An unexpected consequence of globalisation is that it may be more beneficial to invest in firms that are predominantly national

It has become accepted wisdom that investing in foreign stocks helps diversify equity portfolios. But as economies have become more globalised and correlations between stock markets in the developed world have increased, it may be time to revisit whether investing in foreign stocks provides diversification benefits. 

According to a new study,  ‘Mononationals: The Diversification Benefits of Investing in Firms with no Foreign Sales’ by Cormac Mullen and Jenny Berrill, published in the CFA Institute Financial Analysts Journal, there may be a way for investors to obtain meaningful diversification benefits through international equities. But capturing these diversification benefits, the authors warn, requires a willingness to challenge the accepted wisdom and make changes to the investment process. In particular, investors should not focus on where companies are listed but where they generate their sales, and gain a better understanding of companies’ distribution models for their products and services. 

In the 1990s, Mullen and Berrill note, most research showed clear diversification benefits for portfolios that allocated to international equities alongside domestic equities. But by the 2000s, subsequent research was already showing that these diversification benefits were in decline. 

The authors bring the waning diversification benefits of investing in overseas companies into sharp focus by pointing to the case of a single stock. In 1995, a US investor in Vodafone, the UK-based telecommunications company, would have gained exposure to a group with 99.7% of its sales in the UK. So at that time, an investment in Vodafone would have provided diversification benefits if the rump of the investor’s equity portfolio was invested in US stocks.

international diversification benefit for a national investor

However, the authors note that in 2012, a US investor seeking to buy into Vodafone to gain diversification benefits would have had a rude awakening. The same stock, 17 years later, generated just 8% of its sales in the UK; some 30% of Vodafone’s sales were generated in the US, the investor’s home country.

Vodafone is just one of many such examples. However, it illustrates how sales of many companies have become more multi-national, sometimes in a relatively short time following a series of mergers and acquisitions. As a consequence, investors attempting to diversify by investing in a foreign company whose place of listing has not changed may not receive the diversification benefits they expect. 

The authors also point out that, as a result of the growing correlation between stock markets in the developed world, investors and investment managers often make allocations to emerging and frontier markets. The goal is to enhance diversification in their equity portfolios. But such an approach is often unsuitable for risk-averse investors and investment managers whose investment mandates do not allow allocations outside of the developed markets.   

Mullen and Berrill’s study should prove useful to investors and investment managers who want to know whether international diversification in developed equity markets is possible today and, if so, how to benefit from it. In particular, the authors examine the case for investing in foreign companies which make most or all of their sales in their home countries.

The authors analyse data from the perspective of local investors from 10 developed countries. Based on where companies generate their sales, the authors identify five categories of companies, from those that are mostly domestic to those that are mostly global. They then assess the diversification benefits of each category to see which could be most beneficial for investors seeking international diversification. 

The first category the authors identify is foreign, domestic-only companies with 100% of their sales in their home country. 

The second category is comprised of companies with more than half of their sales in their home region – the authors identify three regions, North America, Asia and Europe. 

The third category is of companies with more than half of their sales in a region that is not its home region. 

The fourth category is bi-regional companies, which generate most of their sales in two main regions. 

Finally, the fifth category is global companies which trade in all geographical regions.  

The study measures the international diversification benefits and performs a Sharpe ratio analysis – which measures performance in relation to the risk taken – to unearth potential diversification benefits. 

Despite rapid globalisation in recent years, the authors find that investing in foreign stocks does provide statistically-significant diversification benefits.  

However, this is not the case for US and UK investors. Why? According to the authors, the likely reason is that stocks listed in the US and the UK are predominantly multinational and therefore already contain significant exposure to foreign markets.   

In contrast, the greatest diversification benefits are felt by Belgian investors, who experience a 67.3% increase in Sharpe ratio by adding foreign stocks to a portfolio of domestic stocks. For other euro-zone investors, the Sharpe ratio improvement ranges from 8.6% for French investors to 36.4% for Dutch investors. As for Japanese investors, they enjoy a 37.6% increase in Sharpe ratio. 

The really interesting finding from the study from an investor viewpoint is that diversification can be significantly enhanced by focusing on foreign, domestic-only companies. The authors call these companies “mononationals”. In nine out of the 10 countries, the highest improvement in Sharpe ratio comes from adding the stocks of companies that sell only to their domestic markets and do not seek any sales outside the country in which they are listed.  

“Mullen and Berrill argue that while global economic integration seems to have reduced the international diversification benefits available to investors, a sales-focused approach offers a potential opportunity”

The improvement in Sharpe ratio from investing in mononationals, the study finds, ranges from a 39.5% increase for US investors to 121.7% for Belgian investors. Canada is the exception, with no economically-significant diversification benefits. The authors suggest that the strong performance of Canadian stocks over the period analysed (1998-2012) may explain this anomaly.  

Potential opportunity
In short, Mullen and Berrill argue that while global economic integration seems to have reduced the international diversification benefits available to investors, a sales-focused approach offers a potential opportunity.  

“The really interesting finding from an investor viewpoint is that diversification can be significantly enhanced by focusing on foreign, domestic-only companies. The authors call these companies ‘mononationals’”

Obtaining these diversification benefits will probably require changes in the investment process. The authors note that investors and investment managers will need to approach stock selection, portfolio management and performance measurement processes differently. They will need to identify foreign stocks with a strong domestic focus and capture the diversification benefits provided by investing in these stocks. This calls for a geographic end-market sales analysis as part of the investment process. 

The authors do acknowledge, however, the limitations of using geographic sales data, given the accounting flexibility companies have in reporting the location of their sales and the effect that different distribution models have on geographic sales data. Financial analysts may find it valuable to investigate companies’ distribution models more carefully, and ask management for clarifications. 

Investment firms wishing to develop a strategy based on this study may want to study how the diversification benefits brought by foreign, domestic-only companies can be balanced against the risks associated with investing in these companies. For example, it is important to consider currency risks, interest rate risks, and so on. 

The authors also offer an interesting suggestion for those in search of financial innovation. They point out that their findings offer the potential for the development of exchange-traded-funds (ETFs) of equities with sales concentrated in the companies’ domestic markets. These ETFs, they suggest, could be labelled ‘mononationals’. 

Barbara Petitt is the managing editor of the CFA Institute Financial Analysts Journal