From the December 2006 issue of Wealth Manager Web • Subscribe!

Bric Building

In the late 1970s, retired London money manager Manfred Adami recalls, he would spend hours visiting U.S. pension fund managers, trying to convince them that they should put 5 percent of their assets into foreign equities. Adami, 65, says he remembers feeling even then that having to make a presentation on the virtues of international investing was silly. After all, most of the big U.S. multinationals were already making more money overseas than they were at home. "The Americans used to be very parochial in their investment approach," says the former Warburg wizard. Today, most investors--including Americans--have finally caught up with Adami. "This is now an approach which prevails almost everywhere people have a brain," Adami says.

And Adami is not spouting hyperbole. The Dow Jones Industrial Average may be breaking records, but investors in the U.S. aren't paying much attention. Most of the net inflows to mutual funds this year have been in international funds. From the beginning of 2005 through August 2006, international funds gained $104.8 billion, according to the Investment Company Institute, a mutual fund trade group. Domestic funds gained less than half that amount--$46.42 billion over the same period, according to ICI statistics.

Many investors, of course, are hoping for a replay of the double-digit returns investors in foreign stocks have seen during the past three years. But are they too late? One money manager thinks so. "I think in terms of the outlook for 2007 it is reasonable, but probably not phenomenal. I don't think there is any real doubt that earnings per share growth internationally in 2007 is likely to be at a slower pace than it's been for the last three years," says Dominic Freud, manager of the Oppenheimer Quest International Value Fund in New York.

Other managers agree that it's important to think about the long term, particularly where some of the faster-growing foreign economies are concerned. Maria Gordon, a portfolio manager for the Goldman Sachs BRIC Funds in London, says that it's important to take the long view when investing in Brazil, Russia, India and China--the four new economic giants that Goldman christened the "BRIC" group a few years ago--creating, perhaps, the best investment marketing phrase since "emerging markets."

"The BRIC theme...is really a 30-year investment theme, and it's an investment theme in globalization and in changes in the geography of corporate profits and also the changing demographics of the world," Gordon says.

The case for buying un-American

Although the performance of some emerging markets is still enough to quicken the pulse--the BRIC markets as a group were up 28 percent for the year as of early October--there are also a number of cool-headed reasons for investing abroad, money managers and economists agree. Even if returns next year are nothing to write home about, they say that diversifying overseas is still the smart thing to do. And some managers say that for those who look hard enough, there are places where it's possible to find good companies at good prices.

Perhaps the most sensible reason to invest overseas is diversification. As Meir Statman, a professor of finance at Santa Clara University in California puts it, individual investors tend to look at their foreign allocations as "kind of the spice of the portfolio." But in reality, he says, they need to look at those investments as an opportunity to become more diversified.

Make that much more diversified! The U.S. may still be an economic superpower, but it's not so lonely at the top anymore, according to International Monetary Fund statistics. In fact, IMF now ranks the European Union as the largest economy in the world, with a GDP of $12.4 trillion (in terms of purchasing power parity), $200 billion more than the U.S. China is the third largest economy in the world (in terms of purchasing power parity), with a GDP of $9.4 trillion, followed directly by Japan ($3.9 trillion) and India ($3.6 trillion).

Activity in the world's stock markets reflects these changes, too. To take just one example: In 2005, three-quarters of all initial public offerings--and three-quarters of the capital raised by those IPOs--came from companies outside the U.S., according to a recent survey by Ernst & Young. Of the 1,537 public offerings in 2005, 631 were in Asia, 349 in Europe and 285 in North America. In terms of cash raised, again North America was only the third most active region for IPOs after Europe and Asia. And of the 24 billion-dollar-plus deals that reached the floor in 2005, only one was floated in the U.S.

How to get there

Basically, investing overseas is just like investing at home--only more so: Depending on the country, choosing the right investments can demand more research, more due diligence and in general, just more work.

The easy way to do it is through one of the growing numbers of global ETFs and other passive investment vehicles such as Vanguard's global index funds. At the moment, passivity doesn't seem to be a bad way to go: The Morgan Stanley ex-US Global Index is up 13 percent through the beginning of October--at least 200 basis points higher than any of the other world ex- indices such as ex-Australia, ex-Europe and ex-UK.

Mutual funds and separately managed accounts are the next easiest approach, though even here decisions need to be made about where in the world your client's money should go on any given day.

One quick test that Oppenheimer's Freud uses to assess the value of a foreign stock is to look at the spread between [local] government bonds and the price/earnings ratio of the stock market. The stock of some Turkish companies may look cheap, for example, but the fact that Turkish government bonds return 20 percent "makes for a heck of a hurdle," he says.

The equity-bond yield ratio is not foolproof, he warns, particularly in an accelerating economy, but looking at yields that way tends to be a good yardstick for understanding local values.

"Historically, if you look at Europe and the U.S., that bond yield/equity yield relationship is a very good indicator about broadly what asset class you ought to have been in," he says. "That would have told you for instance that in Japan in 1990, when the Japanese market peaked, you had an overwhelming signal to be in bonds rather than equities. At that point, the yield on Japanese bonds ranged up to 7 percent, and the equity market was selling on 100-times earnings, a 1 percent earnings yield versus a 6 percent or 7 percent bond--a ratio of 6-7:1,," he says.

Today, Freud continues, the situation has reversed. "The cheapest market on that basis is Japan, because obviously the denominator is so low, with interest rates at three-quarters of a percent at the short end of the curve and one and three-quarters at the long end of the curve. If you can get a 6 to 7 percent earnings yield on stocks, that's obviously dramatically higher than the kind of yield you'll see on bonds," he adds.

Keep an open mind

Another necessity, whether picking stocks or funds, is keeping an open mind. One theme that investors in foreign markets frequently mention is the profitable lag they find between the image of the country and its reality. Often, memories of earlier macro-economic difficulties stay priced into a market's stocks long after the event is over, according to Andrew McMenigall, a portfolio manager for global equities at the Aberdeen Group in Edinburgh, Scotland.

As a result, companies in some emerging markets continue to trade at a discount, say McMenigall and others, even when the economic risks investors had originally priced into the stock's value are long gone. For example, he says, in present-day Russia, "You're looking at significantly growing budget surpluses. It's the opposite but equal situation that the U.S. finds itself in," he says.

John Connor Jr. has landed at the very top of Barron's/Value Line's list of 100 top fund managers in 2003 and 2006 precisely because this perception of Russia as a shaky country has endured. The fact is, the situation is very different today, according to Connor. "The ruble risk is nil at this point because they have the third largest reserves in the world after Japan and China," says Connor, manager of the Third Millennium Fund which has returned a load-adjusted 38 percent average annual return for the last five years.

Other misconceptions exist as well. Russian companies are less dependent on oil prices than is generally believed--in fact, non-energy companies are growing faster than energy companies, Connor says. "People think of Russia as an energy play, but for years I outperformed with telecoms, fertilizer, steel, and had a pretty light energy component in the portfolio," he says.

Even the energy companies themselves are not as dependent on high prices as might be expected, since the government taxes away 90 percent of oil revenues above $25 a barrel, according to Connor.

While many informed investors still see political risks in Russia, Connor believes they are overrated and largely the function of a lack of the kind of domestic lobby in the U.S. that's coalesced around China, for example.

Of course, misconceptions are in the eye of the beholder. James Moffett, the lead manager of the UMB Scout WorldWide Fund, runs a top-performing foreign equity fund. Among the emerging markets, he likes Brazil, but shies away from both Russia and China out of concerns about political risk and investment transparency. "We run a relatively conservative fund, and we just have a real skepticism about those places as investments," he says.

Of course, countries that have problems aren't necessarily without opportunities. Venezuelan stocks are performing well now, says Adami, despite President Hugo Chavez's speeches against the U.S. and globalization. In Zimbabwe, a country with tremendous political problems of late, he says, "the market has done reasonably well." But those kinds of investments are best left to specialists, he adds.

Use your local knowledge

As with any kind of investment, local knowledge can be helpful. "My nationality is German, and so I know the German market," says Adami, who invests primarily in a concentrated portfolio of individual stocks and a few hedge funds. ("That's my way," he says. "Keep it simple, stupid.") He likes Allianz, the German insurance company, Munich Re, and also a variety of Swiss companies. "It's an astonishing country, given its size and six million population," he says.

Scott Hood, a portfolio manager at First Wilshire, a top-ranked small-cap-value boutique based in Pasadena, Calif., also tries to use his personal knowledge when it comes to foreign investing. Hood, who spent a few years in Hong Kong, says that First Wilshire includes a small percentage of small Chinese companies in its portfolios, mostly companies that are traded on American exchanges. Although that helps due diligence to some degree, the team supplements that by going to China every year. His team is still finding good companies, he says--in general, the quality of the small cap in China is better than it once was--but now they have to look harder for them.

As Hood has observed in his Chinese travels, investing abroad is changing, in part because there are so many more investors out looking. Others have seen this, too. A number of economists have noted that increasingly, the markets are moving more and more in sync as they become more closely aligned. "The path to U.S. investing overseas is quite a well-trodden one," says McMenigall.

But Moffett of UMB Scout, isn't worried about that development. "Just because there's a correlation... it doesn't mean they go up and down the same amount," he says.

Still, Freud points out that at least as far as mega-caps are concerned, most companies are global almost by definition. "Think about the oil sector," he says. "The three biggest oil companies in the world are Exxon Mobile, BP Amoco, and Royal Dutch Shell," he says. "If you look at those three companies, you'd be very hard pressed to tell which was American, which was Anglo-Dutch, and which was British. Essentially they're the same company in terms of their geographic profile. It just happens that the headquarters of BP Amoco are in London and Royal Dutch Shell's are in Holland and in the UK, and ExxonMobil are in Irving, Texas."

In time, the whole idea of investing by country may be pass?.

Fear of Flying

Many clients may still be worried about sending their money overseas. Here are some common excuses for not buying abroad, and what some economists and international money managers say in rebuttal.

"I don't need to invest abroad--the big American companies are already there."

"It's an incredibly stupid argument," says Dominic Freud of Oppenheimer. "What you're essentially saying is, I want to limit myself to investing in companies that are domiciled in X....." Imagine, he says, "If X was New Jersey: 'I'm only going to invest in companies domiciled in New Jersey?' Does that sound like a rational way to invest?"

"The markets are getting more and more correlated, so what's the point?"

"No, no, no, that's bunk," says Meir Statman, Santa Clara (Calif.) University. professor of finance The world's markets are more correlated than they were in the past, he explains, but they're still not completely correlated, and 80 percent correlation translates into a difference in returns of plus or minus 4 percent to 6 percent--not the 50 basis points or so that people sometimes believe.

Another economist agrees with Statman. While the fact that the major markets are becoming more correlated does lower the value of diversification, that disadvantage is partially offset because there are more assets to diversify across, according to Geert Rouwenhorst, a professor of finance at the Yale School of Management. "Sometimes it seems like a race between the correlations going up and the investment opportunities expanding," Rouwenhorst says.

"I just feel safer with an American company."

That sense of safety is kind of an illusion, experts agree. In objective terms, diversifying around the world is much safer than leaving your investments only at home--for the same reasons you don't want to put all of your 401(k) in your company's stock, according to Freud.

Consider what would have happened to a Japanese investor who had stayed invested in Japan when its long, 16-year recession hit, Freud says. He could still well be down 60 percent today. On the other hand, someone who had diversified half his assets in the U.S. would be ahead by 120 percent.

"If you are an American investor, before you put your first dollar into stocks, you are very heavily invested in the U.S.," Freud adds. "Your primary asset, your house, is located where? In the U.S. Therefore the value of that investment or asset is a function of the U.S. economy. The other huge asset that you have is your job, and if you work in the U.S., then the value of your job is also a function of the U.S. economy," says Freud.--BV

Bennett Voyles is a New York-based freelancer who wrote about gas prices in the September issue of Wealth Manager.

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