Now Is The Perfect Time To Diversify Internationally

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Includes: ACIU, BT, FM, IMO, IXUS, JCI, SFGIX, SIGIX, SSW, VTMGX, VXUS
by: Bottom Fisher Ideas
Summary

Research indicates that high price-to-earnings and price-to-book ratios of markets lead to lower ten-year returns on average and greater likelihood of drawdowns.

International markets are trading at a significant discount to US markets, indicating a higher probability of superior returns.

Even without taking valuation into consideration, most investors are underexposed to international equities and could benefit from more diversification.

Investment Thesis

While US markets are expensive by most metrics, international markets are fairly valued to undervalued. This increases the odds that international markets will outperform the US over the next ten years. Many investors are underexposed to international equities and should increase their exposure to lower risk and potentially increase returns.

Overview

If you are looking for prognostication about what will happen to US or international markets over the next week, month, or year, you've come to the wrong place. I don't know which market will perform the best over a short time period and anyone who claims they know is probably lying to you.

If you already have 1/2 of your equity allocation in international markets, then I'm probably not going to tell you anything that you don't already know. You are ahead of the game with a well-diversified portfolio.

If you are like the average US investor who only has 1/4 of their equity allocation in international investments and you have a ten-year investment horizon or longer, then read on. International markets are historically cheap compared to the US right now, and this means a greater chance that they will outperform over the next ten years. That makes it the perfect time to add more international diversification to your portfolio.

Lower Valuation, Higher Returns

Vanguard published research in 2012 that showed that historically, price-to-earnings ratios of the S&P 500 have proven to be one of the only meaningful indicators of long-term returns, explaining approximately 40% of future ten-year returns. They write that "valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns." I took my own look using Shiller's data on CAPE ratios of the S&P 500 and the inflation-adjusted returns of the index and found this to indeed be the case. While there is no guarantee that the current high valuation will result in lower returns or that this historical inverse relationship between valuation and returns will continue going forward, it does seem likelier than the argument that "this time is different."

Does this effect also hold for international markets? StarCapital published research in 2016 on the effects of both CAPE and price-to-book ratios on future ten-year returns of international markets. They conclude:

Existing research indicates that the cyclically adjusted Shiller CAPE has predicted long-term returns in the S&P 500 since 1881 fairly reliable for periods of more than 10 years. Furthermore, the results of this paper indicate that this was also the case for 16 other international equity markets in the period from 1979 to 2015, and in addition to this, CAPE also enabled equity market risks to be gauged. In this manner, low market valuations were not only followed by above average market returns but also lower drawdowns. On the contrary, high market valuations led to lower returns and faced higher market risks.

Somewhat lost in recent discussions of how expensive the US stock market has become is the fact that this overvaluation is not universal. International markets are significantly cheaper by most metrics.

Using publicly available data from Research Affiliates on CAPE ratios of different world markets for the past 12 years, I was surprised at the extent of the difference between US and international valuations.

The US market has traded at a small premium to the entire world over the past 12 years on average, and that premium is likely justified by strong corporate governance, rule of law, and economic factors. The US has had an average CAPE of 23.5 over the time period, which is a 17.5% premium to the entire world's average of 20.0. The most recent reading from July 2017, however, has the US with a CAPE of 29.9, which is 48% higher than the world's July reading of 20.2.

Meanwhile, Canada, EAFE (Europe, Australasia, and Far East), and EM (Emerging Markets) have CAPE ratios of 19.4, 16.1, and 13.4 as of July 2017. These readings represent 13%, 15%, and 32% discounts to their 12-year averages, respectively. While it is entirely possible that the low multiples of international markets and the high multiple of the US market will persist indefinitely, the data does not support this argument. Instead, the data suggests that markets with high valuations will have lower returns over the following ten years on average and a higher probability of losses.

CAPE is not the only metric by which international markets look undervalued compared to the US. According to data provided by MSCI on its indexes as of July 2017, traditional price-to-earnings and price-to-book ratios tell a similar story.

Trailing P/E Forward P/E Price/Book Value
MSCI USA 23.64 18.39 3.18
MSCI Canada 20.86 15.46 1.88
MSCI EAFE 19.07 14.81 1.67
MSCI Emerging Markets 15.45 12.53 1.73

Just as with CAPE, the US market has traditionally traded at a higher price-to-book multiple than have international markets. The long-term average price-to-book for the US since 1979 has been 2.5, so its current valuation of 3.18 represents a premium of over 25%. Canada, EAFE, and Emerging Markets, meanwhile, are trading at a slight discount to their long-term averages.

Greater Diversification, Lower Risk

Home bias is the tendency of investors to invest primarily in their own country. This tendency was famously documented in a journal article by Kenneth R. French and James M. Poterba titled "Investor Diversification and International Equity Markets" in 1991. At the time, the average US investor held 94% in US stocks, the average Japanese investor held 98% in Japanese stocks, and the average UK investor held 82% in UK stocks. There are many possible reasons for this tendency, including familiarity, national pride, and the perception that foreign investment is riskier than domestic investment. Many investing titans, such as Warren Buffett and Jack Bogle, have advocated for US-centric investing which further muddies the waters surrounding global diversification for some investors.

A more recent paper by Vanguard from 2014 indicates that US investors hold 73% of their equity allocation in US stocks. While this is progress compared to 1991, the average investor is still considerably underweight international stocks.

If we go by the figures of the MSCI ACWI All Cap Index, US equities make up 51.42% of the investable equity universe.

Other methods of calculating global market capitalization provide slightly different numbers. The World Bank's figures show that US markets make up only 42.19% of the world's market cap as of 2016, partly because it includes China's A-shares which have traditionally been out of reach for international investors.

Fear of the unknown and the different leads investors to think that foreign stocks are inherently more risky than familiar, domestic stocks. If one were to invest all of their money in emerging markets instead of US stocks, this might be the case. But nobody is recommending that. The argument is that investors who are underexposed to international stocks should increase their investment levels. Not only do non-US stocks currently look appealing from a value perspective, but their addition to a portfolio actually reduces risk.

The reduction of risk that comes from diversification is one of the tenets of modern portfolio theory, as championed by Harry Markowitz in his 1952 paper titled "Portfolio Selection." While some point to increasing correlations between markets, particularly in times of crisis, there is still ample reason to diversify internationally if you are a long-term investor. There is a particularly good article on the subject from 2011 titled "International Diversification Works (Eventually)". In it, they conclude:

Common, short-term crashes can be painful, but long-term returns are far more important to wealth creation and destruction. We showed that over the long term, markets do not tend to crash at the same time. This finding is no surprise because even though market panics can be important drivers of short-term returns, country specific economic performance dominates over the long term.

Overcoming home bias and improving international diversification is a worthy goal at any time, and it is especially important when value indicators favor international stocks.

Ease of Investing

25 years ago, an investor might have been forgiven for having little or no international diversification. Expenses were high on international mutual funds and there were fewer ADRs to choose from on US stock exchanges. Not so today. International investing has never been so easy.

For the stock picker, there is a wealth of ADRs from dozens of countries to invest in. Of the 12 individual stocks that I own, 5 of them have headquarters outside of the US: Seaspan Corporation (SSW), Imperial Oil (IMO), BT Group (BT), AC Immune (ACIU), and Johnson Controls International (JCI). If you expand your stock picking universe to include ADRs, there are plenty of value, growth, and dividend choices, whatever your preferred style of investing is.

The quickest and easiest means of gaining international exposure is through an ETF. Vanguard Total International Stock ETF (VXUS) and iShares Core MSCI Total International Stock ETF (IXUS) are the most complete ETFs for international stocks. They cover both developed and emerging markets and have low expenses of 0.11%.

Besides the 5 of 12 individual stocks that I own from outside of the US, I personally use a combination of the Vanguard Developed Market Index Fund (VTMGX), the Seafarer Overseas Growth and Income Fund (SFGIX) (SIGIX), and the iShares MSCI Frontier 100 Fund (FM) to round out my international equity exposure.

In my opinion, there is no one right answer for how to get international equities into your portfolio. The most important thing is making the decision to adequately diversify your portfolio.

Conclusion

International markets are cheap relative to US markets, making now the perfect time for an investor to increase international diversification. I've been increasing the share of international equities in my portfolio up to 50%, and I expect that it will produce superior returns at lower risk over the next ten years and beyond.

Disclosure: I am/we are long VTMGX, SIGIX, FM, SSW, IMO, BT, ACIU, JCI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.