Outperform With International Stocks

Last year was a good one for domestic stocks, and an even better one for international equities. Indeed, international stocks outperformed the S&P 500 for the fifth consecutive year in 2006. That fact hasn't been lost on investors -- inflows into emerging-market funds topped the amount that flowed into domestic funds in 2006.

Foreign stocks are hot, though we might have seen a reversal of this trend in recent days. But that still shouldn't be a problem. As long as you devote approximately 20% of your portfolio -- diversified among equities from developed countries and emerging markets -- to international stocks, you will benefit over the long term, despite the ebbs and flows of individual markets.

A simple allocation strategy
When allocating to international stocks, investors should aim to do the following:

1. Balance your stock selections among both large-cap stocks and small-cap stocks.
2. Look for stocks in developed countries such as France and Japan, as well as emerging markets such as India and Brazil.
3. Pay attention to valuations, just as you would with domestic stocks.

This last point is particularly significant, since international stocks have had a great run over the past five years. Discerning investors can still find good values, however. In a recent article in The New York Times, Paul Lim notes that "valuations are still lower outside the United States." And Bill Mann, in a recent issue of his Global Gains investment service, has also noted several undervalued markets.

The proof of the pudding is in the eating
We used this broad-based approach to picking international stocks for The Motley Fool International Stock Report, published in March 2006. Our selections and subsequent returns are provided below:

As you can see, we were able to outperform the global MSCI EAFE index by 13 percentage points, and our domestic S&P 500 by nearly 22 percentage points (and that's after the recent sell-off in international markets) by balancing large caps such as AstraZeneca and Sanofi-Aventis with more volatile small caps such as Gruma and Flamel. As one of the editors for the report, I can say that we hunted for stocks with compelling valuations -- though I confess that there was disagreement about Baidu even before it doubled last year.

It's difficult to know what the next year will bring for this basket of stocks. Take BP, for example. Despite its lackluster performance last year, it remains well-positioned to take advantage of strong long-term demand for energy products worldwide. And the appointment of Tony Hayward as the company's new CEO could be a catalyst here.

Baidu, on the other hand, might be heading in the other direction. That's the consensus, at least, from our Motley Fool CAPS investment community, where Baidu receives just one star (our lowest rating). Global Gains analyst Nate Parmelee notes that "you can pick price to earnings, price to free cash flow, or even price to sales, and you can't find a way to make the valuation on this business make any sense."

There's no need to see the future
These 12 stocks outperformed because we looked for good companies trading at the right prices. As you search for international stocks for your own portfolio, keep these guidelines at the front of your mind.

And if you'd like some help filling the international portion of your portfolio, you can view the latest selections from the Global Gains team absolutely free with a 30-day guest pass. You'll have access to all our picks, as well as commentary and analysis on the most intriguing international markets. Click here to learn more about the free trial offer.

John Reeves owns shares of Flamel. Embraer is a Motley Fool Stock Advisor selection. Telecom New Zealand is an Income Investor pick. Flamel Technologies is a Motley Fool Hidden Gems selection. Baidu is a Rule Breakers pick. The Motley Fool has a disclosure policy.