TCS Daily


The World, Your Oyster

By James K. Glassman - November 12, 2002 12:00 AM

In the good old days, foreign stocks provided balance. Typically, if U.S. stocks were having a bad year, non-U.S. stocks would be having a good year. One study found that for the 25 years between 1970 and 1995, foreign stocks beat U.S. by a wide margin in 12 years, U.S. beat foreign by a wide margin in 12 years, and in only one year were the two groups close. The rule was that if you owned a globally diversified portfolio, you got a smoother ride while sacrificing few, if any, profits.

But U.S. stocks have performed miserably over the past three years - and so have foreign stocks. And when American shares were rising in the late 1990s, so were foreign shares. In fact, something profound has happened to the relationship among stocks in nearly all developed countries: It's gotten tighter. In technical terms, the correlation between U.S. and non-U.S. stocks has increased - from about 65 percent at the start of 1994 to 85 percent in 2001. In other words, stock prices in markets from Italy to Australia to the United States are moving nearly in lockstep.

These high correlations are not good news. No longer can you reduce the volatility - the wild ups and downs - of your holdings simply by owning a portfolio with regional variety. But there is some good news on the international front. If you think U.S. stocks look attractive, then look at non-U.S. stocks. They're gorgeous.

I'll explain why in a second, but first let's understand what's happened to correlations. The numbers are startling. The Standard & Poor's 500-stock index, the U.S. benchmark, is down 22 percent for the year. Every other international index has also dropped, most by similar amounts. The Bloomberg European 500 was off 19 percent in terms of the dollar; France's CAC was down 25 percent; Britain's FTSE, down 15 percent; Hong Kong's Hang Seng, down 14 percent; Italy's MIB30, down 17 percent. Look at mutual funds: According to Lipper, the average global stock fund lost 20 percent for the first 10 months of the year; the average U.S. fund, 22 percent.

If high correlations are permanent - and my guess is that they are - you will need to adjust your thinking about foreign stocks. You might start by changing your view of the word "foreign." Consider Nokia (NOK), the cell-phone maker. It's based in Helsinki, it does business all over the world, and a majority of its shares are owned by Americans. Is Nokia a Finnish company or an American company? I'd call it global and leave it at that.

The point is that no sensible investor owns Nokia because it lends "Finnish balance" - or even European balance - to a portfolio. The reason to own Nokia is that it is a well-run business and that it represents a sector (high-tech telecom) that's depressed today but should revive in the future.

Why have correlations increased? "First and foremost," says a recent report by Sanford C. Bernstein & Co., the New York money-management and research firm, "is the rising tide of globalization." Companies do business all over the world, so practically every large corporation is exposed to the customers in the same countries.

Not long ago, it was odd to run across a McDonald's (MCD) fast-food outlet in France or Japan; now, 57 percent of the company's units are outside the United States, and last year two-thirds of total profits were earned abroad. Conversely, Luxottica Group (LUX), a wonderful company based in Milan, operates seven eyeglass-frame plants - six in Italy and one in China - but owns two American retail chains, LensCrafters and Sunglass Hut, and the quintessential American sunglass brand, Ray Ban, and collects only one-fourth of its revenue outside the United States.

While the U.S. economy is far and away the largest in the world, Bernstein points out that U.S.-based firms account for only one-fourth of the total market capitalization (that is, value according to stock price) of the global auto industry; less than half the market cap of the global banking industry and only one-tenth the market cap of worldwide household-durables firms.

Other factors are boosting correlations, too, says Bernstein, including "the rise in foreign ownership of stocks in most markets and the growing global convergence of interest rates - the latter courtesy of the European Union and successful inflation-fighting by the world's major central banks." These confluences aren't going away.

The best approach to building a portfolio today is to forget the old notions of balancing by country or by continent (10 percent Japanese stocks, 20 percent European, whatever) and instead concentrate on owning the best companies in different sectors, wherever those companies happen to be headquartered.

But right now, there's good reason to put a non-U.S. spin to your holdings. European companies, especially, have become much cheaper than American. Greg Jensen and Jason Rotenberg of Bridgewater Associates in Wilton, Conn., recently wrote to clients: "On a relative basis" - that is, compared with American stocks - "European equities may be the cheapest they have ever been."

For example, they point out that if you add up the market caps of all U.S. stocks, you get $9 trillion. That's 58 percent of the market cap of all the stocks of major industrialized nations (as shorthand, we'll call this the "global" market). Over the past 12 months, the earnings of U.S. stocks have amounted to $411 billion - or 53 percent of global earnings. In other words, when you consider their profits, U.S. stocks are slightly overvalued compared with stocks worldwide; that is, American prices are high in relation to profits.

Now look at European stocks. British companies account for 11 percent of global market cap but 15 percent of global earnings, so they appear to be undervalued. With France and Germany, the differences are even more dramatic. Together, their firms account for about one-tenth of the world's market cap but nearly one-fifth of the world's earnings. The opposite situation prevails in Japan, which, even after the sickening slide of the past two decades, still accounts for 13 percent of global market cap but just 7 percent of earnings.

Another way of putting this is that the price-to-earnings (P/E) ratios in France and Germany are considerably lower than those in the United States. But before you rush out and buy any French stock you can get your hands on, understand that there may be a good reason for this discrepancy: in a word, growth. European profits have been growing more slowly than U.S. profits. Still, the difference is so extreme that it's hard to resist.

Jensen and Rotenberg conclude: "Either European companies' earnings will continue to grow at a much slower rate (in terms of dollars) than that of the rest of the world, or they are incredibly attractive. We tend to believe the latter to be the more likely scenario."

Thomas Tibbles, who manages the Forward Hansberger International Growth Fund (FFINX), agrees. When you relate them to interest rates, he told me, "U.S. valuations are as low as following the 1987 crash, but other parts of the world are cheaper." In much of Europe, he says, it's "like the early 1970s."

While the fund's prospectus allows Tibbles to buy stocks anywhere outside the United States, his top five holdings (and eight out of his top 10) are European. No. 1 is Total Fina Elf (TOT), the French energy company, whose American depositary receipts (ADRs are tantamount to U.S. shares) trade on the New York Stock Exchange. Total's P/E ratio is just 15, or about one-fourth less than the P/E of a similar U.S.-based energy company.

Tibbles's fourth-largest holding, Unilever (UN), the giant British-Dutch consumer-products firm (Lipton, Q-Tips, Dove soap) whose profits have been growing at about 10 percent annually, is projected to earn a little less than $4 a share next year, about the same as Cincinnati-based Procter & Gamble (PG), another well-run brand-rich behemoth. But Unilever closed Friday at $63.69 while Procter & Gamble closed at $87.69. Forward Hansberger is a relatively new fund (started in 1999) that has enjoyed three solid years in a row, beating the category averages in each. A more venerable institution, Oakmark International I (OAKIX), founded in 1992, has whipped the primary international stock index by an annual average of 6 percentage points over the past five years. As a result, it's a leading recommendation of Bob Carlson, who edits Retirement Watch, a cautious newsletter based in Annandale. The fund's managers, David Herro and Michael Welsh, have also chosen to emphasize European stocks, which account for their top eight holdings.

No. 1, at last report, was the pharmaceutical company GlaxoSmithKline (GSK), based in England. It trades at a P/E, based on next year's estimated earnings, of just 15. Another major holding, Netherlands-based Akzo Nobel (AKZOY), the world's largest paint company, with $13 billion in sales, trades at a P/E, based on 2002 earnings, of only 11. About 15 percent of Oakmark's holdings are in French stocks, including BNP Paribas, banking; Aventis, drugs; Pernod Ricard, alcoholic beverages; and Publicis Groupe, advertising.

Another fund that has whipped the averages in the past five years, Julius Baer International Equity (BJBIX), is also currently overweighted in European stocks. Among the top holdings of managers Ruldoph-Riad Younes and Richard Pell are two highly regarded German firms, automaker BMW and cosmetics and adhesives manufacturer Henkel.

The Julius Baer managers have kept losses this year down to 6 percent -- or about two-thirds lower than the average international fund. They may owe part of their success to another change that's occurred over the past few years. While global market correlations are increasing, sector correlations are declining. In other words, they move up and down at different rates and at different times. Low correlations are good for portfolios. If you concentrate on diversifying across sectors, as Younes and Pell have done, you can hold down risk while maintaining decent returns.

So the rules of the game have changed. Throw away the map. Focus on sectors - technology, energy, consumer goods, finance, real estate and so on. Own lots of them, and own the very best companies in each. Of course, finding great companies in other countries isn't as easy as finding them in your own, so you can let managers of global (all over the world) or international (non-U.S.) stock funds do the work for you.

Finally, don't ignore Japan. Yes, overall, its prices are still relatively high, but there are some fine companies at decent valuations. Tibbles cites Honda Motor (HMC), which trades at a P/E of 9, based on earnings projections for the fiscal year ending in March 2003. "Honda is gaining market share in the U.S.," he says. Earnings last year set a record, despite the economic slowdown, and cash flow is impressive. Value Line reports that Honda earnings have risen an average of 19 percent for the past five years and are projected to rise 12 percent for the next five.

A good lesson for investors: Scour the world.

 

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