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Redefining foreign stocks: It’s a small word after all

Among the more dangerous notions in investing is the idea that this time, it’s different. It is almost never different, my friends.

The economy does what it does. Companies and owners of other assets make money, and we have an opportunity to invest alongside them and share in the profits. Trees don’t grow to the sky, and all things revert to the mean.

At great peril to my longtime reputation as a believer in the “it’s never different” doctrine, I am willing to acknowledge a genuine paradigm shift in the investment landscape. A paradigm shift occurs when some underlying system or pattern or sequence does actually change, and the change becomes permanent.

In 1989, the Berlin Wall fell. After the atrocity of Tiananmen Square, China began a slow path toward embracing a free market system. Later in the 1990s, India underwent some little noticed but profound regulatory and political changes regarding foreign investment.

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In little more than a moment, more than 2 billion workers joined the global economy. Over the ensuing decade, those and other emerging-market countries seemed to have learned some tough lessons about fiscal and monetary management. The entire block of emerging market economies has been engaged in a virtuous cycle of trade, investment and fiscal restraint.

The results are profound. Over most of the last century, the developed nations have accounted for more than two-thirds of global gross economic production. The emerging market countries now account for just over half of global production, a share that is rising fast.

Throughout my career, my profession has viewed overseas stock investments in two distinct categories. The category that most of us thought of as foreign stocks is known as EAFE, which means Europe, Australia and Far East. The “Far East” part really means Japan.

These countries are well-developed and are what we consider the developed world outside of America and Canada. Despite the fact that these economies are more like ours than they are different, even this category of foreign stocks made many investors uncomfortable, and it would typically account for only 10-15 percent of a stock portfolio.

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The second category of overseas investing has been the emerging markets stocks. Emerging markets stocks have long been viewed as utterly unpredictable. More than a few of these countries have experienced complete stock-market meltdowns within memory.

Every time any given country looked like it was doing fine, things would explode with hyperinflation or a currency write-down or a coup or other disaster. Emerging market stocks were truly a high-risk proposition with little or no information available to even make informed decisions.

The investment paradigm shift that we are experiencing is that the group of stocks we used to think of as foreign stocks - the EAFE group - really isn’t so foreign anymore. I don’t know that General Electric is any less foreign than Nokia. Is Daimler-Chrysler a foreign or domestic company? I don’t even know for sure.

The major developed countries’ economies are more and more joined at the hip. Our fiscal and monetary policies are similar, we share employees and customers with almost no barriers, and we are increasingly reporting financial results in each others’ currencies.

While there will surely be differences in growth rates between these countries - just as there are between American states - for the most part, we are highly correlated. The traditional basket of foreign stocks just isn’t so foreign anymore and does not offer the diversification benefit it once did.

On the other hand, the emerging market stocks are not the roll of the dice they used to be. Three-fifths of the globe has yet to experience an economic surge in the manner of the post-war boom in North America, Europe and Japan. Many of these countries have very sound monetary policies in place. Most have large foreign currency reserves, and most are receiving waves of foreign investment.

Going forward, it is my view that the diversifying role that foreign stocks that have played in our portfolios should be played by the emerging markets stocks. Will it be a bumpy ride? You bet. It’s supposed to be a bumpy ride.

The key feature is that it bumps along to a different beat than the American and European stock markets. Added together, they make for a smoother and higher-yielding ride. As is my usual preference, I will allocate emerging markets dollars to specialist stock-pickers with a strong value orientation to their style.

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Things are almost never different. This is a rare case where the wise investor will take note of real changes going on in the world.

As Lord Keynes said, “When the facts change, I change.”

E-mail Richard Ashburn at rick@richardashburn.com.