A New Perspective on Geographical Diversification

Domicile has long been an investor's only way of geographically diversifying a portfolio, but that gives a misleading impression of the actual diversity of a portfolio. Large multinational companies have global revenue streams, as do lesser-known companies whose revenue exposures can be surprising. Consider Millicom International Cellular TIGO. MSCI regards it as a Swedish business, whereas Morningstar assigns it a U.S. domicile. Incorporated and headquartered in Luxembourg, Millicom International Cellular formed in 1990 when the international operations of Swedish mobile-telephone firm Tele2 combined with those of U.S.-based Millicom.[1] Reflective of that history, Millicom International Cellular's primary exchange is the Swedish NASDAQ OMX STOCKHOLM AB, and it maintains a corporate office in the United States.[2]

Neither domicile designation does justice to the economic drivers behind Millicom International Cellular's current business, however. It is focused on Latin America and Africa. As of fiscal 2017, the firm got more than 85% of its total revenue from Colombia, Paraguay, Bolivia, El Salvador, and Costa Rica, with most of the rest coming from Tanzania and Chad.[3] Viewing such companies through the lens of revenue offers a significant advance over domicile.

How Different Does a World Defined by Revenue Look? Looking at revenue exposure by region alongside domicile highlights the importance of China and the U.S. to the global economy. Exhibits 1 and 2 compare the MSCI All-Country World Index's domicile- and revenue-based exposures by region and country, respectively, as of September 2018. Each region's revenue exposure is within about 3 percentage points of its domicile-based weighting, except for Asia Emerging and the U.S. Asia Emerging's 9.4-percentage-point increase is driven by China, which has a 3.5% domicile-based weighting in the MSCI All-Country World Index but a 10.6% revenue-based weighting--a threefold increase. While the U.S.' relative stature diminishes in the shift to revenue from domicile, its absolute importance remains paramount. Only Australia's S&P/ASX 200 Index rivals the U.S.' S&P 500 for the percentage of revenue it receives from its home country: 57.9% versus 62%.

For Revenue Diversity, Mind Your Cap Ladder and Style U.S. investors can decrease or increase home-country revenue exposure by paying heed to market cap and style. Exhibit 3 shows the revenue exposure by region for U.S. benchmarks with differing market-cap orientations. As the average market cap increases, the percentage of revenue from the U.S. decreases and the percentage of revenue deriving from other regions increases. Investors who want to magnify home-country exposure should tilt their portfolios toward small caps; conversely, investors seeking greater revenue diversity within their portfolios can tilt them toward mega-cap stocks.

Granted, with more than half of the S&P 100 Index's revenue still deriving from the United States, tilting toward mega-cap stocks won't remove revenue-based, home-country bias for U.S. investors. Attending to style, however, offers another lever that investors can pull. Exhibit 4 maps the growth and value versions of the Russell 1000, Russell Midcap, and Russell 2000 indexes to the Morningstar Style Box, including the percentage of each benchmark's U.S. revenue. The growth version of each index has a lower weighting to U.S. revenues than its value counterpart, and, in general, the tilt away from the U.S. and toward other regions once again becomes more pronounced as one moves up the market-cap ladder.

Even for investors without access to Morningstar's revenue by region data, these insights about market cap and style provide a number of ways to increase international revenue diversification within a portfolio. One is to build a portfolio oriented toward mega-cap growth stocks, as these companies have the business models and resources to pursue opportunities irrespective of geography. Another option is to build a diversified global portfolio oriented toward small-cap value stocks because these companies tend to have businesses that receive most of their revenues from their home countries. Investors can also combine these two contrasting approaches. This third option results in a portfolio characterized by market cap, style, and geographic diversity--whether measured by domicile or revenue source.

How Do Sector Weights Affect Revenue Diversity? Investors mulling which option to choose should bear in mind the kind of businesses associated with mega-cap growth stocks versus small-cap value stocks. Exhibit 5 shows the S&P 500's aggregated U.S. revenue exposure for each of the 24 Global Industry Classification Standard's industry groups. Those industry groups with the lowest U.S. revenue percentage tend to have a heavier weighting in growth-oriented benchmarks and funds, while those with the highest U.S. revenue percentage tend to have a heavier weighting in value-oriented benchmarks and funds. The financials sector, for example, is often the biggest weighting in value indexes, and all three of its industry groups (banks, diversified financials, and insurance) receive between 70% and 85% of their revenue from the U.S.

Yet, at the individual company level, outliers exist. Per Morningstar data, as of September 2018, Citigroup C bucked the trend within banking by receiving less than half of its revenue from the U.S. and as much as a fifth from Japan. The semiconductor company Analog Devices ADI received 39.1% of its revenue from the U.S., nearly 3 times its industry group average.

Even as drilling down to the individual company level provides insight into the revenue variation within industries, it also shows the data isn't as standardized as one might wish. Indeed, sometimes differences start with the definition of revenue itself. When comparing the fiscal 2017 annual reports of Analog Devices and Skyworks Solutions SWKS, one finds that these companies on the surface seemed to differ dramatically in the percentage of revenue received from China, with Analog Devices garnering 17% and Skyworks 82.7%.[4] Yet Analog Devices defined revenue in terms of "the primary end customer location" for its products, whereas Skyworks' revenues did "not necessarily correlate to end market demand by region." In fact, Skyworks even went to the trouble of highlighting that its China revenues included "sales of products to a company that is not headquartered in China but that manufactures its products in China for sale to consumers throughout the world." That company was almost certainly Apple AAPL, and, had Skyworks defined its revenue in terms of end customer location, its China revenue would have dropped significantly.

In fiscal 2018, Skyworks redefined its geographic-based revenue definition for that year and for the two previous ones from "country of destination" to the site of the original equipment manufacturers' headquarters, or end customer location.[5] That cut Skyworks' fiscal 2017 China revenues to 27.9%, a nearly 55-percentage-point drop from under the prior definition. To the extent that this change represents a trend toward data standardization, it's an encouraging sign.

Conclusion A company's country of domicile will continue to be important, but domicile-based measures cannot capture the geographic diversity inherent in most companies' revenue streams, much less a portfolio of those companies. And in certain cases, domicile-based measures prove misleading. The revenue exposure by region lens offers a major step forward.

[1] Millicom International Cellular. 2012. Annual Report, P. 1.

[2] Swedish holding company Kinnevik KINV A, which had owned Tele2, still owned 38% of Millicom International Cellular as of September 2018. See https://www.kinnevik.com/our-investments/millicom.

[3] Millicom International Cellular. 2017. Annual Report, P. 114

[4] Analog Devices Inc. 2017. Form 10-K, PP. 7, 73; Skyworks Solutions Inc. 2017. Form 10-K, P. 60.

[5] Skyworks Solutions Inc. 2018. Form 10-K, P. 62.