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Does Magic Formula Investing Provide International Diversification?

International diversification is one of the most often cited piece of portfolio advice from financial planning experts. In his book The Future for Investors (MagicDiligence review), Wharton professor Jeremy Siegel describes how younger demographic population trends in emerging economies like China and India will eventually shift the center of worldwide economic power eastward. In light of this, and the fact that U.S. investors have about 85% of assets invested in domestic companies, he and many others recommend that 30-40% of your stock portfolio should consist of foreign companies, or companies generating a significant amount of revenue from outside of North America.

The primary reason for not ignoring foreign companies is the faster growth in these markets. While creating and expanding new product and service categories is one way to grow, it is much easier to ride the "rising tide" of macro-economic growth, profiting as large numbers of formerly uneducated people go to school, start businesses, make money, and (most importantly) start buying goods and services they could not afford before. Have a look at the nominal GDP growth of the "BRIC" (Brazil, Russia, India, China) countries against the United States for most of the past decade (values in trillions):

United States9.7614.2045.5%4.80%

Clearly, it was much easier to grow revenues in any of the BRIC countries than in the United States over the past decade. Going forward, these countries still provide significant growth potential, especially China and India, both of which have population bases 4 times as large as the U.S. Even China's GDP would have to more than triple to catch the U.S.

So how does all of this pertain to Magic Formula Investing (MFI)? The question to ask is: do I sufficiently diversify my portfolio to take advantage of superior growth opportunities in foreign countries by following MFI?

At first glance, it appears that perhaps the answer is "no". Joel Greenblatt, the creator of MFI, specifically designed the strategy to consider only U.S.-listed securities, as these are required to follow certain conventions when reporting financial statements. This is important, as MFI is a mechanical strategy. Also, while foreign-based companies that are structured as U.S. holding firms do appear in MFI, foreign stocks that trade using American Depository Receipts (ADRs) are not, as many report revenues in foreign currencies. This eliminates a lot of big international companies based overseas, such as Finland-based Nokia (NOK) or Germany-based SAP (SAP).

However, it is important to note that foreign exposure does not necessarily have to come via foreign-headquartered companies. Over 40% of revenues to S&P 500 companies come from outside of North America. U.S.-based companies like Coca-Cola (KO) and Pfizer (PFE) generate well over half of their sales overseas, giving them the ability to take advantage of higher secular economic growth trends. Additionally, as mentioned, there are several U.S. holding companies with their only operating subsidiaries overseas, making them effectively foreign firms.

To see how well MFI automatically diversifies investors, MagicDiligence looked at the Top 50 over 50 million market cap screen for stocks that generate at least 30% of sales outside of North America. Of the 50, 18 meet the criteria (36%), and several others generate a smaller percentage of sales overseas. The 18 with significant foreign exposure are:

Chicago Bridge & Iron (CBI)

China Biologic Products (CBPO)

China Education Alliance (CEU)

Cherokee (CHKE)

Dyadic International (DYAI.PK)

Corporate Executive Board (EXBD)

Fluor (FLR)

Foster Wheeler (FWLT)

Graham Corp (GHM)

InterDigital (IDCC)

KHD Humboldt Wedag (KHD)

PRG-Schultz (PRGX)

Pervasive Software (PVSW)

GT Solar (SOLR)

Tessera Technologies (TSRA)

Net 1 UEPS Technologies (UEPS)

Universal Travel Group (UTA)

Versant (VSNT)

Several of these generate virtually all of their revenues in foreign districts (CEU, CBPO, UTA, UEPS are a few).

36%, ironically, is roughly the percentage recommended by portfolio managers for international exposure, but many still have a majority of sales from the U.S. and Canada. Overall, MFI will not diversify you internationally to the extent recommended by "experts", but it does give you some foreign exposure and by design keeps you away from the overvalued "story stocks" that wreck many a portfolio. The MagicDiligence Top Buys portfolio contains several picks that are well-positioned to take advantage of growth in emerging economies. Growth plus a cheap stock price is a recipe for big gains.

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