Why Buy Foreign Stocks?

by: Tom Au, CFA

The U.S. stock indices no longer dominate the world markets as they did even ten years ago, when they accounted for more than half of the world's market cap. With about two thirds of the world's stock market value (and even larger proportions of GDP and population) overseas, American investors would be well served by getting at least some foreign stock exposure. Similar, although weaker, arguments apply to the purchase of foreign bonds.

There are basically two ways Americans can buy foreign stocks. One is to buy them directly in the home markets, using a foreign broker. That offers a number of hassles, insofar as paperwork and tax reporting requirements may differ in foreign countries. And payments (and receipts) will be in local currency necessitating foreign exchange transactions.

For the larger stocks of many countries, there is an easier way to get foreign exposure, through ADRs, or American Depositary Receipts. These are claims on foreign stocks that are, however, traded on the New York or American Stock Exchanges, or NASDAQ. A number of large U.S. banks (mainly Bank of New York Mellon (NYSE:BK), JP Morgan Chase (NYSE:JPM) and Citigroup (NYSE:C)), will buy foreign shares, and then issue a corresponding number of these ADRs. Although the underlying shares are quoted in foreign currencies, the ADRs will carry a price that reflects the foreign quotation, multiplied by the prevailing exchange rate.

Higher level ADRs listed on the exchanges are more liquid, but they have to meet essentially the same SEC disclosure requirements as comparable U.S. companies. Because of the onerousness of Reg FD (Fair Disclosure), a number of large foreign companies, notably German, have elected to downgrade their listing to the "Pink Sheets," where the requirements aren't so stringent.

One reason for buying foreign stocks is that countries produce goods and services on the basis of what is known as "comparative advantage," based on labor, land, skill sets, etc. For instance, America is the world's innovator in technology, and therefore has a large concentration of companies that specialize in information, medical, financial, or other technologies. Other countries, with cheap labor or abundant raw materials, may concentrate more on various manufacturing endeavors.

For instance, the largest U.S. cement companies have been bought out in the past fifteen years by Mexico's Cemex (NYSE:CX) and France's Lafarge (OTCPK:LFRGY). The main way for an American to get exposure to the cement industry would be through Cemex, which has an ADR. (Lafarge does not, although it, and Swiss competitor Holcim (OTCPK:HCMLF), offer local shares in their respective countries.) Likewise, an American investor may want steel exposure, but be afraid to invest in U.S. concerns with high pension liabilities. Here, the ADRs of foreign companies like South Korea's Posco (NYSE:PKX), or Brazil's CSN might serve the purpose better.

Another reason for buying foreign stocks is to have the full range of choices within a global industry such as pharmaceuticals. Large American drug companies like Bristol Myers Squibb (NYSE:BMY), Eli Lilly (NYSE:LLY), Merck (NYSE:MRK), and Pfizer (NYSE:PFE) compete with similar European companies like Glaxo SmithKline (NYSE:GSK) of England (which bought the former SmithKline Beckham of America), Sanofi-Aventis (NYSE:SNY) of France, and Novartis (NYSE:NVS) of Switzerland. They may have similar mixes of sales, except that an American company might be 60% domestic and 40% foreign, while an European company might be 60% foreign and 40% American. In the example I constructed, the difference in sales mixes is only 20% between one company and another. Nonetheless, some stocks in the group will likely outperform at any given time.

A third reason to buy foreign stocks is to take advantage of macroeconomic factors, such as a stronger foreign currency (which lifts returns in U.S. dollars), or even a rapidly burgeoning economy (China, India, Brazil). Here, there are country baskets of ETFs, (Exchange Traded Funds) listed by Morgan Stanley and others that may be helpful.

All in all, there are a reasonable number of foreign alternatives to satisfy a variety of tastes. The menu of choices is likely to grow larger in the years ahead.

Disclosure: Long PFE