What to look for in international equities

Did you know that even as Indian engineering bluechip Larsen & Toubro gained 8 per cent over the last year, another pivotal stock from the capital goods and engineering sector in the US — Deere & Co. — delivered a stellar 55 per cent return in the same period? Perhaps not, given that the limelight is now entirely on emerging markets such as India. The fast-tracked economic growth in emerging market economies, in contrast to the sluggish advance of the developed markets, has ensured that foreign money has been flowing in faster into markets such as India.

Compounded annual returns of 10.6 per cent delivered by the Sensex over the last five years, as against the poor 1.7 per cent return by the Dow Jones Industrial Average, only supports this case further. At a time when foreign money is chasing the Indian bourses, is there a case for Indian investors to scout for opportunities in international markets? Actually, there is, for the reasons discussed below.

Diversification

Just as you diversify your portfolio across asset classes, geographic diversification too partly helps hedge the portfolio, for a couple of reasons. For one, not all markets across the globe move in the same direction at the same time as local events significantly impact the respective markets.The outperformance of the developed markets in Europe and the US, even as the Indian market slid in the last 4-5 months, is a case in point. While the Sensex dropped sharply by 17 per cent between the November 2010 highs and February 2011 lows, dragged by inflation fears and higher interest rates ; the S&P 500 index in the US rallied a neat 8 per cent as macro-economic data provided hope for a revival in the US economy.

Two, while global events tend to affect world markets, the extent of the impact varies across regions. Despite events in the US being the root cause for the economic crisis of 2008, emerging markets such as India took a sharper hit.

The Sensex, in 2008, fell 52 per cent even as the Dow Jones declined by 33 per cent. Three, contrary to the general belief that companies in developed markets cannot grow their earnings at a respectable pace; part of the growth profile of US companies, for instance, comes from their exposure to emerging economies.

The S&P-500 derives a third of its revenue from overseas while the Nasdaq 100 derives 40 per cent of its revenue from outside the Americas. Caterpillar, for instance, records over half of its machinery sales in developing markets . Diversification need not always result in muted growth prospects.

But how should you kick-start diversification? To start with, you may take pride in holding stocks of corporates that showcase a strong competitive edge or other inimitable traits. Have you ever thought of owning shares of an Apple Inc. or Google or a Berkshire Hathaway? Their distinct business model ensured strong growth in their numbers even during the slowdown in 2008 and 2009.

Similarly, not many online shopping companies such as e-Bay or a retail chain the scale of Wal-Mart Stores are available in the listed Indian domain nor are there many aerospace companies in the world such as Boeing! Holding on to unique businesses assures returns — one, because of the scarcity premium in the bourses and, two, through their strong earnings growth, given the typically limited competitionand their very wide geographic spread.

New sectors

If the above niche businesses are hard to come by in India, so are some lucrative sectors and themes. It is simply not possible for you to look for a gold mining company listed in India nor a real estate investment trust (REIT) that steadily generates dividends.

Natural resources : You may have to turn to US, Australia, Western Europe or Canada for mining companies. In the last few years, securing raw materials such as coal or iron ore has become a key focus for many companies, thereby pushing these resource companies high up on the investment radar.

Companies of the size and diversified product profile (mining multi-commodities) of a BHP Billiton or a Rio Tinto may be hard to come by in the Indian listed space, barring a single-commodity public sector plays such as Coal India.

Similarly, while Indian investors are only too familiar with gold returns, gold mining companies such as Newcrest Mining have, in fact, delivered a tad higher than gold returns.

Energy : There are also other key sectors, such as energy, where there is a dearth of choice in the Indian context. Most of the oil and gas companies, barring perhaps Reliance Industries, are majority government-held and are also constrained by policies and regulations.

Globally, though, independent oil majors such as Shell Refining Company or Anadarko Petroleum Corporation are not only free from such constraints but have a more diversified product profile, enjoy higher reserve replacement and are present across the globe..

Agri-biz : One other theme that has limited choice in India is agriculture-related commodities. Soaring food prices, especially across India and Africa, has not only affected consumers but has brought instability to stock markets. Adding agri-related stocks to your portfolio is one way of countering the rising food prices.

One way to achieve this is to hold agri-related stocks. Globally, you can play the agri theme through farm equipment makers such as Deere & Co. or Caterpillar or pesticide/fertiliser makers such as Syngenta or Agrium or Monsanto or fertiliser input provider Potash Corp.

Remember, as long as food is in demand, fertilisers that improve yields cannot go out of demand. And the companies mentioned here are some of the largest in the globe in their respective fields.

REITs : REITs such as those listed in Singapore or Hong Kong, unlike the Indian real estate companies, hold huge commercial leased space and are able to distribute over 90 per cent of their income from the pool of leases as dividendsTheir payouts make them a less risky bet compared with realty stocks in India.

There are a host of other sectors such as consumer electronics, semi-conductors, consumer durables and retail chains – which are limited in the Indian listed space but available in the global domain.

Arbitrage opportunity

While the Sensex valuations, at about 15 times estimated earnings for FY-12, can be justified by earnings growth prospects, other emerging markets with lower valuations may feature blue-chips that are value buys. Samsung Electronics or a Hyundai Motor Company trading at 9 and 12 times their respective per-share earnings, are at a steep discount to their Indian peers.

A Microsoft Corp. at 11 times or a Unilever at 14 times could well be a value pick compared with any large IT or FMCG stock traded in the Indian bourses.

And note that these companies also grow their revenues on the strengths derived from emerging markets such as India.

The risks

This said, investors need to know some risks involved in international investing. Currency risk is the biggest threat as it can drag returns. Holding a basket of stocks across different markets and currencies may help; this is best done through mutual funds.

Two, country-specific funds or ETFs, especially in emerging markets, carry higher risks as they seldom fully reflect the opportunities in the country and often mimic other indices. The Hang Seng fell along with the Sensex in recent times as inflationary and interest rate concerns pulled down markets across Asia.

Three, diversifying involves allocating a small portion of your funds overseas, not a huge chunk. For better or for worse, it is best to retain a chunk of investments in familiar territory.

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