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Own the ‘best’ companies in the world

Reprinted courtesy of MarketWatch.com.

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Many U.S. investors are understandably reluctant to invest in international companies. But I think they are missing an important opportunity.

The most common international asset class is large-cap blend stocks, roughly equivalent to the Standard & Poor’s 500 Index SPX, -0.37%  in the U.S. International large-cap blend stocks are represented by an index called EAFE, which stands for Europe, Australasia and Far East.

The S&P 500 holds the blue-chip companies of the U.S., and EAFE represents the blue-chip companies of the rest of the world.

Quite often, these indexes move up and down together. But just as often, one outperforms the other. Last year, 2014, EAFE lost 5.7%, while the S&P 500 gained 13.5%. Yet In 2015 through April 9, EAFE was up 8%, producing four times the 2% gain of the S&P 500.

Over the past 45 years, from 1970 through 2014, EAFE compounded at 9.7%, compared with 10.5% for the S&P 500. At those rates, a $100 initial investment would have grown to $6,405 in EAFE and to $8,845 in the S&P 500.

Also interesting: The combination of just these two indexes, rebalanced annually, produced a return of 10.3%.

EAFE’s best one-year gain was 69.9% in 1986; the best year for the S&P 500 was 1995, with a gain of 37.6%. The year 2008 was the worst for each index: EAFE lost 43.1% while the S&P 500 was down 37%.

For real-life investors, I think 15-year periods are more relevant than individual years.

In the 31 15-year periods from 1970 through 2014, EAFE’s average compound return was 11%, compared with 11.8% for the S&P 500.

Every one of those periods was profitable for EAFE; its best 15 years were from 1975 through 1989, with a compound return of 21.6%. (For the S&P 500, the best 15 years were from 1985 through 1999, with a gain of 18.9%.)

The worst 15-year period was the same for both indexes: 2000 through 2014. EAFE compounded at 3%, the S&P 500 at 4.2%.

By themselves, these numbers don’t make a compelling case for investing in EAFE. A number of investment advisers recommend skipping EAFE even by investors who own other international asset classes.

Some advisers go so far as to advocate skipping both the S&P 500 and EAFE. However, I believe 10% of any long-term equity portfolio should be in the S&P 500 and another 10% in international large-cap blend stocks. Let me tell you why.

Perhaps the most compelling reason is that as I mentioned above, together these asset classes represent the blue chip companies of the world. They invest in “the best” companies with “the best” management, “the best” products and “the best” prospects.

As such, they are rarely available at bargain prices. That means they aren’t likely to have the best long-term performance.

However, in any severe market downturn, the stocks of these blue-chip companies are likely to hold their value better than those of value companies, small companies and emerging markets companies.

The best way to reduce overall portfolio risk is to invest in bond funds. But when you’re focusing on the equity side of a portfolio, I think a good case can be made that large blue-chip companies help mitigate risk.

It’s easy to invest in international large-cap blend stocks.

The performance numbers in this discussion are based on returns of two excellent and inexpensive Vanguard index funds: 500 Index VFINX, -0.37%  representing the S&P 500 and Developed Markets VTMGX, -0.81%  representing EAFE.

There’s no way to know the future, of course, but I think Vanguard Developed Markets has the potential to produce better long-term returns than the S&P 500.

Developed markets holds 1,367 companies with an average size of $31.5 billion. The 500 Index, Fund on the other hand, holds only 504 companies with an average size of $73.8 billion.

With so many more companies, the EAFE fund is less subject to potential damage that any one or two stocks could do. At the same time, more than doubling the number of holdings provides lots of corporate diversification.

The size issue is significant, because over the long term, smaller companies have done better than larger ones. Although $31.5 billion hardly qualifies as “small,” it is less than half the average in the S&P 500.

The two funds also differ in their balance between growth and value, as measured by the price-to-book ratio (a lower ratio indicates a stronger value orientation). Developed Markets has a P/B ratio of 1.52; the S&P 500’s is 2.63.

The bottom line for me is that large-cap stocks, U.S. and international, represent two great asset classes that might or might not go up and down together.

They provide currency diversification. And are both quite different from value and small-cap asset classes.

I can’t prove that these asset classes will improve your returns. But my portfolio includes them, and I think yours should do the same.

I will be speaking in Ventura, Calif. for the American Association of Individual Investors on May 7 and again in Portland, Ore. on May 16. Each presentation lasts three hours.

Richard Buck contributed to this article.