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Bob Tattersall

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Diversification dilemma

Bob Tattersall

 

TORONTO (GlobeinvestorGOLD) — One of the supposed advantages of international investing is that it diversifies away exposure to problems that are specific to your home market. So, you can imagine my surprise when reading the financial report of a company located in the small town of Blackburn in the north of England to see that the NHL strike was a contributor to the weak earnings year to date.

Scapa Group Plc manufactures technical tape, such as those used in a surgical bandage or in an automotive electric wiring harness where the performance features are critical. One of its subsidiaries happens to be Renfrew Tape, not far from Ottawa, and this is where the NHL connection comes into play. In addition to tapes used for wrapping electric cables, Renfrew Tape also makes the tape used by many players on their hockey sticks. This season, of course, a lot of hockey sticks are not being wrapped and Scapa is seeing the impact on the bottom line.

You may be tempted to dismiss this as only an amusing anecdote, but it illustrates the impact of globalization on international diversification. The traditional way of presenting a global portfolio report is to show the geographic diversification based on the location of the head office. The more countries represented the better, because we intuitively assume that more countries mean wider diversification. This is obviously not the case if the portfolio is made up of large cap multinationals: Nokia, Ericsson, Electrolux and Vodaphone, for example, are heavily-dependent on market share success outside of their home market and the head office location is almost irrelevant. Scapa Group, however, is a small-cap company with annual revenues less than $500-million (U.S.), so now even the smallest companies are part of the globalization story.

All of this makes intuitive sense, but it would be good to have some reliable statistics to back up this assertion that the global economy is becoming more intertwined and less beneficial to international risk reduction. By chance, a recent book by Jeremy Siegel titled The Future for Investors contains a fascinating chart on this topic. The chart plots the correlation coefficient between annual stock market returns in the United States and the rest of the world since 1970.

A low or negative correlation coefficient is good news for portfolio diversification whereas a high number implies that the assets under review are effectively marching to the same drummer.

For the period 1970 through 2000, the correlation was in the range of 0.4 to 0.5, which is acceptable diversification. Since 2000, however, the correlation has shot up to the current level of 0.75, which means that investors have to work much harder to achieve risk reduction through international diversification.

This last point is key: there are benefits from international investing, especially if the company sells into its domestic market and doesn’t simply process raw materials and sell the finished product back into North America. But, you need to check the end markets as well as the head office location before you can be sure you have really moved the risk offshore.

Robert Tattersall is President and partner at Howson Tattersall and a recognized expert on small cap stocks in Canada.

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