Diversifying in a Shrinking World

 Oak Value 
This fine fund has just two holdings based overseas:  Willis Holdings  and  Cadbury Schweppes . They alone account for the fund's reported 8% foreign stake. But we estimate that 37% of the portfolio's revenues come from overseas. In fact, several of the fund's domestic-based stocks generate more revenue overseas than Cadbury Schweppes--a foreign stock--which gets about half its revenue in the U.S. For example, insurer  Aflac  gets 72% of its revenue in Japan, while  3M ,  United Technologies , and  DuPont  all get more than 60% of their revenue outside the U.S.

 Clipper 
All 20 of this fund's holdings are headquartered in the U.S. As a result, its foreign stake is 0%. But don't be fooled. This is a fairly global portfolio. Twelve of its 20 holdings generate at least a third of their revenues abroad. And  Altria ,  Procter & Gamble ,  American International Group , and  American Express  are all wonderful plays on the global economy, pulling in nearly half their revenues from outside of the U.S. We estimate that 35% this portfolio's underlying revenues come from outside the U.S.

What to Do?
First, don't panic. There never has been a magic number for foreign exposure. Even past attempts to use set formulas were rendered inaccurate by rising globalization. Current efforts are even more limited. Your domestic stock funds likely have much more foreign-economic exposure than you think, while the opposite is true for your foreign funds. Not surprisingly, we see the greatest globalization among the largest firms. This explains why performance has become more correlated between the major indexes around the globe. Local-market issues further down the market-cap range tend to depend a bit more on their local economy--but not always.

And more help is on the way. Improving financial reporting overseas is moving us closer to formalizing the peek-through analysis that we did in this piece. Once enough data is public, we'll be able to systematically compare a fund's foreign stake by domicile with the percentage of its revenue generated outside the U.S. This will provide a much more accurate representation of a fund's foreign flavor.

A peek at the major benchmarks illustrates this point. As Chris noted, recent research estimates that nearly 45% of the S&P 500 Index's underlying revenue comes from outside the United States. Data is tougher to come by on the main foreign index, MCSI EAFE, but I piled through the footnotes of enough foreign annual reports to see that a similar global trend exists in that index as well. Just as many U.S. companies derive a big share of their revenues from overseas, so do foreign firms earn a big share of their profits from outside their home market.

This trend got us thinking about the impact on investors. So, we dug into the financials and found that labeling firms domestic and foreign based on their domicile isn't always an accurate indicator of their economic reality. The effect on a portfolio can be meaningful, so investors need to dig beneath the surface to understand the true geographic makeup of the firms a fund holds.

It's Not Where You're Located
There are clear similarities in the upper reaches of both benchmarks. The top firm in the S&P 500 is  Exxon Mobil , while  British Petroleum  grabs the same position in EAFE. Both oil companies generate about 30% of their revenue in the U.S. and the remainder around the globe. Nearly all major oil firms have similarly global profiles--regardless of domicile or which index they call home. The story is the same with big drug makers.  GlaxoSmithKline ,  Roche , and  Novartis  are foreign-domiciled members of EAFE.  Johnson & Johnson ,  Pfizer , and  Abbott Labs  are U.S.-based constituents of the S&P 500. All six firms generate close to half their revenues in the U.S. and the remainder around the globe. Similar patterns permeate both benchmarks.

Foreign Exposure at Home
Digging into the S&P 500's holdings revealed a few surprises about the extent of its constituents' foreign operations. I was aware that such U.S.-based firms as  Coca-Cola  and  McDonald's  had a big global presence. But chipmaker  Intel  garnering nearly 80% of its sales abroad was news to me. Ditto for computer maker  Hewlett-Packard : It hauls in two thirds of its revenue abroad. Below is a sample of firms with prominent positions in the S&P 500 that also have with big foreign-revenue streams. 

U.S. Companies with Overseas Revenue
Company	Industry	Estimated % Revenue from Outside U.S.
Intel Corp	Semiconductors	79.0
Coca-Cola	Beverage Mfg.	72.3
ExxonMobil Corp	Oil & Gas	69.0
Schlumberger	Oil & Gas Services	67.0
McDonald's Corp	Restaurants	65.5
Hewlett-Packard	Computer Equipment	65.0
3M Company	Diversified	61.4
United Technologies	Diversified	60.0
E.I. du Pont de Nemours	Chemicals	60.0
Altria Group	Tobacco	58.0
Procter & Gamble	Household & Personal Prods	57.0
IBM	Computer Equipment	57.0
Caterpillar	Construction Machinery	53.0
Aon Corp.	Insurance (General)	53.0
FPL Group	Electric Utilities	52.0
American Intl Group	Insurance (Property)	49.0
Oracle Corp	Business Applications	48.0
Praxair	Chemicals	48.0
Google	Business/Online Services	47.0
Abbott Laboratories	Drugs	47.0
American Express	Finance	47.0
News Corp	Media Conglomerates	47.0
General Motors Corp	Auto Makers	47.0
Symantec Corp	Systems & Security	47.0
Pfizer	Drugs	46.6
General Electric Comp	Electric Equipment	46.0
Bristol-Myers Squibb	Drugs	46.0
Cisco Systems	Data Networking	45.0
Johnson & Johnson	Drugs	45.0
Eli Lilly & Company	Drugs	45.0
eBay, Inc.	Online Retail	43.0
Yum Brands	Restaurants	43.0
Apple	Computer Equipment	40.0
Merck & Co.	Drugs	39.0
Boeing Co	Aerospace & Defense	38.0
PepsiCo	Beverage Mfg.	37.0
Merrill Lynch & Co	Securities	37.0
Medtronic	Medical Equipment	36.0
DELL	Computer Equipment	35.0
Microsoft Corp	Business Applications	34.0
Kraft Foods	Food Mfg	33.0