Posted on October 2, 2013 by Ben Connard
As you may have noticed, we’ve been adding more individual international companies to portfolios. These additions have been through buying American Depositary Receipts (ADRs) and ordinary shares of foreign companies trading on US exchanges. For example, ABB is an ADR for the Swiss company ABB Ltd and TD is a Canadian company (The Toronto-Dominion Bank) with ordinary shares trading in the US. As a note, we’ve purchased Exchange Traded Funds (ETFs) holding a basket of foreign securities in accounts since 2007 (DGS for example).
We purchased these securities to gain more exposure to faster growing overseas markets and to increase the pool of companies in which we are investing. A larger pool means more opportunity to find a quality company at a reasonable price. But with these purchases comes the question of what the proper allocation between the US and the rest of the world is.
It is our position that US investors should have most of their assets in the US. The dollar is the world’s reserve currency as no country is currently on the gold standard (the US officially dropped the gold standard in October 1976). More importantly, one’s assets should match one’s dollar denominated liabilities. When we buy an ADR or foreign ordinary share traded in the US, we are still using dollars. However, that security is now subject to currency fluctuations as well as the company’s underlying fundamentals. For example, the Japanese Yen has depreciated 18% against the dollar since Prime Minister Shinzo Abe embarked on stimulus measures last November (as mentioned in last quarter’s commentary). The Japanese stock market climbed since the stimulus, but for US investors, all appreciation was offset by the 18% depreciation in the Yen. Of course the opposite could happen and the stock could get a currency bump, but either way it adds a layer of risk. In other words, to balance the currency risk, the portfolio should hold diverse securities across multiple currencies (and hopefully strong currencies) while maintaining an overweight in dollars.
According to the CIA World Factbook, global GDP was $72 trillion in 2012. The US represented $16 trillion (22% of the total) with China in second place at $8 trillion (11%) followed by Japan at $6.0 trillion (8%). We view a 22% US stock allocation as far too low and we are definitely not allocating 11% to China. The MSCI All Cap World Index and the S&P Global 1200 Index peg the US as a little less the 50% of the world’s market cap (see Chart on first page). If we use revenue instead of market cap, the US drops to 35%. Fifty percent, and especially 35%, is also too low an allocation to the US for US clients.
We could try a more granular level and categorize companies based on the actual geography of their revenue. For example, Nike is a US company, but only 41% of its revenue comes from North America, meaning even less comes from the US. On the other hand, Reed Elsevier is a British company and 52% of its revenue originates from the US. In other words, country of domicile is not always indicative of the currency exposure. We run into problems determining where revenue is actually generated as the data is not complete. Not all companies report revenue to the US specifically or even to North America. We do know that companies in the S&P Global 1200 that do report a North American allocation average about 50% to North America—70% for US companies and 30% for non-US companies.
We’ve decided a 70-75% US allocation is the best choice. Fifty percent is too low and 100% is too high. Splitting the difference gets the 75% exposure to US domiciled companies. The specific revenue exposure will be closer to 60% dollars based on our rough calculations. Using this allocation, we’ve gained exposure to faster growing foreign countries, increased the investable universe and limited exposure to foreign currencies.