Does It Still Make Sense to Diversify Internationally?

One class of investors will be only too glad to wave 2011 goodbye. If you had
any money riding on overseas stock markets, chances are you've taken some
pretty nasty lumps. This past year, the broadest measure of developed foreign
markets, the iShares MSCI EAFE Index Fund (NYSE: EFA ) lost 15.62% in dollar
terms (excluding dividends). The emerging bourses, according to the iShares MSCI
Emerging Markets Index ETF (NYSE: EEM ), fared even worse, skidding 21.12%.
Painful indeed, especially when you consider that the headline U.S. stock
indexes were either slightly above (Dow Jones industrials) or slightly below
(S&P 500) the breakeven line. So the question arises: Does it still make sense
to diversify internationally? Or has another investment fairy tale gone poof at
midnight? Values Point to Profits Ahead Tempting as it is to be cynical about a
financial world that often seems broken, I don't think we've seen the end of
great profit-making opportunities in foreign markets. In fact, the recent
weakness in overseas stocks is probably setting us up for exceptional returns
once the current distress passes. The main reason, of course, is valuation. As
of mid-December, according to Bloomberg, the stocks in the Stoxx Europe 600
index were quoted at a slender 10.1 times estimated 2011 earnings, versus 12.2X
for the Standard & Poor's 500 index a discount of 17%. The iShares MSCI
Pacific ex-Japan Index (ETF) (NYSE: EPP ), which normally trades at a sizable
premium to the S&P because of Asia's superior economic growth, was at 12.6X.
Some emerging markets are even cheaper. Brazi is selling for about 8X trailing
12 months' earnings, and India about 12X both well below their norms for the
past five years. Remember also that despite a recent slowdown, these countries
are still growing much faster than the developed economies of North America or
Europe. For the opening months of 2012, I'm taking a cautious view of most
foreign stock markets. Europe's sovereign debt travails will weigh on economic
activity around the world, but especially in the EU homeland. In addition,
we're picking up early signs that China's credit-fueled boom may be due for
a setback in 2012. Chinese purchasing managers report that the country's
manufacturing sector is now contracting at the steepest rate since early 2009.
From North to South Accordingly, I recommend that you proceed slowly and
judiciously with new commitments. In Europe, I advise you to favor
recession-resistant health care and consumer-staples names, such as drug maker
Novartis (NYSE: NVS ) and food processor Nestle (PINK: NSRGY ). Not so
coincidentally, both are based in Switzerland with its friendly business
climate and sound currency. Both stocks also throw off generous dividend yields:
4.07% for NVS, and 3.41% for NSRGY. Dividends are typically paid once a year, in
April. Switzerland extracts a 15% withholding tax on dividends remitted to U.S.
shareholders, but you can obtain a credit against this tax if you hold the stock
in a taxable account (not an IRA). Among the other developed markets, my top
choice is Australia, whose tax law encourages corporations to pay out the
lion's share of their profits in the form of dividends. As a result, most
Australian stocks yield considerably more than their U.S. counterparts. Take
Westpac Banking (NYSE: WBK ). Strong and conservatively managed, this Aussie
bank has boosted its dividend more than 400%, in dollar terms, over the past 10
years. Current yield: a mouth-watering 7.8%. Dividends are paid semiannually, in
July and December. No withholding tax is currently imposed on U.S. residents.
For a diversified portfolio of Australian stocks, consider iShares MSCI
Australia Index Fund (ETF) (NYSE: EWA ). This ETF owns a large slug of
financials (44% of the portfolio), but it also gives you exposure to
Australia's natural-resources sector. Current yield: 4.71%. Submerged, Not
Sunk Given that emerging markets have taken it on the chin, I'm confident that
Brazil and India, my two longtime favorites among the developing bourses, will
eventually snap back to their 2011 highs and beyond. Before a lasting turnaround
can occur, however, investors will need to get a sense that the growth outlook
in these countries is stabilizing. That will take time. So, I suggest dribbling
cash into vehicles like iShares MSCI Brazil Index (ETF) (NYSE: EWZ ) and
PowerShares India Portfolio (ETF) (NYSE: PIN ) in equal-dollar installments over
a period of three to six months. For the immediate future, emerging-markets
bonds seem to hold greater potential than stocks. Unlike U.S. Treasuries, EM
bonds offer worthwhile yields that exceed, in most cases, the dividends you
could earn on stocks from the same countries. The J.P. Morgan U.S. Dollar
Emerging Markets Bond Fund (NYSE: EMB ) is the safest pick, suitable for
virtually all investors. If you want to shoot for a little more income, go with
TCW Emerging Markets Income Fund (MUTF: TGINX ), which invests mainly in
private-sector bonds rather than governments. Current yield: 6.94%.