The Challenges of International Investing[Fool on the Hill] May 31, 2000

An Investment Opinion

The Challenges of International Investing

By Bill Mann (TMF Otter)
May 31, 2000

One of the tenets of modern portfolio theory is that the broader the diversification, the lower the risk of the overall portfolio. This means holding growth, value, small- and large-cap, domestic, and international stocks, bonds, and even gold. I've never been a huge fan of MPT, believing that one of the largest risks that some investors take is assuming too little risk. On the other hand, portfolios that contain one stock, or stocks in just one industry, contain so much systemic risk that they should be avoided in most circumstances. On the subject of investing internationally, I would say this: It is not necessary.

That's right. The United States contains more than 50% of all public equity share value on the planet, and the 10,000-plus companies here cross so many industries that even the most risk-averse can find some that have negative correlation with one another (in other words, when one goes up, the other drops). Plus, many U.S. companies have so much of their sales overseas that we can gain international exposure by investing right here in the U.S. of A. Coca Cola (NYSE: KO), for example, nets over 60% of its revenues overseas. Yep. Plenty of opportunities right here.

But The Motley Fool would be stupid not to recognize that people want to invest in companies and opportunities outside of the U.S. I have a large portion of my holdings in foreign stocks. And as more large companies overseas cross-list their shares on the New York Stock Exchange or on the Nasdaq, it is easier than ever to buy them. So for those of you who do want to invest in international countries, here are some of the risks and challenges of which you should be aware. For those of you reading this who ARE overseas, I encourage you to post information about investing in your home country on the Fool on the Hill discussion board. In such a brief article I can only touch on generalities, and while I have a lot of specifics for many countries, it is impossible to impart all of this knowledge in this limited space.

1. Most countries are dangerous places to invest. Point blank. The shareholder rights and protections you have in the United States, whether you are a resident or not, are reduced or non-existent in many places. The basic reality is that the United States, from an economic and regulatory perspective, is a world leader. Investing overseas means placing your money under the regulatory oversight of the country where the company is domiciled. In developing economies, you are taking a very large risk. Some countries (e.g., China) have gone so far as to create different classes of shareholders, domestic and international, and there can be no guarantee that these classes have the same rights to the free cash flows of companies in those markets.

2. You are assuming more currency risk. The shares and earnings in other countries are denominated in the native currency, be it pounds, yen, cedi, or ruble. So you can have done all of your homework on a company and picked a winner, and yet your returns can lag due to external economic factors causing the local currency to weaken against the dollar. For example, U.S.-based owners of Nokia (NYSE: NOK), one of the most significant growth companies over the last two years, have seen its earnings (stated in euros) diluted by 11% as the euro has dropped by that much against the dollar. The euro may eventually rebound, but there is no natural law that says it has to. Many developing economies have seen their currencies gradually erode against the dollar. This is a risk that is completely external to the performance of the company, and unless you have some higher knowledge of currency hedging, this is yet another factor out of your control. Even boom companies based in Canada have faced the reality of a declining rate against the dollar. What earnings advantages has Nortel (NYSE: NT) seen evaporate as the Canadian dollar remains depressed against the U.S. dollar?

3. Different reporting standards. A company that is listed in the United States and domiciled here must report its earnings on a quarterly basis. In the United Kingdom, as an example, this only must be done twice a year. This is not a knock on the U.K. in particular, but each country has its own reporting requirements, and generally speaking they are not as stringent as in the United States. Other things that may or may not be tracked are insider buys and sells, lock-ups, insider information, deals with related entities, executive salaries, and dividends. In many countries, for example, the largest shareholder is allowed to charge a "management fee," a special charge levied in exchange for assistance and expertise granted to the company in the course of business. This charge is in most cases external to the operational budget of the company and is essentially a preferred dividend paid to the largest shareholder. In countries with partially privatized companies, guess who is often the largest shareholder? Yep, you got it -- the government.

Certain countries -- Singapore and Finland in particular -- do have excellent reporting standards, ones that adequately protect the individual investor. But even such money centers as Hong Kong have lousy shareholder rights records. The simple rule of thumb is that you should balance the benefit of investing in a certain country with the knowledge that the information you receive may not be as reliable as that to which you are accustomed.

Even if the country has adequate protection, there is another item to consider. You might receive full disclosure and not know what you are looking at. Each country has its own form of Generally Accepted Accounting Principles (GAAP). United States GAAP is vastly different from British GAAP, is different from Japanese GAAP, is different from Namibian GAAP, and so on. By the way, there is a Namibian company listed in the U.S.: Namibian Minerals Corp (Nasdaq: NMCOF). If you lack experience with the accounting standard in which these earnings are reported, you are at a disadvantage. At the same token, if you are deeply familiar with a country's accounting principles and have knowledge of a certain industry, you have a distinct advantage. This is why, though the Fool recommends sticking to the U.S., we cannot ignore overseas investing.

4. International investing is generally more expensive. The United States was the first major market to deregulate brokerage fees, and has the most competitive brokerage atmosphere. This point speaks mainly to buying international stocks in their home market, as you are then forced to use either a local broker or one that works in tandem with your home brokerage. In either case you are apt to spend a great deal more money than you would buying a stock on a U.S. exchange using a discount broker. But for foreign shares purchased on U.S. exchanges, there are also some additional costs. For example, when I recently received a dividend from Nokia, a tax of 10% was taken out in advance. Since I am enrolled in a repurchase plan, that 10% will hit my bottom line over time. With U.S. companies, we are also charged tax, but it is taken out after the fact, when we file those 1099s with our tax return. By so doing, we have had use of those additional shares for up to a year prior to being taxed on them. Over the years, this difference in timing will loom quite large.

There can be no doubt that some of the most compelling investments lie outside the United States. Any reasoning that dictates that a certain percentage of one's investments must be overseas ignores the above factors. And since the level of correlation of foreign markets to the U.S. markets has increased by a factor of three over the last decade, the globalization of the economy has lowered the level of diversification international investing brings a portfolio.

Fools should look for great investments wherever they exist, but the truly Foolish also surveys the landscape surrounding those investments to ensure that the risks do not overwhelm the chance for superior returns.

The Fool has sites in the U.K. and in Germany (in German, but Babelfish or some other translation program will help) to complement its U.S. site. Fools wishing to learn about companies in those countries should take a look to see what the native Fools have to say. We also have a series of discussion boards on international investing, inhabited by Fools from around the world. If you have a question about specific countries, this is a good place to post it.

Fiat Fool! Narr Weiter!

Bill Mann, TMFOtter on the Fool Discussion Boards