International Equity Diversification Still Works

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Includes: ADRD, IOO, SPY
by: IndexUniverse

A quick search of the Internet reveals that not everyone thinks the debate over the virtues of international diversification has been settled in its favor. Although international diversification is touted by mainstream investment advisors and pundits as a key part of any standard portfolio, there is a segment of investors and experts who feel that, as large-cap stocks around the globe exhibit increasing correlation with each other, the need to include international stocks in a portfolio is diminishing. Some new data may add further fuel to the controversy.

A recent S&P news release highlighted that revenues from foreign sources among the companies of the S&P 500 in 2006 were up almost 37% from 2001 levels. And the numbers are pretty fascinating. The 238 companies in the S&P 500 providing full information represent nearly 54% of the index’s total market value and reported total sales of $4.20 trillion. Of that, $1.86 trillion, or 44.2%, was attributed to foreign sales. If anything, the data is simply another piece of information confirming the rise of globalization.

Not surprisingly, the sector with the largest percentage of foreign sales and the largest increase in foreign sales since 2001 was Energy. Nearly 56% of 2006 revenues were foreign sales, up from not even 11% in 2001. The Energy sector consists mainly of companies operating in the oil and natural gas industries. It makes sense that as other countries such as India and China experience further rapid industrialization, their demand for oil and natural gas would increase in kind.

Another sector that experienced a strong, though not nearly as dramatic, increase in foreign sales is Consumer Discretionary, at 40.2% in 2006, up from 29.1% in 2001. Once again, not terribly surprising: As industrializing nations see their per capita incomes increase, consumers have more to spend, creating opportunities for U.S.-based companies with products and services to sell.

Information Technology saw the smallest change in foreign sales since 2001, but has the second-highest amount, increasing from 51.8% to 55.2%. Presumably, the IT sector had seen its strongest international growth during the years of the tech bonanza and its most dramatic phases are behind it; the data indicates that perhaps information technology is nearing its maximum level of globalization.

“Despite the lack of full reporting information, the growing significance of international sales and profits among U.S. domiciled companies should not be overlooked as more U.S. companies are positioning themselves, via greater production abroad, to take advantage of the growth in the foreign middle class,” says S&P senior index analyst Howard Silverblatt. He attributes the growth of foreign sales at the S&P 500 companies to “the rapidly expanding foreign market for goods and services.”

But if domestic companies are seeing more than 40% of their sales coming from foreign sources and if the U.S. is experiencing increasing correlation with international markets, is it still necessary to invest in international stocks?

Given that S&P, the source of this latest data, recommended a 25% weighting in international stocks in a recent quarterly teleconference, it would seem so. In fact, in that same teleconference it was noted that international markets have outperformed the domestic market by significant margins since 2002 and were expected to continue outperforming, although at a moderating pace. So while markets are seeing increasing correlation, they are by no means moving in tandem. An investor dismissing the value of an internationally diversified portfolio would be missing out on roughly five years of outperformance—and possibly more, should the trend continue as expected.

Moreover, although globalization shows no signs of slowing down, it seems unlikely that it will ever eradicate the need for international diversification in a stock portfolio. Individual countries—including the U.S., as recent years have proven—will always be subject to fluctuations in their economy spurred by events and developments in such areas as politics, the law, international relations and technology. Even natural disasters can have an impact on financial markets. Although companies’ operations may be more diversified than ever before, it does not mean that investors will see the same diversification should they invest only in domestically based multinational companies.

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