Global Investing: Easy As (American) Pie

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 |  Includes: CTSH, EEB, EEM, EFA, EWZ, FXI, NIHD, PGJ, SPY, VWO
by: Nicholas Vardy, CFA

Last year marked the second year running that U.S. investors embraced global stocks. Trading in American depositary receipts [ADRs], or U.S.-listed shares of foreign firms, reached record levels. Seven of the 10 best performing large-cap stocks in the U.S. last year were ADRs -- including Italy's Fiat and Global Bull Market Alert pick China Life (NYSE:LFC). So it's no surprise that U.S. investors have swarmed into global markets in record numbers. Net U.S. buys of foreign stocks jumped 64% in 2005 to a record $136.7 billion. And the pace has only accelerated, with U.S. investors putting $39.1 billion to work in foreign markets in November 2006 alone.

Investing in Global Stocks: Dipping Your Toe

The easiest way to invest in foreign stocks is through the iShares MSCI EAFE Index Fund ETF (NYSEARCA:EFA). This approach gives you exposure to a massive 1,000 stocks in foreign markets, including 20% in Japan -- a favorite market of pundits for 2007. The iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM) tracks fast-growth emerging markets. Over the past two years, investors in EFA have doubled the returns of the S&P 500. But the very best performers since early 2003 have been stocks in fast-emerging global giants like the BRICs (NYSEARCA:EEB) -- Brazil, Russia, India and China. Investors willing to endure the sometimes vertigo-inducing volatility of these red hot markets have been aptly rewarded and have tripled the returns of the S&P 500 over the same period.

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You sometimes hear that the best way to tap into international stock markets is to plunk dollars into shares of U.S. companies that have extensive operations overseas. On first blush, this strategy makes sense. After all, non-financial companies in the S&P 500-stock index generate about 40% of their revenue outside the U.S. So an ETF that tracks the S&P 500 (NYSEARCA:SPY) provides you with all the foreign exposure you'll ever need.

But that argument is bunk. The returns of the S&P 500 already include the benefits of U.S. companies' exposure to foreign markets. Companies in the S&P would have done even worse without operations in fast-growth foreign markets. To benefit from diversification and higher returns, you need to invest in foreign markets directly. Buying Coca Cola doesn't cut it. There are a handful of exceptions: U.S. companies that have all their operations in their foreign target markets, such as Cognizant Technologies (NASDAQ:CTSH) or NII Holdings (NASDAQ:NIHD).

The verdict is clear. Investors who stuck to tried and true U.S. stocks have done much worse than those who wandered outside U.S. borders.

Investing in Global Stocks: Easy as (American) Pie

Owning foreign stocks has never been easier thanks to American Depositary Receipts [ADRs]. These are securities that trade on U.S. exchanges and represent ownership in shares of foreign companies. ADRs are quoted in U.S. dollars and pay dividends in U.S. dollars. You can buy and sell ADRs just like you can buy and sell Microsoft or GM. And in most cases, you pay a maximum 15% tax rate on the dividends of the companies -- far less than what you'd pay than if you owned them directly.

A deeper pool of foreign stocks exists in the pink sheets or over-the-counter [OTC] markets. Pink sheet stocks look and function the same as a normal ADR, but aren't listed in New York. Indeed, dipping into pink sheets almost triples your investment opportunities. There are 489 U.S. exchange-listed ADRs and 899 are traded on the pink sheets.

Pink sheets have a bad rap among U.S. investors. But foreign companies who seek to list on the pink sheets are different. They include some of the top global blue chips, such as Nestle, Heineken, and Volkswagen. So why don't these companies list in New York? They are simply put off by costly and complicated Sarbanes-Oxley Act legislation. Sadly, this has resulted in more and more foreign corporations exiting the listed U.S. markets. Vivendi Universal SA recently became the latest victim of Sarbanes-Oxley.

This is not to understate the risks involved with buying shares that aren't listed on a major exchange. Few pink sheet stocks are global brands like Nestle. And even fewer provide as much financial disclosure. Liquidity can also be a problem. It's often easier to buy, than it is to sell -- particularly during market hiccups. And the spread -- the difference between bid and ask price -- can be yawning. And often, you will not be able to place these trades online. Not all brokers can deal with pink sheet stocks and you will often pay higher commissions.

Investing in Global Stocks: Outlook for 2007

Foreign markets will continue to outperform the U.S. in 2007. There will always be a handful of markets where you can double your money in 12 months. Measured by prices relative to company cash flow, international stocks are about 20% less expensive than U.S. shares. Growth in Europe has picked up and Japan's economic recovery means earnings growth of between 10% and 12%. And the much heralded weakness for the greenback is bullish for U.S. investors who invest in foreign stocks.

The decline of the dollar increases the value of foreign-denominated securities to U.S. investors. Just about half the 30%+ gains in European stocks last year was due to the Euro's appreciation against the dollar. One market to be wary of is China. Although it may again be the fastest-growing economy on the planet, the mania in Chinese stocks is flashing red. Financial manias -- whether in biotech, Russia, the Internet -- often end with cover stories in Time Magazine and drops of 50% to 90%. Make sure you get a chair before the music stops.