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How The iPhone Tells Investors to Diversify Internationally
December 1, 2011
Some once-persuasive arguments for international equity diversification are losing their luster, as global economies become so interconnected they often seem to rise and fall together. Persistently high market correlations threaten to negate the most sought-after benefits diversification can provide: lower volatility returns and reduced overall risk. So, can an argument still be made for international diversification, or is it just creating headaches with no added benefit?
The traditional argument for international equity diversification is premised upon the independence of international markets: when one economy experiences a downturn, another may experience a boom. Historically, investors who diversified internationally across economies were able to smooth out their long-term portfolio returns while reducing their overall risk.
Over the past few years, however, highly correlated markets have become the trademark of globalization, with major economies noticeably experiencing boom and bust cycles together. For example, the chart below illustrates the closely correlated price performance of the U.S. market, developed non-U.S. markets, and major emerging markets. Using the S&P 500, MSCI EAFE Index, and MSCI Emerging Markets Index as proxies for their respective markets, we see that despite higher volatility present in emerging markets versus their developed peers, all three have generally tended to move in a similar direction over the past five years.
The convergence of these market cycles is further highlighted by the chart above, which plots rolling 12-month average weekly correlations. If two indices have a correlation of 1, their up and down movements mimic one another exactly, while a correlation of -1 indicates they move in opposition directions. For the most part, correlations between the U.S. market and developed non-U.S. markets have been well over 0.80 for the past couple of years. Over the same period, correlations between the U.S. market and emerging markets fell slightly from around 0.80 to 0.70, but appear to be back on the rise.
So, if the benefits of international equity diversification are dissipating, why bother? One good reason would be to gain exposure to global up-and-comers that won't necessarily be sprouting from domestic soil.
As a part of our research process, the investment team at Saturna Capital frequently studies the global production and supply chains of particular investment ideas or themes. This can be an effective way to identify manufacturers and service providers on the leading edge of niche industries. The supply chain of Apple's popular iPhone, for example, reveals a list of cutting edge, high-growth companies on their way to becoming tomorrow's blue chips. Of the iPhone's US$560 average retail price, Apple keeps an impressive 66%, but where does the rest go? A diverse collection of companies supply the iPhone's essential parts, including South Korea's Samsung Electronics, Italy's ST Microelectronics, Japan's AKM Semiconductor, and Taiwan's Digital Semiconductor. Foxconn, which operates in both Taiwan and China, takes a cut for putting everything together.1 These companies are all tech industry leaders who supply "little" devices that make the world go around.
Moving further down the supply chain, we find the touch sensor module (TSM), which was a key differentiator during the iPhone's early years. In its basic form, touch technology is a relatively simple concept. The touch panel senses touch or pressure, and it coordinates the contact points via X and Y patterns inside the module. The TSM then sends the coordinates to an integrated circuit (chip) that digitizes the received signal. The signal is then sent to the driver software, which executes the command.
The iPhone's TSM suppliers are top-notch companies that stand to benefit from continued success of the iPhone product line. Further, and more importantly, the technological know-how gained while working with Apple can be used to win business from other players seeking to enter the market. We have already seen this happen with TPK Holding Co., Ltd. and Wintek Corporation, who have been the leading TSM suppliers to Apple and are now supplying advanced TSMs to HTC and Amazon's Kindle Fire.
Despite the harmonizing effect that globalization has had on markets worldwide, there are still many valid reasons why investors might benefit from broadening their scope beyond U.S. borders. Traditionally, the investment community argued for international diversification as a hedge against domestic economic down cycles. Today, international investing should be considered a staple strategy that acknowledges dispersion of industry-leading firms across the globe. It also offers U.S.-based investors something potentially even more valuable: the opportunity to identify today the many cutting-edge technology companies that are poised to become tomorrow's blue chips.
Investors should note that investing in foreign securities does involve risks, including fluctuations in exchange rates of foreign currencies; less public information with respect to issuers of securities; less governmental supervision of exchanges, issuers, and brokers; and lack of uniform accounting, auditing, and financial reporting standards. There are also risks of adverse political, social or diplomatic developments that affect investment in foreign countries.
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Copyright 2011 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 5 · No. 11
1 Daily Chart: Slicing an Apple. The Economist. August 10, 2011. http://www.economist.com/blogs/dailychart/2011/08/apple-and-samsungs-symbiotic-relationship.
As of 11/30/11, mutual funds managed by Saturna Capital held the following securities mentioned in this edition of The Market Navigator: Apple Inc. represented 3.6% of Amana Growth Fund, 8.1% of Sextant Growth Fund, and 1.7% of Sextant Core Fund. Amazon.com represented 1.8% of Amana Growth Fund and 5.1% of Sextant Growth Fund.
As of 11/30/11, none of the following securities mentioned in this edition of The Market Navigator are held in mutual funds managed by Saturna Capital: AKM Semiconductor, Cirrus Logic, Dialog Semiconductor, Digital Semiconductor, Foxconn, HTC, Infineon, Micron, Murata, Samsung, Skyworks, ST Microelectronics, Texas Instruments, TPK Holding, TriQuint, and Wintek.
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