International stocks can add diversification to your portfolio, and could even give you the opportunity to boost your returns. However, there are some drawbacks to be aware of before you invest.
In this clip from Industry Focus: Financials, analyst Michael Douglass and Fool.com contributor Matthew Frankel discuss the pros and cons of investing in international stocks.
A full transcript follows the video.
This video was recorded on May 14, 2018.
Michael Douglass: Let's turn to the advantages of international investing. I think one of the key core ones is the other side of that volatility, which is fast-growing, exciting investments. There are real opportunities with countries that are growing their GDP at 5%, 7%, 10% annually. Here in the U.S., it's a good year if we get to 2%. So, you really have to consider what the opportunity might be for a well-placed company in a fast-growing economy.
Matt Frankel: Right. There have been periods in the past 20 years when you could have owned a China ETF for a 10-year period and quadrupled your money. These are investments that can be growing faster. Even what we think of as boring companies like telecoms, in some of these developing nations, they can be growing at 10-15% a year. So, these are opportunities that you don't have domestically, just because of the maturity of our economy.
Douglass: Right. One of the other things to consider is, in general, diversification. When you think about your portfolio in general, think about correlation. How much are you tied to particular trends or particular commodity prices, as I mentioned earlier? Well, one of the things that a primarily domestic stock portfolio is highly correlated to is, well, U.S. economic performance. And, to some extent, the rest of the world is, too. But, there are opportunities to diversify your holdings to make sure that you have these opportunities to benefit when other countries are prospering in ways that the United States isn't. That's a really important thing to consider here.
Frankel: Yeah, it's kind of the same thought process as when you put all of your portfolio in bank stocks. We love bank stocks. We talk about them every Monday.
Douglass: [laughs] We sure do!
Frankel: But we're not going to put all of our money in them. The same kind of concept applies here. We love America, we think American business is going to do great over the next 50 or 100 years. But that doesn't mean you want to put all of your money into America's economy. If something like 2008 happens, a lot of the stock markets around the world did a lot better than ours did in 2008 because of, obviously, what happened to the U.S. banking system. That's another reason you don't want to be 100% in banks.
Douglass: [laughs] Right.
Frankel: But, my point is, when a bad situation happens, you don't want to be completely levered to that one country's economy. The same thing is true for other countries, as well. If there's, say, a U.K.-specific incident that happens, you don't want to be too levered to that market. It kind of balances out your geographic risk, by investing in foreign companies.
Douglass: Yes. And I would say, more broadly, when I think about stocks, I'm usually considering their geographic risk. If one company does all of its business in California or Virginia or South Carolina or wherever, that's, to some extent, a concern, because a change in the regulatory environment in that one state can have a really outsized impact, or a natural disaster, or who knows? In the same way, being levered all to one country, again, there's a bit more spread-out of risk because we have 50 states in United States, but there's still some of that risk.
One of the other things to consider with international stocks, it can be both an advantage or a disadvantage, depending, is currency headwinds or tailwinds. U.S.-based companies operate on the dollar. When they have significant international operations, depending on whether the dollar is weak or strong, that can be a benefit or a drawback to their reported earnings. Now, it's not something we really consider a lot in terms of looking at investments because, let's face it, if the underlying business is strong, then currency headwinds or tailwinds are just a thing that you notice. But it's certainly something that you need to be aware of before considering investing in international stocks.
With that, let's turn to some of the drawbacks. We've highlighted some of these already, but we'll go through and talk about them a little bit more. First one, obviously, political risk.
Frankel: Yeah. Not every country is as stable as the U.S. A lot of people think our political climate is kind of shaky. Go to one of these emerging nations and see how uncertain things are in emerging markets. Venezuela comes to mind as a really big example right now, with the hyperinflation going on there. Things like that. If a political regime is overthrown, that could have a huge effect on investments in that country. Hyperinflation is a big risk in a lot of these emerging nations that don't have currencies that are quite as stable as the U.S. dollar. In short, be aware that not every country is as developed as America, and that's why they call some of these emerging markets.
Douglass: Right. And, of course, we've already talked about volatility, so I'll skate by that one, but I just wanted to reemphasize it one more time. Volatility is definitely a bigger concern with emerging markets in particular, in part because the expectation is, if a country has been growing its GDP at, I'm making this up, 7% annually, then, well, if they report 5% annual growth for a year, that can really shake a lot of investor confidence. Now, that may not necessarily change your underlying thesis around the country and around the specific companies that you might be investing in in that country, but you just need to be aware that things are probably going to be more volatile because there's more expectation for growth built in -- just like when you invest in growth stocks in general.
The other thing to point out here is that there's limited information available on many foreign companies. Basically, there are different regulatory requirements country by country, and that can make a really big difference in terms of what story you learn about a company.
Frankel: Yeah. Not every country has the SEC looking out for investors. Not every company around the world is required to file a 10-Q every quarter. There's limited information available on companies, especially in the emerging markets. That makes them kind of tough to research and value properly, especially for people listening who are looking at some of the metrics and consider themselves value investors. It can be much more difficult to value companies from emerging markets especially, and even developed countries around the world that don't have the same regulatory requirements that we do here.