Tuesday, May 30, 2017

Consider These Issues Before Investing In Foreign Stocks

Market pundits and investment experts have been telling us to start investing in foreign stocks. This is mainly because the US stock market is at its all-time highs and due a major correction whereas foreign markets have been lagging considerably for the past few years and now are primed to grow again in double digits.

If you look at the 5-year chart below which compares developed international stocks fund MSCI EAFE ETF (blue line) with US S&P 500 Index (green line), you will notice that international stocks have been grossly lagging US stock market since about mid 2014 and it is only recently that they have started to grow again.

Source Yahoo Finance

Just on dividend basis, the MSCI EAFE ETF pays 2.9% dividend vs. S&P 500's 1.9%. Cumulatively, foreign stocks are paying a higher dividend by almost a percent when compared to US stocks.

There is some truth in what these experts are saying; however, before you go and start investing in foreign stocks or ETFs, you should consider the following implications:
Issue #1:  Political and Economic Risks

Political and economic risks can greatly impact a business's ability to make money and prosper. There are certain countries where governments have a lot of control over how private businesses operate. In some countries, governments may have over 50% voting rights. This means these companies may not be shareholder friendly and may make decisions that are especially counterproductive to their foreign shareholders.

When thinking about these risks, countries like Brazil and Venezuela come to mind. Investing in stocks from these countries can be hugely profitable, but can also be extremely risky.

Think about this, Barclays has decided that Venezuela is too dangerous for even its bond-investor clients. Bonds are supposed to be the safest type of investment after cash.

Therefore, choose foreign stocks from countries that are politically stable and economically sound. This pretty much weeds out most of the emerging markets and leaves us with only the developed foreign countries such as: Canada, UK, Japan, China, and like.

One can argue that we are starting to see a bit of political uncertainty in the US and a few other developed countries mainly in Europe, but nothing at the level or scale of what usually occurs in the underdeveloped world.

Issue #2:  Tax Withholding Implications

When you buy a foreign dividend paying stock, the dividend payment is taxed twice. Once in the country of origin and then again in the US for the US tax payers. This is what is called double taxation.

The foreign government takes the tax out as a withholding before it even gets paid to you. Following is a list of withholding rates by country:

Source: NYSE
Note that many of the countries in the list have 0% withholding rates while others have withholding rates as high as 34% (Venezuela).

For now, I'm sticking to these three developed countries: Canada, UK, and Ireland for any foreign stock investing. Below are a couple of stocks from these countries that I've been following:

A couple of blue chip foreign dividend paying stocks
I have owned Ireland based Eaton Corporation (ETN) for the last few years and have recently added Canadian Enbridge Energy (ENB) to my portfolio at a 4.5% yield.

Canada has a foreign tax withholding rate of 25%. However, because of a special tax treaty, for the US residents, the withholding rate goes down to 15%. Even better, this 15% tax withholding can be recovered by a US tax payer at the time of filing taxes. The IRS allows taxpayers to claim either a deduction or a credit on their tax returns up to a limit ($300 or $600 if filing jointly).

If you had foreign dividends in access of the above limits, then you are required to file a IRS Form 1116 in order to claim a tax credit. See IRS Foreign Tax Credit publication for more details.

As much as I love doing my own taxes, filling out an additional tax form does not sound fun and I would rather avoid having to file additional tax forms as much as possible by staying within the above foreign dividend limits. But if you have an accountant that takes care of your taxes then it should be a non issue for you.

For US residents, there are two ways to completely avoid tax withholding on foreign stock dividends:

1) Only buy foreign stocks from countries that have 0% withholding rate or have a tax treaty that completely exempts the withholding tax for US residents. 

When it comes to foreign dividends and taxes, nothing is better than a 0% withholding rate. Countries like UK, Hong Kong, Hungary, and Singapore make the best of such countries. Though note that 0% withholding rate is only for corporations and not real estate (REITs) or other types of foreign investments.

2) Only buy foreign stocks that pay dividends as a Return-on-Capital. 

Ireland has a 20% withholding rate. However, I'm able to avoid foreign tax withholding by buying shares in Eaton Corporation which pays regular quarterly dividends to US shareholders as a Return-on-Capital (ROC).

A ROC type dividend is not taxed like a normal dividend, instead it is taxed at the time you sell your shares. In other words, the ROC type dividend has no tax withholding in a foreign country as it is not seen as a dividend payment/income but rather a return of your invested capital.

At the time when you sell your stock, the cost basis is adjusted for the dividends payed and is then taxed by IRS as a long-term capital gain (given you kept your shares for at least 1-year).

Issue #3:  Foreign Exchange Fluctuation

This one you can't really avoid as whatever dividend you get from a foreign source will need to be converted into US dollars before you get payed.

The conversion rate is always in a flux and can be unpredictable as many factors can cause it to move. For example, a short-term political or economic concern can cause the foreign currency to decrease in value when compared to dollar, thus making your dividends worth less.

For example, as of today, 1 Canadian Dollar equals 0.74 US dollar. This means on a 5% dividend yield from a Canadian company trading at $20/share, I would receive only 3.7% (not accounting for tax withholding).

Therefore, I like my foreign stock dividend yields to be as high as possible while still staying within the limits of what I consider a safe dividend.

Another Likely Issue

The issue is that many of the foreign companies don't pay dividends quarterly like their US counterpart. Instead they pay dividends semi-annually or annually.

This may not be an issue for some investors; however, for income focused investors or retirees who depend on regular and frequent dividend payments, this could be a deal breaker.

For me, I like to receive quarterly dividend payments as it provides a good indication of company's financial health and I like this indicator to be at least quarterly updated/tracked rather than once or twice a year. Besides, who doesn't like being payed quarterly rather than semi-annually or annually?

Both my foreign holdings Eaton Corporation and Enbridge Energy pay quarterly dividends similar to US stocks.

Conclusion

Foreign stocks can be great for enhancing dividend yield and portfolio diversification; however, it is prudent to understand the key implications for investing in foreign markets/stocks and avoid any bad surprises.

By keeping the above issues in mind when investing in foreign stocks, you will be better prepared to handle or even avoid such issues completely while benefiting from higher income and diversification.

Previous Blog Post: Having A Stock Watchlist Can Help You Become A Better Investor

Disclosure: I am long ETN and ENB.

Disclaimer: Author of this article is not a licensed/registered financial or investment or tax adviser and does not provide investment or tax advice. Any mention of stock names/tickers in this article or website is not a recommendation to buy or sell. This article is for informational purpose only. Full disclaimer can be read here: Full Disclaimer


4 comments:

  1. I currently don't own any international stocks but I would love a few for diversification purposes. However, they also charge you extra fees when purchasing them through an online broker. So instead of paying $5 a trade, you may have to pay $20 which will increase you cost basis. And while it's nice for diversification, I don't think it is required to have. I'm pretty sure Warren Buffett has only 100% US companies in his portfolio.

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    Replies
    1. Hi Dividend Daze, higher commissions would be an issue for buying foreign stock on foreign or over-the-counter (otc) stock exchanges.

      Many of the blue chip international stocks trade on US stock exchanges such as NYSE and NASDAQ as ADRs (American Depository Receipts).

      ADR is a special treatment that allows these foreign stocks to trade just like American stocks on US exchanges and hence there are no higher commissions for trading such stocks for a US resident. I payed regular broker commissions ($5 or $6 depending on the broker) to buy ENB and ETN shares.

      Now, if I had gone to Toronto stock exchange to buy ENB then yeah I would probably have payed a higher commission.

      So I guess one more issue to keep in mind is to only buy foreign stocks that are traded on local exchanges to avoid paying higher commissions.

      Thanks for your comment and stopping by.

      Mr. ATM

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  2. It's also worth considering that international stocks likely correlate with domestic ones, especially with so many large multi-nationals on the big indexes in the USA. Or, put another way: it may not actually diversity your portfolio as much as it seems.

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