These higher correlations should not, however, deter investors from international diversification. In the United States, many of the ten sectors highlighted in Chapter 4 have returns that are highly correlated, but I have not heard anyone suggest that one should refrain from investing in the industrials sector because, say, it is highly correlated with the materials sector. More important, where a firm is headquartered will become increasingly irrelevant to investors.
FIGURE 16.3: CORRELATION BETWEEN UNITED STATES AND INTERNATIONAL RETURNS
Sector Diversification versus Country Diversification
The most successful companies are going to be those that envision the global economic changes outlined in the last section. They will be headquartered anywhere in the world. In fact, the term “foreign investing,” which is defined by where a firm keeps its home base, is a relic of the past. Why should we identify firms by where their headquarters are located and ignore where they produce or sell their goods?
Coca-Cola, ExxonMobil, Altria (formerly Philip Morris), Texas Instruments, and Intel sell at least two-thirds of their products abroad, but they are defined as U.S.-based firms. Similarly, Unilever is a Dutch firm, Nestlé is Swiss, Toyota and Sony are Japanese, and HSBC (Hong Kong Shanghai Bank Corporation) is English despite the fact that all these are global firms that buy, sell, and produce goods and services in international markets. For the S&P 500 Index, over 20 percent of all sales come from foreign markets, but that percentage will certainly increase as the global solution becomes a reality.
A Morgan Stanley report titled “How Global Is Your Industry” echoes these views: “We think that regional allocation is passé; indeed, research has shown that global industry influence has now surpassed country influence in explaining outcomes.”7 As noted in the chapter discussing sector returns, the Morgan Stanley report concludes that investors ought to focus their asset allocation strategies more prominently on global sectors. Unfortunately, investing by global sectors remains difficult because a complete set of global sector investment products is not yet available.8
Recommended Allocation
After considering all the factors, my recommended weight for foreign-based holdings of equity is 40 percent of the stock portfolio, somewhat short of the share of foreign stocks in the world markets. This is based on risk-return analysis that takes currency fluctuations into account, but uses a longer perspective than the standard risk analysis done in financial markets.
Investors may be persuaded to follow the crowd and underweight foreign holdings. The economist John Maynard Keynes perceptively maintained, “Worldly wisdom teaches that it is better to fail conventionally than succeed unconventionally.”9 If you make an investment that everyone else made and the investment fails, you have others with whom to commiserate, and misery loves company. If you fail by purchasing stocks that no one else buys, you bear the sole responsibility for the decline and will get little sympathy from others.10
Although copying the actions of others affords some psychological comfort, it pays to stand apart from the crowd. Conventional wisdom in the financial markets is generally wrong. We have seen that the future lies with the global market economy. Profits will flow to firms that take advantage of this growth. You should put your money to work in the international markets, no matter where the firms are headquartered.
How to Invest Abroad
How, then, should investors buy foreign-based firms for their stock portfolio? The best way to achieve broad-based international diversification is through global index funds. An index fund allows investors to match the returns of representative indexes at very low cost.
Index funds have gained popularity and should continue to do so because they have the lowest costs while still achieving excellent returns. There is much literature written on the underperformance of actively managed stock mutual funds. Jack Bogle, the founder of the Vanguard Group, the world leader in index products, has written extensively on the topic, as did I in Stocks for the Long Run.11 The index funds noted below are available in mid 2004, but investors should be alert to new products that will become available.
Outside the United States the most popular indexes are those developed by Morgan Stanley’s Capital Index Group. Vanguard’s Total International Stock Index Fund (VGTSX), which is based on these Morgan Stanley Indexes, is the most inclusive non-U.S. indexed fund available. It includes stocks based in developed Europe12 (around 60 percent of the fund), the Pacific13 (nearly 30 percent), and an emerging-markets index (10 percent of the fund). The European, Pacific, and emerging-markets mutual funds can also be purchased separately.
Except for the emerging-markets segment, the Vanguard international fund is based on Morgan Stanley’s EAFE Index, which stands for Europe, Australia, and the Far East. The EAFE Index constitutes the best-known and most widely cited non-U.S. index of the developed world’s equities.14
Indexation of foreign stock markets, although more expensive than that in the United States, is no longer costly. The Vanguard Total International Stock Index charges 0.36 percent a year, twice the stated cost of Vanguard’s S&P 500 or Total Stock Market Index funds.15
Vanguard has always been the undisputed low-cost and largest provider of indexed mutual funds. However, in the summer of 2004, Fidelity Mutual Funds of Boston, the world’s largest mutual fund group, threw down the gauntlet and announced that its major index funds would slash fees to only 0.10 percent per year, lower than the stated fee on Vanguard.
This competition is great for investors. But investors should be forewarned that stated fees may differ from actual fees and that Vanguard has offset most of its stated fees through its proprietary trading techniques. Tiny differences add up to significant dollars for the long-term investor.
Exchange-Traded Funds
In recent years an innovation, exchange-traded funds or ETFs, has skyrocketed in popularity because of the funds’ low fees and simple replication of index products. ETFs, in contrast to mutual funds, can be bought and sold throughout the trading day. The annual costs of ETFs are even lower than the stated fees on indexed mutual funds, although a brokerage commission must be paid to buy and sell these funds.
For investors who seek exchange-traded funds, the Morgan Stanley EAFE Index has a very actively traded and liquid ETF (ticker EFA) that charges fees of 0.35 percent a year. The emerging-markets ETF is a separate fund (ticker EEM) with an annual expense ratio of 0.78 percent.
Unfortunately, our northern neighbor, Canada, is not included in the EAFE index because of its high correlation with U.S. stocks. But Canada should not be ignored, being home to such firms as Inco, Alcan, and New-mont Mining, which were eliminated from the S&P 500 Index in S&P’s purge of non-U.S.-based firms in 2001. One can complete the non-U.S. portion of the international market by buying the Canadian exchange-traded fund (symbol EWC), which accounts for 2.6 percent of the equities in the world market.
Indexing at Home
For equity exposure to the United States, the best choice of index products is the Dow Jones Wilshire Total Stock Market Index. This index is a capitalization-weighted index that contains all stocks that are traded on the major U.S. indexes. Vanguard’s Total Stock Market Fund, which tracks the Wilshire Index, was founded in April 1992, and its average return, including all fees, has been only 0.19 percent per year less than its benchmark.16
Vanguard has a very strict policy against trading in and out of its index mutual funds. To satisfy those who wish to do so, Vanguard has instituted a group of exchange-traded funds called VIPERs (Vanguard Index Participation Equity Receipts). Each of Vanguard’s VIPERs amounts to a new class of shares of one of the company’s well-known index funds. This includes the Vanguard Total Stock Market Fund (VTI) as well as others.
There are two reasons why I prefer the Total Stock Market Fund to an index that covers part of the market, like the S&P 500 Index. First, I prefer to achieve the greatest diversification, and it is important to add small and midsized stocks, which make up about 20 pe
rcent of the U.S. stock market but are not in the S&P 500 Index. Second, investors should be wary of linking their wealth to very well known and widely replicated indexes that cover only part of the market. As I discussed in Chapter 2, these indexes advertise well ahead of time what stocks are being added or deleted. This enables speculators to buy stocks prior to their inclusion, pushing up their prices and putting the indexed investor at a disadvantage. With a fund linked to all stocks, this is impossible.
However, for those who prefer to decide their own allocations, one can add small and middle-sized capitalization indexes to the S&P 500 Index to achieve the total market or tilt the portfolio toward smaller or larger stocks. The S&P 400 midcap index (which contains about 7 percent of U.S. capitalization) and S&P 600 small-cap complement (which contains about 3 percent of the index) can be added to the S&P 500 Index to form the S&P 1500, an index that contains about 90 percent of the tradable U.S. market. Standard & Poor’s monitors the entire U.S. market and chooses stocks in its index depending on market capitalization, industry representation, and liquidity, among other factors.
Alternatively, one could invest with the popular Russell indexes. The Russell indexes, in contrast to the Standard & Poor’s indexes, are based almost exclusively on market capitalization.17 The Russell 3000 contains the 3,000 largest stocks traded on all exchanges, comprising about 97 percent of the value of all U.S.-traded stocks. The Russell 1000 contains the 1,000 largest stocks by market value, and the Russell 2000 is a popular small-cap index comprising the 2,000 smallest of the 3,000 stocks belonging to the Russell universe. Russell has a host of exchange-traded funds.18
Again, for those who prefer ETFs, the two most popular exchange traded funds are those representing the S&P 500 Index, called spiders (after the acronym SPDR, for S&P Depository Receipts) and the Nasdaq 100, called cubes (after the ticker symbol QQQ), which represents a tech-heavy index of the 100 largest nonfinancial stocks traded on Nasdaq. Spiders and cubes are so popular that the average daily dollar volume in these issues often exceeds that of any listed stock on either the New York or Nasdaq exchange. Another popular exchange-traded fund is called diamonds, named after the symbol DIA, which represents the venerable Dow Jones Industrial Average.
International Indexation at the Core of the Portfolio
This chapter advances an international approach to holding equities. This approach emphasizes the importance of holding a substantial fraction of your equity assets—approximately 40 percent—in stocks that are headquartered outside the United States. This world indexed equity exposure should be considered the core of your portfolio.
We also learned that the growth trap is just as applicable to stocks of individual countries as it is to individual firms. Fast-growing countries such as China do not necessarily have the best-performing stocks. Broad-based diversification is the key to achieving the gains from global growth. In the next chapter we will talk about strategies investors can use to supplement this indexed core to achieve higher returns.
CHAPTER SEVENTEEN
Strategies for the Future:
THE D-I-V DIRECTIVES
Good thoughts are no better than good dreams, unless they be executed.
—Ralph Waldo Emerson, 1836
From Indexing to the D-I-V Directives
When I lecture to investors about the stock market, two questions invariably arise: “What will happen to the economy and my investments when the baby boomers retire?” and “Which stocks should I buy for the long run?”
The research that I undertook for this book confirms that the future is bright for equity investors. Growth in the developing world will provide both enough goods and enough demand for stocks to offset the impact of the age wave in the developed world. The future performance of stocks should easily outpace those of bonds, precious metals, and other inflation hedges.
On the second question, “Which stocks should I buy for the long run?” my answer has shifted since I conducted the research for this book. Formerly, I recommended that investors put all their money allocated to equity into a fund that tracked the broadest possible index of common stocks. Since the overwhelming evidence indicates that active equity managers and mutual funds, after fees, do not perform as well as low-cost index funds, I believed indexing was the best way for investors to accumulate wealth. Now I am convinced that there are strategies that can do even better.
Don’t get me wrong. I still believe that indexing should be a core component of your stock portfolio. I spoke to the importance of indexing to the world markets in the last chapter. But my historical studies of the firms in the S&P 500, industry performance, IPOs, and dividends have revealed that investors may obtain better returns by supplementing their indexed portfolios with the strategies analyzed in this book.
I have distilled the portfolio implications of my new research into three directives, using the mnemonic D-I-V. The D-I-V directives are designed to help investors focus on strategies they can use to construct their stock portfolio.
Dividends: Buy stocks that have sustainable cash flows and return these cash flows to the shareholders as dividends.
International: Recognize the forces that will swing the balance of economic power away from the United States, Europe, and Japan toward China, India, and the rest of the developing world.
Valuation: Accumulate shares in firms with reasonable valuations relative to their expected growth and avoid IPOs, hot stocks, or other firms or industries that the consensus believes are “must-have” investments.
Dividends
HIGH-DIVIDEND STRATEGIES
This book emphasizes the importance of dividends in generating superior stock returns. The primary function of management should be to maximize current and future cash flows to shareholders. The payment of dividends has provided management with that discipline throughout most of the stock market’s history, and I believe that stocks that pay good dividends will yield superior returns in the future.
Table 17.1 summarizes the risks and returns of the dividend strategies described in Chapters 9 and 10. All of these strategies beat both the S&P 500 Index and the Dow Jones Industrial Average.
The reward-risk ratios, which are the measure of the extra return per unit risk, are all superior to the indexing strategy.1
Which companies appeared on these dividend lists most often? The large integrated oil companies stand as high-yielding winners. In the top yielder strategy, which chooses firms in the S&P 500 with the highest (top 20 percent) dividend yields, Royal Dutch Petroleum has been in this group for twenty-nine years, and in those twenty-nine years it returned 17.11 percent per year. This is over three percentage points more than its buy-and-hold annual return from 1957 to the present. ExxonMobil was on the list twenty-three years and returned almost 20 percent per year during that time, a full 6.5 percent above its buy-and-hold return. Mobil Oil (now merged with Exxon) earned 18 percent per year in its sixteen years in the strategy.
TABLE 17.1: DIVIDEND STRATEGIES, 1957–2003
Oil stocks were also important in the Dow and S&P dividend strategies, as Standard Oil of New Jersey (now ExxonMobil) was in the Dow 10 strategy a record thirty-eight years, from 1957 through 2003.
Another industry that frequents these high yielding strategies are the cigarette manufacturers, such as Philip Morris and Fortune Brands (formerly American Tobacco). Philip Morris, which has never lowered its dividend payment, had a return of nearly 32 percent per year for the thirteen years that it was in the Core 10 strategy.
An important reason why these high-dividend strategies work so well is because of the basic principle of investor return. This principle, discussed in Chapter 3, states that stock returns are based not on earnings growth alone but on growth relative to expectations. For many of these dividend-paying stocks, investors became overly pessimistic at a dip in earnings growth, leading to lower-than-justified valuations and higher-than-average returns. For stocks paying a dividend, these lower valuations led to higher dividend yields, and investor
s were able to accumulate more shares at discounted prices. The return accelerator, described in Chapter 10, worked its magic on these stocks.
The evidence supporting dividends extends beyond the borders of the United States. Dimson, Marsh, and Staunton, authors of Triumph of the Optimists, found that the highest dividend yielding stocks in the U.K. outperformed the lowest-yielding stocks, just as I found for the United States. The divergence was substantial, amounting to 3 percent per year over the past 103 years.2 I am certain that future research will find that dividend-based outperformance is present in other countries as well.
IMPLEMENTATION OF DIVIDEND STRATEGIES
The Dow 10, the S&P 10, and their associated core strategies involve just ten stocks, so they can be implemented by individual investors. For those who do not wish to purchase individual stocks, unit investment trusts that implement the Dow 10 strategy as well as similar strategies in other countries are available.
The list of companies in the 2004 portfolios of the Dow 10, Dow Core 10, S&P 10, and S&P Core 10 are found in Table 17.2. Four of the Dow companies also appear on the S&P list: SBC Communications, Altria, General Motors, and J.P. Morgan Chase.
It should be emphasized that this list changes every year, and by the time you are reading this book, it is likely that some of these stocks will no longer be in these dividend strategies. You can find the stocks that currently make up the Dow 10 strategy, also known as “Dogs of the Dow,” on the Internet.
The Future for Investors Page 25
