• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>Diversifying in a Shrinking World

Related Content

  1. Videos
  2. Articles

Diversifying in a Shrinking World

Simple formulas for foreign exposure lose luster.

Michael Breen, 09/11/2007

Turbulence in domestic stocks has exacerbated debate over how much foreign exposure a portfolio needs. A few decades back, it was simple. Investors dedicated a set percentage of their portfolio to foreign-domiciled firms and received proportionate exposure to foreign economies. Not anymore. Globalization has blurred the lines. A firm's address is no longer an accurate indicator of where it does the bulk of its business.

A peek at the major benchmarks illustrates this point. Recent research estimates that nearly 45% of the S&P 500 Index's underlying revenue comes from outside the United States. Data is tougher to come by on the main foreign index, MCSI EAFE, but I piled through the footnotes of enough foreign annual reports to see that a similar global trend exists in that index as well. Just as many U.S. companies derive a big share of their revenues from overseas, so do foreign firms earn a big share of their profits from outside their home market.

This trend got us thinking about the impact on investors. So, we dug into the financials and found that labeling firms domestic and foreign based on their domicile isn't always an accurate indicator of their economic reality. The effect on a portfolio can be meaningful, so investors need to dig beneath the surface to understand the true geographic makeup of the firms a fund holds.

It's Not Where You're Located
There are clear similarities in the upper reaches of both benchmarks. The top firm in the S&P 500 is Exxon Mobil XOM, while British Petroleum BP grabs the same position in EAFE. Both oil companies generate about 30% of their revenue in the U.S. and the remainder around the globe. Nearly all major oil firms have similarly global profiles--regardless of domicile or which index they call home.

The story is the same with big drug makers. GlaxoSmithKline GSK, Roche RHHBY, and Novartis NVS are foreign-domiciled members of EAFE. Johnson & Johnson JNJ, Pfizer PFE, and Abbott Labs ABT are U.S.-based constituents of the S&P 500. All six firms generate close to half their revenues in the U.S. and the remainder around the globe. Similar patterns permeate both benchmarks.

Foreign Exposure at Home
Digging into the S&P 500's holdings revealed a few surprises about the extent of its constituents' foreign operations. I was aware that such U.S.-based firms as Coca-Cola KO and McDonald's MCD had a big global presence. But chipmaker Intel INTC garnering nearly 80% of its sales abroad was news to me. Ditto for computer maker Hewlett-Packard HPQ: It hauls in two thirds of its revenue abroad.

On the next page is a sample of firms with prominent positions in the S&P 500 that also have with big foreign-revenue streams.PAGEBREAK 

 U.S. Companies with Overseas Revenue
Company

Industry

Estimated
% Revenue
from Outside U.S.
Intel Corp INTC
Semiconductors
79.0
Coca-Cola KO
Beverage Mfg.
72.3
ExxonMobil Corp XOM
Oil & Gas
69.0
Schlumberger SLB
Oil & Gas Services
67.0
McDonald's Corp MCD
Restaurants
65.5
Hewlett-Packard HPQ
Computer Equipment
65.0
3M Company MMM
Diversified
61.4
United Technologies UTX
Diversified
60.0
E.I. du Pont de Nemours DD
Chemicals
60.0
Altria Group MO
Tobacco
58.0
Procter & Gamble PG
Household & Personal Prods
57.0
IBM IBM
Computer Equipment
57.0
Caterpillar CAT
Construction Machinery
53.0
Aon Corp. AOC
Insurance (General)
53.0
FPL Group FPL
Electric Utilities
52.0
American Intl Group AIG
Insurance (Property)
49.0
Oracle Corp ORCL
Business Applications
48.0
Praxair PX
Chemicals
48.0
Google GOOG
Business/Online Services
47.0
Abbott Laboratories ABT
Drugs
47.0
American Express AXP
Finance
47.0
News Corp NWS.A
Media Conglomerates
47.0
General Motors Corp GM
Auto Makers
47.0
Symantec Corp SYMC
Systems & Security
47.0
Pfizer PFE
Drugs
46.6
General Electric Comp GE
Electric Equipment
46.0
Bristol-Myers Squibb BMY
Drugs
46.0
Cisco Systems CSCO
Data Networking
45.0
Johnson & Johnson JNJ
Drugs
45.0
Eli Lilly & Company LLY
Drugs
45.0
eBay, Inc. EBAY
Online Retail
43.0
Yum Brands YUM
Restaurants
43.0
Apple AAPL
Computer Equipment
40.0
Merck & Co. MRK
Drugs
39.0
Boeing Co BA
Aerospace & Defense
38.0
PepsiCo PEP
Beverage Mfg.
37.0
Merrill Lynch & Co MER
Securities
37.0
Medtronic MDT
Medical Equipment
36.0
DELL DELL
Computer Equipment
35.0
Microsoft Corp MSFT
Business Applications
34.0
Kraft Foods KFT
Food Mfg
33.0

 

 

What's the Impact?
To see portfolio-level impact of this globalization trend we looked at a couple of large-blend funds that we consider good core holdings. We took the percentage of overseas revenues reported by each firm and adjusted it for the stock's weighting in the portfolio to get an overall estimate of the portfolio's true foreign exposure. Stocks that didn't breakout revenue by source were left at 100% U.S. In both cases, we found that the true economic exposure of the underlying firms differed greatly from the portfolio's reported stake in foreign-domiciled stocks.

Oak Value OAKVX
This fine fund has just two holdings based overseas: Willis Holdings WSH and Cadbury Schweppes CSG. They alone account for the fund's reported 8% foreign stake. But we estimate that 37% of the portfolio's revenues come from overseas. In fact, several of the fund's domestic-based stocks generate more revenue overseas than Cadbury Schweppes--a foreign stock--which gets about half its revenue in the U.S. For example, insurer Aflac AFL gets 72% of its revenue in Japan, while 3M MMM, United Technologies UTX, and DuPont DD all get more than 60% of their revenue outside the U.S.

Clipper CFIMX
All 20 of this fund's holdings are headquartered in the U.S. As a result, its foreign stake is 0%. But don't be fooled. This is a fairly global portfolio. Twelve of its 20 holdings generate at least a third of their revenues abroad. And Altria MO, Procter & Gamble PG, American International Group AIG, and American Express AXP are all wonderful plays on the global economy, pulling in nearly half their revenues from outside of the U.S. We estimate that 35% this portfolio's underlying revenues come from outside the U.S.

What to Do?
There never has been a magic number for foreign exposure. Even past attempts to use set formulas were rendered inaccurate by rising globalization. Current efforts are even more limited. Your clients' domestic stock funds likely have much more foreign-economic exposure than you think, while the opposite is true for their foreign funds. Not surprisingly, we see the greatest globalization among the largest firms. This explains why performance has become more correlated between the major indexes around the globe. Local-market issues further down the market-cap range tend to depend a bit more on their local economy--but not always.

And more help is on the way. Improving financial reporting overseas is moving us closer to formalizing the peek-through analysis that we did in this piece. Once enough data is public, we'll be able to systematically compare a fund's foreign stake by domicile with the percentage of its revenue generated outside the U.S. This will provide a much more accurate representation of a fund's foreign flavor.

Michael Breen is a senior analyst with Morningstar.

blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.