Why International Stocks Have Lagged

Christine Benz: Hi, I'm Christine Benz for Morningstar. As U.S. investors well know, foreign stocks and foreign stock funds have underperformed U.S. for the better part of a decade. Joining me to discuss the factors driving that underperformance is Dan Sotiroff. He's an analyst in Morningstar's Manager Research group.

Dan, thank you so much for being here.

Daniel Sotiroff: Hi, Christine. Thanks for having me.

Benz: Dan, let's just look at the level of underperformance of foreign stocks relative to U.S. How big has it been?

Sotiroff: It's been pretty big. I think most people at this point are kind of aware that--that dichotomy that exists between the U.S. and foreign markets. So, to just put some numbers on it and to set the table here, the U.S. market, if we're looking at March 2009, so the bottom of the financial crisis, right up through last month, December 2019, the U.S. market, as measured by the S&P 500, returned about 17.1% annualized. A huge number, right?

Benz: Right.

Sotiroff: So, sort of the comparable index overseas is the MSCI All-Country World Index ex-USA. So, what that has done is about 9.9 percentage points per year. So, you're seeing around 7% annualized return difference between those two indexes. So, it's pretty large and understandably so. It's what a lot of people have noticed.

Benz: Right. Definitely in our portfolios we've seen it too.

Sotiroff: Oh, yeah.

Benz: So, let's go factor-by-factor. One that kind of jumped out at me and you and I were exchanging emails about this, currencies. Is it the fact that the dollar has outperformed relative to foreign currencies? Is that part of the issue?

Sotiroff: So, it is a component there, right. So, what we've seen over the most of this period, this 10-plus years that we're talking, is the dollar has appreciated relative to a lot of foreign currencies, the euro, yen, pound, you name it. So, that obviously creates a drag on your foreign stock returns. When you go to repatriate your assets from overseas back to the U.S., the exchange rate is going to be less favorable in the future than it was when you made those investments. So, it drags on. It's part of it. But of that 7% delta that we were talking about, the currency effect has only been about half a percentage point. So, you still have another 6.5 percentage points to go to explain the gap there. So, it's part of it. It's just relatively small.

Benz: So, another factor that I think might be reasonable to think about would be the sector composition of the U.S. market versus the non-U.S. indexes. And so, let's talk about that. The U.S. tech stocks have been rocking the house…

Sotiroff: Tech stocks, right. You got the FAANG stocks and everything. They've been really, really providing some tremendous returns, been driving a lot of the U.S. stock market appreciation over the past decade or so. And it seems pretty reasonable. When you go overseas, back into March 2009, the starting point I referenced, foreign stocks were really kind of dominated by financials and then you also had some materials and industrials. It was a very different market composition over there. So, it seems reasonable to suspect that market composition played a role in it. So, we kind of tested that and we ran it through Morningstar's attribution tool. And what we found was that sector composition was actually a very, very small component of that return difference. Most of it really came down to like what you would call just other factors. It was U.S. companies just really broadly outperformed their foreign counterparts pretty much across the board in every sector. So, there was a component there. But again, it was very, very small, even smaller than the currency effect that we were seeing.

Benz: So, you're saying that it really owes to fundamental factors. And you're saying that U.S. companies have performed better? Or has it been P/E expansion or…?

Sotiroff: So, it's other things going on. And you could probably frame this in a lot of ways. One way we framed it when we were starting to dig into this is, kind of like you're saying, there's other fundamental drivers, right?

Benz: Right.

Sotiroff: These are actual businesses at the end of the day, and they have to earn a profit at the end of the day. So, what we did is, we took the returns, the total returns, from those two indexes and then decomposed them based on the P/E multiples. So, we basically came up with two components that if you add them together, you get the total return. So, that is, the multiple expansion, which is how has price grown relative to the earnings generated by that index. And then, you have EPS growth, which is sort of like, basically how have you grown your profits over time. So, when you add those two together, you get total return.

So, if we break those two things down, what we see is that U.S. stocks and foreign stocks performed very comparably in terms of multiple expansion. They both expanded their price relative to earnings at about 6 to 6.5% per year, which was kind of interesting. But then, when you got to the EPS growth, that is where U.S. companies just blew away foreign stocks, and it wasn't even close. Foreign stocks grew their EPS, earnings per share, by about 4% per year. The number for U.S. stocks was a little over 10%, I think around 10.3%, 10.4%. So, that's where you see that extra 6.5% gap that I was referencing before. It was really at the end of the day U.S. companies were just growing their earnings and their fundamentals much more stronger than the overseas companies were.

Benz: So, that really underpins that narrative that we hear so often is that the U.S. emerged from the financial crisis stronger than most non-U.S. economies?

Sotiroff: Yeah, for sure. I mean, you could point to all sorts of reasons. I'm not going to get into them now. Some of them maybe have more validity to them. Some of them maybe more speculative. But yeah, for sure, the U.S. has been incredibly strong, it continues to be very strong. To put kind of a bow on this, though, I think, it's really--you have to come away from this with, like, well, what does this mean for the future…

Benz: Exactly.

Sotiroff: So, when you look at your portfolio now, it's like this in mine, because I'm diversified internationally as well, U.S. stocks are kind of a lion's share right now. And my foreign allocation has been dwindling just because of the appreciation of U.S. stocks. So, this doesn't exist--this isn't going to continue indefinitely. At a certain point, things are going to turn around. I think if you go back to the mid-2000s, you saw a pretty long period where we came out of the dotcom bust and foreign stocks took off. So, this isn't going to last. These things move in cycles. Currencies move in cycles. Foreign markets move in cycles. You have to rebalance. You have to get rid of some of your U.S. stocks and buy foreign stocks and be ready for when it turns around. And we were talking before--you know, we've been saying this for the better part of 10 years now, it's getting a little annoying. But yeah, the prudent advice, I think is, rebalance and shore up your allocations back to whatever your portfolio targets are.

Benz: Dan, terrific research, really interesting to me. Thank you so much for being here.

Sotiroff: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.