Sunday Morning Coffee

Last Thursday Seeking Alpha published a post they asked me to write about some things I think will be important to the markets in 2010.

A good portion is devoted to country selection, investing at the country level, why this has been important and my opinion that it will become increasingly more important in the year to come.

My article is part of a series SA runs and they draw a lot of comments. I'm not sure what the ratio of you're a complete idiot to makes some sense comments is but there was one comment in particular that I thought could be useful to answer in some depth as I think it gets to the core of what country selection is all about.

In the article I listed most of the countries I own across the board (Australia, China, Chile, Norway, Canada, Israel, Sweden, Switzerland, Brazil and UK) and a few I would consider adding as across the board exposure in the future (Denmark, Egypt, Peru, Singapore and Vietnam) but there are more than just those that I follow in this context.

The reader went down the list of countries and itemized various things about each one (some I would agree with and some I would not) but said he had "a bit of an issue with your country selection from the asset correlation perspective." He mentioned that several of the countries are tied to going up with the risk seeking trade and going down with the risk aversion trade but he worded it differently. He then added comments on the rest of the countries. He asked why not just buy commodities instead of the the countries tied to commodities.

My thoughts here have been part of a running dialogue that has lasted for years now and is still ongoing and so for someone who has never read my stuff before there is likely to be a lot of context missing.

The reason to invest in foreign anything is for diversification. One way to think of diversification is always having a few things that are going up and a few things that are going down. More specifically as pertains for foreign is to own countries whose economies have different attributes than your home country. A service based economy has different attributes than a commodity based economy, exporters different from importers, deficit different than surplus and so on. These different attributes might then mean that the timing of the economic cycles in these respective countries are not in sync which might mean that the respective stock market cycles are not in sync.

This manifested itself in the last couple of years as the markets for quite a few of the countries mentioned above kept going up for months after the US had peaked. Some countries ended up going down a lot less and some turned up a little sooner. Chile peaked in Q2 2008 so an equity portfolio that was 50% Chile and 50% US would have still gone down plenty (assuming no defensive action was ever taken) but it would have gone down less and the ride would have been smoother.

While a 50/50 split like that is not realistic a combo of different countries is but it takes time and a willingness to go narrower than EAFE and EEM for foreign exposure. The reason I say that doing this requires going narrower than EFA is that with EFA you end up with a lopsided exposure to foreign countries whose attributes are very similar to the US. Some of that is fine of course but too much of that and the diversification becomes far less effective. You can compare EFA's results over varying periods of time to many different countries and see for yourself.

Whatever countries are selected for inclusion in the portfolio, they must be blended in some sort of proportion consistent with some expected outcome. Someone favoring commodity based economies would not want nothing but commodity based economies because any expected outcome could be wrong so owning some countries that do not, in this case, benefit from commodity production could be protection against being wrong.

In past posts I've broken countries down into different types of categories. Some countries are part of the global build up and out or modernization of the emerging world. Other countries are in their own world--these countries tend to have large populations that are going to grow no matter what, even if it is in fits and starts. And other countries still are becoming increasingly more important in the world economic order. Of course some countries are a combination of two or three those descriptions.

Obviously including a country comes after some sort of study is done to understand the economy, determine that there is some reason to buy the country (or in some cases avoid it) and then figure out the best way to add it in to the portfolio while still working with the rest of the holdings. I say it often but this is a time intensive process and understand there is certainly no guarantee of always being right. As with any form of investing, some decisions will be right and some wrong.

A few years ago I had a foreign allocation in the low 30s, percentage wise, and now that is generally in the neighborhood of 40% and will probably get closer to 50% in the next couple of years. From quarter to quarter or year to year the benefits may or may not be obvious but over longer periods of time the difference can be huge. A lot of the countries I've been writing about over the last five plus years of this blog have done much better than the US and so have contributed to the result over that time. Concluding that a country could be healthier than the US is not exceedingly difficult but again this does not guarantee success but I do believe it puts the odds in the favor of anyone able to spend the time.

The picture is from Molokai.