By Nir Kaissar
It’s well known that investors have a home bias — they prefer investing in companies in their home country — and US investors are no exception. What is different about US investors is that their stock market is the envy of the world, so their home bias garners a lot of support.
Renowned investors like Warren Buffett and the late John Bogle have long urged US investors to keep their money at home. The US is also widely viewed as the world’s safe haven, in part because big US companies are reputed to be the most stable and highest quality. If you’re a US investor, as Buffett and Bogle have argued, why go anywhere else?
Buffett is no stranger to foreign markets, though, and investors would be wise to take note.
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US companies’ reputation for quality is well deserved, and broad market indexes reinforce it. A key attribute of quality is high profitability as measured by accounting measures such as profit margin, return on equity and return on capital. Based on all three measures, the S&P 500 Index’s profitability has been higher than that of the MSCI World ex USA Index and the MSCI Emerging Markets Index — which together cover most of the developed and developing world outside the US — for at least the past two decades.
But that doesn’t mean the US has a monopoly on highly profitable companies. In fact, I ranked the roughly 10,000 companies in the Bloomberg World Large, Mid & Small Cap Index from high to low based on most recently reported annual profit margin. Yes, the US is the most represented country in the top 100, but it accounts for only 15% of that group.
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I did the same with return on equity and return on capital. The US accounts for 36 of the top 100 based on return on equity and only 14 based on return on capital. And just for fun, I ranked the top 100 again using an equal-weighted blend of all three profitability measures. The US claims 18 of them.
Granted, most investors don’t have the time or resources to comb through thousands of stocks and pick out the most profitable ones, but they don’t have to.
There are low-cost index funds that do just that, curating the highest-quality companies based in part or predominantly on profitability. These funds are usually grouped by region, allowing investors to decide how much they want to allocate to the US relative to other developed or emerging markets.
The kicker is that, as a group, high-quality stocks outside the US are much cheaper than the S&P 500 by most measures of price relative to fundamentals, including assets, sales, earnings and cash flow, while offering comparable or higher profitability. The S&P 500, for example, trades at 19 times last year’s earnings, compared with 15 times for the MSCI World ex USA Quality Index and closer to 13 times for the MSCI Emerging Markets Quality Index.
Buffett started as a deep value investor but eventually pivoted to quality. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Buffett has famously said of his investing evolution. Even so, with the US stock market richly valued for many years, Buffett has struggled to find attractively priced US companies for Berkshire Hathaway Inc.’s $130 billion cash hoard.
That may explain another Buffett evolution: hunting for wonderful companies abroad. Buffett was in Japan last week, promoting his investments in five Japanese trading houses and encouraging them to partner with Berkshire in new ventures. This isn’t Buffett’s first foray overseas. In the last two decades, Buffett has invested in Chinese energy company PetroChina, Korean steelmaker Posco, UK retail giant Tesco, French pharmaceutical giant Sanofi-Aventis and European insurers Munich Re and Swiss Re. And he may not be done in Japan, telling Nikkei last week that he’s thinking about further investment in Japanese companies.
It’s no wonder. Those five Japanese trading houses Buffett bought averaged a return on equity of 20% last year and trade at an average of just 6 times last year’s earnings. That compares with a return on equity of 19% for the S&P 500 at 19 times earnings — more than triple the price. Wonderful companies at a fair price indeed.
Perhaps the best argument for global investing is that there are great companies everywhere, and sometimes they can be had more cheaply than the ones at home. Just ask Buffett — or better yet, look at his portfolio.