Geographic diversification via ETFs

Investment Analysis Clubs Saul’s Investing Discussions
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Hi all,

I have been thinking about adding some geographic diversification to my portfolio.

I know we have discussed that the “market” being pricey doesn’t really impact our investments as long as our choices reflect good tradeoff between ‘valuation’ and ‘growth rates’. Additionally, many of the companies we hold have significant international exposure, so in that sense almost any decently diversified portfolio will have some depth of international exposure.

With the above considered, I 'm still considering adding some international exposure, for the following reasons:
o The stocks I have are almost exclusively US-based companies. The only exception is Yandex. I would like to have some exposure to Europe-based and Emerging market companies.

o There are quite a few high-quality European stocks that trade on various stock exchanges and these might benefit from the European central bank’s recently announced QE policy. Europe is launching QE while the US is bringing QE to closure, so I wonder if the QE money from Europe is going to drive European stock performance in the coming years.

o I have zero direct exposure to high growth emerging economies. While the burgeoning middle class in Asia and Latin America does benefit companies in the US and Europe, without exposure to these markets we miss out on the developments in the financial services, local information tech, and local consumer discretionary markets. These markets expand rapidly in growing economies.

Now, I can’t see myself studying individual companies, so I have been essentially looking at getting market performance via ETFs. I like the Wisdom Tree approach of weighing growth and dividends, although their expense ratios are higher than those of straight up ETFs that are based on market capitalisation. Over the past few days, I have looked at the following:

  1. Europe Dividend Growth Fund (EUDG)
    http://www.wisdomtree.com/etfs/fund-details.aspx?etfid=103

The top holdings for this ETF are Novartis, Nestle, BP, Roche, Shell, Glaxo, Siemens etc. The fund has 201 holdings.

Based on the data (12/31/2014) for the underlying index, EUDG trades for
P/E of 15.6
P/Cash Flow of 9.6

  1. Emerging Market Dividend Growth Fund (DGRE)
    http://www.wisdomtree.com/etfs/fund-details.aspx?etfid=86

I can’t really tell much by looking at the top holdings of this fund! I don’t really know the names (Astra Int., MTN Group, Sasol, …, I know Taiwan Semiconductors!).

Based in the fund fact sheet data from 12/31/2014, the underlying index trades for
P/E of 14.4
P/Cash Flow of 10.7

  1. With respect to valuation, both seem similar. I compared these with two US funds, the US Dividend Growth Fund (DGRW) and the Madcap Dividend Fund (DON).

The underlying index data for DGRW suggests the following valuation metrics:
P/E of 18.1
P/Cash Flow of 12.6
http://www.wisdomtree.com/resource-library/pdf/materials/DGR…

The underlying index data for DON suggests the following valuation metrics:
P/E of 20.5
P/cash Flow of 10.2
http://www.wisdomtree.com/resource-library/pdf/fundfacts/Wis…

On a ‘market’ basis, it is indeed appears that the US market is pricier compared to the European or the Emerging Markets. This sort of makes sense. After all, the US economy has been able to crawl it’s way nicely out of the 2008 financial crisis. The unemployment numbers are down and the businesses have been doing well. The emerging markets has to take it in their chin in the aftermath of the financial crisis with funds moving out of ‘riskier’ assets. Europe is still a mess, especially with all the problems in the Euro zone.

An investment in the Europe dividend growth fund or the Emerging markets dividend growth fund would be a bet that high-quality companies in these economies will eventually be able to command the richer valuation commanded by their US counterparts. The European companies might benefit from the weaker Euro and European QE; may be they will be able to resolve some of their economic woes that divide the rich and poor countries in the Euro zone. Similarly, I think a stronger US economy will help the emerging economies. India has a growth focussed government, one that wants to build even stronger ties with the US. If I do buy any of these ETFs, I would buy with the idea of holding them for a while, say 5 - 10 years, and selling when their relative valuation is rich versus say the US market.

Anyways, so I tried to post this out to lay out some of my rambling thoughts. Writing it out helps me think better. I 'm hoping there will be some pearls of wisdom from the board members.

Anirban

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I have been thinking about adding some geographic diversification to my portfolio.

Anirban, that’s an interesting idea about diversifying to Europe, at least. Here are my preliminary thoughts:

Positives

  1. The EU is starting QE, which theoretically at least, could eventually start growth in Europe.
  2. The companies are probably cheaper than US companies.
  3. The Euro has been plummeting which may help Europe export.

Negatives:

  1. Europe is an economic basket case, with no growth, danger of deflation, high unemployment, a considerable amount of social unrest, with the rise of nationalistic parties who are somewhat fascistic (prejudiced), but also want to withdraw their countries from the EU.
  2. There is danger of the Euro zone dissolving, which gives a certain amount of uncertainty.
  3. Saying these companies in Europe in the ETFs have a lower PE than the S&P is meaningless if the S&P companies are growing and the European companies are not. Growing companies always have higher PEs.
  4. Even fiscal stimulation will take a long, long, LONG…time to work in Europe, because the anti-capitalism and anti-enterprise mentality is imbedded in the culture in many of the countries (I’m thinking of France especially, the second biggest economy, which is just plain stuck!).
  5. The Euro has been plummeting, and there is no reason to think this will stop, which will decrease the stock price of the stock of these companies when expressed in dollars.
  6. I’d have to divert investment funds from rapidly growing, great companies I already have to invest in this dubious enterprise.

Emerging markets are another matter, which I know little about, but I have been badly burned investing in Chinese companies with the mistaken idea that shareholder rights would be protected in the same way as in the US. Cultures are very different, and these Chinese companies were run for the enrichment of the management and the families of the principal stockholders, and outsiders were just considered suckers who put up money. Besides which, in Emerging Markets, devaluation and expropriation are always possibilities. Makes me stick close to home.

Saul

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Saul - right now Emerging markets are one of the most undervalued equity sectors. You don’t necessarily need to go for China and by avoiding Russia and LatAm you cut out the majority of the devaluation/ expropriation risk territories. India and South East Asia look very undervalued. China overall looks attractive but yes has its risks although with a basket approach you are unlikely to get hit with too much funky stuff that you can’t handle.

Japan also looks good if you believe in Abenomics and yes Europe looks low priced although probably for good reasons.

Ant

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Negatives:
1. Europe is an economic basket case, with no growth, danger of deflation, high unemployment, a considerable amount of social unrest, with the rise of nationalistic parties who are somewhat fascistic (prejudiced), but also want to withdraw their countries from the EU.

The problems in Europe are more systemic than cyclical. Here is an anecdote.

My company had a plant in the EU (France) for a good number of years, for over a decade. When the decision was made to close the facility, the severance packages exceeded the sum of all the profit ever made. The CFO said the law is the law, so of course there is no way we would ever contest it, but there is also no way we would ever place another plant the country.

I am one of the little guys and I completely agree with concious capitalism, that the employer/employee relationship can and should be win/win, etc… But when laws outpace marketplace metrics by such a degree they wind up hurting the employees in a broad sense, rather than helping them in a specific way, like benefiting the employees of just that one place.

Jeb

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My company had a plant in the EU (France) for a good number of years, for over a decade. When the decision was made to close the facility, the severance packages exceeded the sum of all the profit ever made. The CFO said the law is the law, so of course there is no way we would ever contest it, but there is also no way we would ever place another plant in the country.

Jeb, Companies do anything they can to avoid hiring people in France, for exactly the reason you suggest: If they have to lay anyone off it’s exorbitantly expensive. Thus there is very high unemployment. But if anyone tries to reform the laws the unions go out on strike. (They don’t care that there are no new jobs created in the country, and loads of people unemployed. They just want to protect their own lifetime employment. And the population supports the strikes and considers it solidarity, and employment never grows. We create a couple of hundred thousand jobs every month. They haven’t created half that many jobs in five years). I just Googled job creation in France and here is a wonderful news clip:

Paris (AFP) - A summit aimed at creating half a million badly needed jobs in France got off to a rocky start on Monday, with two major labour organisations saying they would boycott the event. President Francois Hollande opened the two-day conference, where he hopes to hammer out a deal to create more jobs to lower France’s record unemployment in return for corporate tax and benefit cuts. But his plans were dashed when the CGT and Force Ouvriere (FO) union federations said they would shun crucial talks scheduled for Tuesday, accusing Hollande of siding with employers.

That’s typical.

Saul

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Companies do anything they can to avoid hiring people in France, for exactly the reason you suggest: If they have to lay anyone off it’s exorbitantly expensive. Thus there is very high unemployment. But if anyone tries to reform the laws the unions go out on strike. (They don’t care that there are no new jobs created in the country, and loads of people unemployed. They just want to protect their own lifetime employment. And the population supports the strikes and considers it solidarity, and employment never grows. We create a couple of hundred thousand jobs every month. They haven’t created half that many jobs in five years).

This is why I’ve avoided investing in CRTO, a France-based company.

Chris

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Thanks all for chiming in with your thoughts.

I understand the systemic issues in Europe. I have many French colleagues at my workplace, so 'm quite familiar with the issues plaguing countries such as France, Italy, etc.

So, here’s the kicker and this is one reason I was looking at EUDG from Wisdom Tree. Let’s look at the country allocations for the fund:
o Switzerland: 24.4%
o United Kingdom: 24%
o Germany: 16%
o France: 7.4%
o Sweden: 4.6%
o Netherlands: 4.5%
o Italy: 4.4%
o Belgium: 4%
o Norway: 3.7%

It looks like France has a relatively modest allocation. In fact, Norway & Sweden combined are allocated more than France. Allocation to Italy is behind Sweden & Netherlands. If one were looking at country-specific GDPs and their contribution to the EU’s GDP, then we might expect allocation to be weighted towards Germany, UK, France, Italy, Netherlands … in that order.

I have to look at the individual holdings (at least the names) but if I were to hazard a guess than I would say that assigning equal weight to the earnings stream and the dividend stream biases the index towards well performing solid companies. If that’s indeed happening, the the cheap valuation of the fund suggests a good entry point.

I think similar arguments hold for the emerging market dividend growth fund. While one might expect it to be heavily weighted towards China, the fund in fact has tiny exposure to China. China has only about 2.5% allocation. The biggest allocation is to South Africa (17.4%), followed by Brazil (16.4%), Taiwan (16.2%), Indonesia (12.7%), Thailand (11%), Russia (4.8%), India (4.5%), and Turkey (3.4%).

Anirban

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Anirban,

Here are my thoughts.

I think you will better off picking companies rather than funds. I say this because you delve into details, you enjoy analyzing stocks, and you will learn a lot more if you select and follow a few carefully picked companies.

I joined Global Gains about 10 years with the same idea that you now have. I thought

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Anirban,

Here are my thoughts.

I think you will better off picking companies rather than funds. I say this because you delve into details, you enjoy analyzing stocks, and you will learn a lot more if you select and follow a few carefully picked companies.

I joined Global Gains about 10 years with the same idea that you now have. I thought that I should have a lot more money overseas than in US companies because that’s where the growth would be over the coming years and decades. It turns out that my US based companies did no worse and often better than my foreign headquartered companies. Many US companies are multinational companies with significant sales from overseas. Take a look at SKX which is rapidly expanding in Europe. SWKS will benefit greatly from China’s, and then India’s (and other countries), adoption of wireless LTE…China alone should sell 500 million LTE handsets in 2015. The list of US companies with overseas operations and sales goes on and on so you don’t need to own foreign based companies to benefit from those region’s growth.

Regarding Europe specifically, Germany is the strongest economy because it is a huge exporter and is really benefiting from the weak Euro. The other Northern European countries like the Netherlands are benefiting as Germany but are not talked about as much just because their economies are smaller. Countries like Greece, Italy, Spain, and Portugal have trouble competing because their countries us the EURO so everything costs more than when they had their own respective currencies. Back to Germany…have a close look at the funds and you will probably find that these funds contain large companies such as SAP, Siemens, Volkswagen, BMW, etc. Yet much of Germany’s economic strength lies in the smaller companies called the Mittelstand. These companies are usually privately owned, family businesses. There were some good articles about them in the Economist with in the past 2 years (Google “Economist Mittelstand” and you’ll surely find them). The problem is that they are mostly private and so you can’t buy them.

As I mentioned above, if you buy a fund then you don’t really know what you own unless you go through the trouble to check what the fund is comprised of. This means that if the fund’s NAV goes up or down then what does that mean for you and how you will evaluate if it’s worth owning or selling? What will you learn? Relying on market price to make investment decisions is not a good strategy.

Good luck.

Chris

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Personally, I think this pointless. There are so many good investment opportunities in North America (US & Canada, Mexico, not so much) I can’t see chasing unknowns abroad simply by virtue of the fact that they are abroad.

As for emerging markets - buyer beware. Saul mentioned getting burned by the Chinese mentality. My wife is Chinese. There are many Chinese people I consider friends and really good people - all the same, I’ve learned my lesson the hard way (same as Saul). You’re crazy if you invest in a Chinese company. I don’t know for certain, but I don’t think investing in India or Singapore or anywhere in Asia is any safer. As for Latin America, graft and corruption are so endemic I can’t think of any company I would feel comfortable with. Europe - maybe a lot safer culturally and market controls and all that good stuff, but Saul did a good job of summarizing many of the hazards.

What’s left? Israel, Middle East and Africa. Good luck. Teva is pretty good. OK - I’ve got a stake in CRTO, maybe that’s a mistake, but it’s one of those companies that will never have a large employee base, so they are reasonably well protected from a lot of the French labor craziness. I had Orange and Vodaphone for a while. sold them both at a small profit. They paid decent dividends.

If you think you can get better performance by geographical diversification, more power to you. But if it’s just a matter of diversification for the sake of diversification I suggest you reconsider.

The one thing where you might do well is in Central American real estate. But that takes a bit of time, study and travel.

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