International—Why Bother?

“The factor of price fluctuation has been more of a dominant and important consideration in the matter of investment than has the factor of long-term growth or decline. Yet the market tends to greet each upsurge as if it were the beginning of an endless growth, and each decline in earnings as if it presaged ultimate extinction…” — Benjamin Graham, 1954

2011—A Tough Year for International Investments
Last year was difficult for international markets, leading many U.S. investors to question any allocation to non-domestic holdings. Interestingly, just a few years before, as the U.S. sat idle, some questioned why they hadn’t increased their weighting to international equities. Each is a reasonable question. It is common practice to hone in on a success in the hope of repeating its outcome. Following a period of relatively strong performance, investors are typically drawn toward a “winning” investment and vice versa following a period of underperformance.

However, this practice is predicated on the assumption that an underlying trend, circumstance or environment will continue. Performance divergence (run-ups or sharp drops) can endure over sustained periods leading even practiced investors to rationalize that solid fundamental drivers must be behind the momentum. While this may be true on occasion, it cannot be an assumed outcome.

Why Allocate to International?
The U.S. market capitalization is now less than half of the global marketplace, forcing acknowledgment that today’s playing field extends across wider borders. With this, most foreign exchanges operate with comparable security transaction processes as the U.S. Furthermore, international accounting standards have converged significantly.

We believe it ill-advised for investors to ignore worthwhile companies based on geography but recognize the existence of a marketplace does not substantiate an investment. An investor must question whether a competitive rate of return will be provided for the level of risk.

Historically, both the U.S. and developed international markets (e.g., Germany, Japan and Australia) have provided similar risks and rewards. Over the past 40 years, average annual returns have hovered between 9% and 10%, with risk between 15% and 17% (annual standard deviations). Since 1980, while not perfectly comparable time frames, emerging markets (e.g., China, India, Brazil, Russia, Malaysia, Taiwan and Indonesia) have exhibited higher metrics on both counts. During this time, returns have averaged near 12%, with risk near 24 percent (annualized standard deviations). Investors in any one of these three broad areas should achieve reasonable long-term returns relative to the risks.

Next, an investor should consider if an investment is worth the time and effort relative to its overall contribution. International equities alone do not generally provide a disproportionate return or reward opportunity. While each region is at times more advantageous than another, longer-term risk and reward are roughly equivalent.

However, an international allocation provides a counterbalance to the domestic allocation, enhancing the portfolio in a less direct manner. The net result is typically a smoother ride on the whole and a slight enhancement of returns from actively rebalancing when individual performance diverges. A U.S. investor holding a 20%-to-40% percent allocation to international equities from 1970 through 2010 generally experienced a modest enhancement of returns with either no material change in risk or even a modest reduction, depending on how risk was measured.

Arguably, diversification may be one of the only free lunches available to investors, though admittedly international markets are not as rewarding today as in the past. Today, when one market swoons, others tend to follow. However, since these correlations are not yet perfect, there is still some ongoing opportunity for diversified investors.

Cycles, Valuations and Opportunities
Let’s now return to Benjamin Graham, who believed investors should ignore economic cycles. According to Graham, if “Mr. Market” offers to buy or sell an investment, entertain the offer only if it is reasonably attractive from a valuation standpoint. In contrast, he would caution the investor against reading too much into the pattern of offers provided by “Mr. Market.”

While we agree with Graham’s thought process, we believe qualifiers are needed. Most importantly, we recognize that investment cycles tend to run longer than anticipated. We believe this is prompted by a combination of events, including but not limited to, coincident and lasting shifts in economic and fundamental performance, shifting investor sentiment and follow-on wealth and economic effects of rising stock prices.

These inputs can drive the economy and financial markets to experience prolonged cyclical patterns that ultimately reward patient, value-oriented investors who wait for these cycles to play out at both the high and low ends. Investors should tread slowly into newly identified value opportunities, understanding that discounts can still become more appealing. Conversely, when an asset surpasses its fair value estimate, it may still run further. However, at some point, a level is reached that provides a sufficient deviation to merit fighting the trend. At Glenmede, significant effort and time is allocated to identifying the level of disconnect between the market price and fair value, as well as the fundamental and market forces driving shifts away from or toward fair value.

International Equities: Valuation Opportunities with Caveats
The emerging market story is relatively robust. Government finances were restructured in the 1990s/early 2000s and are much better than developed markets. In fact, many nations still technically classified as emerging are now grouped alongside developed nations in terms of industrial capacity and business friendliness. Furthermore, in many of these nations, wage disparity is improving as greater economic wealth is shared with the general populace, creating a major shift in consumer attitudes and habits. As always, unanswered issues remain, such as swelling land prices in China’s fast-growth cities, but generally emerging markets present a positive picture. Valuations appear relatively well contained, providing investors a reasonable opportunity to benefit from the outsized growth potential.

International developed markets remain a more difficult story. Europe continues to face outsized sovereign debt and the austerity measures implemented to stabilize the situation place further downward pressures on European economies.

International developed equities, mostly European, are trading below their 75th percentile and have occasionally flirted with their 90th percentile level in the past year. Such discounts can lead to relatively strong future returns but can require a good amount of patience. Although last year’s performance of international developed equities was a disappointment, it was not wholly out of character given the propensity for some investment cycles to last longer than expected.

European leaders appear to be addressing sovereign debt problems far more readily than U.S. leaders. If the movement toward EU fiscal unity were to succeed, the Eurozone would suddenly look considerably better than the U.S., with lower overall debt-to-GDP and deficit-to-GDP ratios.

Investors should remain aware that resolution of the situation in Europe could still take quite a long time. Despite the risks, valuation disparities are large enough to warrant a position.

Investment Strategy: Maintain International, Focus on Emerging Markets
Overall economic activity has improved markedly from the tail of 2011 through the beginning of 2012. The European Central Bank’s (ECB) actions to calm debt markets appear to be working. Given the attractiveness of equity assets, we continue to believe investors will be rewarded for taking some risk. Specifically, we believe opportunities falling in the middle of the risk spectrum continue to offer the best long-term risk adjusted returns given the sub-par economic growth period of the coming years.

Jason Pride is the director of investment strategy at Glenmede