I have argued over the years that markets in the age of globalization are becoming more alike and that prices between localities are coming into balance. That’s good news for the world and not-so-good news for investors. We investors like differences. With difference, there is opportunity. Opportunity suggests a chance—a chance to win, or to try to win. But a world in balance smells of everybody doing the same thing all at once, an odor of equal and average performance.
And what’s to blame for this global sameness? Two things, predominantly: the emergence of the large-cap multinational corporation and the global push for freer trade. As more locations seek to be competitive in the world marketplace—attracting those mobile, elastic, multiplant large-caps—global tax and regulatory policies are trending lower. This is happening more or less in a coordinated fashion. Across the planet, this means the transportation costs that long divided localities are coming in line, an event that is reflected in an increased parity between global prices.
Parity. There’s not much opportunity in that. For starters, if no price differences exist between locations A and B, any prospect for arbitrage between these regions evaporates. Why chase something far away that you can get at home for the very same price? In the age of parity, the same thinking applies to stocks. Why look over an ocean for an investment opportunity that you very well might find at home?
Well, for a couple of reasons.
First, and most importantly, attractive international investment opportunities still can arise when parity is interrupted. Markets are not perfect, and shocks do occur—in regions, countries, and individual smaller localities. Basically, these shocks raise or lower transportation costs, causing a disparity between the purchasing power of currencies and the relative value of assets between regions. As I see it, this is the case for investing internationally in the age of globalization, and it’s from here that we can build a prudent international strategy.
However, a second, and certainly more fashionable, rationale exists for investing around the globe. If today you opened an account with a reputable financial-management firm, at some point your advisor would discuss the importance of international diversification. By diversification, the advisor here refers to the practice of international investing as a way of reducing risk in a portfolio. Just as you want to be invested in different classes of stocks and bonds, so as never to feel the full downside when one asset class performs poorly (a topic we address in greater detail in Chapter 8, “Pipelines to Our Investment Returns: How We Get What We Want, in the Amount We Want, and When We Want It”), international investing arguably provides one more level of diversification, or risk reduction.
I agree with this, but only to a certain level. Unlike the typical financial advisor, I argue that international investing provides opportunities for risk reduction. As stated, with trade barriers dropping and economic integration on the upswing, prices are equalizing across the globe. This clearly means that, in the bigger picture, the diversification effect of international investing is on the decline. However, in the smaller picture—region to region and shock to shock—the international diversification story is alive and well.
Here we switch from defense to offense in terms of the location effect. In the last chapter, we developed a defensive play: A negative shock occurred, one that generally would bring down all stocks in the infected region. The defensive move was based on the idea that the smaller, less-mobile, location-fixed companies would suffer the most. Playing defense, we would avoid these stocks at all costs. The difference in prices between regions, however, switches us to the offensive mode—in effect, turning us into arbitragers who take advantage of price disparities whenever they arise and wherever they exist.
That said, I hope to simplify the international investment process in the pages ahead. Our new phrase is purchasing power parity (PPP), which basically is a measure of the relative purchasing power of global currencies. PPP is something of a dry acronym, but it comes to life when thought of in terms of hamburgers. Yes, hamburgers. Flashing forward, when parity exists between the prices of Big Macs in different regions, we can say there is no investment opportunity. But when a Big Mac in Location A is pricier than one in Location B, we can go on the offense.
International investing can be just this straightforward, but only if you track the shocks that bring about differences in price.
In the last chapter, I was able to separate California from the rest of the U.S. not just because of its size and integrated economy, but also because the government in that state acted independently by placing a large regulatory burden on its power utilities. In other words, California determined California’s behavior.
This is an important point. As investors, we are interested in the behavior of stocks. In terms of location, we are interested in the behavior of locations. Sometimes a location acts just like a country; it asserts a level of independence whereby it holds its economic fate in its own hands. And sometimes a location acts just like a state, beholden to the policies of a larger governing union. Such a location can, by definition, be a state, but it also can be a country or a group of countries.
Take France, for instance.
France ranks as the fifth-largest country in the world in terms of economic output, while the “country” of California ranks eighth.[1] But this does not necessarily mean that France is any more of a country than is California. Over the past decade, France increasingly has acted more like a state within a larger governing region: the European Union. The EU now lists 25 members, all of which must abide by a certain set of economic rules. This development in general has been a positive for EU members. Trade barriers have lowered, and individuals, companies, and factors of production within the EU territory have displayed increased mobility.
In this scheme, France—a cog in a larger machine—exhibits stateness. In the last chapter, California—large and integrated, yet independent—exhibited countryness.
The lesson here is that to fully understand and react to location-specific shocks, you should erase the borders on your globe as they are currently drawn. From there, you want to redraw borders based on the levels of transportation costs (or the levels of friction) that exist between regions when economic shocks occur.
Because these costs are readily knowable, redrawing borders is not much of a chore.
In the introduction to this book, I asked, “What can an increase or decrease in the price of something tell us about the profits that thing is generating or the quantities of it that are being transacted?” And my answer was, and still is, “Not very much.” However, in the context of the location effect, important information is embedded in the differences in prices between regions. Without transaction costs, you would expect that identical commodities would fetch the same price in different localities; if they don’t, a profit opportunity will occur. Arbitrage will ensure that the differences are eliminated and the prices will be equalized. This is known as the law of one price.
When economists or financial analysts measure purchasing power parity, or “the law of one price,” they are gathering price information using a very simple method: comparison. Because countries use different currencies, PPP measures the relative purchasing power of the various world currencies. Parity fails to occur when the purchasing power of currencies differs—when, for instance, the U.S. dollar and the British pound (adjusted into dollars) can purchase differing amounts of a given good.
Consider, for example, a hamburger.
In a very clever article two decades ago, The Economist magazine introduced an innovative measure of purchasing power parity. This indicator, an index that has been published annually since its inception in 1986, is the price in local currencies of a McDonald’s Big Mac hamburger.[2]
Here’s the theory: In an idealized, frictionless world—one without transportation costs, regulations, taxes, and the like (think of an air hockey table that’s on full blast)—the price of a Big Mac is the same everywhere. In reality, however, transportation costs, taxes, and regulations alter the friction between regions and bring about differences in the price of a Big Mac. Thus, Big Mac prices, at differing times and to various degrees, must be different location to location across the globe.
How different? For a sense of scale, here’s a recent (and partial) snapshot of the Big Mac index (see Table 7.1):[3]
When this measure was first conceived, the authors argued that, given the standardization of a McDonald’s Big Mac (two all-beef patties, special sauce, lettuce, cheese, etc.), price differences between the burger, location to location, would give investors a quick and reliable measure of the differences in PPP across locations. This indicator thus could be used to identify the overvalued and undervalued economies of the world. However, what interests me is what causes these differences in prices. For instance, at the time this Big Mac snapshot was taken, I’d have wanted to know why Switzerland was cooking up such an expensive hamburger, or why Australia could do it at half the price.
In asking the “why” questions, we are inquiring about economic shocks. And in answering them, we’ll know just how to invest.
Markets are not perfectly correlated, nor are prices; the price of a Big Mac is not, and likely never will be in our lifetimes, fully equalized across regions. In formal terms, this means that PPP is not complete and that international investing will still produce some additional diversification within a portfolio.
To take advantage of this opportunity, our guideline for success again combines the location effect and the size choice. Interestingly, in the example of the California energy crisis, the correct defensive move was to lean away from small-cap stocks. But when playing offense in terms of location, you want to lean toward small-caps, which exhibit the least physical mobility of all public companies.
This process has you gathering two pieces of information. First you want to know the nature of an economic shock: Is it positive or negative? Second, you want to know the price of a Big Mac: Is it high or low relative to Big Macs in other locations?
Here’s how the process breaks down: In most cases, countries (or global locations) that adopt lower levels of taxation and regulation witness higher economic growth and higher rates of return.[4] This is a positive event that, for a time, results in a violation of PPP. Because a reduction in taxes and/or regulations represents a positive shock, the violation of PPP will be upward in the location that underwent the shock: The price of a Big Mac will climb.
And here’s a closer look at why: In prosperous places, the demand for immobile factors of production is high and the returns for those factors tend to be above average. The Big Mac is not necessarily an immobile factor because it is a food source that technically can be imported. However, locally and logically speaking, the Big Mac has to be cooked somewhere, a fixed place where rent and wages have to be paid. Meanwhile, rent and wages in prosperous areas are likely relatively high because people have a strong desire to live and work in such places. Over time, these higher prices will attract investment, which, in turn, will increase supply. Finally, when that new supply is established, prices will return to their long-run trajectories.
Such is the cyclical nature of arbitrage: After an initial shock brings about a disturbance in prices, an influx of capital restores the long-run equilibrium of prices. In Big Mac terms, a location undergoing a positive shock will experience an increase in prosperity that will be reflected in greater earning power, particularly for the least mobile factors of production. This violation of PPP is a window of opportunity for the international investor, and a rule we established earlier again can be applied:
When a positive shock impacts a specific location, most likely all public companies in that location will benefit. However, (immobile) small-caps very likely will outperform large-caps as they will capture the full upside of the shock.
But this rule takes on a nuanced flavor when described in hamburger terms:
Invest in places where the price of a Big Mac is high and considered expensive, favoring (immobile) small-caps in these locations.
Internationally, these windows of opportunity open and close all the time. Capital is mobile and tends to flow to areas where it will see the highest return. If a positive shock makes the return for capital higher in a location, capital will stream toward that location. Eventually, however, as capital flows change to bring about economic equilibrium, higher rates of return will be eliminated and PPP will be restored.
But the window of investment opportunity (the temporary deviation from PPP) will remain open for as long as policy shocks make one region more attractive for investment than another. At this point, you’ll want to play offense with the location effect, chasing down those pricey Big Macs.
At this point, capturing the location effect appears to be a small-cap investor’s activity. To a good degree, it is. Looking internationally, you want to shift toward small-caps undergoing positive economic shocks and away from small-caps experiencing negative shocks. But that doesn’t mean you shouldn’t have international large-caps in your portfolio.
As noted, professional financial advisors often recommend international investing as a way to reduce portfolio risk. And a big reason for this is that large-cap international stocks are an insurance policy against negative localized shocks. Because they are so big and so mobile, they feel the good and bad of economic shocks worldwide, although they will never experience all of the bad or all of the good.
I agree that this is a good argument for an investor to have some exposure to international large-caps. But when selecting from this asset class, you want to be thinking elastically: Choose large-cap international stocks by focusing on the industries they are in and the elasticities and betas of those industries in relation to the economic environment (as discussed in Chapters 4, “Catch Elasticity If You Can: An Introduction to Industry Behavior,” and 5, “Putting High-Beta to Work: Industry-Based Portfolio Strategies”).
I always stress that there is a time and place for everything. Sometimes you want those international large-caps in your portfolio, and at other times not. The same holds for small-caps. But if the boon of international investing, as it is discussed today, is to add another level of risk reduction to a portfolio, shouldn’t investors always own some international stocks, whether large-cap or small?
Not necessarily. For instance, if your home stock market is reasonably diversified and a level of purchasing power parity exists between major world currencies, why would you look to invest elsewhere? Markets in this case would be somewhat correlated, at which point you can make things a little easier on yourself by simply looking for the best domestic industries in which to invest your money. Conversely, when PPP does not hold, turn back to international. Just be sure you are identifying the shocks (positive or negative) that cause those violations to PPP.
Putting together everything we’ve discussed so far in terms of the location effect, we can draw some international investment rules relative to the size of stocks:
When to Own International Small-Cap Stocks
When positive shocks impact locations, buy small-cap stocks in those locations. This will put you in the best position to gain all the upside a positive location shock has to offer.
When PPP does not hold—meaning disparity exists between the exchange rates of currencies and the markets are not correlated—favor small-cap stocks in the regions where the local currency has strengthened.[5]
When to Own International Large-Cap Stocks
Investing in international large-cap stocks should be based on an analysis of industries that are abundant across nations. (If not abundant, meaning their facilities are concentrated in only a few areas, they might be inescapably tied to a region that could be infected by a negative shock.) Choose these stocks based on an understanding of the elasticities and betas of industries in relation to the economic environment.
Do not go out of your way to buy international large-cap stocks when owning large-cap domestic stocks will offer you just as much diversification. This will be the case when PPP holds (or, in other words, when markets are highly correlated).
Little in this book isn’t shock-based. Shocks are the starting point from which you should make all your investment decisions. There’s work involved in this: You need to understand the nature of each shock you encounter while grasping how different shocks affect different industries. And there’s no getting off the hook when it comes to an international strategy: Because the location effect alters the performance of small-cap stocks to the highest degree, you have to keep track of changes to tax, regulatory, and monetary policies (the shocks themselves) region to region across the globe. This is work, but it’s not that much work.
Other than natural disasters and other unpredictable events, the great thing about economic shocks is that they’re so easy to anticipate—even from the point of view of you, sitting in your chair, a solitary speck on the surface of this planet. To see an international shock coming, all you usually need to do is read the newspapers—or surf the Internet, or do whatever you do in the digital age to stay informed. Here’s an example:
Not so long ago, the news was that Japan was going to lower marginal tax rates. This information was in the newspapers and on the Internet, and was a topic of conversation on financial TV. As I’ve noted, a suddenly lower tax burden most likely will represent a positive economic shock. In Japan’s case, marginal tax rates were being lowered from about 65 percent to 50 percent, which is a very strong incentive for Japanese companies to change their behavior. In particular, they could take advantage of higher after-tax cash flows by increasing production and therefore profits. This is exactly what happened, and it was easily predictable if you 1) kept current on world events and 2) understood that lower marginal tax rates bring about increased economic activity.
Here’s how a savvy investor would have taken advantage of this situation. Theoretically, a Japanese large-cap company with, say, 20 percent of its operations in the country would see 20 percent of its total operations benefit from a positive shock. Meanwhile, a Japanese small-cap company with 100 percent of its operations in the country would benefit by 100 percent. That’s the theory, and did it hold up? Indeed. In 1999, following the arrival of the tax cuts, the total Japanese stock market climbed near 50 percent. The Japanese small-cap market? It soared by more than 100 percent.
It took some effort to understand that small-caps were the way to go in Japan in 1999. You had to read the newspapers and know that small-caps and positive economic shocks go together—say, like burgers and buns. But in doing so, you would have separated yourself from those who invested broadly in Japan—the crowd that climbed 50 percent with the market. That’s pretty good, but a 100 percent gain is worlds better. You also had to do some work to understand that small-caps were going to tank in California in 2001. You had to read the newspapers and know that small-caps and negative shocks go together more like oil and water. If you did so, however, you would have been able to weed out some ugly underperformance from your portfolio.
Applying the location strategy, or any strategy outlined in this book, requires you to be well informed on current events and have a sound understanding of the inherent elasticities of industries and companies shock to shock. Whether you are playing defense or offense, the extra effort is decidedly worth it.