There are unique and differing risks when it comes to investing in foreign stocks compared to public companies in the United States traded on the U.S. stock market exchanges. I will cover these risks in some detail, but the conclusion I want you to draw from these risks is that you had better attach a hefty premium in terms of the potential return you are seeking to compensate you for taking these additional risks. Most U.S. investors apply U.S.-learned basic analysis to foreign company investment opportunities. At the end of the article, I will describe a real-life example of George, an MBA, CFA, and experienced investor, who was financially hammered when he invested in a Chinese company called Alibaba.
- A broad international portfolio
- A portfolio focused on emerging markets or developed markets
- A specific region, such as Latin America or Europe
- A specific country or countries, such as China or more in the Asia Pac region
- Economic risk. On a national level does the country have a balance sheet that gives us assurance that they can meet and pay their debt obligations? Financial stability comes from economic growth, lack of excessive debt, inherent wealth in the form of natural resources and an educated workforce, and a government that encourages investment, capitalism, and competition.
- Political risk. This requires good understanding of the government, its priorities, and its policies. Would you invest in your own business in the country? If so, you believe the political climate is conducive to run a good business and grow it profitability. Far more difficult—but equally important—is to assess the future of government and policy. If instability coming from a discontented and disenfranchised citizenry threatens the existing order, or if outside powerful groups seek to change or even topple the status quo, we need to connect those possibilities to our investment decision.
- Sovereign risk. This risk applies more to bonds than to stocks and is probably too complex for the average investor to evaluate, but we list it because it too is a real risk. The nature of the central bank and its policies and regulations regarding foreign exchange are an important factor to consider. This is especially true if you are evaluating a potential investment in the country’s bonds.
Credit ratings to assess a country’s ability to repay its debt are available from Moody’s, Standard & Poor’s (S&P), and other large rating agencies. In addition, other sources of information that cover the economic and political climate in foreign countries can be found in the New York Times, Wall Street Journal, and Financial Times, as they have a heavy focus and extensive coverage of overseas events. The weekly publication of The Economist is another excellent resource. - Currency risk. Currency fluctuations change the value of your return when it gets converted back into U.S. Dollars. This can result in additional, incremental investment gains or losses, solely the result of whether the U.S. Dollar is strengthening or weakening against the foreign country currency.
George loaded up his spreadsheet to assess revenue growth, price of the Alibaba stock versus earnings, and many other analytical tools and measures that in theory should provide enough information to make his investment decision. What did George neglect in his extensive analysis?
Current leader Xi Jinping is now in power in China. His role model and mentor was not Deng Xiaoping, however, but Mao Zedong. This meant a decided shift away from the capitalist elements in the economy and into the state-controlled economic model for the nation.
Xi removed the CEO Jack Ma from Alibaba, following some allegedly subversive commentary Mr. Ma apparently made about China. Later Alibaba was broken into pieces. Long story short, the promise of growth and profitability Alibaba once had was suddenly shifting into business prospects of slowing growth, as the state oversight would hamper the former competitive advantage it enjoyed under the erstwhile creative genius of the former CEO.
Indeed, all the highflyers that U.S. investors adored in China were pummeled. One exception however was Charlie Munger’s investment in BYD, the China “me too” version of Tesla and hot new EV vehicles. The chart below illustrates what happened to the most favored China stocks. Over a five-year time horizon, some made a small gain of single digit returns per year, while others have fallen below their stock price of five years ago:
Once you have become familiar with the risks, you can determine the return you need to target to compensate you for taking these risks. And while investing in foreign companies can be lucrative, the research you do concerning both the risks and rewards will help you make an informed decision. The more information you have, the less overall risk you will be taking. The bottom line is this: Investing overseas, intelligently, improves the benefits in terms of the overall diversification of your investment portfolio.
