International Overdiversification

Most investors are told that they should hold a diversified portfolio of stocks, bonds and real estate, each of which would have several subcategories for further diversification. Stock investors are typically encouraged to hold at least a certain portion of their share holdings in international shares, rather than stick with domestic only stocks. The rationale behind this idea is that not all economies follow the US economic cycle, which could possibly prevent investors from losing money if the US stock market crashes while international markets decline less or even increase. In fact, investors who had an allocation of foreign stocks over the past decade did outperform the US benchmarks, as international stocks rose more than their US peers.

This year, however, most global funds are down much more than the major US benchmarks. The reasons for this underperformance include the strong dollar in 2008 as well as falling prices worldwide after a five-year bull market. It does feel as if an international exposure could be beneficial in the long run, though its positive effects haven’t been felt so far in the credit crisis of 2008. Furthermore, most US investors who are purchasing domestic stocks are most likely to own several large multinational behemoths which derive a large portion of their revenues from abroad.

In order to conduct my experiment, I selected the ten largest companies by market capitalization from the S&P 500 index. The ten largest S&P 500 stocks account for over 22% of the daily fluctuations in the index. So what is the portion of financial results that these large cap companies derive from abroad?

It is interesting to note that few of the companies listed above broke down the contributions of their global operations in different formats. Some of these breakdowns focused on revenues, while others focused on net income or income from continuing operations. Adding to this is the fact that most of the companies close their books annually on different dates.

Despite the limitations of the data available for public use in relation to actual international operations in some cases, I think that on average the findings present an interesting way of looking into the issue of international over-diversification. It seems to me that if the ten stocks with the highest weights in the S&P 500 index derive about 44% of their aggregate financial contributions from foreign operations, then the overall contribution to financial performance would be similar for the index as a whole. Thus an investor who is simply invested in an S&P 500 index fund is also properly diversified internationally.

As a dividend investor, I have occasionally expressed concerns that I can’t find enough international dividend growers with a history of growing their dividend payments for over one decade. After conducting this experiment, I can see that most of the large cap multinational dividend stocks that I cover in this blog are good proxies for global market performance. Adding any further international stocks could increase my international exposure, without adding any further incremental benefits.

Disclosure: I own shares of GE, PG, JNJ and WMT

Comments

[keithpiccir...:]

Thanks for bringing this to our attention.
Most funds are "watered down" enough with diversification, and that is why I use a focused growth mutual fund and play individual stocks for the dividends in the S & P (JNJ & MSFT) whom I think can have limited downside and it's worked out fairly well in this recession so far...

2008 Dec 13 02:12 PM

[Steven Hansen:]

good investigative work. this is what seeking alpha is all about.

2008 Dec 14 12:37 AM

[BlueOkie:]

I find the biggest problem with investing outside the US is currency exchange. If I were to buy a stock using cheap US dollars, then both the stock I bought and the $US rise 10%, have I made any money after the exchange? I own IBM. A quarterly report gives a great education in the international markets.

2008 Dec 14 08:58 AM

[swygert@law...:]

Creating at least a trillion US dollars out of the air -- which the fed bailouts have accomplished to date -- can only mean that the US dollar will begin (perhaps it started already) a long and significant downward trend versus other major world fiat currencies. To be diversified in the ten US based international companies listed in this article is, I agree, a good way to have international exposure with a degree of transperancy not typical in the BRIC countries. Buy them, sit back, and smell the roses for the remainng years of our lives, with a semi-annual readjustment of one's portfolio based on two factors: market cap and percentage of revenues generated internationally (more difficult to ascertain).

2008 Dec 14 12:30 PM

[Anonymous 2:]

I believe the author is providing a good example of how to attempt to "capture the growth of dividends" from individual companies on a global basis.
The following is another more diversified way to do the same:

Consider a "portfolio" of TEN (as an example) different MFs and ETFs each of which which have as their investment objective to invest in portfolios which focus on domestic (US Based) and other global (International based) companies which have generated "Growing Dividends" over a period of years.

Assume these MFs and or ETFs consisted of 50 to150 companies in each of their portfolios. Some of these are in fact focused on global companies an others use various "growing dividend" benchmarks to structure their allocations and weightings toward company stocks which have other criteria IN ADDITION TO "Growing Dividends"
This portfolio would for al;l practical purposes be a "Fund of Funds" focused on GLOBAL companies with a track record of generating "growing dividends" over a period of time.

Obviously, some will feel that this resulting "overdiversification" will result in with too much "duplication" in terms of the number of times any one specific company name appears in more than one of the ten above suggested INDEPENDENTLY MANGED portfolios.
Another way of looking at this would be to consider that IF, for example, all TEN independent managers using various independent factors in evaluating one - or more - specific companies with a record of "growing dividends", ended up selecting one stock "ABC" in common.
I would expect that ABC would be considered to be overweighted (relative to other positions) in the total portfolio of the above suggested Fund of Funds.
Based on the fact that 10 independent managers using various methodologies - fundamentals, computer generated, black box and or techincal indicators - concluded that ABC fit their criteria, I would be willing to accept this overweighted position in this Fund of Fund with the idea that this overweighted position would have better odds of out performing many/most of the companies which were seleted by only ONE of the ten managers.
This "naturally selected" process of independent selections would tend to overweight the potentially better performers and underweight those with less potential for over performing on a relative basis. This would help offset the "extra costs" of the transction and management fees of evaluating a portfolio of funds vs attempting to choose "THE" best fund.
As most readers of this blog know, S&P has research significant research showing that "International Indexes of Growing Dividend companies" have outperformed BOTH the US S&P 500 Aristocrats (about 55 of the S&P 500 index companies) and the S&P 500 over various periods of time.
The following are a few of the MFs and ETFs which might be candidates to consider for evaluating for such a focused [growing dividend income] strategy:
AVEDX, BDV, DES, DVY, DWX, ETJ, FDL, FRDPX, ICRDX, IDV, LVL, PEY, PFM, PHJ, PID, SDY, VIG,VYM.
Disclosure: I own relatively small positions in about half of these - the total is between 5 and 10% of my overall equity investments.

2008 Dec 14 03:46 PM

[Sportsbiz:]

What your analysis and reliance on the international aspects of US multinationals does not do is allow you to choose where your international diversification comes from. If you want to add Japan or Brazil for instance, there is no guarantee that any of your current holdings, whatever they may be, will do that. That is why you can choose dividend paying international stocks to provide sector and country diversification with more targeted results than provided by indistinct data from American multinationals. Use them for what they are: domestic companies operating in dollar economies.

2008 Dec 14 09:23 PM