“Many felt the euro zone would blow apart and that China and the emerging world economies would hard-land,” said James W. Paulsen, chief investment strategist at Wells Capital Management.
Yet despite widespread worries over Europe’s debt crisis and China’s rapidly slowing economy, a broad swath of foreign stocks in the developed and emerging markets delivered double-digit gains for the year.
As 2013 begins, it looks once again like a tough slog for international investors — and this time, conditions may actually make it harder to generate strong portfolio returns. For starters, investors will have to be far more selective with their foreign stocks if they hope to enjoy the type of success they did last year, money managers say.
This is partly because much low-hanging fruit has already been picked. Value-minded funds that bet that blue-chip European stocks were being unfairly punished for the region’s debt troubles earned 6.8 percent in the recently ended quarter and 16.8 percent for all of 2012. And growth-oriented funds that focus on China had impressive gains of 11.6 percent in the fourth quarter and 20.4 percent for the year.
To be sure, “the long-term story of the emerging markets — with their faster-growing economies and younger populations — has legs,” said Jason Hsu, chief investment officer at the investment consulting firm Research Affiliates. “And in Europe, stocks are still trading at historic discounts.” For instance, based on 10 years of averaged earnings, the price-to-earnings ratio for European equities was less than 16 as the new year began, versus an average of slightly more than 20 over the last decade, he said.
But the risks are clearly on the rise, fund managers say.
For instance, while valuations abroad remain generally attractive, the same cannot be said about the pricing of high-quality companies in both the developed and emerging-market worlds that fund managers most covet.
Consider emerging-market companies that sell largely to consumers in their home regions, as opposed to customers in the much slower-growing developed world. While the P/E ratio for the Morgan Stanley Capital International Emerging Markets index was only 12 at the start of the year, based on projected earnings, it was more than 25 for consumer-related stocks in that index, according to Bloomberg.
“The disparity in valuations in the emerging markets between high-quality consumer companies and the rest is much wider than in the developed world,” said Simon Hallett, chief investment officer at the asset management firm Harding Loevner.
“Investing in the emerging markets is a question of price as well as relative growth,” Mr. Hallett added. “My point is that P/E expansion in the companies we want to buy in that region has at least largely taken place.”
This explains why the Harding Loevner International Equity fund, which outpaced 70 percent of its peers over the last year, has more than half of its portfolio in Europe and just 13 percent in the developing world.
Yet there are risks in betting on European equities, other managers say.
For instance, in recent years, a popular strategy among investors with European shares has been to concentrate on multinational companies that generate the bulk of their sales in the faster-growing emerging markets. These companies are generating stronger revenue and earnings growth than European concerns that do most of their business in their recession-racked home region.
While this strategy has worked, “valuations are looking stretched among these companies,” said Harry H. Hartford, president of Causeway Capital Management and co-manager of the Causeway International Value fund, which beat 98 percent of its peers in 2012 and 92 percent over the last five years.
A good example is Diageo, the spirits maker. After surging more than 36 percent last year, shares of the company — the seller of brands like Johnnie Walker, Smirnoff and Tanqueray — traded at a frothy P/E ratio of 38 as the year began, based on projected 2013 earnings. And after gaining 19 percent in 2012, shares of the household products maker Unilever traded at a forward P/E of nearly 17, versus 15 for Procter Gamble, its United States-based rival.
The choice for investors is difficult. They may need to pay uncomfortably high prices for quality stocks or assume a different type of risk by going down the quality curve to companies with poorer balance sheets and earnings prospects.
Mr. Hartford added that investors should be aware of yet another risk, even if it seems unlikely right now. In 2012, global stocks were supported by cheap capital made available by central banks worldwide. Thus far, there’s little indication that those central banks, including the Federal Reserve in the United States, will turn off the spigot of cheap liquidity. But it could happen.
“If there is a withdrawal of that liquidity, or if we get higher interest rates in the U.S. or Europe for that matter, you’d have to be much more selective with stocks,” Mr. Hartford said.
“I don’t anticipate that happening anytime soon,” he added. Still, he said, “it is undoubtedly the case that the further we get into 2013, in the absence of another round of unanticipated economic weakness, there is a greater likelihood of interest rates rising.”
Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.
Article source: http://www.nytimes.com/2013/01/13/your-money/investing-abroad-may-require-a-detailed-map-this-year.html?partner=rss&emc=rss
