Monday, October 29, 2007

How will U.S. stocks perform versus foreign equity markets?

Reader's Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors--softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar--have potential to derail the current bull market and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth--and this long-term trend, with solid footing in our world's market economy and capitalism, is unlikely to subside anytime soon.

Think Global

Rather than focussing solely on U.S. equities, I would encourage you to think and invest globally, if you aren't already doing so. The pie chart below shows how the U.S. accounts for about 27% of the world's economy as measured by nominal GDP. This means that almost three-quarters of the world's economic output (i.e., the overwhelming majority of the pie) is generated outside of the U.S. Certainly, the U.S. remains the world's largest economy by a wide margin; however, rapid economic growth rates elsewhere provide a reason to look beyond U.S. borders.

Economic Growth Matters

The world's three largest economies--U.S., Japan and Germany--all have real GDP growth rates in the neighborhood of 2% to 3% annually. That's very sluggish when compared to high growth rates in many other countries among the world's largest 15 economies. Most notably, China continues to show robust 10% to 11% growth, India around 9% or 10%, Russia around 7%, and South Korea and Mexico about 4% to 5% growth. Since GDP growth in the underlying economy drives corporate revenue and earnings growth, which in turn determines stock price performance, it behooves us to focus in on high-growth countries.

As investors, we want growth, but we also want to make sure that we are not paying too much for the growth we get. A good way to gauge the cheapness or richness of entire stock markets is to look at the P/E ratios of representative ETFs. Barclays iShares manages country-specific ETFs that can serve as proxies for most of the largest economies. For example, one of their most popular ETFs is the FTSE/Xinhua China 25 Index (NYSE: FXI), which invests in H-shares of 25 large companies listed in Hong Kong and doing business in China. This China ETF has a market capitalizaion-weighted P/E ratio of 31, as of the end of September.

It is helpful to plot P/E ratio against GDP growth to develop an intuitive feel for how cheap or expensive the various stock markets are. In the graph below, I have drawn lines sloping upward from the origin for the four countries with the most attractive (i.e., lowest) ratios of P/E (for proxy ETFs) to GDP growth rate (for the corresponding countries). This composite ratio is a type of "PEG ratio" that measures P/E relative to growth, allowing for a quick comparison of low-P/E, low-growth and high-P/E, high-growth investment alternatives.

Observe how the ETFs of India (NYSE: INP) and China (NYSE: FXI) offer the most attractive PEG ratios, indicating that even though their respective stock markets are currently trading at relatively high P/Es of 23 (estimated) and 31, respectively, the double-digit (or near-double-digit) growth of their underlying economies appears to support their high-P/E valuations. The ETFs of Mexico (NYSE: EWW) and South Korea (NYSE: EWY) also show attractive PEG ratios.

Prospects for Growth and Profit

Although it is extremely difficult to predict which stock markets will rise the most over the next year or two, or whether the recent strength of global equity markets (particularly China and India) will continue in the near-term, I offer two suggestions:

1. Invest Globally: As a baseline when investing in equities, weight countries in approximate proportion to their contribution to world GDP. ETFs provide a means for taking on exposure to foreign equities while keeping costs and management fees low. Buying ADRs (U.S.-listed shares of foreign companies) is another way to go for those who enjoy (as I do) investing in individual companies. While U.S. equities may comprise the largest single-country contribution, all of the non-U.S. countries together should, in my opinion, add up to more than half of your overall portfolio.

2. Over-weight High-Growth Countries: Given their high GDP growth, China, India, Russia, South Korea and Mexico are good places to search for equity investments. Investors willing to take a long-term view and ride out the higher volatility of these markets stand to benefit from the tailwind that higher GDP growth provides.

Reporting this week of Mukesh Ambani and Carlos Slim's rapid ascent to the #1 and #2 positions in world wealth ranking (both appear to have edged out Bill Gates) is a sign of India and Mexico's strong economic growth and soaring stock market fortunes (as well as evidence of how concentrated wealth is among the super-rich in these countries of relatively low per-capita GDP). Also, Warren Buffett's investment in POSCO (NYSE: PKX) and other South Korean stocks is indicative of the potential upside this Asian market offers.

(Disclosure: The author does not currently have positions in any of the ETFs or stocks mentioned in this article but is overweight in non-U.S. equities from high-growth countries.)


Anonymous hedge fund manger said...

ok I agree with you that investing globally. All the professional investors saying about diversifies one's investment profolios. As those diamond four are going strong so I think it is wise to have your stock on these markets.

9:51 AM, November 03, 2007  
Anonymous Fox said...

Certainly you should diversify your portfolio, especially in time of total globalization. Just look how Chinese companies win the market. Pay attention to the Pink Sheets’ leaders, they all are Russian oil and gas companies. My portfolio includes 40% of non-domestic stocks. I hope it is a correct balance.

7:43 AM, November 09, 2007  
Anonymous Anonymous said...

A perspective from Far-East.

Beside diversification, global investing has opened up endless opportunities to buy undervalued securities. Information democratization by Internet has enabled this process. One no longer has to board on the plane and travel around the world to research investment opportunities. Much of the information especially annual report is available on the Internet makes investment research much easier nowadays.

However, the secret of making large investment gains is the ability to detect mis-pricing. This could exist anywhere in the world; the price you pay and your holding period determine your return.

Mis-pricing could come from emotional and analytical errors, lack of information or liquidity. Of late, there are a lot of worries among investors whether US could slip into recessions caused by housing recessions, financial turmoil and etc, of which I don’t care. This is almost a perfect description of Mr. Market by Ben Graham. Overreaction or over pessimism among investors resulted many depressed valuation for many well run companies.

Many of these US companies have global operations which deriving more than 50% earning internationally. Assuming these companies are able to maintain half of their earnings in USA but international businesses are growing at 20% plus 20% currency gains from international businesses, these multinational companies will be able to deliver almost 20% earning growth. If some of these companies are valued less than PE 20, when US companies resume the normal growth, you can expect your return in excess of 15% over a long period of time.

The advantage of managing own investment is one does not need to benchmark oneself or to beat a specific benchmark. Money managers have this pressure because of the need to attract more clients or retaining existing clients in the worst-case scenario. We have the holding power to wait for the market to recognize its true value.

The problem of the same investors chasing after the same stocks outside US drive up valuation. Hence reducing overall return or at best average return. One may not be able to exploit true undervalued securities due to lack of home ground advantage. Though I have invested outside my country, I am still maintaining overweight my own country securities due to home ground advantage. I have seen foreign funds coming into my country drive up valuation of popular securities. Due to home ground advantage I still can find enough undervalued securities.

You will notice I did not mention specific securities because I believe one will be able to make independent judgment how much a security is undervalued by hands-on approach. I do not believe one can make superior return by taking stock tips. If one is lack of skills, time or not wired to pick stock, hire best money manager around and stick with them during good and bad times --- dollar averaging will help you win.

Beside geographical diversification, there are many sources of diversification techniques available such as managing own money, let other manage your money, using different technique of valuations (DCF, P/B, PE, PEG, etc), value vs. growth stocks, properties, commodities, collections, etc. However one needs to know the more money you spread around the less money you put into you # 1 undervalued investment. Diversification makes sense if one is really wealthy – I am talking about million of dollars in your bank account – or else stay focus.

10 November 2007.

3:24 AM, November 10, 2007  
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5:15 PM, July 11, 2008  
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5:47 PM, September 15, 2008  
Anonymous retiredebtfree01 said...

Foreign stocks are soaring and Americans are pouring money into them.

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11:34 PM, November 12, 2008  
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Aw, this was a really quality post. In theory I'd like to write like this too - taking time and real effort to make a good article... but what can I say... I procrastinate a lot and never seem to get something done.


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