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Fund Spy

Your Portfolio's Invisible Risk

What you don't see can crush your returns.

If you chose "All of the above," pat yourself on the back, grab a gold star, and ponder these particulars:

CompanyFY 2009 Revenue (USD in Millions)% from Non-U.S. OperationsCoca-Cola30,99078HP114,55264McDonald's22,74560

 

Now, with the data above in mind, here's a follow-up question: Should investors in these companies--whether they own shares directly or through mutual funds and exchange-traded funds--consider their positions as part of their portfolio's international or domestic exposure?

Time's Up
If you follow Standard & Poor's lead, the correct answer is: domestic.

Per S&P's revenue requirements, a company needs to ring up a mere plurality of its sales stateside to qualify for domestic indexes such as the S&P 500, thereby earning a spot in massively popular S&P trackers such as  Vanguard 500 and the  SPDR S&P 500 (SPY) ETF. Even companies that don't clear the revenue hurdle can find domestic bliss, provided the lion's share of their fixed assets reside on U.S. soil.

As sensible as such criteria may be for index-construction purposes, it's hard to argue, from an investor's point of view, that a plant's physical location or the exchange on which a company trades (another S&P domestic qualifier) matter more than the markets in which a firm mainly does business.

Forewarned Is Forearmed
A revenue-centric point of view can have dramatic implications for the care and feeding of your portfolio--not to mention its risk management. Gauged according to underlying sales, after all, the S&P 500 isn't a domestic-stock index. It's an international benchmark, one whose companies streamed in 46.6% of their revenue from foreign shores last year, according to S&P's estimates. Approximately a third of that sum, moreover, was rung up in emerging markets.

The upshot: Seen through a revenue-focused lens, Vanguard 500 and SPDR S&P 500 aren't plain-vanilla domestic-market trackers, and your portfolio likely tilts further in the direction of foreign fare than you might have imagined--or planned for.

Who Knew?
My colleagues Mike Breen and Christopher Davis homed in on this issue way back in 2007. And in light of the past three tumultuous years, the broader point here--that what investors see isn't necessarily what they get--has even greater relevance today. A portfolio's geographic revenue exposure, that is, isn't its only "invisible" risk.

Consider  Sprint Nextel (S), the third-place telecom player (behind  AT&T (T) and  Verizon Communications  (VZ)) whose shares several Fidelity offerings--Will Danoff's $68 billion  Fidelity Contrafund among them--have been buying lately.

The firm boasts a seemingly robust top line, with 2009's total sales topping $32 billion amid the company's so-far, so-good effort to tamp down customer churn. (Our analyses of Fidelity Contrafund and Sprint Nextel come gratis with Morningstar.com Premium Membership, but you can read them--and take advantage of a host of tools and features--free for 14 days by clicking here.)

Sprint generates the vast majority of its sales domestically, so owning the company doesn't meaningfully increase Contrafund's foreign-revenue exposure.

It does, however, dial up the fund's business risk: Morningstar equity research indicates that Sprint has no "economic moat" at all--that is, no competitive advantages that fend off rivals and protect the bottom line. It's hardly a coincidence, therefore, that the moat-less Sprint earns a grade of F in our assessment of profitability--another critical risk factor that remains out of view for all too many otherwise savvy investors.

Critical Lists
As a test of just how critical moat and profitability risk can be, I used Morningstar.com's  Premium Stock Screener to create a portfolio featuring just those firms with five years of operating history that have earned Grade A profit ratings and wide-moat status from Morningstar's equity analysts. Gauging that lineup against the broader market (as defined by the S&P 500) is illuminating:

Annualized Trailing Returns Through 10/12/20101-Year3-Year5-YearWide-Moat/Grade A Profit28.644.8616.01+/- S&P 50017.4311.9614.00

 

Gauging Your Portfolio's Invisible Risk
As the numbers above suggest, a portfolio focused on high-quality firms can provide ballast during tough times. What's more, the relatively smooth ride such a portfolio can provide means many folks will have an easier time sticking with their investments when the going gets tough.

As the so-called "junk rally" of 2009 attests, however, portfolio construction isn't a zero-sum proposition. Yet profiting from that dynamic requires understanding your tolerance for performance gyrations and understanding the shape of your current portfolio. It's hard to know what your next investment ought to be, after all, if you don't have a firm grip on your current lineup's risk/reward characteristics. And that profile, as we've seen, likely includes exposures (such as international revenue risk, moat, and profitability) that you may not be accustomed to factoring into your analysis.

I'll follow up on other critical list contenders in upcoming columns. If between now and then you'd like to crunch your own numbers, you can test-drive Morningstar's Portfolio Manager and other tools here.

Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.