Rules of the Game: In International Waters

 | Jan 09, 2014 | 2:00 PM EST
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It's amazing how often new clients come in with portfolios they believe to be "conservative," but, upon a cursory review, turn out to consist mainly of large-cap U.S. stocks. OK, it's actually not so amazing.

Here in the U.S., we're inundated with media reports about analyst actions, boardroom maneuvers, earnings reports and sales comps when it comes to the Dow Jones Industrial Average (DJIA) components or top-weighted S&P 500 companies. The same is true for seemingly sexy techs like Facebook (FB) or Twitter (TWTR), or even "interesting" also-rans such as Groupon (GRPN). (Though why the media consider that particular stock so fascinating is beyond me. But I digress.)

It's crucial to expand your investing horizons beyond our own shores. But here again, the financial media so not offer much assistance. Once in a while, you might hear about big U.S.-traded European pharmaceutical companies such as Novartis (NVS) or mega-techs such as SAP (SAP), but that's about it.

What's the difference between buying those, and buying S&P 500 stocks?

OK, that was rhetorical. The answer is, "There is no difference."

One thing that academics like Eugene Fama and Kenneth French have clearly shown is that over time, small-caps and value stocks perform better than large caps and growth stocks. Why? Who knows? You can posit all kinds of reasons why small-caps do better, and perhaps they are true: Smaller companies are more innovative and more nimble, and have more room to grow. Sure, why not? Ultimately, the reasons don't matter. We know from decades of research that investors demand a higher return for taking on the risk of small-caps. Isn't that enough?

As for value, beaten-up stocks generally have nowhere to go but higher. I know, I know, some keep going down. I'm talking about value stocks as an asset class. Averages. Large numbers. Not cherry-picked examples of single stocks that fizzled and died.

So coming back to the idea of diversification outside the U.S., we know that the small and value factors are even more pronounced internationally. Again, it's tempting to ask "why?" But who knows why? It just is.

For investors, this means that international diversification should be tilted toward small and value. According to Fama's and French's research, over any rolling five-year period, international value, as an asset class, outperforms international growth 96% of the time. That's pretty flippin' impressive!

However, these data look even better when extended over a longer time frame. Over 10-, 15-, 20- and 25-year periods, international value beats international growth 100% of the time. Yep, that means always.

There is similar data for international small vs. large stocks. On a five-year basis, international small stocks outpaced their larger peers 79% of the time. Over a 15-year period, that advantage grows to 83%; in a 25-year period, it clocks in at 100%.

It's important to note: These figures address asset classes, or baskets of stocks, not single equities. It's impossible to guess with any accuracy which of these overseas stocks might show this kind of performance, and, in any case, I'm not talking about ADRs as a group. Instead, I'm referring to companies traded on foreign exchanges, small companies that the cable talking heads have never heard of, and, therefore, can't tell you about.

In my next column, I'll look at ways to get portfolio exposure to these companies, and how to allocate them within your overall investment strategy.

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