What Does “Investing Internationally” Really Mean?

Prospective clients from the U.S. often tell me they want to be "invested internationally," which is usually followed by a statement that they "don't want to trade U.S. companies" or "don't want to be in the U.S. stock market." While I understand the sentiment that prompts these questions—let's face it, the U.S. Dollar and the U.S. economy are really struggling with little sign of recovery on the near horizon—I often wonder: What do these prospective clients "really mean" when they ask to be investing internationally? What are their goals for doing so?

Often, the reasons and goals for being invested internationally don't always lead to investments that are completely divorced from the U.S.

Goal: Get Away from the U.S. Dollar

Assets most at risk from potential problems with the U.S. Dollar are "pure" U.S.-dollar-denominated assets like certificates of deposit (CDs), savings accounts, checking accounts, and money market accounts.

Foreign Currency Exposure

If these clients really mean that they want to get away from exposure to the U.S. Dollar, the "purest" way to do so would be to hold foreign currency in some form, either via directly holding a foreign currency itself, holding certificates of deposit denominated in a foreign currency, or holding foreign government bonds. Other alternatives would be to purchase shares of a foreign currency exchange-traded fund or mutual fund. Sophisticated investors could also consider foreign currency futures or options contracts (FX or "forex" contracts). However, these options come with risks as well: government risk, currency risk, exchange rate risk, economic risk, contract risk, margin risk, interest rate risk, and other risks. But they will get assets "away from the dollar."

Holding Stocks Denominated in Foreign Currency or Paying Dividends in Foreign Currency

While I understand the impulse to enhance exposure to foreign currency by holding stocks denominated in foreign currency, or by holding assets that pay dividends or income in foreign currency, this can be a very "uncontrolled" way to hedge your dollar bets. Mostly because it's playing two markets at once—the stock market, and the currency market—and these two markets can work at cross purposes.

For example, selling a stock held in a foreign currency for a gain can be offset by a loss in "currency translation" if the foreign currency itself has depreciated against the dollar. Neither can you guarantee that your foreign currency dividend will be paid at a time when the currency translation/exchange rate is favorable. Of course the opposite is true, and these two markets can work to enhance each other; however, effectively implementing this strategy requires a constant balancing of profit/loss in the stock versus profit/loss due to currency translation.

Precious Metals Exposure

The Dollar is not the only currency facing challenges. Other foreign currencies around the world are experiencing similar problems due to increased amounts of money printing and economic distress, therefore it's unlikely that a challenge to the Dollar as fiat currency would happen in a vacuum. So if the concern with "getting away from the Dollar" is really a concern about its standing or viability as a fiat currency, then precious metals investments would be my "hedge" of choice against a fiat currency meltdown. Gold-as-money still tends to be the "dollar panic" or "fiat panic" go-to metal, but precious metals as a whole generally—although not always—respond positively to problems with paper money systems.

Yet don't get drawn in by the glitter of precious metals'—particularly gold's—recent run up. Let's not forget the period of the early '80s to the early 2000s when gold didn't really go much of anywhere. And over the last 10 years in particular, this has been a very—let me emphasize that again—very volatile sector, and has generally experienced multiple double-digit downturns in any given 12-month period. What I'm getting at is: This investment is not for the faint of heart; most investors will need a rock-solid philosophical reason for participating in the sector to weather its frequent downsides. 

Goal: Get Away from U.S. Markets

I frequently get inquiries about investing on foreign exchanges. While we can invest on multiple foreign exchanges for our clients, we generally do so more for reasons of availability of specific stocks, or liquidity in specific stocks, rather than to "get away from U.S. markets" per se.

Get Exposure to Foreign Companies/Exchanges

First of all, let's clarify what a "foreign company" is: a company whose legal domicile or home country of incorporation is not the U.S.

I think it's a common misconception that "U.S. stock markets" equals "U.S. companies" and that "foreign markets" equal "foreign companies," so "investing on foreign exchanges" equals "investing in foreign companies." The reality is that the U.S. stock exchanges are open to *any* company that meets the exchange's listing requirements, and isn't prohibited or restricted by the United States Office of Foreign Assets Control. Therefore, foreign companies frequently list on the U.S. stock exchanges to get exposure to their highly active, liquid markets. Likewise, U.S. companies are able to list on foreign stock exchanges, as long as they meet those exchanges' listing requirements, and any applicable regulations in the exchanges' countries.

So investing in foreign companies becomes more a question of:

• Which companies do I want to invest in?
• What exchanges are they traded on?
• How liquid are their listings on those exchanges?
• How reliable are those exchanges?

as the real "why" or "whether or not" to invest in foreign companies or on foreign exchanges, rather than a matter of "I don't want to invest in the U.S. stock market" or "I don't want to invest on the U.S. exchanges."

The answers to these questions will determine if there's any real benefit to investing in a particular company on a particular exchange. Sometimes there is. For example, Nestlé S.A., makers of Dreyer's Peanut Butter Cup ice cream (one of my favorite ways to beat the Southern California summer heat), lists on the SIX Swiss Exchange (NESN.VX). You can trade it on the U.S. exchanges as a "pink sheet" ADR (NSRGY.PK), but it is far less liquid than trading it on the SIX.

Get Exposure to Companies with Revenue Streams from Foreign Countries

If the goal of investing "away from U.S. markets" really is to invest in companies with limited or no exposure to the U.S. economy—and therefore presumably whose profitability is less impacted by problems in that economy—this really becomes a question of a company's revenue streams than of its legal domicile, the exchange it trades on, or the currency it trades in.

Companies domiciled in foreign countries don't always make their profits there. Likewise, U.S. companies (especially large multi-national companies) don't always make the majority of their profits in the U.S. Determining the geographic sources of a company's revenue streams requires homework—translation: reading earnings reports. Determining which companies to invest in based on revenue streams entails deciding:

• Which economies do I think are growing instead of declining?
• Is the company's exposure to the growing economies growing as well, or is it in a downturn?
• What is my target percentage for revenue streams from growing economies?
• How much exposure to revenue streams from declining or decelerating economies am I willing to tolerate?

If the focus is on revenue streams rather than a company's legal domicile or the exchange it trades on, many U.S. multi-national companies may be options for investment.

It's ironic, but many iconic U.S. companies' international revenue streams are significantly larger than their U.S. revenue streams. For example, The Coca-Cola Company's (KO) 2010 Annual Report stated that only 31.7% of its net operating revenues came from North America, and its fastest-growing operating segment is in Eurasia & Africa.

Goal: Get Away from U.S. Taxation

People do ask me about investing overseas as a way of avoiding U.S. taxes.

Again, I understand this impulse. Like many governments, the U.S. weaves a delicate (and sometimes not so delicate) dance between its need for revenue and the impacts of changes to tax law on its taxpayers. Some of these tax law changes affect corporate tax liability, and thus corporate profit margins. Other changes apply to individuals and their income, including their investments and investment income. So there are legitimate reasons to take U.S. tax laws into consideration when determining how, where, and when to invest.

(Keep in mind that I am not a licensed tax professional, so all tax issues should be discussed with your own tax advisor. The following is intended to be solely educational in nature.)

Reduce or Avoid Paying U.S. Income Taxes (Individuals)

There are, of course, hundreds of books about reducing or eliminating individual tax liability (municipal bond investments, contributions to employer-sponsored retirement plans, charitable giving, etc.), but it's not my purpose to write a "how to" manual on tax avoidance or "creative" tax management strategies, just to discuss overseas investment as it relates to individual tax liability.

The U.S. has tax treaties with many countries around the globe; the terms of those treaties dictate whether or not income earned in the U.S. by foreign citizens, or in foreign countries by U.S. citizens is taxable. These treaty terms generally also apply to investment income—dividends and interest, for example—coming from investments in companies domiciled overseas, although some portion of foreign taxes paid by U.S. citizens may be deductible. (The IRS's Publication 901 covers this topic in detail.)

So: Is investing in a foreign company either on a U.S. exchange or on a foreign exchange, or investing in a foreign government bond sufficient to avoid U.S. taxation? Generally speaking, no. More dramatic measures are required.

To truly leave U.S. tax liability behind, generally U.S. citizenship and residence in the U.S. must be left behind as well.

What about setting up an overseas entity in an offshore jurisdiction? This is a tangled legal web I prefer not to enmesh myself in other than to state that generally speaking, any income or dividend drawn from these offshore entities by a U.S. person or entity will still be subject to taxation in the U.S.

And I have bad news for U.S. investors. U.S. financial institutions are required to drill down to the underlying owners or beneficiaries of LLCs, LLPs, trusts, or other structures, regardless of domicile.

So, basically, you can run. But you can't hide. At least, not easily.

Avoid Effects of U.S. Taxation on Corporations and Entities

If the goal of investing overseas is to avoid investing in companies that will be directly exposed to or affected by changes in the way the U.S. taxes corporations, then investing in companies domiciled overseas is certainly an option. But an option with caveats and homework requirements.

Going back to the discussion of revenue streams: If a company has revenue streams coming from business activities in the U.S., it's likely that the corporation will pay some form of U.S. taxes on the revenues from those activities, regardless of the location of the corporation's legal domicile.

However, just because a company *does not* derive any of its revenue from U.S. markets does not mean that its tax situation is necessarily any more or less favorable than a company that *does.* Generally, local taxation laws apply to revenues generated in nearly any jurisdiction, so most revenues will be taxed in the countries/jurisdictions in which revenues were generated. Naturally, this taxation—regardless of whether by the U.S. government or by other countries/jurisdictions—might affect a company's overall profitability. It's the investor's judgement call as to how much "tax impact" on profits is acceptable.

For example, in 2011 Canada's taxation of Canadian royalty trusts changed substantially, requiring the trusts to be subject to the same tax rate as corporations. The impact on the dividends paid out by these investments was, in most cases, dramatic.

Reviewing Overall Reasoning for Investing Internationally

Like I said, I understand the impulse to invest internationally. There is a perception or assumption that diversifying away from the U.S. Dollar or U.S. assets will "cushion" the impact of any economic or financial crises in the U.S. However, this assumption has not held up during recent market downturns. Markets around the world felt pain in the fall of 2008; the same phenomenon has been happening again in recent weeks.

Much of the correlation of seemingly unrelated markets can be attributed to the increasingly inter-dependent nature of economic and banking systems around the world. While we are not yet "one world," we are globalized enough where economic or financial upheaval in nearly any country affects us all.

It is perhaps for this reason that, despite the Dollar's decreasing cachet as the world's reserve currency, central banks around the world have still proven themselves willing to take measures to prop up the Dollar. While this coordinated effort to sustain the Dollar won't last forever, it's still the status quo for the time being, and investors need to be aware of that reality.

From my perspective, there are legitimate reasons to "invest away" from the U.S.; however, a smart overseas investment:

• Achieves specific goals or addresses specific issues relative to investing internationally
• Takes liquidity, taxation, and unique risks into account
• Stands on its own as an investment choice, regardless of its "international merits"

Disclaimer: PFS Group may invest in the companies or strategies discussed above.