How should you play international markets ?

As growth in the US approaches a peak, I’ve been pondering over the best way to look at international markets for growth.

It’s been a period of fairly steady economic growth in the US for pretty much the last seven or eight years. However one wonders how long this stretch of uninterrupted growth will continue. To that end, I’ve been thinking about how I should look at tapping into growth opportunities in overseas markets.

At some point or the other the Federal Reserve is going to be inclined to start reducing the amount of easy money that’s on offer by increasing interest-rates. Admittedly this is going to be a fairly slow and steady pullback of easy monetary policy but at some stage it will happen. My greatest fear is that the economic growth that has persisted over this last period of time will slowly start to reduce to the point that it’s going to be more difficult for mature companies to continue the dramatic share price appreciation that they have showed for this last period of time.

The question then becomes, is there a need to do anything about it? One option is just to continue to sit on whatever I have in large US stocks. Various commentators whose opinions I respect have pointed out the share prices of large US companies will likely languish once easy monetary policy goes away.

In fact Jack Bogle of Vanguard fame suggests that returns on the S&P 500 over the coming decade are likely to only average 4% per annum partly as a result of elevated P/E ratios, but also likely due to the subdued rate of future earnings growth.

Given this, individuals that want to earn greater than 4% only have a few options beyond placing their money in large-cap US stocks. On the one hand they could look to mid-cap and other stocks and sectors that are experiencing growth tailwinds.

Another equally promising option is to consider looking at international stocks. I don’t have much interest in the slower growing economies of Europe, however emerging markets are a source of interest to me. Emerging market stocks have been in somewhat of a stop start pattern for much of the last decade, alternating between being in vogue and then going out of favor.

Emerging market economies on the other hand, continue to ride a long term wave of growth. They’re seeing increasing per user GDP, all of which all augers well for consumer spending and the consumption of new services. Of course many large US economies have significant revenue coming from their overseas operations so they themselves will benefit from international growth.

However the point to be made here is that given these large US companies also have fairly large operations in mature markets, the growth profile of large US multinationals will be weighed down by this exposure even though they have exposure to fast-growing international markets. Thus having some pure play emerging market exposure can actually be a very good thing.

The question arises if you do make the decision to go after emerging markets, what’s the best way to do this? Investing directly in stocks in these economies can be fraught with danger. Varying accounting practices and different ways of doing business can make for investing minefield.

Investing in China illustrates these risks particularly well. Even large Chinese corporations such as Ali Baba haven’t escaped the reaches of regulators concerned about accounting practices and related party transactions.

My personal approach with emerging market economies is to pick one or 2 key emerging market stocks that are large cap and have a US listing. Basically I’m looking for “too big to fail here” as a criteria, even though that’s really a misnomer.

For emerging markets, I’m placing my capital with AliBaba, Baidu and Mercadolibre. All 3 businesses are in the tech sector. AliBaba represents the predominant e-commerce portal in China, Baidu offers the dominant Chinese search engine, while Mercadolibre is the dominant e-commerce portal in Latin America.

All 3 of these businesses have a significant number of users and are building robust network effects into their platforms. As time progresses, these platforms will only get stronger and users on these platforms will only spend more. Its my belief that these businesses will survive and thrive over the long haul.

Having said that, I’m generally not too comfortable taking too much individual position risk on emerging market stocks. I much prefer a broad based index approach which will eventually weed out the performers and underperformers through a market based approach.

To that end, I’m happily slowly and steadily building up a position in VWO, the Vanguard Emerging Markets Index fund. This fund offers some attractive characteristics. Not only does the fund offer low cost management fees (0.12%), but the fund offers a P/E ratio of 12, with expected earnings growth of 11%p.a.

I was interested to see Ray Dalio has significant holdings in VWO, which make up almost 30% of his overall portfolio. With the growth prospects that these funds offer, and the relative valuation discount that the funds provide, VWO may be a good way to snag some future growth at a reasonable price, particularly if the underlying trends driving these economies continue.

Emerging market exposure could be a source of significant growth that allows investors to overcome subdued returns from US stocks over the coming decade. While there are a few ways to go about investing in this space, a broad based indirect holding of a low cost index like VWO is my preferred way to play.

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