Market Intelligence

Stampede to the International Market

Friday, June 27, 2014

Stampede to the International Market

By Edward Friedman, Senior Research Analyst

The global stock markets over the past several years have exhibited a high degree of volatility and disparate returns. Research indicates that most investors are demonstrating a ‘home bias’, a preference to own domestic stocks and specifically stocks of well-known companies. This recent volatility of returns begs the question as to whether international investing carries any benefits as opposed to a purely domestic portfolio.

The benefits of investment diversification, especially international diversification, has been documented since the early 20th century. In this Market Intelligence, we are presenting why we believe that international investing should be an integral part of a well diversified portfolio.

One of the most important facets of an investment portfolio is the management of risk. There are two types of risk:

• Systemic risk - Risk that relates to the entire financial system. A good example is the financial crisis that was precipitated by the US housing market.
• Specific risk - A risk related to a specific company.

Systemic risk cannot be easily hedged though it can be reduced by asset allocation (bonds or equities and international equities). Specific risk can easily be hedged by diversification whether between industries or between other companies in the same industry.

The main method to achieve portfolio diversification and thus reduce risk is to acquire securities that have relatively low correlation with each other and within other assets in the portfolio. Correlation between securities is a statistical metric that measures how two assets move in relation to each other. Correlation ranges between +1 and -1, with +1 being the most positively correlated and -1 being the most negatively correlated. By purchasing securities that have lower correlations, the risk of the portfolio is reduced as when one asset experiences lower or negative returns the other asset mitigates this effect.

Research indicates that the correlation between the TSX index and various international markets is fairly low. The correlation between the TSX and the S&P 500 is relatively high, as would be expected. However, the correlation with other markets is substantially lower. In addition, correlations are not constant and change over time.

Figure 1 depicts the correlation between the TSX index, the German DAX, and the Japanese Nikkei 225.It can be seen that the correlation between the TSX and the S&P 500 is 0.7, between the TSX and the DAX it is 0.5 and with the Nikkei 225 it is almost 0. Nonetheless, these correlations were not constant.

Figure 1: Correlations between the TSX index, the DAX, and the Nikkei 225

Source: Bloomberg, M&P Research

Another aspect of risk reduction is to reduce the volatility of a portfolio. Volatility measures the magnitude an asset or a portfolio moves around its average. Higher volatility indicates that the asset moves around its average more wildly than an asset with lower volatility. In general, equities have higher volatility than bonds and emerging markets have higher volatility than developed market equities.

In theory, a diversified portfolio should have a lower volatility than a portfolio with only one security or only one market. The following simulation clearly shows that low correlation between assets and international diversification reduces the volatility,
in addition to the risk of such a portfolio. In the simulation, we constructed a global portfolio with 0% allocation to North American equities and the volatility over three years of that portfolio was 13% while the volatility of its components varied between 14% and 25%. A portfolio that had 40% exposure to North American equities had volatility of 11% while its components’ volatility varied between 12.5% and 25%.

We believe that international diversification is especially important for Canadian investors. Due to the structure of the Canadian economy, the largest sectors within the TSX index are financials and energy which collectively make up 60% of the benchmark. The All Country World Index ex US (ACWI ex US) index, a global benchmark with only one large weight of 27% (Figure 2). Other benchmarks like the Nikkei or the DAX, for example, have higher weights in industrial companies, while other indices have more even distributions, depending on the structure of that local economy.

Figure 2: Composition of benchmarks by industry

  TSX  ACWI ex US Nikkei  S&P 500   S&P Euro 350
Consumer Discretionary 5.5 10.5 21.4 12 10.1
Consumer Staples 2.7 9.9 7.7 9.7 13.2
Energy 26.9 9.4 0.6 10.6 9.6
Financials 33.9 26.8 7.2 16 21.9
Health Care 2.8 8.3 8.5 13 13.3
Industrials 8 10.9 23.4 10.8 11.1
Information Technology 1.7 6.8 13.7 19 3.3
Materials 11.9 8.6 7.4 3.5 8.1
Telecoms 4.7 5.4 9.7 2.4 4.8
Utilities 1.9 3.4 0.4 3 4.6
Total 100 100 100 100 100

Source: Bloomberg, M&P Research

Very high concentration in a few industries may result in significant underperformance of a local stock market when these industries suffer. As seen in Figure 3, the Canadian stock market underperformed that of the US between 2011 and 2013 by 40% due to the high energy concentration in the TSX index.

Figure 3: Performance of the S&P 500 versus the TSX 2011-2013

Source: Bloomberg, M&P Research

International investing allows for taking advantage of the valuation and growth rate differences between countries and industries. Figure 4 presents P/E valuations for the major markets in the world and expected earnings growth. Even though the valuation gap between the US and Europe has narrowed in the last few years, corporate earnings growth expectations in Europe are higher than in the US (13.8% in Europe compared to 11.2% in the US) and we believe that growth expectations in Europe are relatively low due to the psychological effect of the recent sovereign debt crisis.

Figure 4: P/E and 1 year earnings growth rates

Source: Bloomberg, M&P Research

As international investors, we have been taking advantage of opportunities that were not available to investors that were only allocating capital locally.

For example, European banks have suffered tremendous losses due to asset depreciation and capital requirements due to the European sovereign debt crisis. Much like in the US, we believed that the European Central Bank (ECB) would intervene and sever the negative connection between the sovereigns and their banks. When the ECB intervened, we initiated positions in the major French and Italian banks; the banks that suffered the most but were still solvent. Since our purchase two years ago, BNP shares are up 95%, Intesa Sanpaolo up 143%, while TD’s shares increased by only 47%, all in Canadian dollars and including dividends.

Europe is well known for its luxury brands. Well renowned companies like Louis Vuitton, Richemont, and Daimler are not available to Canadian investors who invest only locally. Over the last three years, these three stocks returned between 30% to 82% compared to the 22% return of the TSX index, all in Canadian dollars. Recently, we purchased the shares of Prada and Remy Cointreau, leading brands in the fashion and leather and the cognac segments, respectively. These companies suffered due to concerns around their operations. However, after close examination and implementation of our investment process, we came to the conclusion that these are very high quality companies and we believe that all the bad news is already fully reflected in their share prices. Even though the US has some of the most prominent technology with names like Google, Facebook, Qualcomm, and Cisco; Europe and Asia have just as equally important and prominent technology names like ASML, Infineon, Gemalto, Samsung, Baidu, and Tencent, all up substantially and some in excess of 100% in the last three years.

In conclusion, we believe that international exposure should be a part of every well diversified portfolio. For Canadian investors who are confined to purchasing mostly energy and bank stocks, gaining exposure to various other industries and well renowned companies internationally can help enhance for international funds, is more evenly weighted portfolio performance while at the same time reducing the portfolio’s risk. We will continue looking for opportunities in international markets while implementing our strict investment process which calls for investing in high quality, preferably dividend paying stocks of undervalued companies.

To learn more about how you can diversify your portfolio with international investments, contact us at (403) 234 - 0005 or solutions@mcleanpartners.com.




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