By Matthew McKee, CFA, CFP®
October 1, 2023
Last weekend my wife and I spent a rainy afternoon wallpapering our son’s new bedroom. Out of the many house projects we’ve undertaken over the last two months, this one was the most rewarding.
When James returned from Mimi and Pops house, he crawled up to the wall in wonder and amazement, an amazement only second to his mother’s – such little faith in me!
As he grows, I hope it helps him pick up some geography knowledge, and sparks curiosity about the countries and cultures that lie beyond our borders.
When I finished hanging it and took a step back, I thought about the vast ocean of investment opportunities in our global economy.
International stocks broaden the opportunity set
The United States is a shining example of the benefits of what a free economy, strong legal system, and culture of innovation can accomplish. With about 340 million people – just 4% of the world’s population, it is the home of more than 60% of the world’s investable market.1
The other 40% is a diverse investable universe that ranges from developed countries like Japan, the United Kingdom, and Canada, to emerging markets like China, India, and Brazil.
We’ve found many investors ignore this opportunity set. Consider Nestle, a company based in Switzerland that has you consuming far more of its products than you might realize. (I personally contribute far more than my fair share in Kit Kat sales.) To get me through the second half of writing this newsletter, am about to make another Nespresso. They also own Purina pet food, Lean Cuisine, Perrier, Gerber, and several dozen other brands.
Or how about Toyota, the second largest auto manufacturer? Or technology companies like Samsung, and healthcare companies like AstraZeneca and Novartis? Do global juggernaut luxury brands deserve a place in your portfolio – like LVMH, the parent company for, among others, Louis Vuitton, Tag Heuer, Moet & Chandon, and Glenmorangie?
International stocks have growth potential
Besides the larger opportunity set, there’s the opportunity for growth as emerging markets become developed markets and for other developed markets continue to grow.
There are more than 1.4 billion people in China, and nearly the same in India, making those two countries home to more than one third of the world’s population. While we are cognizant of the risks associated with emerging markets, the potential for economic growth if 2.8 billion people move from poverty to the middle class is enormous. As these countries move more toward free capitalistic societies, that’s 2.8 billion people innovating, putting their human and financial capital to work, making and buying “stuff.”
Japan is the largest developed nation outside of the US, one that has been mired of stagflation and a declining population since its remarkable growth in the 80s. Abenomics has been successful in many ways and Japan has witnessed a robust 11.6% stock market growth this year.2
And there are many developed countries that are facing obstacles but are priced accordingly – countries like Spain or Italy, if they could get their financial house in order, could potentially see their markets quickly appreciate off low valuation levels.
There are regime changes throughout history and yesterday’s laggard can be tomorrow’s leader. The key is to size and source these allocations thoughtfully.
The right exposure.
We beat the drum on diversification often. But we repeat it because it is a fundamental principle – it is the only free lunch in investing.
Our role as wealth advisors is to size, source, and allocate among these various opportunity sets in a way that maximizes our clients’ risk-adjusted return potential in their portfolios.
US and international stocks tend to outperform and underperform each other in cycles. After a period of decisive US outperformance, we believe it’s likely that we could enter a cycle of international supremacy in stock returns.
International stocks have trounced U.S. over the last year. But there was a long period before that where they underperformed. But the truth is, diversification works even when it feels like it doesn’t.
This is how we do it
Our investment process guides us to1.benchmark, 2. budget, 3. invest, and 4. monitor.
The first step is to determine what benchmark we are measuring ourselves against. Target Rock’s equity benchmarks contain 30% international stocks. This is slightly less than the global investable universe of around 40% to account for a “home country bias” that our US clients tend to exhibit. This bias has some rationality to it because of currency risk.
The budget step is how we express our views. Where and how are we are going to deviate from the benchmark in terms of exposure, risk and return? For instance, we are slightly overweight international versus our benchmark, mainly due to more attractive valuations, but we don’t want to spend all of our “risk budget” taking on currency risk, which affects what we do in the next step.
When we invest, we are selecting how we will express those views within the portfolio. We use a currency-hedged international stock ETF for a portion of our exposure. Our baseline is to hedge out around half the risk. We did peel this hedge back slightly earlier this year, following the dollar’s strong rally in 2022.
Lastly, we continue to monitor our positioning and repeat the process regularly. We are wrapping up our quarterly investment positioning review, with rebalancing coming in early October. Stay tuned for our review of Q3 and changes to allocations in late October.
If you’d like to discuss your portfolio or any changes to your financial circumstances that may be relevant, please schedule some time to talk.