Diversifying in a Shrinking World
Simple formulas for foreign exposure lose luster.
Fund Spy
As my colleague Christopher Davis pointed out in a recent Short Answer, 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. As Chris noted, 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. Below is a sample of firms with prominent positions in the S&P 500 that also have with big foreign-revenue streams.
| U.S. Companies with Overseas Revenue | ||
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| Company | Industry | Estimated % Revenue from Outside U.S. |
| Intel Corp (INTC) | Semiconductors | 79.0 |
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| Coca-Cola (KO) | Beverage Mfg. | 72.3 |
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| ExxonMobil Corp (XOM) | Oil & Gas | 69.0 |
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| Schlumberger (SLB) | Oil & Gas Services | 67.0 |
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| McDonald's Corp (MCD) | Restaurants | 65.5 |
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| Hewlett-Packard (HPQ) | Computer Equipment | 65.0 |
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| 3M Company (MMM) | Diversified | 61.4 |
| United Technologies (UTX) | Diversified | 60.0 |
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| E.I. du Pont de Nemours | Chemicals | 60.0 |
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| Altria Group (MO) | Tobacco | 58.0 |
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| Procter & Gamble (PG) | Household & Personal Prods | 57.0 |
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| IBM (IBM) | Computer Equipment | 57.0 |
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| Caterpillar (CAT) | Construction Machinery | 53.0 |
| Aon Corp. (AOC) | Insurance (General) | 53.0 |
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| FPL Group | Electric Utilities | 52.0 |
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| American Intl Group (AIG) | Insurance (Property) | 49.0 |
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| Oracle Corp (ORCL) | Business Applications | 48.0 |
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| Praxair (PX) | Chemicals | 48.0 |
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| Google (GOOG) | Business/Online Services | 47.0 |
| Abbott Laboratories (ABT) | Drugs | 47.0 |
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| American Express (AXP) | Finance | 47.0 |
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| News Corp | Media Conglomerates | 47.0 |
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| General Motors Corp (GM) | Auto Makers | 47.0 |
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| Symantec Corp (SYMC) | Systems & Security | 47.0 |
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| Pfizer (PFE) | Drugs | 46.6 |
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| General Electric Comp (GE) | Electric Equipment | 46.0 |
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| Bristol-Myers Squibb (BMY) | Drugs | 46.0 |
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| Cisco Systems (CSCO) | Data Networking | 45.0 |
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| Johnson & Johnson (JNJ) | Drugs | 45.0 |
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| Eli Lilly & Company (LLY) | Drugs | 45.0 |
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| eBay, Inc. (EBAY) | Online Retail | 43.0 |
| Yum Brands (YUM) | Restaurants | 43.0 |
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| Apple (AAPL) | Computer Equipment | 40.0 |
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| Merck & Co. (MRK) | Drugs | 39.0 |
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| Boeing Co (BA) | Aerospace & Defense | 38.0 |
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| PepsiCo (PEP) | Beverage Mfg. | 37.0 |
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| Merrill Lynch & Co | Securities | 37.0 |
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| Medtronic (MDT) | Medical Equipment | 36.0 |
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| DELL | Computer Equipment | 35.0 |
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| Microsoft Corp (MSFT) | Business Applications | 34.0 |
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| Kraft Foods (KFT) | Food Mfg | 33.0 |
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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
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 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?
First, don't panic. 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 domestic stock funds likely have much more foreign-economic exposure than you think, while the opposite is true for your 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.