, its 14.7 yr total return is 7.0%/yr vs. 2.0%/yr for the S&P 500 Index exchange-traded fund (SPY). Those returns are net of expenses (like commissions and front-end loads assessed for making our typical monthly investment of $200) but include the effect of free dividend reinvestment. MDLOX’s out-performance is because of it’s investment model:  a) a significant allocation to bonds, combined with b) stock investments in multinational companies based in developed countries, e.g. IBM, XOM, CVX, JNJ, and Apple (AAPL). To purchase MDLOX shares, use the same financial services company that you used to purchase bond funds (e.g. Fidelity Investments or T. Rowe Price).
But let’s be honest. MDLOX is expensive (management fees of ~2%/yr, regardless of share class), it doesn’t focus on emerging markets, and it depends on interest payments from bonds to maintain cash flow. Emerging market countries grow fast because of jobs in export and commodity businesses that result in dramatic increases in the standard of living. Every year, almost a hundred million people emerge from poverty. Now, those countries are fast becoming consumer-based economies. This is happening not only in the large BRIC countries but also in Turkey, Saudi Arabia, South Korea, Singapore, Chile, and Argentina. This trend has been present for some time, and certain companies have made it their business to market to those new consumers. For example, instead of making a $200/month investment in one of the examples discussed above (SPY or MDLOX), you could be investing in McDonald’s (MCD) where the 14.7 yr total return (net of the $1.50 commission on each purchase you make through Computershare) is 12.1%/yr. Now that’s a lot better than the 2.0% realized for SPY or the 7.0% for MDLOX!! How can “Mickey D” maintain such an outstanding performance through the bear markets of 1998, 2001-2, and 2008-9? Because for more than 20 years it’s business plan has focused on rapid expansion in emerging markets, capitalizing on the fact that 30% of income for those households goes for food vs. 8% here in the US (T. Rowe Price Report, issue 112, summer of 2011, p. 8).
Bottom Line: The US economy is still “the tail that wags the dog” but the dog (economies outside the US) is growing faster than the tail. Half of your assets need to reflect that growth.

<to continue to Week 14 click here>

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