Since 2009, the United States stock market has outperformed the stock markets of most other countries, and you have not heard as much investment commentary touting the value of international diversification. I think much of the debate is silly, as the kinds of companies that make up the S&P 500 generate a substantial chunk of their profit outside the United States. Coca-Cola may be considered the most Americana of companies, but it makes 80% of its profits outside the United States.
You want 3% of your portfolio in Mexican stocks? Well, Coca-Cola makes 3% of profits in Mexico. Problem solved.
I do understand, however, that people may want to own investments that are focused primarily on a single country so they often turn to the popular index funds of the companies that they are choosing. My argument is that, rather than owning the index fund that represents the economic output of some country, you should look for a high-quality firm that generates a lot of profits in that country but is headquartered in the United States so that you can earn superior returns while taking moderately less risk.
Take a look at something like the most famous index fund that covers Japanese stock, the Japan ETF (EJW) called “iShares MSCI Japan.” This is not something you want to buy in the name of diversification. Look at where you’d be putting your money if you bought the index–financials, cars, and telecom. Your Japanese diversification relies upon the performance of Toyota (cars), Mitsubishi Financial (bank), Sumitomo Financial (bank), Softbank Group Corp. (despite the name, it’s actually telecom), Mizuho Financial (bank), and KDDI Corp. (telecom). Even though the fund advertises diversification of 315 stocks, it does not mention the outsized influence of the largest holdings. For every $100 you invest into a Japanese index fund, you’re putting $6 into Toyota stock alone.
Based on Dr. Jeremy Siegel’s research, these are not the sectors that generate outsized returns over the long haul. Cars are notoriously poor long-term investments, banks tend to “reset” after years of growth and deliver inferior returns, and telecom stocks can range from mediocre to average based on management teams, debt employed, and strategy.
If I saw an index constructed like the Japanese index, I’d run away fast. The businesses that are large in Japan are not in industries that lend themselves to high organic growth naturally, and if any of the big stocks deliver exceptional performance, it will be due to unusually bright management or taking advantage of a low probability event. This is not how you want to go through life investing.
And the returns from Japan reflect what Dr. Siegel’s research demonstrates. If you bought this Japan ETF at the date of inception on April 1st, 1996, you would have earned -0.32% annual returns (and this is before taking into account fees). Every $100 that you invested into a Japanese index fund almost twenty years ago would give you $93 today. And worst of all, you would have paid an average fee of 0.79% along the way (although the annual fee has been reduced over the past 19 years to 0.48% currently).
This is what happened to someone that thought, “I want to invest $10,000 into a basket of Japan’s largest stocks on the first of April in 1996.” Although the nominal value of the index would have taken the $10,000 down to $9,392, there also would have been $1,082 in fees paid along the way as nineteen years of fees approaching one percent of the assets would have taken another bite out of your performance. If you held this money in a tax-advantaged account, you would have seen $8,310 as your balance going into October 5, 2015. With friends like these…
On the other hand, you could have invested in an insurance company like Aflac to seek Japanese diversification. It underwrites medical, life insurance, and cancer policies in Japan. It also does accident policies, but that is primarily in the United States. Although the company is well known in the United States, almost 75% of its revenues come from Japan. It is heavily associated with insurance against the worst results common with ill health.
For every dollar in policy that Aflac writes, it ends up keeping twenty-two cents. This has been the company’s profit margin for the past three decades, only fluctuating to a high of twenty-six cents and a low of eighteen cents during that time frame. It’s been a very consistent company. The leverage is low, and the profits from the underwriting activities are dumped into an investment portfolio that consists of $97 billion in bonds and $29 million in stocks. That’s not a typo. The company’s directors and insiders control 16% of the company, and they keep things conservative (it also means that investment income should balloon a bit when global interest rates begin a meaningful rise.)
Although the huge bond portfolio is nice, the real strength of the company is the long-term underwriting operations that have stayed in that high band. That is why Aflac has been one of those shoot-the-lights-out investments that most people have never heard of, delivering 18% annual returns over the past thirty years so that an initial $100,000 investment would be worth $17.8 million today.
If you invested in Aflac on April Fool’s Day in 1996, the same day that the EWJ index went live, you would have earned 12.5% returns in the interim. That’s intelligent diversification–you would have beaten the American index funds that delivered 8% annual returns over that time frame, and you would have destroyed the Japanese index fund that gave investors substantial losses over that time frame. Instead of turning $10,000 into $8,000+, you would have turned the same amount into $98,400. And better yet, there would have been no ongoing fees chipping away at your returns–you would have owned the whole darn thing outright.
This happens across most countries I study. There is a Mexican brewer that would be a much better investment than a Mexican index fund. There is a famous German industrial that would be better than a German index fund. There is a specialty retailer in Ireland that is astronomically better than an Irish index fund. And so on it goes.
If I wanted to diversify into a specific country, I would focus first on profits generated in that country–I would not care about where it is domiciled. Then, I would look for competitive advantages that seem to hold up well over time and seem to produce growing profits without the need for management brilliance. The top holdings in the index funds of some countries do not impress, and Japan is an example of that.
The characteristics of the industry as a whole act as a gravitational pull, and if the industry selection is bad as is the case in Japan, you shouldn’t be surprised when the long-term returns are unimpressive. It may seem esoteric and needlessly specific to dive into this stuff when it comes to diversification, but the improvement in the final outcome is worth it. Making the decision to invest in Aflac stock directly, rather than something like the Japanese index EWJ, can create a huge improvement for your household’s finances. Japan and Aflac aren’t the only ones. A plurality of the countries you study for international diversification will see this story play out.
Originally posted 2015-10-04 04:26:15.