March 2008

FOCUS ON FOREIGN INVESTING

A shaky domestic economy, jittery investors, a weak dollar and uncertainty surrounding our country’s political future have all made foreign investing a hot topic in the financial press. While investing internationally does offer multiple benefits to investors, it can also be fraught with risks.

There are two major benefits to global investing: capturing the strong growth inherent in emerging economies and recognizing the benefits of broader diversification. In recent years, economic growth of the BRIC countries (Brazil, Russia, India and China) has far exceeded that of the United States. The chart below details the annualized growth rates in Real Gross Domestic Product (GDP) for the past three, five, and seven-year periods.

Source: Bloomberg

Strong country-specific growth can provide a situation where “a rising tide lifts all boats.” It is easier to realize solid corporate earnings growth (and, therefore, stock price appreciation) when a country’s entire economy is performing well. This economic growth is driven by several factors and these factors vary from country to country. Because every country will have unique growth drivers, exposure to different countries can mitigate the impact of the failure of a specific country’s growth drivers. For example, India is in desperate need of improved infrastructure (plumbing, roads, etc.) and is rapidly building this infrastructure. This build-out demands basic construction materials at a higher level than would be demanded by a developed country with a service-based economy like the United States.

While robust growth rates and diversification benefits are strong arguments for investing in international securities, there are some drawbacks as well. One concern with investing internationally is that these emerging economies do not typically enjoy the same level of political stability that more developed countries experience. The potential for dramatic regime changes is greater in developing countries, which could ultimately lead to disastrous results for investors. Another concern is the potential for the nationalization of private companies, often to the detriment of foreign shareholders. Many developing countries have market exchanges that are not nearly as efficient or well regulated as those of developed countries. Accounting rules and regulations can also differ greatly from country to country, making it much more difficult to compare firms across borders. Less stringent accounting standards can also paint a false picture of a company’s financial strength.

These developing foreign markets, while displaying some strength of their own, may still be susceptible to problems in markets of more established countries. The old adage “when America sneezes, the rest of the world catches a cold” describes this risk. During normal economic periods, the returns of stocks around the world may seem to act independently of each other. But in times of trouble or uncertainty, the returns of the world’s markets tend to move more in sync. This was the case in October 1987, during the Asian/Long-Term Capital Management crisis in 1998, and during the bursting of the “tech bubble” earlier this decade. Historically, the degree to which returns of stock markets around the world did not move together was the basis for reducing risk by increasing diversification. However, the correlation among these market returns has diminished somewhat over time with the globalization of economies and has led to decreasing benefits from diversification gained from investing internationally.

China may be a case in point. Over the past 10 years, China’s economy has grown at an average clip of about 9% versus 3% for the U.S. While China’s growth has been a tremendous boon to global economic growth and equity prices, including in the U.S., there are concerns regarding the sustainability of such growth. Despite the Chinese government’s efforts to contain this growth, cracks in the foundation are surfacing. Energy shortages, resource limitations and ballooning cost structures will make the Chinese economy more turbulent in 2008, and coupled with shortages of raw materials and commodities, raise the specter of price inflation there. This, in turn, could easily translate into global inflationary pressures.

At RiverPoint, exposure to international equities is important to a well-diversified portfolio and still timely as a part of our overall investment strategy. We have avoided purchasing shares directly from foreign stock exchanges, primarily because of concerns regarding insufficient trading volume and less stringent regulatory environments. Instead, we choose to invest in American Depository Receipts, or ADRs, high-quality mutual funds and American companies that are globally diversified. These ADRs are essentially American versions of foreign companies. The units are traded on American exchanges, pay dividends in dollars, and are subject to trading rules and regulations similar to U.S. stocks. Many large international firms, such as consumer products giant Unilever, beverage-maker Diageo, and commodity leader BHP Billiton trade on American exchanges as ADRs. We can essentially employ the same analytical tools and techniques with these stocks that we can with their U.S.-based counterparts.

High quality, international equity mutual funds, such as the Dodge & Cox International Fund, are also an excellent way of achieving broad diversification through overseas exposure. Our analysts seek funds with long, successful track records and significant resources dedicated to researching their foreign holdings. These funds are well equipped to invest directly overseas by focusing on foreign shares exclusively. Our clients benefit from the expertise of these mutual fund management teams while also earning potentially higher returns relative to investing in foreign index funds.

While we recognize the critical role foreign investing should play in a well-diversified portfolio, we also remain cautious regarding the valuations of those countries and markets that have led the global surge in equity returns over the last four or five years. We remain vigilant investors on behalf of our clients.

Market Summary	2/28/08	YTD Price Change
Dow Jones Industrial Average	12,582	-5.1%
Nasdaq Composite	2,332	-12.1%
Standard & Poor’s 500 Index	1,368	-6.9%

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.