International Investing Opportunities For Canadian Investors
By: Jonathan L. Passmore
For Canadian investors, investments in overseas markets have long provided an essential element of diversification away from reliance on the local market. To be sure, recent Canadian dollar strength has trimmed the extent of foreign returns. However, the potential for international investments is taking on new relevance, given the cyclical nature of currency trends and the possible relaxation of foreign investment limits.
As we consider the opportunities opening up to the committed investor, the persistent disparity between returns from U.S. markets, long preferred by Canadian investors, and those from non-U.S. markets, should be kept well in mind. In fact, while there are no guarantees that the trend will continue, EAFE and Emerging Market returns have consistently outperformed U.S. returns over each of the last one-, three-, five-, and seven-year periods (See Exhibit I).
Where should a Canadian investor look for returns – at home or overseas? We foresee profound changes ahead, both at home and abroad, and all investors will need to make important choices in the changing world in which we live.
It Was The Best Of Times . . .
In many ways, the global environment of the past few years has been a ‘golden age.’ Investors have benefited from low interest rates, low inflation, plentiful liquidity, instant knowledge available via the web, unprecedented increases in productivity and consumption, and, to cap it all, the emergence of a big new customer in the form of China. The most organized, efficient and well-capitalized companies have been able to increase profits, even with modest revenue growth. Cash flows have increased dramatically, benefiting companies and shareholders alike. Much of this enhanced cash flow has been returned to shareholders via dividends or share buybacks as corporate managements remain uncertain about their business outlook and continue to be rattled by ever-increasing competitive pressures. Dividend yields have often exceeded bond yields, a rare situation that has sparked an unusual amount of debt-financed buyout activity in an echo of the Michael Milken era.
What do these recent trends tell us about the future from an investor’s standpoint? Many investors assume that inflation and the world economy will grow at a sustainable pace. Given this rosy scenario, how should investors guard against complacency, taking full advantage of the opportunities while avoiding the pitfalls? The one certainty to bear in mind is that the environment will change, and not always in predictable ways.
There are several macro influencers that can have an impact, singly or collectively, on developed or emerging markets. These include currencies, interest rates, consumption trends, and commodity prices, all of which have an impact on stocks regardless of whether the companies are based in Beijing or Berlin. The magnitude of the impact will vary depending upon the company’s position as importer or exporter, lender or borrower, manufacturer or retailer, consumer or provider.
Rates, Currencies, Consumers & Commodities
In the developed world, interest rates play a relatively minor role in corporate performance (barring dramatic moves by the Fed), but currencies can have a major impact on results. The fall of the U.S. dollar since January 2002 has only recently begun to decelerate, for technical rather than fundamental reasons given the magnitude of U.S. deficits. In a well-diversified, larger-cap portfolio, the inclusion of many global companies correlates fund performance to U.S. dollar movements almost regardless of the exposure of individual companies. Consumption trends suggest that the plucky U.S. or UK consumer may be running out of steam and that investments in banks, consumer finance companies, retail stores, and consumer products should be re-assessed compared with the last few years.
In the developing world, the picture is somewhat different. Interest rates, amid generally higher rates of inflation, tend to exert a larger influence on companies. If companies in the developing world borrow overseas to broaden their base of potential lenders, rates and spreads take on even greater significance, and the availability of future financing becomes questionable should business conditions deteriorate. Developing currencies that float tend to be weaker than their developed counterparts, offering cheaper commodities to their developed country customers. Interestingly, China currently has a currency pegged to the U.S. dollar, an enormous advantage during a period when the ‘host’ currency has been in a long-term slump.
Consumers in the developing world, lacking disposable income and sophisticated lending institutions, are in their relative infancy compared to their more seasoned counterparts in the developed world. In China, consumption represents approximately 45 per cent of GDP, far below America’s 70 per cent stake, demonstrating China’s enormous potential.
Of all the challenges facing the developed world, the most obvious is increased competition from developing nations. The days of emerging neighbours supplying us with cheap commodities and low-tech products are history. A far-reaching result of the determination among emerging nations to improve their economies has been the emergence of top-class educational establishments. The juxtaposition of thousands of well-educated graduates alongside increased investment has produced advanced businesses no longer playing second fiddle to companies in the developed world. Hua Wei, of China, recently won a major telecom equipment contract from a major British customer Many developed-nation companies understand that heavy, labour-intensive industry has been lost to the emerging world, but value-added businesses are under threat as well.
The Empire Strikes Back
How will businesses in the developed world react? This is not the first time that the old ways have been threatened by new technology or groundbreaking changes in the economic order. Threats have often appeared to doom the status quo. New products such as the automobile, telephone, fax machine, mobile phone, PC, laptop, and iPod have pushed their competitors, from the horse to the CD, to reinvent themselves. Far from causing a breakdown in society, new opportunities have emerged to support the establishment of a new order. The major agent of today’s change, China, may be more impressive in scale but the need for adaptation will foster a dynamic climate in which many countries and companies will prosper.
In the meantime, the basic materials needed to support change and growth will be in demand as never before. The owners of resources – along with the refiners, processors, transporters, shippers, insurers, and financiers of the supply chain – will all have a part to play. The basic materials market has experienced declining prices, lack of investment, and a perpetual search for lower costs over the past couple of decades. Soaring demand from China and India and other parts of the developing globe have changed the picture in basic materials, offering investment opportunities in hitherto dull and stagnant companies. Rising commodities prices encourage new investment and new supply, which may limit the future profitability of these cyclical industries. The long period of under-investment, added to the radical consolidation that has taken place, means that defined oligopolies control supply in some cases.
This all adds up to massive opportunities for investors and for the regional and global companies in which they invest. In a recent book, the Pulitzer Prize-winning author Tom Friedman discussed how the world is really flat, as technology and the increasing power of the individual serve to flatten the conventional international barriers to communication, consumption, knowledge, and entertainment that previously existed. Investors should take a similar approach and look at the whole world as an opportunity, not just the market in which they happen to reside. The beauty of Tom Friedman’s argument lies in the additional potential of the global markets. The potential of the developed markets lies in their ability to change as the developing world takes away what previously belonged to them. Similarly, the potential of the developing world lies in the growth of their consumption class and the establishment of new, ultra-competitive businesses to challenge the ‘old’guard, led by highly-educated leaders. This is the framework in which we perform our investment analysis: we consider the world in which we live, confronting a period of dramatic change where the opportunities, carefully considered, can profitably outweigh the risks.
Jonathan L. Passmore is senior vice-president, portfolio manager, international equities, for GE Asset Management.
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -