Beginning investors looking to get their feet wet are best served putting money behind domestic companies they know and interact with often -- companies like Procter & Gamble (NYSE: PG ) , which produces dozens of iconic household goods.
But seasoned investors know that if you're looking for diversity and growth, international stocks play an important role in balancing out your portfolio. But what, exactly, does it mean to invest in international stocks?
What is the history of international stocks?
Before 1927, it was difficult for the average investor to buy stock in companies operating abroad and listed on foreign indexes. Just before the onset of the Great Depression, however, a new investment vehicle aimed to ease those difficulties: depository receipts, or DRs.
Each DR could represent the same stake in a company as one share listed on the foreign index. It could also represent a fraction of a share; this differs based on each company's policy.
DRs were seen to benefit all parties: domestic investors looking for growth in emerging economies had somewhere to put their money, and foreign companies looking for capital to expand had access to it.
Here in the U.S., we refer to a foreign company's shares as American depository receipts, or ADRs. Any company that lists its ADRs on the Nasdaq or the New York Stock Exchange must adhere to certain SEC reporting duties that help to ensure transparency and protect shareholders.
Level one ADRs are available on the over-the-counter market and have the most relaxed requirements in terms of reporting and transparency duties. Though many small foreign companies opt for level one status, so too do many large companies, as they find the reporting requirements for higher levels burdensome.
Level two and three ADRs have more stringent reporting requirements. At a bare minimum, each is required to make its annual 20-F report available to investors. These stocks are usually traded on the Nasdaq and New York Stock Exchange.
How many international stocks are there?
It's important to recognize that in our globalized world, international borders are starting to matter less and less. Huge American companies like Coca-Cola (NYSE: KO ) and General Electric (NYSE: GE ) count on foreign businesses and consumers for huge portions of their revenue. But for the purposes of this article, we'll focus on companies that are headquartered abroad and have their shares listed using ADRs.
According to the SEC, "There are more than 2,000 ADRs available representing shares of companies located in more than 70 countries."
Why invest in international stocks?
As previously mentioned, there are two huge advantages to investing in international stocks.
The first is diversification. If you are only invested in companies doing business in America, you could suffer disproportionately from the boom and bust cycles experienced by the country's economy.
That said, it's also important to investigate how much business a U.S.-based company does abroad. It's entirely possible that you already have enough international exposure simply by investing in global brands like Coca-Cola (NYSE: KO ) or Johnson & Johnson (NYSE: JNJ ) . These two conglomerates each conducted more than half of their business abroad last year. This type of information can be found in a company's annual 10-K report, which you can find in the SEC database.
The second major reason to invest in international stocks is the opportunity for growth. America has the largest and most mature economy in the world. Though the resulting stability is nice, it also means diminished returns for investors.
Consider China: between 2002 and 2012, the country's GDP grew at a blistering 19% per year. America's growth was 4% per year over the same time frame. While China has had to deal with a bout of stock market scandals, investments in well-established businesses operating in China have rewarded shareholders generously.
For example, Baidu (NASDAQ: BIDU ) , China's largest search engine and one of the largest companies offering Nasdaq-listed ADRs, has returned 1,660% since going public in 2005.
Sometimes it's not even growth that makes ADRs attractive. Sometimes, it's a ridiculously low valuation. Following the European sovereign debt crisis of 2012, shares of Veolia Environmental (NASDAQOTH: VEOEY ) , a company that offers waste and water services and is based in France, traded for less than 11 times earnings while offering an 8% dividend yield.
Investors who purchased Veolia ADRs last summer have enjoyed a 61% return on their investment since then, all while pocketing (or reinvesting) that generous payout.
The bottom line on international stocks
You need to take the same approach to investing in international stocks as you do domestic ones. Conduct your own due diligence, write down your own investing thesis for putting money behind a company, and stick to a long-term time horizon.
There are certainly opportunities for outsize growth in international stocks, but make sure they occupy an appropriate portion of your portfolio so you aren't putting too many eggs in any one basket.