Smart Investor: Acid Test, September 2010

Smart Investor, September 2010

Should you have international exposure in your portfolio?

Do you want to be as diversified as possible? Yes/No

The Australian stock market, while deep, accounts for barely 2% of the world’s total. There are whole sectors that are barely represented in Australia: there’s no tech or software stock to compare with a Microsoft, Apple or Dell; no pharma big hitter like Glaxosmithkline or Novartis; no automotive manufacturer like Toyota or GM. Investors who have all their money in Australian stocks tend to have a very high weighting towards resources and banks, since those sectors have thrived in Australia.

Can you live with potentially lower returns for that diversification? Yes/No

The other side of the coin is that Australia’s sometimes narrow focus has, for years and years, outperformed the more diversified world markets. In the year to March 31 2010, the S&P/ASX 200 was up 41.7%; the MSCI World index, from the perspective of Australian investors, was up 14.5%. In the three years to that date, Australia was down 2.4%, the world down 9.6%; and in the five years to that date, Australia was up 8.1% while the world was down 0.8%. Partly this is to do with the currency, which can be hedged out, but the fact is that Australian markets have been among the best performers for a protracted period of time now.

Are you comfortable with currency risk? Yes/No

One of the main reasons Australian investments have outperformed world investments is because of the continuing strength of the Australian dollar against most other major currencies – largely a function of Australia’s role as a source of commodities, and also the resilience of its economy through the financial crisis. For Australian investors, this has served to cancel out any gains they would otherwise have got from international investments: if you have a US stock that’s up 10% but the US dollar is down 10% against the Aussie, you don’t gain anything. That said, many overseas share mutual funds can hedge out the impact of the currency. And others feel that after such gains in recent years, sooner or later the Aussie dollar must fall back, in which case the reverse would be true – gains in overseas shares would be magnified.

Are you prepared to have exposure to companies you’re not familiar with? Yes/No

One issue with going overseas is that you lose the familiarity of brand names you see every day. You know what Australian companies do because you are always in contact with them, often as a customer, which helps inform your decision about whether they are good investments. Going overseas means losing much of that comfort. Still, most investors gain their overseas exposure through managed funds rather than individual stocks, so it’s more a call on how comfortable you are with your fund manager’s knowledge of international markets.

Do you believe in emerging markets and the China story? Yes/No

Historically, buying overseas shares or managed funds meant a global fund putting half your money into the US and most of the remainder into Europe, with barely a drop allocated to markets like Asia. These days, there are a host of emerging market, Asia or even country-specific China and India funds you can go into if you want to. These markets are volatile but are expected to be the engine of world growth over the next generation. Some Australians prefer to get their exposure to this theme by buying local stocks that get a lot of their business from emerging markets – BHP Billiton and Rio Tinto are two examples.

Are you worried about Australia’s economy? Yes/No

In truth, few people are worried about Australia’s economy, particularly after they’ve had a look at developed country peers around the world. But anyone who thinks that Australia or its stock markets are due a stumble ought to think hard about diversifying into other parts of the world.

Do you want exposure to the world’s biggest blue-chips? Yes/No

Australia gives you world-leading miners and the biggest banks in the Southern Hemisphere but nothing else that registers on a world scale. ExxonMobil, Coca-Cola, Microsoft, ICBC (from China – now the biggest bank in the world by market capitalization) – the true heavyweights of the world are elsewhere. If you believe scale translates into the best prospects you need to go overseas to reach them.

 Do you think the Aussie dollar is overvalued? Yes/No

 This relates to the question about comfort with the currency. If you think the Australian dollar is due a slide after such meteoric recent gains, one way to express that view is to buy overseas shares or an overseas managed fund, unhedged. However if you’re wrong, and the currency continues to strengthen, you will lose out.

 Do you think resource stocks are due to decline? Yes/No

 If commodities end their run and start to fade, that’s bad for Australia, and Australian stock portfolios will suffer. That’s when diversification will become important.

 Are you a contrarian who wants to buy at the bottom? Yes/No

The markets that suffered worst in the financial crisis could, in one view, represent the best opportunities for a rebound. At the moment, that’s European markets. A treacherous business this, though: many have gone awry either by buying too early when there is further to fall, or buying in markets that are low but that stay low.

Mostly yes: you understand the risks but think they are outweighed by proper diversification. Invest in overseas shares.

Mostly no: you believe the best opportunities are at home, and that there’s safety in sticking with what you know. Stay domestic.