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Going against the Grain in American Funds' Global Lineup

How to buy right within the firm's foreign- and world-fund roster.

Paul Herbert, 08/29/2006

Below is an article from the June issue of the Morningstar Fund Family Report on American Funds, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. To review a risk-free trial issue, click here. Fund Family Reports on Fidelity and Vanguard are also available.

American Funds' managers have notched successful long-term records thanks to their finely honed contrarian instincts. I'd argue that successful fund investors should also swim against the tide. Periodically rebalancing your holdings--cutting back on winners while adding to laggards--can be a very sensible strategy.

In this article, I'll discuss how you can apply a contrarian sensibility when managing foreign-stock holdings at American, and I'll also provide other ideas for managing a portfolio's foreign exposure.

Think Globally, Act Globally
Before I delve into specific strategies for adjusting foreign-stock allocations, I want to clarify one thing. I'm not suggesting that you reduce your overall foreign-stock allocation, but rather that you consider adjusting holdings within a foreign stake.

Yes, foreign fare has had a multiyear run of outperformance versus U.S. securities. So aren't I contradicting my own advice about lightening up on what's done well? Not really. That's because I've long observed that the typical U.S.-based investor is light on non-U.S. securities and overly exposed to the U.S. market. It's true that the U.S. market is the best-regulated in the world, and many U.S. companies are leaders in the global marketplace. But the U.S. market accounts for just half of the world's market capitalization. By extension, an investor who sticks with the typically recommended 25% in foreign stocks is making a big bet on the U.S. market. With the backdrop of increased liquidity and transparency in foreign bourses, as well as our government's sky-high current-account and budget deficits, that's not a bet I'd be willing to make right now. Fortunately, American is home to some top-flight international funds.

Where to Trim
In January, I harnessed the Morningstar Rating for stocks to help determine which U.S.-stock funds within American's lineup were the most attractively valued and which were the least attractive. It's not possible to apply this tool to American's international-stock funds, however, because our equity analysts don't cover a large-enough universe of foreign stocks for us to assert that a given portfolio is over- or undervalued.

Looking strictly at the portfolios' valuation ratios is another way to tackle this issue. Viewed strictly on the basis of the aggregate portfolios' price/earnings ratios, American Funds New World NEWFX would appear to be the most attractively priced foreign fund right now, while American Funds Smallcap World SMCWX has the highest aggregate P/E.

Although P/E can be a simplistic means of gauging a portfolio's attractiveness (more on the limitations of P/E in a second), I'm comfortable telling you to lighten your position in Smallcap World at this juncture. Smaller-cap stocks around the globe have beaten the pants off of larger names for more than five years, but if you believe--as I do--that stock performance reverts to the mean over time, smaller names are overdue for a breather. And, because this fund focuses on smaller names, it's arguably more at risk of asset bloat than any other offering in the firm's lineup.

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