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SALOMON SMITH BARNEYEQUITYRESEARCH:GLOBAL

Global Asset AllocationJuly 16, 2001

Reasons for Global InvestingFive Good Reasons to Invest Globally

► Many opportunities exist outside the UnitedStates. Currently, there are 3,702 companiesglobally with capitalizations of $1 billion or more,1,774 of which are outside of the U.S. Many ofthese are highly profitable and have attractivevaluations and high earnings growth.

► Since many industries are competing globally, inorder to invest In the best company in anindustry, one has to set one's Investmentuniverse globally.

► Regional leadership In terms of returns tends tovary over time. Since 1984, a strategy ofInvesting solely in the regions that hadoutperformed in the past five years would havedone poorly.

► Diversification benefits from investing abroadstill exist.

► Emerging markets offer a unique opportunity to invest In an asset class selling at a discount to developed markets.

Reasons for Global Investing -July 16, 2001

Global Investing

The Efficient FrontierDuring the early 1990s, many investors became convinced that international investing was a good idea after seeing the data displayed in Figure 1. This figure shows the "efficient frontier" (risk/return curve) for different combinations of U.S. and international investing between January 1977 and December 1990. International investing is represented by the EAFE Index, which is an index of developed markets, excluding the United States and Canada. The efficient frontier curve shows the pattern of higher return and reduced risk that was the backbone of the arguments for investing abroad up through the mid- 1990s. For example, if one invested 60% in the United States and 40% in EAFE rather than investing 100% in the U.S. market, one could not only have achieved a higher return (15. 1 % versus 13. 1 %) but also have lowered the volatility of returns (14. 1 % versus 15.8%). However, between January 1991 and June 2001, a shift occurred in the "efficient frontier," as shown in Figure 2. During this period, the EAFE Index underperformed the U.S. market, and if one invested 60% in the United States and 40% in EAFE, rather than achieving a higher return, one would have achieved a lower return (12.2% versus 16.0%). Therefore, some have questioned the rationale for investing abroad.

To further clarify: Some of the reason the EAFE Index underperformed the U.S. market during that period was that Japan, which was a large part of the EAFE Index, had a zero annualized return from January 1991 through June 2001. This can be seen in Figures 3 and 4, which display the returns in U.S. dollars and local currency of fourteen of the largest global markets for this time period. Although the larger European markets (France, Germany, Italy, and the UK) had a lower return than the United States when measured in U.S. dollars, they had local currency returns that were very similar to those of the United States.

Reasons for Global Investing - July 16, 2001

In spite of the recent unattractive risk/return trade-off between the U.S. and EAFE markets, we believe there are still many reasons to invest globally. This report looks into some of the considerations that favor global investment today.


Reasons for investing GloballyThere are five strong reasons for investing globally. They include:

1 Number of opportunities,

2 Global competition,

3 Regional performance differences,

4 Diversification, and

5 Emerging market opportunities

Number of OpportunitiesAn investor should not be cut off from opportunities in a larger global marketplace. In terms of regional comparison, companies outside the United States represent about 50% of the world's capitalization (see Figure 5). Currently, there are 3,702 companies around the globe with market capitalizations of $1 billion or more. Out of these companies, 1,774 are based outside the United States. The number of these companies with forecasted earnings growth greater than 15% compares favorably with the number in the United States. Figure 6 indicates the number of these companies both inside and outside the United States with forecasted earnings growth greater than 15%.


Figure 6. Number of Companies with Forecasted Earnings Growth Greater than 15%

(Market capitalization greater than $1 billion as of July 3, 2001)

Region Number of CompaniesUNITED STATES 406NON-U.S. 495

EUROPE 265JAPAN 180AUSTRALIA/HK/SINGAPORE 50

Source: I/B/E/S.

With Global Competition in Many Industries, Investments Should Not Be Limited to U.S. Companies Many companies in the United States are faced with competition from abroad, as well as at home. The American automobile industry revamped production practices after imports from Japanese carmakers such as Toyota, Honda, and Subaru became widely chosen by consumers. General Motors, for example, set up its Saturn division with the motto of "a different kind of car company" in response to consumer demand for reliable, quality compact cars. In the retail industry, the Swedish company Hennes and Maurtiz has positioned itself in the American marketplace with affordable, trendsetting apparel that rivals the Gap and Abercrombie and Fitch. In the pharmaceuticals arena, Novartis and AstraZeneca are the two biggest players in an industry that thrives on research-driven innovation and where the successful placement of new drugs onto the marketplace becomes key for growth. Within telecom equipment, the Finnish-based Nokia and the Swedish-based Ericsson compete with the U.S.-based Motorola for the handset market. Within the chemical industry, BASF and Akzo Nobel are two chemical companies that have


shown an ability to grow at rates faster than the underlying industry. These are just a few examples in the growing global competition in certain sectors.

Diversification Is Important Because Regional Leadership in Performance Tends to Change over Time During the past 25 years, a strategy of investing only in those markets that had performed well during the previous five years would have performed poorly. As can be seen in Figure 7, during 1984-88, Japan was the best-performing market, with an annualized U.S. dollar return of 45%, followed by Europe, with an annualized U.S. dollar return of 26%. During the subsequent five years, 1989-93, Japan was the worst-performing region, returning -7% in U.S. dollars. During this same period, Latin America became the best-performing region, with a 44% annualized U.S. dollar return, followed by emerging Asia, with a 29% annualized U.S. dollar return. Between 1994 and 1998, Japan continued as a poor-performing region, returning -4% in U.S. dollars. However, the emerging markets that were the best-performing regions in the previous five years had a dismal performance, with Latin America returning -2% in U.S. dollars and emerging Asia returning -18% in U.S. dollars. For the two years of 1999 and 2000, in fact, no region achieved a higher return.

One cannot predict 100% in advance where in the world's the highest- and the worst-performing regions will be.

Opportunities for Diversification Still Exist by Investing AbroadOne concern about investing abroad has been that the U.S. market and foreign markets have been moving more in tandem over the last few years. When we measure the risk of combining different asset classes, we not only measure the volatility of each asset class but also the degree of correlation between the asset


classes. The lower the correlation between the asset classes, the lower the overall volatility of the portfolio made up of the asset classes for a given level of volatility of each asset class. In fact, as Figure 8 shows, the correlation of the U.S. market with EAFE markets has been increasing since 1998.

There are several reasons for this increased correlation. One of the reasons is greater synchronization globally on a macroeconomic level. Since 1998, central bankers around the world have, in general, enacted similar monetary policies. During the late 1990s, we saw the development of the European Economic and Monetary Union (EMU) and the introduction of the euro, which, together, have produced a more uniform monetary policy for Europe.

Another factor has been the globalization of certain industries, such as the technology, media, and telecom (TMT) sectors. The bursting of the TMT bubble had a global impact because it simultaneously affected companies in Europe, Asia, and the United States. In recent years, the practice of cross-listing stocks on multiple exchanges has become more common, which has also led to greater correlation. One last reason is the phenomenon dubbed the "CNN effect," whereby people all over the world have round-the-clock access to financial news and can act on information at the same time.

If the correlation between markets remains at these high levels, the risk-reduction argument for international investing could be compromised. We continue to think there will be two reasons why the diversification story will continue to hold. First of all, the correlations of the United States and foreign markets might not remain at the very high levels seen in the last several years. They could drift somewhat lower in the future, since most countries continue to have separate monetary and fiscal policies, and the magnitude of the TMT bubble will probably not be seen again. Secondly, as Figure 9 shows, the 36-month correlations starting in April 1998 between the U.S. market and different sectors in different regions around the world vary greatly. The correlations have been calculated in local currencies in order to


take out the exchange-rate effect. As can be seen, the correlations range from -0. 17 (U.S. market and cyclical conglomerates in Australia and New Zealand) to 0.71 (U.S. market and Latin American telecoms). Of course, investments should be made only if the opportunity for attractive returns exists, but Figure 9 shows that low-correlation opportunities still exist globally. Thus, we believe investment abroad remains a viable diversification strategy as long as a range of different sectors as well as regions are taken into account.

Many Opportunities Exist in the Emerging MarketsThe sharp rebound of the emerging markets in 1999 from the lows reached during the devastating financial crises of 1997-98 had induced many investors to take a second look at that asset class. Then the emerging markets fell once again in 2000 as concerns grew about the coming slowdown in the G-7 economies, and the sell-off in global technology led investors to shun virtually all assets perceived to be of higher-than-average risk. Now, once again, many investors are concerned that the return-risk relationship in the emerging markets may be chronically unfavorable. A glance at the historical returns and risks presented in Figure 10 goes far in explaining these apprehensions. Since December 1987 (the date at which the MSCI's Emerging Markets Free Return Index begins), returns on emerging market equities have been higher than those on stocks in the developed markets, but the variability in returns has also been higher, making the risk-adjusted returns on emerging markets substantially lower than those in the developed markets.


Figure 10. Returns and Risks in the Emerging and Developed Markets, December 1987-June 2001

Average Return Volatility

Emerging Markets 11.8% 23.9%

Developed Markets 9.7% 14.2%

Emerging Market returns measured using the MSCI Emerging Market Free index; developed market returns are measured using the MSCI World index. The volatilities are annualized standard deviations ofmonthly returns.

Source: MSCI.

If anything, the figures on performance over the past 14 and one half years mask the massive losses investors would have incurred over fairly short periods of time. Between Thailand's devaluation of the bhat in mid- 1997 and the collapse of Russia's markets in August 1998, for example, MSCI's Emerging Markets Free Index fell by 55%. In August of 1998 alone, investors in the emerging markets would have lost 32%. As can be seen in histograms of monthly returns shown in Figures 11 and 12, extreme returns - both positive and negative - are far more likely in the emerging markets than in the developed markets. Moreover, emerging markets are likely to remain volatile, if only because they are small relative to the size of potential cross-border flows. Argentina's market capitalization of about $24 billion, for example, is small relative to the estimated $3.5 trillion in overseas equities held by investors in the United States, the United Kingdom, Japan, and Germany as of the end of 2000. Even small changes in investors' allocations to markets such as Argentina can generate flows that are massive relative to the size of those markets.


Despite this volatility, there are a number of reasons to believe that the risk-return relationship in the emerging markets will be more favorable in the future than it has in the recent past. These are:

Returns Since December 1987 Are Unlikely to Be a Reliable Guide to Long-Term Relationships Between Returns and Risk In the Emerging Markets Judgments about the returns and risk that can be expected for a given asset class are typically based on data spanning a long period of time. Ibbotson Associates, for example, uses data beginning as far back as 1926 in seeking to uncover the relationships between return and risk for stocks, bonds, and Treasury bills in the United States.1 The reason for looking at performance over a long period of time is to include most or all of the major types of events that investors have experienced and may experience in the future. In this light, the 14 and one half years for which consistent return data are available for the emerging markets are a small sample. Moreover, the sample ends just after a down year (2000) in those markets. Under such circumstances, judgments based on historical measures of returns and risks can be seriously misleading as guides to future performance.

The Acceleration of Growth in the Emerging Markets Should Result in Strong Equity Market Performances Real economic growth in developing countries is expected to decelerate this year with the slowdown in growth in the advanced economies (see Figure 13). The deceleration in growth in the emerging markets, which was anticipated late last year, is one of the reasons that the emerging markets declined in 2000. The consensus among economists is that emerging Asia and Latin America will by 2002 resume growing at rates similar to those achieved before the onset of the global financial crisis in 1997 (see Figure 14).

1 lbbotson Associates, Stocks, Bonds, Bills, and Inflation 1997 Yearbook (Chicago: Ibbotson Associates, 1997).


To be sure, it is not clear that higher long-term economic growth rates will translate into higher long-term equity returns. The return to shareholders in any market in the long run depends, among other factors, on corporate governance, tax policy, the division of income between capital and labor, and the extent to which earnings are generated by foreign-owned firms, domestic firms with listed equity, and domestic firms with unlisted equity. Even if rapid trend growth does not necessarily mean high equity returns, however, emerging equity markets should perform well in the medium term as those economies move back onto their long-term high growth rate path.


Emerging Market Valuations Are Now Particularly AttractiveThe slowdown in growth in the advanced economies, high oil prices, low non-oil commodity prices, and heightened investor sensitivity toward risk all combined to produce a 3 1 % decline in the in the emerging markets in 2000. As a result, valuations in the emerging markets are currently inexpensive relative to those available in the developed. The consensus forecast P/E ratio in the emerging markets, for example, is 14x as of June 2001, versus 30x in the United States and 21x in the EAFE markets. Historically, valuations that low have been strong buying signals in the emerging markets. Valuations such as price-to-earnings ratios or price-to-book ratios in the emerging markets tend to be mean-reverting, with low valuations followed by periods of strong price appreciation and, therefore, high equity returns. The tendency for low valuations to be followed by high returns can be seen in Figure 15, in which the aggregate consensus forecasts P/E ratios for each month since August 1992 (the first date for which consensus earnings figures are available for more than a few markets) have been plotted against returns in the emerging markets over the next 12 months.

The Emerging Markets Are Home to Some of the World's Most Promising Growth CompaniesPerhaps because the aggregate valuations in the emerging markets tend to be substantially less expensive than the developed markets, there is a tendency to think of those markets as "value" markets dominated by Old Economy companies. The emerging markets, however, are the home to many companies that offer growth opportunities that rival any in the developed world. One indication is Business Week's annual information technology survey, which ranks companies globally on revenues, revenue growth, return on equity, total return, and profits. In this year's survey, no fewer than six of the top 20 information technology companies were headquartered in the emerging markets. These were: China Mobile, United


Microelectronics (Taiwan), America Movil (Mexico), Check Point Software (Israel), Telmex (Mexico), and Hon Hai Precision Industry (Taiwan).

Demographic Trends Favor the Emerging MarketsSurveys conducted in a variety of countries have confirmed that saving and spending patterns are closely related to individuals' life cycles. People try to smooth out their consumption of goods and services evenly over their lives. Their savings rates tend to be low when they are young and have relatively low incomes, to rise as they become middle-aged and are saving for their retirement, and to fall again during retirement. Hence, the demand for savings vehicles such as securities and bank deposits should be high in countries with relatively large middle-aged populations and low in countries with relatively young or old populations. Currently, a massive shift in age structures is under way in the advanced and developing countries that will affect savings, investment, and capital flows for decades to come. Populations are aging rapidly in Europe, Japan, and the United States. The large, young populations in the emerging markets, meanwhile, are moving toward the middle years in which they will be earning and saving more. This can be seen in Figure 16, which presents United Nations figures on the dependency ratio in 1998 and on what it is expected to be in 2025. The dependency ratio is the number of persons under the age of 15 or 65 or older divided by the number of persons aged 15-64. By 2025, developing countries are expected to have dependency ratios almost as low as those in the developed countries in 1998, while that ratio in the developed countries is expected to rise markedly. Since countries with low dependency ratios can be expected to have higher savings ratios, other things being equal, the implication of these trends is that the pool of savings will be increasing in the developing world in coming decades as it diminishes in the developed countries.


ConclusionWhether investing in the developed markets or the emerging world, the reasons to invest globally have to do with opportunity. There will be companies and countries that offer as much of and at times a higher return than investing solely in U.S. companies. In addition, with the globalization of certain industries, picking the best companies in an industry involves investing in companies outside the borders of the United States. Also, as the macroeconomic conditions improve in the emerging world, accompanied by very cheap valuations, opportunities can arise, offering some of those extremely high returns that can be the hallmark of emerging markets. Since none of us has a complete crystal ball and since regional leadership in returns tends to vary over time, we believe global investing tends to help reduce the riskiness of a portfolio.

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