As we look ahead to our and our children’s welfare, there is no other economic goal that should have higher priority. We must embrace this future.
PART FIVE
Portfolio Strategies
CHAPTER SIXTEEN
Global Markets and the World Portfolio
“Today let’s talk about a growth industry. Because investing worldwide is a growth industry. The great growth industry is international portfolio investing.”
—John Templeton
My optimism about the growth in developing countries raises an important question: what does the global solution mean for your portfolio? Most investors, lured by the heady growth prospects in China and India, reflexively want to buy stocks from these rapidly growing countries.
But that would be a mistake. Recall the growth trap that we illustrated in Parts 1 and 2 of this book. Strong growth does not imply better returns for foreign firms any more than it does for domestic firms. As the basic principle of investor return states, what matters is growth relative to expectations, not growth alone. The evidence from the study of international returns strongly supports this proposition and is not comforting to the growth enthusiasts.
This does not mean that you should ignore foreign investing. Quite the contrary. Today, almost half the world’s equity is headquartered outside the United States. To ignore the foreign markets would be akin to forming a domestic portfolio filled only with firms that begin with the letters A through L. Unbalanced portfolios increase risk without increasing returns.
But before we learn how to structure an international portfolio, I want to again emphasize the difference between growth and returns by examining the recent history of two countries, China and Brazil. This case is parallel to the tale of two companies, IBM and Standard Oil of New Jersey, that I presented in the very first chapter of this book.
China and Brazil
Travel back in time to the end of 1992. The global economy looks ripe for growth. The Berlin Wall fell three years ago, and Eastern Europe is anxious to integrate with the West. The First Gulf War ended in a big victory for the West—the United States, with its coalition allies, ousted Saddam Hussein from Kuwait and has emerged as the world’s sole superpower. Russia relinquished parts of its former empire, and the one-time beacon of world communism shifted to a capitalist economy.
Your investment advisor suggests stocks in either China or Brazil to capitalize on this growth. China is the most populous country in the world, and Brazil has the largest economy in the Americas outside the United States. Both countries have enormous economic potential. Which country presents you with the greatest potential to build your wealth? Let us examine the record.
CHINA
China’s economic growth had already taken off by the early 1990s. Ten years earlier, the Chinese government, under the leadership of Deng Xiaoping, began implementing an economic reform program that would catapult its economy from an inefficient Soviet-style centrally planned state to a market-oriented system. In 1990, the Chinese economy, already clicking on all cylinders, went into overdrive.
That year the Shenzhen and Shanghai stock exchanges were opened, to the tremendous excitement of both Chinese and foreign investors. In 1992 the number of listed stocks increased from twenty to seventy and had an aggregate market value of over 100 billion yuan ($20 billion). Trading volume expanded nearly thirtyfold over the previous year, and in December 1992 Morgan Stanley began calculating its China stock index of total returns.1
After a slow start, Chinese stocks soared in the second half of 1993, and American investors responded eagerly. Newsweek reported:
In China, it’s the year of the Rooster. But in America, 1993 has become the year of China. Out in Peoria, Mom and Pop are pouring their savings into mutual funds that pursue heady gains in China’s booming market. For those who don’t get the message, President Jiang Zemin touts the fact that his country is now Boeing’s biggest customer.2
Those who predicted that China’s economy was going to surge ahead were absolutely right. Real GDP growth in the following eleven years averaged 9.3 percent a year, far above that of any other country in the world and nearly three times the rate in the United States. By 2003 China, in terms of purchasing power, had become the second largest economy in the world, and it was the world leader in foreign direct investment.
BRAZIL
Brazil, on the other hand, began the 1990s in political and economic crisis. In 1992 President Fernando Collor de Mello was impeached by the Chamber of Deputies and forced to resign. Brazil faced economic chaos as inflation soared to over 1,100 percent by year’s end.
Those expecting things to get worse were right. By 1994 inflation surpassed 5,000 percent and real output dropped. Fernando Cardosa, who was elected president in October 1994, temporarily stabilized inflation but was forced to devalue the currency in January 1999 when increasing budget deficits prompted a flight of international reserves.
Then came a series of corruption scandals and an energy crisis that led the government to order widespread cuts in electrical consumption. Popular dissatisfaction with these austerities brought Luiz Inacio Lula da Silva, an avowed leftist of the opposition Workers’ Party, to the presidency in 2002.
During these troubled years, Brazil’s GDP grew at only 1.8 percent per year, among the lowest in the developing world and less than one-fifth the growth rate of China. While the Chinese economy expanded by a cumulative 166 percent over these eleven years, Brazil’s increased by only 22 percent.
Once again Brazil’s huge potential was squandered. Frustrated optimists bemoaned, “Brazil is the country for the future … and it always will be.”
THE VERDICT
Those who predicted China’s economy would grow faster than Brazil were right; China outpaced Brazil by a wide margin in virtually every category of economic output. China also enjoyed a stable currency, low inflation, and relative political stability, while Brazil had none of these.
But as Figure 16.1 shows, the returns to stock investors tell a very different story. From 1992 onward, China experienced the world’s worst stock returns as investors saw their portfolio shrink, on average, by almost 10 percent per year. A $1,000 investment in China at the end of 1992 shrank to $320 by the end of 2003. Brazil, on the other hand, produced extraordinarily good returns of over 15 percent per year, with the same $1,000 investment in 1992 accumulating to $4,781, handily beating U.S. stocks.
How could this happen? For the same reason, as we learned in Chapter 1, that Standard Oil of New Jersey had better returns than IBM even though IBM beat Standard Oil on every measure of growth. Low prices and high dividend yield were the keys to Jersey’s better returns and the reason why Brazilian investors outpaced the Chinese investors.
The conventional wisdom that investors should buy stocks in the fastest-growing countries is wrong for the same reason that buying the fastest-growing firms is wrong. China was indisputably the world’s fastest-growing country, but investors in China realized horrible returns because of the overvaluation of Chinese shares.
FIGURE 16.1: A TALE OF TWO COUNTRIES: CHINA AND BRAZIL STOCK RETURNS AND GDP GROWTH
On the other hand, stock prices in Brazil were cheap in 1992, and all its economic troubles kept its prices low over the subsequent decade. As a result, the dividend yield on Brazilian stocks stayed high. Patient investors, buying value instead of hype, won out.
The Conventional Wisdom Is Wrong Again
The failure of economic growth to produce good stock returns extends far beyond the case of Brazil and China. Figure 16.2 plots the economic growth and stock returns in twenty-five emerging markets.3 Countries with reasonably priced markets, such as Brazil, Mexico, and Argentina, gave investors the highest returns, although their economic growth was among the slowest. Even if we exclude China (the fastest grower and worst performer) and Brazil (the second slowest grower with the third best returns), the relation between real GDP growth and return in these countries is still negative.
The same conclusion holds for developed economies. When Dimson, Marsh, and Staunton, in their landmark study Triumph of the Optimists, analyzed the data from sixteen countries from 1900 forward, they also found a negative relation between GDP growth and real stock returns.4 Japan had the highest growth of real GDP but poor stock returns. South Africa had the lowest GDP growth but the third highest stock returns, surpassing returns in the faster growing United States. Australia and the United Kingdom had among the weaker real GDP growth rates but relatively high stock returns. Growth is not enough to sustain a profitable investment strategy.
Growth and Stock Returns
At this point you may be confused. In Chapter 15 I extolled growth as the global solution to the developing world’s economic and financial problems. Now I claim that growth may be bad for the stock returns of individual countries. These claims seem contradictory, but they are not. Growth does produce more output, more income, and more buying power. This tends to support stock prices. But the prospect of growth often creates too much excitement and results in overpricing, especially in newly emerging economies.
That is what happened in China, when too much money chased too few shares. This caused overvaluation and poor future returns. Given the opportunity, many Chinese would have preferred to invest in U.S., European, or even Japanese firms. But they could not, so all the demand for shares was focused on a relatively small group of stocks.
Fortune magazine gave an insightful view of the pandemonium that broke loose when the Shenzhen market was opened in 1992:
To buy stock in the West, you pick up the phone. To buy stock in China, you must first secure a permit to enter Shenzhen, the special economic zone near Hong Kong. You then bring 100 yuan, or half a month’s wages, and wait in line for three days and nights. Then you get mad.
Chinese police used batons and tear gas to contain parts of a fractious crowd of a million people attempting to buy application forms to purchase shares in the exchange’s new listings. China’s “savings overhang,” all that money stuffed in mattresses or tied up in savings accounts earning 2% a year, is estimated at one trillion yuan, or $185 billion. The old stock market was shut down more than 40 years ago, and there are simply too few shares available on the new markets to meet demand.5
The crowd erupted because some had accused government officials of hoarding the application forms. Imagine one million Chinese waiting in line for three days hoping to buy stock. The frenzy at the opening of the markets in China was like the South Sea bubble in England in 1708 or an IPO during the Internet craze in 1999. Insiders made out like bandits, whereas almost everyone else lost. The prices for Chinese firms priced in Hong Kong, where investors were free to buy foreign assets, were much cheaper than the prices of the same shares in Shenzhen or Shanghai.
As restrictions on share ownership are lifted, the Chinese will be able to buy foreign stocks and bonds as opportunities arise in the foreign markets. Chinese shares will become more moderately priced and the demand for investments outside of China will increase. As the age wave hits the developed world, the Chinese investors will have what the American, European, and Japanese retirees need: willing buyers of financial assets.
The World Portfolio
What does all this say about how much of your stock portfolio should be invested in foreign markets? Before we answer that question, it is important to look at the numbers in Table 16.1, which reports what percent of the market value of world equities are headquartered in each major region of the world.
As of September 17, 2004, the Morgan Stanley All-World Index, which contains most of the largest, most liquid firms in each country, had a market capitalization of $19.2 trillion. The value of firms headquartered in the United States is 52.3 percent of the world’s market value; the figure for developed Europe is 27.8 percent and that for Japan 9.1 percent. Developed Asia (Hong Kong, Singapore, Australia, and New Zealand) contains 3.2 percent, while Canada has 2.6 percent. All these above named countries contain 13 percent of the world’s population, although they serve as headquarters for firms that comprise 95.1 percent of the world’s firms based on market value. The rest of the countries, or 87 percent of the world’s population, are headquarters for firms with only 4.9 percent of the world’s market value.
TABLE 16.1: ALLOCATION OF WORLD’S EQUITY VALUES, SEPTEMBER 17, 2004
Region Percentage
North America 54.9%
United States 52.3%
Canada 2.6%
Europe 27.8%
United Kingdom 10.2%
France 3.8%
Germany 2.7%
Other Developed Europe 11.1%
Japan 9.1%
Developed Asia Excluding Japan 3.2%
Australia 2.0%
Hong Kong 0.7%
Singapore, New Zealand 0.5%
Emerging Markets 4.9%
Korea 0.9%
Taiwan 0.5%
China 0.4%
Brazil 0.4%
Mexico 0.3%
India 0.3%
Russia 0.2%
Other Emerging Markets 1.9%
Finance theory dictates that investors should hold the broadest of all possible portfolios, each country weighted by its market value, to achieve maximal diversification. If these precepts were followed, then U.S.-based investors would hold nearly half of their stock portfolio in non-U.S. companies.
Home Equity Bias
But the reality of most investors’ portfolios is very different from this market value–based allocation. Recent data show that U.S. investors, both professional and individual, hold only 14 percent of their stocks in non-U.S.-based companies, less than one-third of the indexed proportion.6 The reluctance to invest in assets outside the home country is called the home equity bias. Why does this bias exist?
The following reasons have been cited: (1) the additional risks incurred by currency fluctuations, since the prices of most foreign firms in their primary markets are quoted in foreign currencies, (2) higher transaction costs for investing abroad, and (3) investors’ greater knowledge of, and therefore greater comfort in buying, domestic companies.
Currency fluctuations appear to be a valid reason to prefer equities denominated in your home currency. Exchange rates between countries can be very unstable. From 1997 through July 2001 the dollar rose 35 percent relative to a basket of foreign currencies but fell 30 percent from the peak through 2003. If Americans had bought foreign stocks in 1997, they would have had to deal with a strong headwind of foreign currency depreciation for four years before the tide turned in their favor.
Despite short-term exchange rate fluctuations, there is very strong evidence that in the long run the returns on foreign stocks cancel out these currency movements. Over the long run, movements in exchange rates are determined by relative inflation between the countries, and stock returns will compensate investors for this difference in inflation.
Brazil and China illustrate this point. Since 1992 the Brazilian currency has depreciated more than eighty times relative to the dollar, but this was more than compensated for by appreciation of Brazilian stocks. Brazilian stock prices held up well because when inflation hits, investors run to tangible assets, such as real estate, precious metals, and stocks. The impact on foreign investors of the depreciating currency is offset by the rising price of output and increasing profit margins, as wages generally lag inflation.
On the other hand, China, which for the last decade maintained an extremely stable exchange rate with the dollar (it was fixed at 8.25 yuan to the dollar in 1995), has offered investors extremely poor returns. Currency stability does not guarantee good performance.
The importance of transaction costs and the unfamiliarity with foreign stocks, the other two factors cited in favor of overweighting home equities, has declined over time. Transaction costs in international funds have fallen dramatically, and the annual fees of internationally based exchange-trad
ed and indexed mutual funds are now not much higher than indexed products matching U.S. markets. Furthermore, it is now common for analysts to cover both foreign-based and domestic firms, so the information gap between U.S. and foreign-based firms has declined significantly.
Rising Correlations of International Markets
Recently another argument has been raised in favor of investors staying with domestic equities: the increasing correlations of the returns between the world’s stock markets. Diversification is valuable because some stocks go up when others go down. If returns between stocks are increasingly correlated, the benefit from diversification is reduced.
The correlations between world stock returns are indeed rising. Figure 16.3 shows the correlation coefficient between annual stock market returns in the United States and the rest of the world over a nine-year moving period since 1970. When correlations are near zero (or even negative), diversification works well. But when correlations reach unity, all markets move together and there is no gain from diversification. One can see that since 1996, the correlation has been in a steady uptrend, reaching .75 in 2003.
The increased correlation between world financial markets is not surprising. The communications revolution has made the financial markets increasingly interconnected, as traders in one market react to news and developments in other markets. In Tokyo the day’s trading often takes its cue from what happens in the United States the day before; the Europeans look at both the U.S. and Japanese markets; and before-market trading in the United States often takes its cue from Europe. Reactions to events and short-term fluctuations in investor sentiment, which in the past would have been confined to individual markets, now roll through the world’s markets much like the wave of hands that rolls through sports stadiums.
The Future for Investors Page 24
