(PUB) Investing 2015

INTERNATIONAL Stick With the Basics

outperformed U.S. stocks in all but one year from 2002 through 2009. U.S. stocks have outperformed in four of the last five years. 2014 saw huge gains in the U.S. market relative to foreign markets not so much because say, Europe’s and Asia’s markets didn’t rise—some did, with Germany up almost 3% and Japan up more than 7%—but because the dollar strength- ened against the euro and yen. I know I am at risk of kicking a dead horse with this story, but diversification, though often met with derision, works in the long run and is one of the building blocks of my approach to investing. At some point, foreign stocks will lead U.S. stocks, and the dollar will weaken against other currencies. Maybe we are starting to see that already, with Total International Stock leading 500 Index 5.7% to 2.5% so far in 2015. Or maybe this is just a two- month blip, and U.S. stocks will regain their leadership role. Rather than try to guess which scenario plays out, I’d rather stay diversified, knowing that I am posi- tioned to benefit whichever way the story unfolds. n

ASWE OFFICIALLY ENTER the seventh year of a very, very strong bull market in stocks, it’s only natural for investors to look back and say “if only”—as in, “If only I had invested all my money in [insert the current hot asset class], I would be sitting pretty.” This is a potentially hazardous game to play as it discourages investors from sticking to a core investment tenet—diversification. Today the hot asset class is U.S. stocks. Since the end of February 2009, which marked the month-end bottom of the Great Recession’s bear market, 500 Index has gained 231.9%, or nearly double Total International Stock ’s 124.2% gain. No doubt this raises the question of why, given the strong outperformance of the U.S. stock market, and all the negative headlines overseas, investors would even consider investing beyond of our shores. I’ve noticed a new “com- mon wisdom” that diversifying your portfolio to hold foreign stocks is sim- ply a losers’ game. I firmly disagree. Consider the chart above that shows the difference in performance between

U.S. vs. Foreign Stock Return Gaps

-60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40%

U.S. Stocks Outperformance Gap

U.S. Stocks Underperformance Gap

12/84

12/87

12/90

12/93

12/96

12/99

12/02

12/05

12/08

12/11

12/14

U.S. stocks (as measured by the S&P 500) and foreign stocks (as measured by the MSCI EAFE) over the past 31 calendar years. You’ll notice that last year saw the largest divergence between U.S. and foreign stock returns since 1997. But also look for a couple of other things. The largest single year of diver- gence between U.S. and foreign stocks took place in 1986, when foreign stocks outperformed U.S. stocks by more than 50%. Also, note that foreign stocks

The rapid growth companies’ prospects are higher risk, less certain, particularly than the growth stalwarts. We think in today’s market envi- ronment, investors are not fully appreciating those sorts of companies because of the element of uncertainty. The likes of Amazon or Google we consider to be attractively priced at the moment and in both cases have added to over the last few months. The next growth category is “cyclical growth.” The first two [categories] I talked about typically are regular year-on-year growers—they either have it or they haven’t. It doesn’t tend to go up or down with economic cycles. Whether GDP is 2% or 3% is not really going to have a noticeable differ- ence to Amazon. Whereas if you are a highly geared [leveraged] bank, you are geared into GDP—there is a cyclical element to it. So these companies don’t grow every year, and they may not be growing at the moment, but we can see through the cycle that they can add value and outperform their peers. Our cyclical exposure is very often in companies that try and benefit by investing at the bottom of a cycle and holding off at the top. The last is “latent growth” stocks, which are companies that have minimal operational momentum. Their last five years, maybe even 10 years, looks pretty terrible, but we believe there can be a growth stock in there waiting to get out. A change either on the supply side or the indus-

try structure or the demand environment or maybe through a technology means the future is going to be very different from the past. There aren’t so many of these because real dramatic change doesn’t happen to very many industries or companies at any one time, but when we can find them, we are very excited. Can you give me an example? Only this morning I had a meeting with [a latent growth company], one of the biggest Japanese non-life insurance companies, MS&AD. That industry has gone from 18 players to three over the last 15 years. These three players have 90% of the market between them. This bodes very well for future pricing, competition and returns because all three are focused on profitable underwriting. No one is fighting for market share— so it’s all about profits now, and that is very different from the history. How many stocks do you currently own and in what kinds of weights? It’s 96 stocks at the moment. There has been [virtually] no change over the last four or five years. I wouldn’t really expect any dramatic change in the number of holdings. >

The Independent Adviser for Vanguard Investors • March 2015 • 5

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