Going International

Ten or fifteen years ago, institutional investors began a quest for international investing. The question was rarely whether to invest internationally but how much allocation should one have. Individual investors have pursued international diversification with greater zeal in the last few years, but primarily in emerging economies and markets.

Diversification per se is useful only if correlations between stocks or asset classes is low. It reduces risk or volatility of an overall portfolio and consequently tends to improve risk-adjusted returns.

But increasing correlation of returns, at least in well-developed international markets and the U.S. market have increased significantly through the last decade. Markets such as Japan through most of the 90's represented a sinkhole of returns, negative correlation but dreadful returns. Most other markets provided not especially compelling returns and increased correlation, thus the sought after reduction in portfolio volatility never happened.

The tendency toward dropping restrictive trade barriers leads to greater integration and less segmentation of markets. Consequently, international diversification should offer diminishing opportunities as an aggregate strategy as economies become more connected. But as Buffett says, if past history was all there was to the game, the richest people would be librarians.

For the value investor who believes that diversification is a protection against ignorance, international diversification per se holds little appeal. What is most important however, is the increase opportunity set that global markets provide.

Consequently, my portfolio often will incorporate some international stocks. In every case, they represent some value characteristic whether price or profitability that is superior to what is available within the U.S. marketplace.

Buffett's purchase of Iscar is partially an "escape" out of US dollar denominated businesses reflecting his bearishness for the currency. But more importantly, the company enjoys wonderful economics as the best in the industry. Please check out previous posts on Iscar and its major competitor Sandvik.

A Little More on Iscar, Its Reputation, Its Major Competitor

Iscar Comments from Berkshire Meeting

People have asked about Kennametal (KMT) and its position in this industry. Though returns on capital are improving at Kennametal, they have moved up to 9% versus years of 6 and 7% returns. Contrast this with Sandvik and the reputed returns of Iscar which have hovered at 20% or better for some time. Yet Kennametal and Sandvik trade at parity with each other on an EV/EBIT basis.

How do we find these discrepancies, other than individual stock analysis? I always look at companies on an individual basis and apply computer screens for the attractive characteristics that any value investor would seek. In pursuing DCF models, it is always useful to apply a somewhat heavier discount rate for foreign companies due to lesser disclosure, lesser transparency, lower governance standards, etc. Buffett describes this process well in his description of his PetroChina (PTR) investment. Much as speculation circled about his attitude about China in 2003 when he made the investment, speculation has been rife in Israel. Nothing further in Chinese stocks ensued from the initial foray. Buffett does not pursue global investments, merely excellent investments. He is not Jim Rogers though their views on the dollar are quite parallel.

Relative performance statistics for the S&P Global 1200 versus the S&P 500 may disclose some interesting discrepancies within the sectors. Here are YTD figures as of last night:

Global Domestic
Energy......................................17.45%........................16.60%
Materials..................................25.89%........................13.58%
Industrials................................13.72%........................11.07%
Consumer Discretionary........10.96%..........................5.12%
Consumer Staples.....................5.99%...........................1.97%
Healthcare..................................1.33%.........................(4.09%)
Financials..................................12.73%..........................5.49%
Info Technology.........................2.65%........................(0.89%)
Telecom.......................................8.87%.........................8.62%
Utilities.......................................11.04%.......................(0.04%)

Bottomline, the benefits from pursuing international diversification for its own sake seem exaggerated. The extraordinary returns of the US market relative to international markets sacrificed returns for this cause through much of the 90's. Increasing correlations, as a corollary of international trade flows reduced the risk/return benefits. For the value investor, in my view, the role of international stocks should be to augment the opportunity set. Careful research will still provide opportunities here despite the reduced diversification benefit.