Foreign Stocks: Good for a Long Run?

Every January, many investors find themselves looking back at the previous year’s biggest financial winners and wondering why they didn’t own them -- or more of them.

This year, that exercise would highlight the fat 2003 returns of mutual funds that own foreign securities.

The average international stock fund soared 39.2% last year, according to fund tracker Morningstar Inc. in Chicago. That was more than six percentage points above the 32.9% average return of U.S. stock funds.

Funds that focus on stocks traded in so-called emerging markets, such as Mexico, South Korea and Poland, scored even bigger returns: 55.3%, on average, according to Morningstar.

The weak dollar was a factor in powering foreign returns (more on that later), but many overseas markets rose more than U.S. stocks even without the dollar’s influence.

The problem with last year’s big numbers from foreign markets is that they might encourage jumping on the bandwagon by investors desperate to juice up their portfolio returns.

Yet the last 10 to 15 years haven’t been kind to most investors who’ve taken a chance on foreign stock funds. There are some reasons to believe that trend could be changing. Even so, the risks shouldn’t be understated.

Foreign-stock investing has periodically been a hot topic among U.S financial advisors. In the early 1990s, many advisors touted the potential diversification benefits of allocating 10% to 20% of a client’s assets to foreign issues.

Those advisors looked like geniuses in 1993, a huge year for foreign stocks compared with U.S. shares. The average emerging-markets fund rocketed 77.8% in ‘93, according to Morningstar. It was a time of great excitement about the benefits of globalization, including the spread of democracy, open financial markets and free trade.

But disappointment has been the rule rather than the exception for U.S. investors in foreign shares since the late 1980s. Buy-and-hold investors have been much better off keeping all of their equity dollars in the United States than venturing abroad.

A few numbers tell the story:

* In the 10-year period through 2003, the average annualized return on U.S. stock funds was 9.3%, according to Lipper Inc. That was about twice the 4.7% average annualized return of foreign stock funds in the period, and far above the 1.2% figure for emerging-markets funds.

* U.S. funds also had the edge over foreign funds in the five years ending with 2003. The U.S. average return was 2.6% compared with 1.3% for foreign stock funds.

If foreign investing entails greater risk for U.S. investors -- a reasonable assumption, given the threat of political upheaval and other unpredictable market-moving events overseas -- then the dismal foreign-stock returns of the last 10 years look even worse.

The question is whether the improved foreign market returns of the last two years are signaling that the next decade could look much different in terms of world stock performance.

You might believe that if you subscribe to the idea that the United States is becoming a much less appealing place to invest relative to the alternatives. Pessimists on Wall Street say that’s the central message in the dollar’s continuing plunge compared with other major currencies such as the euro, the Canadian dollar and the yen.

The dollar tumbled anew on Friday after the government said the economy created just 1,000 net new jobs in December, far below expectations. What’s more, previous totals on job creation in October and November were revised lower.

The upshot, according to some economists: The U.S. recovery isn’t as strong as other data have been suggesting.

By late Friday, the euro currency was trading at $1.284, a record high. Over the last two years the euro’s value has soared 44% against the dollar.

On the face of it, the dollar’s slump is saying that many global investors don’t want to buy dollar-denominated assets and are taking their money elsewhere. That is partly true.

But the reasons a currency is weak, or strong, always are terribly complicated. Investors play a role, but so do foreign governments and central banks.

Certainly, the dollar is down because some investors believe that the huge U.S. budget and trade deficits will restrain the nation’s economy in coming years, perhaps by forcing interest rates up and by slashing Americans’ purchasing power.

It’s also true, however, that the Bush administration has been happy to let the dollar slump as a way to fix the trade deficit. As the dollar falls it makes U.S. exports less expensive abroad, and can force up prices on imported goods.

How low is too low for the dollar? Probably at the point where foreign investors would begin panic selling of U.S. assets they own, because they’re fed up with watching the value of those assets depreciate.

There has been no sign yet of that sort of panic, in part because the dollar’s fall has been more or less gradual.

For many foreign investors, “It’s probably the rate of volatility that is more important than the absolute level of the dollar,” said John Rothfield, a currency strategist at Bank of America Corp. in San Franscisco.

In any case, if the dollar’s slide really is pointing to a problem-ridden U.S. economy in this decade, it might be logical for investors to bet that the U.S. stock market, too, would struggle -- and that many foreign markets might generate better returns.

But there are two major caveats. One is that Wall Street heard this same talk in the late 1980s, when the Japanese economy was ascendant. As it turned out, the U.S. economy boomed in the 1990s while Japan sank into a prolonged recession and its stock market crashed (the latter being one of the key reasons for dismal foreign-stock fund returns over the last 10 years).

The second caveat is that, if U.S. economic growth is subpar in this decade, it begs the question of whether the rest of the world would stagnate as well. After all, America still is the principal engine pulling the global economy.

One of the main attractions of foreign-stock investing in the 1970s and ‘80s was that, in a world much less integrated than the one we live in, foreign markets often zigged when the U.S. market zagged. So foreign stocks were a way to add valuable diversification to a U.S. portfolio.

In the last 30 years, however, “that diversification benefit has become smaller,” said Andrew Clark, senior research analyst at Lipper Inc. in Denver. “Global markets are much more correlated now.”

Still, that doesn’t mean that foreign markets, overall, couldn’t significantly outperform U.S. stocks in the next few years, and perhaps for the decade.

For example, as China rises as a consumer society, its demand could help stoke the economies of many of its trade partners in Asia and elsewhere.

On the other side of the world, the European Union is expected to expand this year from 15 nations to 25, as more Eastern European countries join the group.

Beyond adding 75 million people to the current EU population of 370 million, the expansion could be a catalyst for corporate and government reforms that could make the major European nations’ higher-cost economies more competitive with the lower-cost economies of the new members, said Rob Buckland, market strategist at Citigroup Global Markets.

In the long run, the prices of foreign stocks will be determined primarily by what happens with the companies’ underlying earnings growth -- no different than with U.S. stocks.

Michael P. Reilly, who helps manage $450 million in foreign stocks at Trust Co. of the West in Los Angeles, including money in the TCW Galileo Select International Growth Equities mutual fund, said his team’s focus has been on foreign companies in Europe and Japan that have been restructuring and reducing debt in recent years.

“What we’re looking for is earnings growth -- and it doesn’t matter in which industry we find it,” said Reilly, whose mutual fund includes names such as the London-based wireless telecom firm Vodafone Group, the Royal Bank of Scotland and Japanese factory automation company Fanuc Ltd.

Some analysts say emerging-market stocks are the most appealing foreign issues because they’re arguably cheap. Despite the big gains in many of those markets last year, a Merrill Lynch & Co. tally in December of stock price-to-earnings ratios pegged the average emerging-market stock P/E at about 11 based on estimated 2004 earnings. That is about half the U.S. average stock P/E.

Interestingly, emerging-market stock mutual funds have beaten the average U.S. stock fund not just for the last two years, but also for the last five years.

In a recent report to clients, investment firm Bridgewater Associates Inc. in Wilton, Conn., made the case that “a typical emerging market rally continues until [those countries] overconsume to the point that they are heavily dependent on foreign capital, at which point even a minor event can trigger a reversal in foreign sentiment and subsequent capital flight.”

That was what sparked the Asian currency crisis of 1997. But the trend has yet to develop in the current cycle, Bridgewater said. “The boom in emerging markets is not showing signs of age yet,” the firm said.

Still, many analysts warn investors against betting aggressively on volatile emerging markets. Political risks are ever present, they note. “There are seven presidential elections in Southeast Asia this year,” said Lipper’s Clark. “Any one of them could be scary for markets,” depending on the outcome.

In Europe, there also is the risk that the massive financial scandal involving Italian food company Parmalat could lead to revelations of wider accounting scandals.

What about the dollar? As it falls, it automatically boosts the value of foreign stocks for U.S. investors as the shares’ value is translated back to dollars. That could continue to help foreign stock funds shine this year.

But as the dollar slides it also makes it tougher for many foreign companies to compete with their U.S. rivals. If the dollar worsens from this point, “The currency benefit could be canceled out by the economic effect on foreign companies,” said Gregg Wolper, senior fund analyst at Morningstar in Chicago.

Weighing the opportunities versus the risks, Wolper and other advisors say the long-standing advice about foreign-stock investing still applies: It’s appropriate for a modest share of a diversified portfolio.

About half of the world’s stock market capitalization now is outside the United States. That half hasn’t acquitted itself well over the last decade. For investors who like to bet that market laggards inevitably become leaders, foreign stocks may be an intriguing long-term bet.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: latimes.com/petruno.