International equity investments are generally made by institution­al investors for some combination of the following reasons: portfo­lio diversification, access to outstanding companies headquartered outside the U.S., or exposure to developing economies which are expected to grow more rapidly than the U.S. Each of these reasons may help investors reach their objectives, but each, in our view, can also lead investors to make poor decisions which won’t improve their returns. In the case of diversification, the globalization of fi­nancial markets in the past 20 years may have reduced the incen­tive to invest globally for this reason. As we all know, financial markets are closely linked to each other now and in many cases act more like one big stocks market than fifty or so individual ones.

Investors often cite exposure to emerging markets as a key reason for investing internationally. While this idea has merit, an important question is how this is to be implemented. International benchmarks are composed almost entirely of mature, as opposed to emerging markets, with Japan, England, and Germany being the largest. Investors may choose an emerging markets benchmark, but these are highly volatile, which may lead investors to make small allocations that don’t have a meaningful impact on overall performance, or conversely to over-commit and then make poor asset allocation decisions following a period of sub-par perfor­mance.

There are several themes currently at play in international markets. The first is the strong economic recovery seen in the developing nations of the world, particularly in Asia. Whatever your view about the recovery in the United States and Europe, there is no doubt that Asian economies have seen a classic “V” shaped recovery. There is much talk currently about the poten­tial for a speculative bubble in these markets. While it is certainly possible in the future, this isn’t likely to happen in the near-term.

A second theme in our view is that high quality companies are currently undervalued following the recovery rally of the past 18 months, which focused on those companies which had been most affected by the crisis. As an illustration, we recently came across a list of ten valuation criteria used by legendary val­ue investor Benjamin Graham to uncover investment bargains. Having just read a report on Johnson and Johnson, we evaluated the company using Graham’s criteria. We found that at current levels, J&J appeared to meet nine out of ten criteria proposed by Graham. In essence, investors can purchase this company for the value of its current operations, paying nothing for the strong likelihood that it will continue its long term record of growth.

Much has been made of the sub-par recovery in the U.S. when compared to previous economic cycles. This has been seen most notably in employment figures, which have lagged far be­hind previous cycles. At the same time, corporate earnings for the second quarter have recovered strongly, and productivity figures for the U.S. are very good. It is possible the U.S. is in what we would call a “Productivity Recession,” which has hurt hiring in both the service and manufacturing sectors of our economy. Our definition of Productivity Recession requires some expla­nation. Over the past several decades a combination of rapid technological improvements and a growing supply of low cost labor from recently opened up economies led to a large number of jobs leaving the U.S., primarily in manufacturing. While this caused disruptions in many parts of the country, the overall job market in the U.S. grew due to a boom in other sectors including financial services, real estate, health care, and other primarily service sector jobs. This made sense to many economic observers since it seemed logical that economic development would lead the U.S. to move to a higher value added, service sector oriented economy while developing economies focused on manufactur­ing. Service sector jobs, the argument went, are higher paying, cleaner, and less cyclical and take advantage of our educated and creative workforce. Unfortunately this scenario ran into several problems during the current slowdown. First of all, many ser­vice sector jobs are actually in very cyclical industries which can shed jobs as fast as any manufacturing company. Financial services and real estate are two examples. Secondly, service sec­tor jobs are not immune to the forces which led to a reduction in manufacturing jobs over the past 30 years, specifically, they can be shipped overseas and they can be replaced by technology. Outsourcing of service sector jobs has been seen for years with things like call centers and IT outsourcing, but it is certain to re­place jobs in other sectors eventually. Technology improvements in the service sector occur at an astounding rate, which is one reason for the good productivity numbers the U.S. has seen. For years this was masked by the long-term secular growth in many service industries, but now that growth has stalled productivity gains are reducing the need for workers. This may explain why we have an economy in which many companies are profitable but where employment lags.

William Andersen, CFA, Portfolio Manager,
Wanger Income and Growth Strategy