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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Many beginning investors prefer to look first at U.S.-focused investments. But as you develop as an investor, you'll want to expand your horizons. International investing lets you do exactly that.
Dispelling some myths
For me, international investing entails investing in companies that are based outside the U.S., or in companies that may be based in the U.S. but derive a substantial proportion of their earnings from international operations. There are a number of reasons to invest internationally, but the ones that many brokers invariably recite are either false or must be qualified.
The first is that investing internationally adds diversification to your portfolio. That's true to a (small) degree, but the evidence suggests that the correlation between the U.S. stock market and foreign equity markets -- developed and developing -- has risen substantially over the last few years.
The other reason that brokers often cite is that the largest contributors to global growth over the coming years and decades are emerging rather than mature economies. While that is overwhelmingly likely, it does not follow that investors in these markets will capture that growth, either because it may accrue disproportionately to private companies or to insiders at public companies, or because investors are prone to overpaying for it.
As far as I'm concerned, the main reason to invest internationally is that it hugely expands your opportunity set. Stock markets are unlikely to be valued uniformly on a worldwide basis and at all times. When the U.S. market is overvalued, investors would do well to underweight U.S. stocks and look abroad for better opportunities.
Where the risks -- and rewards -- are
The risk/reward relationship of investing abroad has changed significantly over the past few years, and the financial crisis has contributed to an acceleration of that shift. The fundamental dichotomy isn't really between investing domestically or investing abroad, it's between investing in developed or developing markets. Conventional wisdom was that developed markets are safe because of their political stability, high standards of governance, the rule of law, and a stable macroeconomic environment. Developing markets, on the other hand, were considered risky: The politics could be unpredictable, markets opaque and illiquid, and the macro environment was a minefield of inflationary episodes and banking and currency crises.
Today, that divide is a lot murkier; in fact, the roles have been reversed in some respects. Developed markets are currently the ones prone to crises. Inflation isn't a risk (in the near term), but deflation is and growth is likely to remain tepid for several years, particularly if governments continue to embrace austerity as the cure to their ills.
Nevertheless, risks remain in emerging markets. Governance and regulatory/legal environments often fall short of the standards you may be used to. Currency risk hasn't disappeared, either; returns from stock price gains can easily be wiped out by an unfavorable swing in the exchange rate.
How to pick strong international stocks
There is an old joke that asks how hedgehogs have sex. "Very carefully" is the answer, and it's the same one I would give when asked how to pick international stocks. Stock picking is difficult enough when restricted to U.S. stocks, in an environment that is already familiar. I think this is an area in which investors have much to gain by delegating the task to the market via index funds (traditional funds or ETFs) or to an experienced, value-conscious fund manager such as Charles de Vaulx at International Value Advisers or Matthew McLennan at First Eagle Funds.
If you feel absolutely compelled to do it yourself, I have two recommendations: Pay attention to valuations -- more so even than you would at home -- and try to zero in on high-quality global companies that have exposure to emerging economies. These four sectors look attractive:
Consumer products (global brands). As emerging market consumers become wealthier, they will want to buy branded products from companies such as Nestle, Unilever (NYSE: UN ) , Philip Morris International (NYSE: PM ) , and Diageo (NYSE: DEO ) .
Luxury products. The target clientele is much smaller, but the logic behind luxury products as a promising sector is similar to that for consumer brands. At the top end of these societies, growth is creating a class of wealthy consumers who are hungry for luxury goods. Companies that stand to benefit from this growing source of demand include LVMH Moet Hennessy Louis Vuitton, Hermes International, Bulgari, and Compagnie Financiere Richemont.
Resource sector. Emerging markets -- particularly China -- have huge resource needs that continue to grow. That represents a secular increase in demand for commodities, whether it's industrial and precious metals or oil. Companies such as Vale (NYSE: VALE ) , Rio Tinto (NYSE: RIO ) , Total (NYSE: TOT ) , and Royal Dutch Shell (NYSE: RDS-A ) will satisfy part of that demand.
Building materials and infrastructure. As emerging economies become increasingly urbanized, cities are built out, requiring adequate infrastructure on a larger scale. Building products company Lafarge or water services provider Veolia Environnement will be only too happy to supply their products and services.
International investing is a fascinating and potentially profitable area. If you are set on picking your own stocks, I would recommend sticking to world-class companies that are well-positioned to capture some of the growth in emerging economies. Once you have identified these companies, focus on buying their shares at reasonable valuations. In that regard, international investing is no different than investing at home -- price matters.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.