Investing in companies around the world as a tool for broadening opportunities and managing risk is an old idea that still relies on an even older technology: maps. But as globalization rolls on, the economic value of national borders for designing portfolios continues to fade. That’s old news, although many investors may be shocked to learn just how different the world looks when analyzing companies and markets through the lens of what some call the new geography of money management.

“Investment benchmarks based on domicile may not be as useful as they once were,” says David Polak, a veteran equity specialist and senior vice president at American Funds’ parent Capital Group, which manages over $1 trillion. Instead, he recommends crunching the numbers based on where the revenues are generated for analyzing companies and stock markets around the globe. In other words: follow the cash flows—and ignore or at least minimize the knee-jerk habit of allowing lines on a map to dominate your plans for investing overseas.

The conventional approach of using political boundaries to define multinational portfolios was compelling before the current wave of globalization reshuffled the standards of investment analysis. Once upon a time, a company’s base of operations told you most of what you needed to know for evaluating stocks. But from the late 1990s on, industry and company-specific factors started to cast more influence over equity prices.

As a recent research paper from the Capital Group says: “The economic world today is structured differently than it was just two decades ago. Free-trade agreements, the European Union and its common currency, economic reforms and the rise of a middle class in Asia, Latin America and parts of Africa [have] allowed companies to compete for customers, labor, capital and natural resources on a global basis. Average tariffs have declined from 26% in 1986 to 8% in 2010. Exports as a percentage of GDP have grown to almost a third of global activity, compared to 20% in 1994 and 15% in 1973. Economies are more closely linked than at any time in history.” (From Investment Insights, April 2013.)

It may be obvious in 2014 that people would want to design a global equity strategy that reflects the changing macroeconomic landscape, but such a strategy hasn’t always been easy to implement. The lack of data was one past obstacle, but corporate reporting standards have caught up with the economic evolution of the last two decades. More companies around the globe routinely publish local sales and earnings and other financial information.
“We’ve reached the point where the majority of companies break down their revenues by region,” observes Polak.

Think Globally, Invest Locally
The combination of an increasingly globalized economy and the availability of detailed accounting data opens up a brave new world of multi-factor possibilities for equity investing. Consider two examples: Burberry Group and Sun Pharma. At first glance, these publicly traded companies appear to be representative of their home countries and regions. But a closer look reveals a more nuanced profile.

Let’s start with Burberry, the iconic British apparel company based in London. On the surface, it’s one more U.K. company, so a naïve investor might assume that it’s closely tied to the ebb and flow of England’s economy. The shares certainly look British, in part because the stock is among the holdings in the FTSE 100, the popular U.K. equity index that claims some of the biggest names on the London Stock Exchange. But appearances can be deceiving in the 21st century.

Less than one-third of Burberry’s revenues come from Europe. By contrast, the Asia-Pacific market accounts for nearly 40% of revenues, followed by the Americas, which generate roughly a quarter of Burberry’s sales. In fact, growth beyond Europe is expected to remain a critical factor. The firm projects sales will rise 13% in the Asia-Pacific region, a bit more than twice as fast as the pace of growth in its European operations.

Is Burberry a British company? It all depends on how you define “British,” although the numbers suggest that its fortunes will be largely determined by distinctly non-British trends.

Meanwhile, it’s easy to see Sun Pharma as a classic “emerging markets” stock. Based in Mumbai, the company is one of India’s biggest pharmaceutical players in the generic drug industry. But here again the initial view is misleading: More than half of sales originate in the U.S. The Subcontinent is the company’s home base, but India accounts for just one-quarter of revenues. If you expect U.S. generic drug sales to rise in the years ahead and you’re looking for a company to ride the wave, Sun deserves consideration.
 
Emerging Weights
What’s true for individual companies applies to stock markets. Consider how the major equity-market regions of the world compare from two perspectives: market capitalization and revenues. Using the yardstick of total share value, North America (which is dominated by the U.S., of course) holds a bit more than half of the global opportunity set: 51% of market cap, according to Capital Group’s analysis of MSCI indexes (see Figure 1). Stocks in the emerging markets are minnows by comparison with a mere 11% of the planet’s market cap (in U.S. dollar terms).

Those figures shift dramatically, however, when measured through a revenue prism. Emerging markets generate roughly one-third of global revenues (based on the MSCI All Country World Index), or a bit more than North America’s share.

The lesson for designing equity strategies: Looking at the world through revenue-tinted glasses tells us that emerging markets—India, China, Brazil and the like—deserve roughly the same weight as U.S. equities.



Questioning Mr. Market
Market-cap data still dominates portfolio design in the grand scheme of money management, but investors are increasingly rethinking the old rules. One catalyst is the growing body of research that highlights: 1) the limits (some say the inferiority) of market-cap-weighted strategies; and 2) the potential for enhancing returns, reducing risk or both with strategies tied to alternative indexing rules.

Analyzing and benchmarking stocks based on revenues is just one piece of the asset-pricing revolution that falls under the broad heading of factor investing. Decomposing return into its constituent parts and looking for new ways to profit from the data is old hat from a theoretical perspective. The pioneering research in the 1970s led the way, albeit in an era when few investors had the resources or the investment products to implement the ideas. Fast-forward several decades, and familiar concepts on paper are rapidly moving into the mainstream.

An expanding menu of ETFs and mutual funds offer a new generation of indexing choices. The origins of many products in recent years can be traced to new indexes that incorporate a more granular perspective on revenues, sales and other fundamental variables. The five-year-old RevenueShares Large Cap ETF (RWL), for instance, tracks a revenue-weighted version of the stocks in the S&P 500 index, the widely cited yardstick of U.S. companies that’s usually quoted based on its market-cap incarnation.

The common theme for these and dozens of other so-called “smart beta” indexes is a deeper appreciation for what Rob Arnott of Research Affiliates likes to refer to as benchmarking that breaks the traditional link between a stock’s price and its portfolio weight. Cutting the link, which is at the core of weighting stocks based on market cap, creates a new paradigm of risk and return possibilities. Research Affiliates describes its various non-price-weighted indexes, which serve as the foundation for numerous mutual funds and ETFs, as a third choice instead of traditional active and passive strategies.

MSCI has pushed the possibilities a bit further with the recent launch of its family of Economic Exposure Indexes (EEI). The firm describes the benchmarks as tools that “reflect the performance of companies with significant exposure to specific regions or countries, regardless of their domicile.” Consider the MSCI EAFE Index, a widely used benchmark of stocks in developed markets excluding the U.S. In its standard form, the EAFE’s market-cap weights translate into a heavy allocation to European and Japanese companies. The EEI versions of EAFE offer a twist on this index’s conventional design. For instance, they reweight the EAFE’s developed-world shares according to their “economic exposure” to emerging markets, creating a benchmark with a tilt that favors faster-growing corners of the world yet doesn’t invest in the stocks of those nations per se.

Figure 2 compares the standard market-cap version of EAFE with its emerging-markets-exposure counterpart and against the MSCI’s standard Emerging Markets Index. Predictably, MSCI EAFE, with an emerging-markets tilt, has outperformed the standard EAFE mix for the decade through November 2013. There’s no mystery here: Emerging market stocks have delivered higher returns over developed-market equities for the past 10 years. Reweighting EAFE stocks toward firms that draw relatively high levels of revenue from these markets has juiced performance—even for companies that aren’t formally based in emerging markets.

“Some clients feel like they’re already invested in emerging markets but don’t want to buy more emerging stocks directly,” says Diana Tidd, head of MSCI’s Americas index business in New York. A portfolio of EAFE stocks that target emerging-markets-related revenue is a way to tap into these markets without investing in the countries directly.

The Usual Caveats (And Unusual Opportunities)
Building indexes and investment strategies that tap into risk factors defined by something other than market cap isn’t new. Equal weighting, for instance, has been around for decades. But the effort has reached critical mass as ETFs, mutual funds and even separate account structures turn theory into practical investment choices. Revenue weighting is merely the tip of the strategic iceberg. Critics charge that it’s all a marketing ploy—an excuse to roll out new products under the banner of a new story. That may be true in some cases, but don’t confuse questionably designed products with legitimate, perhaps even superior alternatives to market cap for weighting stocks. As always, each product stands (or falls) on its own design and logic (or lack thereof).

Still, it’s best to remember that for all the potential that non-market-cap weighting offers, you’re asking for trouble if you think it’s a free lunch or a sure thing. Consider one of the oldest alternative risk factors—small-cap stocks, a slice of the equity market that was formally “discovered” more than 30 years ago.
There’s wide agreement that small firms are expected to earn a premium over large-cap firms in the long run, although there’s still plenty of debate about why that’s so. That’s a reminder that the potential for higher performance comes with the risk of falling short of familiar big-cap indexes in the short run, perhaps for years at a time when these companies fall out of favor, as they sometimes do. Expect no less with revenue-weighting strategies and other alternative benchmarking concepts. No factor tilt shines all the time—sometimes the risk premium goes into hibernation, or worse.

The bigger opportunity, at least in theory, is rethinking asset allocation strategies overall by using a mix of alternative risk factors, ranging from revenue weighting to momentum to the familiar small-cap and value risk premiums and beyond. Several research studies tell us that there’s lower correlation among such factors compared with a set of traditionally defined asset class betas.

In turn, that opens up the possibility of building portfolios with stronger defenses for bear markets and other hazards that can create trouble for conventionally designed asset allocations. Factor-based portfolio strategies that use revenue and other variables may not be a total solution. But looking at markets through a different set of risk definitions suggests that there’s still room for improvement for defining “diversified” when building investment portfolios.