Reasons to consider increasing your international portfolio.

Making the case for a diversified and significantly larger international portfolio (rather than that one large-cap international growth fund you've been using in client portfolios for years) got a whole lot easier this year.

The average foreign small- and mid-cap growth fund returned hefty year-to-date returns of more than 37%, while the foreign small- and mid-cap value sector paid investors close to 36%, according to Morningstar Mutual Funds in Chicago. Compared to the S&P, which was up 18% through October 6, international investors, especially those straying from the straight and narrow of large-cap funds, were richly rewarded. Of course, those staying the course with international large-cap growth haven't exactly been severely punished. The funds are up on average nearly 21% year to date, while their value peers have returned, on average, 24.4%.

As dazzling as it has been, performance is only one reason to rethink and increase international holdings. Today, international companies account for more than 45% of all market capitalization in the world, making it clear that investment opportunities outside the United States not only abound but are growing harder to resist. Fund managers argue that U.S. company valuations are still seriously high relative to the rest of the globe. And last but certainly not least in the arsenal of those making the case for international investing is the precarious perch of the U.S. dollar, which appears poised for more of a tumble.

"In general, we think that investors should look at international investing not only for diversification, but because there really is no reason for them to limit themselves to the U.S. stock market. There are as many good opportunities elsewhere as there are here," says Bridget Hughes, a senior fund analyst who follows international funds at Morningstar.

The story for international investing is as strong and deep as it's ever been, maintains Giulio Martini, co-manager of the AllianceBernstein International Value Fund, which has rewarded investors with a 53% one-year return.

Martini, who spoke on the "Rethinking International Investing" panel at The 6th Annual Financial Advisor Symposium in Chicago on September 18, says that on the emerging market front especially, timing and valuations are highly attractive. "One of the more important misvaluations we're seeing is emerging markets, which remain very cheap as an asset class," says the chief investment officer for currency and quantitative strategies at Sanford C. Bernstein & Co. in New York.

Structural problems started much earlier in emerging markets than they did in the United States, so these countries have had longer to cope, says the economist, who traces the bursting of the emerging market's bubble back to the Mexican currency crisis of 1994. Nine years later, emerging market stocks, which have historically traded at a discount of 15% to U.S. stocks, are now in some cases trading at a discount that has grown to 50%. These crises also caused financing in emerging markets to dry up, so companies were forced to do more with less capital. As a result, their returns on capital now often are very high.

"The other theme that I think has a high level of importance is the vulnerability of the U.S. dollar," adds Martini, who points to the $550 billion U.S. trade deficit on top of a $500 billion federal budget deficit, the volatility of the U.S. stock market and lagging U.S. company profits as drivers of further devaluation. To buoy the dollar, "the deficit needs be financed with capital inflows, and the investment opportunity here in the U.S. isn't as attractive as it was before."

Today, Martini likes non-U.S. auto and auto parts companies, pharmaceuticals and telecom. The Swedish auto airbag manufacturer Autoliv was a good buy for the fund, providing 50% returns in the past two years. Martini also likes Honda, Nissan, Volkswagen and auto parts companies such as Canada-based Magna International and Germany's Continental. The fund has also bought pharmaceuticals in the past year including Glaxo, Smith Kline and France's Aventis, in addition to telecom stocks like France's wireless subsidiary Orange, which the government is now buying back at a tidy profit for the fund.

Interestingly, Martini notes, three years ago the AllianceBernstein portfolio had none of these stocks because of their expensive valuations and the wide diversions between sectors like technology, which was trading at 109 times earnings, and utilities, selling at just 12 times earnings. "Today, the valuations are more compressed, which allows us to find opportunity wherever it exists," Martini adds. "We're not looking at the world in terms of countries or regions, but bottom-up, from a company by company perspective. Now, with more compressions, we get to look at the things that bubble up to the top of the list we feel good about."

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