Foreign Stocks Are Too Cheap to Ignore

Just thinking about foreign stocks makes my stomach hurt. In recent years, just about every dollar I’ve invested for my clients in foreign stocks rather than in U.S. stocks has been a mistake. Over the past 12 months, the MSCI EAFE index, which tracks foreign stocks in developed markets, fell 7.1% and the MSCI Emerging Markets stock index tumbled 13.9%. This during a period when Standard & Poor’s 500-stock index returned 3.0%.

Foreign stocks have been inflicting pain for many years now. Over the past 10 years, the S&P 500 returned a sturdy 7.5% annualized. The EAFE index earned a meager 2.7% annualized, and the emerging markets benchmark gained just 3.7% annualized. (All returns in are through June 6.)

The future for international stocks doesn’t look promising, either. With the United Kingdom holding a referendum on June 23 on whether to abandon the European Union—the so-called Brexit—Europe’s grand experiment with economic union is at risk. Japan’s Herculean efforts to stimulate its economy have hit a brick wall, and the Nikkei 225 continues to trade at about half of where it stood 27 years ago. China’s economy, which grew at an average annual pace of 10% for three decades, is now struggling to achieve a 5% to 6% growth rate. Other emerging nations, such as Brazil and Russia, are in far worse shape. Compared with these countries, the U.S. economy, which has been expanding tepidly since 2009, is experiencing a boom.

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But before you click away from my column and stash more of your savings in an S&P 500 index fund or some other domestic stock fund, hear me out: Foreign stocks are simply too cheap to ignore. What’s more, when the outlook is dim, as it is for foreign economies, just a little good news can ignite a new bull market.

How cheap are foreign stocks? The Leuthold Group, a Minneapolis-based investment-research firm, computes price-earnings ratios based on “normalized” earnings—which it defines as average earnings over five years—to strip out some of the short-term hills and valleys from corporate results.

By Leuthold’s calculation, the S&P 500 trades at a rich 21 times normalized earnings. But foreign developed stocks change hands at just 15 times earnings, and emerging markets fetch only 10 times earnings. Price-earnings ratios computed using other methods provide similar results. Foreign developed and emerging-markets stocks are also cheap according to other measures, such as dividend yield and price to book value (assets minus liabilities). “At these valuation spreads, I’m quite confident that foreign stocks will outperform U.S. stocks over the next five years,” says Doug Ramsey, Leuthold’s chief investment officer.

Goldman Sachs Asset Management also sees increased opportunity abroad, thanks to both valuations and monetary policy. “Particularly with the Federal Reserve tightening but central banks in Europe maintaining a loose stance, we expect [an economic] tailwind for developed international stocks,” Goldman says in a research note.

Regression to the mean is one of the most powerful forces in investing. It means, in this instance, that valuations of different types of stocks tend to move back toward their long-term averages. Foreign developed stocks historically have traded at about the same P/Es as U.S. stocks, and emerging-markets have traded at slightly lower P/Es.

What you can’t predict is how long it will take before stocks in these broad asset categories regress to the mean. Foreign and U.S. stocks historically have taken turns leading each other for multiyear periods. Leuthold looked at the last seven times that foreign and U.S. stocks had swapped places, and five of them occurred during bear markets. Ramsey suspects that foreign and emerging-markets stocks will eclipse U.S. stocks beginning with the next bear market.

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The Vanguard Group didn’t wait for a bear market before it made a move in anticipation of a shift in market sentiment. In February 2015, Vanguard raised the allocation of foreign stocks in its popular Target Retirement funds from 30% of total stocks to 40%. Roger Aliaga-Diaz, a senior Vanguard economist, says the boost in allocation to foreign stocks wasn’t a market call but rather represented a desire to increase diversification and lower the funds’ volatility. A big plus of owning some foreign stocks is that they don’t always move in lockstep with U.S. stocks.

Adding a 25% weighting in foreign stocks to an all-stock portfolio produced the same 10.2% annualized return as an all-U.S. stock portfolio over the past 46 years through March of this year, but with lower volatility and less-severe losses, says Gregg Fisher, chief investment officer of Gerstein Fisher, a New York City investment firm. “Both common sense and research dictate that investors should hedge bets and hold a global portfolio,” he concludes.

Vanguard recommends that investors keep about 10% of their stock money in emerging markets. “The headlines really scare investors, but valuations have really adjusted to the economic news,” says Aliaga-Diaz. “One has the feeling that we’re reaching the bottom here” for emerging markets.

In the developed world, the differences between large foreign and U.S. companies continue to shrink. About half the revenues of the S&P 500 companies come from foreign countries, and multinational firms that do a lot of business in the U.S dominate the EAFE index. The top 10 holdings of the foreign benchmark include food giant Nestlé (symbol NSRGY), automaker Toyota (TM), four huge drug companies, beer giant Anheuser-Busch Inbev (BUD) and British American Tobacco (BTI), whose brands include Kent, Lucky Strike and Pall Mall.

In recent years, a strong U.S. dollar has contributed to the poor performance of foreign stocks, Aliaga-Diaz says. A stronger dollar makes foreign stocks worth less to U.S. investors. But the dollar has been trending down since late November.

The simplest way to invest in foreign stocks is with Vanguard Total International Stock ETF (VXUS), an exchange-traded index fund that has about 15% of its assets in emerging-markets stocks. The fund, which is a member of the Kiplinger ETF 20, charges just 0.13% annually for expenses. Fidelity International Growth (FIGFX), a member of the Kiplinger 25, and Oakmark International (OAKIX) are my favorites among actively managed no-load mutual funds. For emerging markets, consider Harding Loevner Emerging Markets (HLEMX), also a member of the Kiplinger 25.

I recommend putting 20% to 25% of your stock money in foreign stocks, including 10% of that amount in emerging markets. Just be patient. Meanwhile, you may want to follow my lead and keep a good supply of Tums around.

Steve Goldberg is an investment adviser in the Washington, D.C., area.