If you feel like international equities in your portfolio aren’t holding up their end of the bargain, then you’re not alone. It’s one of the most common concerns we hear today. And the global landscape remains as uncertain as ever. A trade war with Chinaslowing global growth and Brexit are just a few sources of uncertainty. After a decade of dominance by U.S. stocks, you might be wondering: Why bother investing outside the U.S.?

There have always been reasons not to invest in international stocks. And this guide is not a prediction that markets are set to rise in the near term. But for long-term investors, we believe international equities hold great promise, and there are many reasons to stay invested. International investing has changed dramatically in recent years, but one thing that has not changed is its rightful place in a well-diversified portfolio.

This guide will cover 10 things you need to know to help navigate the challenging investing environment outside the U.S: 

 

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Think all the best stocks are in the U.S.? Think again.

International equities have trailed U.S. markets over the past 10 years, but the index-based returns that most investors follow don’t tell the whole story. On a company-by-company basis, the picture is quite different. In fact, it may come as a surprise that the companies with the best annual returns each year have been mostly based outside of the United States.

How have U.S. markets done so much better while a higher percentage of the top stocks each year are non-U.S. companies?

  • Many more companies are located outside the U.S. than in it. While this may seem obvious, it is an important point. As an investor, why would you limit where you invest based on geography?
  • Indexes do not necessarily represent the best growth opportunities, especially outside the U.S. Fundamental research of individual companies is often a better way to uncover attractive investments.

We’ll explore both ideas in greater detail, but first let’s dig into how non-U.S. markets have changed in recent years, and why investors need to rethink their approach to international investing.

Bar chart showing what percentage of the top 50 stocks each year in the MSCI ACWI Index have been located outside of the U.S. for each year since 2010. The average of these years has been 74%, including in 2019 when it has been 80% through 8/31/19. The bar chart includes a table showing annual returns of the S&P 500 and the MSCI ACWI ex USA. The U.S. index had higher overall returns than the non-U.S. index in eight out of 10 years. Sources: RIMES, MSCI. 2019 as of 8/31/19. Returns in U.S. dollars. S&P 500 and MSCI ACWI ex USA used for U.S. and non-U.S. returns

 

4 ways international investing has changed

 

1. Correlation between global stocks has risen

In some ways, international investing used to be much easier — as simple as dividing your stock portfolio into two buckets, U.S. and non-U.S. The result? Instant diversification. But not anymore. The easy button is gone.

That’s because the correlation between U.S. and non-U.S. markets has more than doubled over the last 25 years.

But why have correlations risen so much? Globalization is partially responsible. Without overlooking the impact of escalating trade tensions in recent years, companies and countries are more integrated than ever. As companies have become more global, the lines between U.S. and non-U.S. indexes have started to blur, and correlations between the two have risen. This reduces the diversification benefits of blindly allocating to both areas. As we’ll see, a focus on companies rather than broad indexes can help overcome this trend.

Line chart showing rolling five-year correlation between U.S. and non-U.S. equities. From 1974 through 1996 the average five-year rolling correlation was 0.51. From 1997 through August 31, 2019 the average five-year correlation was 0.85. Sources: Capital Group, MSCI, Standard & Poor’s. S&P 500 Index and MSCI World Index ex USA used to represent U.S. and non-U.S. equities, respectively. Includes all five-year rolling periods ending between 12/31/74 and 8/31/19.

2. Revenue has become more important than real estate

If real estate is all about “location, location, location,” investing may be all about “revenue, revenue, revenue.” As the shift toward globalization continues, the address of a company’s headquarters has become less important to its growth prospects than where it makes money.

Consider that a company’s products are often made with parts manufactured in several countries and then sold to customers around the world. This rise of multinational companies means investors should re-evaluate how they think about global stocks. Instead of where a company is based, look at where it earns its revenue.

For example, the 10 largest companies in Europe generate less than a third of their revenue from their home region. Political strife or an economic slowdown can still hinder European stocks, but will affect every business differently. A careful examination of revenue exposure can help identify companies that are less likely to be disturbed by macro headwinds.

The bottom line? Follow the money, not the mail.

This horizontal bar chart shows the revenue exposure of the 10 largest companies in the MSCI Europe Index, divided into four regions — Europe, emerging markets, North America and Asia-Pacific. The top bar of the chart shows the average of the 10 companies in each of those regions. The average exposure was 30% to Europe, 31% to emerging markets, 29% to North America and 10% to Asia-Pacific. The exposures of the individual company bars are not labeled but indicate a generally diversified exposure to the four regions. The companies listed are Nestlé, Royal Dutch Shell, Novartis, Roche, HSBC, BP, Total, SAP, AstraZeneca and LVMH. Sources: Capital Group, FactSet, MSCI. Average shown is the market capitalization-weighted average of the 10 largest companies in the MSCI Europe Index as of 8/31/19. Country revenue exposure is as of 12/31/18.

3. Company fundamentals have become more significant

With company locations becoming less significant and correlations on the rise, where should investors look for returns? It comes down to company fundamentals.

A study by Empirical Research Partners shows that in 1992 most of an emerging market company’s return could be explained by its sector or region, and only 36% was accounted for by the business itself. That was at a time when investing in emerging markets (EM) was a relatively new concept, and the macro environment drove returns. In many portfolios they were grouped together as a basket of higher growth but riskier assets.

Today that relationship has flipped. As EM companies have become more established on the global stage, 64% of their stock returns can be explained by company fundamentals. This is the same proportion found in developed markets. So no matter where you invest, company fundamentals matter most.

Sector and country-specific issues will still influence business profits, but the best companies are often led by strong management teams able to overcome external factors. This is where bottom-up research becomes essential — and can be the difference between investing in a company that succumbs to macro headwinds, or one that becomes the next big growth story.

Stacked area chart shows what percentage of emerging markets’ returns can be attributed to each of the three factors: 1) region and country, 2) sector and industry, and 3) company-specific factors. At the start of the chart in 1992, 36% of the return can be attributed to company specific factors. This value increases over time, finishing at 64% in August 2019. Source: Empirical Research Partners. As of 8/31/19. Data shows the percentage of emerging markets’ returns that can be attributed to various factors over time, using a two-year smoothed average.

4. High-growth sectors are a smaller component of non-U.S. indexes

There are many reasons for lackluster non-U.S. returns over the last decade: a strong U.S. dollar, political turmoil and trade tariffs — just to name a few. But another factor is the way in which we typically measure international markets.

International indexes generally have a greater concentration of value-oriented stocks in “old economy” sectors such as materials, financials and energy. Contrast that with the U.S., where technology, health care and consumer tech dominate local indexes. That alone accounts for much of the decade-long return disparity between U.S. and non-U.S. stocks.

That’s not to say that growth can’t be found in international markets. It just requires more work to uncover promising companies that may be hidden within indexes. And that’s where company-by-company analysis becomes so critical. The average stock in Europe may be growing slower than one in the U.S., but growth can still be found by those who look past index averages and examine each opportunity based on its individual characteristics.

Stacked horizontal bar chart with one row for each sector within the MSCI ACWI Index. Each bar is divided into two sections to show the sector’s market value in either non-U.S. stocks or U.S. stocks as a percentage of the total market value of the sector. In order from highest non-U.S. exposure to least are the following: materials (76%), financials (68%), energy (67%), consumer staples (63%), utilities (60%), industrials (59%), consumer discretionary (57%), real estate (57%), communication services (47%), health care (40%) and information technology (30%). Sources: MSCI, RIMES. As of 8/31/19.

 

3 reasons to consider international today

 

1. Many market leaders are located outside the U.S.

If you were going fishing, would you limit yourself to half the lake, or would you want to seek opportunities wherever they were available? Investing shouldn’t be any different. One of the greatest benefits of global investing is that it allows you to consider the world’s best companies, no matter where they are located.

In certain sectors, European companies are among the world’s most dominant players, including large pharmaceutical companies Novartis, AstraZeneca and Novo Nordisk. The luxury goods industry is another example, centered in France, Italy and Switzerland with companies such as LVMH, Kering and Richemont.

Outside Europe, the story remains just as valid. Japan is home to many cutting-edge robotics firms, including Murata and FANUC. Some of the world’s most successful technology companies are based in Asia: Samsung, Taiwan Semiconductor, Tencent and Alibaba, to name a few.

To have a well-rounded and robust portfolio of stocks, investors should consider international markets — even if you think the U.S. market in aggregate will continue to do better in the short term.

Chart displays the total market capitalization and total number of companies within the MSCI ACWI Pharmaceuticals Index, separated by U.S. and non-U.S. The total market capitalization for U.S. companies is $1.1 trillion. The top four companies in this segment are Johnson & Johnson, Pfizer, Merck and Eli Lilly. There are eight other companies not listed. The non-U.S. market capitalization is $1.5 trillion. These companies include Novartis, Roche, Sanofi, AstraZeneca, GlaxoSmithKline, Novo Nordisk and 66 not listed by name. Sources: MSCI, RIMES. As of 8/31/19. Companies listed represent the 10 largest by market capitalization.

2. Greater dividend opportunities overseas

The idea of fishing in a bigger pond may be even more beneficial to income investors. That’s because outside the U.S., more companies have tended to pay dividends and have done so at higher levels. There were more than six times as many non-U.S. stocks with yields over 3%, as of August 31, 2019.

International dividend investors don’t have to give up growth potential either. For example, semiconductor manufacturers TSMC and Samsung each had dividend yields above 3%. Likewise, pharmaceuticals such as Roche and Novartis are on the cutting edge of cancer research and offer both the potential for capital appreciation and consistent dividend payouts.

At this late stage of the economic cycle, a sharper focus on dividend-paying companies and lower volatility portfolio strategies may be a good idea. But with such a large pool of stocks available, deep fundamental research is key. Indeed, not all dividend-payers are created equal. Many companies appear solid on the surface but carry significant debt burdens and may be on the cusp of losing their investment-grade credit rating. A missed payment or a downgrade could send share prices tumbling, so investors should focus on companies that are most likely to maintain consistent dividend payments.

Chart shows the number of companies with dividend yields higher than 3% in the MSCI ACWI Index. There are 498 international stocks, 518 emerging markets stocks and 158 U.S. stocks that fit this criteria. The index dividend yields are 3.4% for international, 2.9% for emerging markets and 2% for the U.S. Sources: Capital Group, MSCI, RIMES. As of 8/31/19. Regions represented by MSCI USA, MSCI World ex USA and MSCI Emerging Markets indexes.

3. International stocks are on sale

Valuations matter. There is evidence that stocks trading at a discount average higher long-term returns in future periods than those selling at a premium. But the key phrase here is long term, because there is almost no correlation between valuations and short-term returns.

This may not help those trying to time the market, but it's great news for investors looking to hold onto non-U.S. assets for the long haul. In nearly every sector, there are comparable non-U.S. companies trading at lower valuations than their American-domiciled counterparts. Unicredit and Samsung are just two examples.

Companies overseas often trade at a discount due to political or economic issues in their home countries, even if these factors don’t directly affect the business itself. Over the long term, company fundamentals, not geopolitical turmoil or a company’s address, drive stock returns.

Chart compares the forward price-earnings ratio of a U.S. company and a non-U.S. company in five industries. In each comparison, the non-U.S. company has a lower valuation. Banking: JP Morgan Chase (10.0) and Unicredit (6.2). Energy: ExxonMobil (15.4) and Total (10.0). Food: Hershey (25.3) and Nestlé (22.1). Aerospace: Boeing (19.7) and Airbus (19.2). Electronics: Apple (15.9) and Samsung (12.8). There is also a table below the chart that shows the current forward price/earnings ratio and the average over the last 15 years for three regions — the United States, developed international and emerging markets. The U.S. has a P/E of 16.6 compared to 14.8 over the previous 15 years. Developed international index has a P/E of 13.2 compared to its 15-year average of 13.3. Emerging markets have a P/E of 11.6 compared to its 15-year average of 11.1. Sources: IBES, MSCI, Refinitiv Datastream, Standard & Poor’s. As of 8/31/19. Forward price-earnings ratios are for S&P 500, MSCI World ex USA and MSCI Emerging Markets indexes.

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2 portfolio construction decisions

 

Regional or global?

When markets are uncertain, it can be good to have some flexibility in your portfolio. Deciding on the right balance between traditional regional funds and more flexible global funds is one of the first asset allocation decisions investors need to make.

A regional approach is the most traditional, typically including three dedicated geographic segments: U.S., developed international and emerging markets. This allows portfolios to be constructed with specific geographic allocations in mind.

On the opposite end of the spectrum, a more flexible approach would include global funds. These mandates typically allow portfolio managers to dynamically shift their holdings and choose companies that they find most attractive from anywhere in the world.

Both approaches have their merits, and investors may want to consider combining dedicated international funds with a more flexible global strategy.

This graphic shows three hypothetical investment approaches to equity portfolios that range in flexibility. The first is the least flexible and divides portfolios into three sections (U.S., developed international and emerging markets). The second is divided into two sections (U.S. and non-U.S.). The third is one section labeled global. Source: Capital Group. Diagrams are for illustrative purposes only and do not reflect actual portfolios.

Active or passive?

Much of this article has emphasized fundamental research of individual companies as one way to overcome international investing headwinds. But at a time when index investing has become increasingly popular and non-U.S. equities have lagged, is it worth the effort? Or would all investors be better served investing in a passive U.S.-only index fund?

The truth is, the average active mutual fund may not offer an advantage over the index, and passive funds only seek to replicate rather than beat their benchmarks. But there’s no need to settle for average. Not when you consider that the top quartile of active funds outpaced the indexes by a wide margin in the 20 years ending December 31, 2018.

Global fund managers have shined the brightest, outpacing the MSCI ACWI by 4.9% per year. These funds also handily beat top quartile U.S.-only funds in a period when U.S. indexes dominated. One explanation is that these global managers were most successful in benefiting from flexible mandates that allowed them to choose from the best companies, no matter where they were located.

When selecting non-U.S. and global fund managers, remember that it’s impossible to cover the entire world from New York. Consider partnering with investment managers whose research teams travel the globe and have access to company management.

Chart shows the excess returns of top-quartile active mutual funds over the index for U.S., non-U.S. and global strategies. Top-quartile mutual funds had an excess return of 3.1% in U.S. strategies, 3.0% in non-U.S. strategies and 4.9% in global strategies. A table shows the total returns of the top-quartile mutual funds, the average mutual fund and the index in the three regions. Returns were highest in the U.S. and lowest in non-U.S. for both the average fund and the index. However, among top-quartile mutual funds, global funds had the highest returns. Sources: Capital Group, Morningstar, MSCI, Standard & Poor’s. Average annualized returns for the 20-year period ending 12/31/18. Data include all active funds in the following Morningstar categories. For the United States: U.S. large value, large blend and large growth. For non-U.S.: foreign large value, foreign large blend and foreign large growth. For global: world stock. S&P 500, MSCI ACWI ex USA and MSCI ACWI are used to represent U.S., non-U.S. and global indexes, respectively.

 

1 answer to a key asset allocation question

 

How much international equity do you really need?

When it comes to answering this question, the simple answer may be, “More.” Whether it’s due to a home bias or a lack of rebalancing during the long U.S. bull market, many investors may find themselves underexposed to non-U.S. equities.

At Capital Group we don’t make top-down asset allocation decisions based on geography, and we don’t believe there is a magic number to target. But having about a third of your equity allocation within non-U.S. stocks may be appropriate. For a standard 60/40 portfolio, that would be 40% U.S. equity, 20% non-U.S. and 40% fixed income. Our objective-based model portfolios and target date series may also provide good starting points for discussions around international exposure levels for various risk profiles and life stages.

Digging one step deeper, the type of equity should vary depending on an investor’s risk tolerance. In the current late-cycle environment, investors may want to consider more conservative portfolios, which generally include more dividend-paying equities with a history of lower volatility. Outside of equity, investors can seek additional diversification by allocating a portion of their fixed income portfolio to international bond funds.

Two donut charts show sample portfolio weights, divided into U.S. equities, non-U.S. equities, fixed income and cash. In the model portfolio example, U.S. equities are 40.3%, non-U.S. equities are 22.9%, fixed income is 32.0% and cash is 4.8%. In the target date portfolio example, U.S. equities are 44.2%, non-U.S. equities are 20.9%, fixed income is 28.2% and cash is 6.7%. Source: Capital Group. Data in chart represent the current weightings as of 6/30/19. Target allocations are disclosed on the website. As of 6/30/19. The model portfolio example is American Funds Moderate Growth and Income Model PortfolioSM. The target date example is American Funds 2030 Target Date Retirement Fund®. Although the target date funds are managed for investors on a projected retirement date time frame, the fund’s allocation strategy does not guarantee that investors’ retirement goals will be met. American Funds investment professionals manage the Target Date Fund’s portfolio, moving it from a more growth-oriented strategy to a more income-oriented focus as the fund gets closer to its target date. The target date is the year in which an investor is assumed to retire and begin taking withdrawals. Investment professionals continue to manage each fund for 30 years after it reaches its target date. Changes in the equity allocation within the underlying equity-income and balanced funds may affect the overall equity exposure in the target date funds.

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Rob Lovelace is an equity portfolio manager with 33 years of investment experience. He is vice chairman of Capital Group and president of Capital Research and Management Company, Inc. Rob holds a bachelor's in geology from Princeton and is a CFA charterholder.

David Polak is the investment director for Capital Group's global equity services. He has 35 years of investment industry experience. Earlier in his career at Capital, David was a research portfolio coordinator for several global equity portfolios. He holds a bachelor’s in economics from University College London. 

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