Why American Investors Should Buy British Shares

This article is the first of a two-part series that explains why and how American investors should buy British shares. You can read the second article here.

LONDON -- The textbook way to reduce the risk inherent in a portfolio is to diversify through buying shares in different companies. If a company does lots of business outside America, like Coca-Cola and Yum! Brands, its shareholders are also diversifying geographically because these businesses aren't so dependent upon the American economy.

Another way to diversify is to buy shares in a foreign company, and one of the easiest foreign stock markets for American investors to access is that of my home country, Great Britain. While Britain doesn't have the variety of companies that you have in America -- especially when it comes to information technology -- it is London, rather than New York, that leads the world in some sectors of the global economy.

Income-seeking investors should certainly look at British companies. That's because British shares generally pay higher dividends, mostly because our government doesn't tax dividends twice. A fair number of British companies are already listed on the New York Stock Exchange, so you don't need to worry about foreign-exchange costs, and these companies pay their dividends to American shareholders in dollars.

British shares are generally cheaper than American shares, and our accounting standards aren't all that different -- though we are still two nations divided by a common language, many of us prefer to drink warm beer, we play "football" as opposed to "soccer," and our national summer sport is cricket, where games can last up to five days and still end in a tie!

Cheaper shares
If you take two companies that are identical in every respect, except that one is based in America while the other is located in Britain, then the British company's shares would probably trade at a lower price-to-earnings ratio.

One reason for the discrepancy is that it's easier to do business in America, mostly because British society is still influenced by the lingering remains of a mixture of socialism and the medieval feudal system that America rejected in the Constitution. So some Britons still consider trade and commerce to be "vulgar" and beneath them, longing for the days depicted in television's Downton Abbey, while others (far fewer than there used to be) still believe that every problem can be solved by more government.

But in several industries, Britain leads the world, and when you buy shares in some "British" companies, what you're really obtaining is an investment in a global company that just happens to be listed on the London Stock Exchange. We're the nation that invented international capitalism, along with the Dutch, and we're still pretty good at it!

The Footsie
Britain's equivalent of the S&P 500 index is the FTSE 100 (INDEX: ^FTSE) index, otherwise known as the "Footsie." And as its name suggests, the index consists of the 100 most valuable companies quoted on the London Stock Exchange.

While the S&P 500 closely represents the American economy, the FTSE 100 isn't a particularly good proxy for the British economy, because it is dominated by multinational corporations. Almost 30% of the FTSE 100 consists of oil, gas, and mining companies, most of which don't do much business in Britain.

For example, five of the ten largest companies in the FTSE 100 are:

  • Australia's BHP Billiton and Rio Tinto, which are among the world's largest mining companies.

  • Two oil super-majors, the Anglo-American BP and the Anglo-Dutch Royal Dutch Shell.

  • The world's second-largest telecommunications company, Vodafone.

  • The banking giant HSBC, which does much of its business in the Asia-Pacific region.

London is the center of the global mining industry, so a disproportionately large number of foreign mining companies are listed there. Many are members of the FTSE 100, such as Africa-based Anglo-American, Chilean copper miner Antofagasta, and India's Vedanta Resources.

London's importance to the global mining industry also means the FTSE 100 contains several miners from the former Soviet Union, where corruption is rife and corporate governance isn't up to American and British standards. But that's another story.

Global exposure
Many British companies do business in the fastest-growing economies of the world -- emerging markets such as Brazil, China, India, Indonesia, and South Africa -- and buying their shares is an easy way to invest in their growth.

One such play on emerging markets is Unilever (NYS: UL) , the closest thing Britain has to Procter & Gamble (NYS: PG) in the global consumer goods market. More than 50% of Unilever's sales are made to emerging markets, compared to P&G's 35%, and the company expects this to rise to 75% by 2020.

Another play is Vodafone, the owner of 45% of Verizon Wireless, which has operations in more than 70 countries.

Alternatives to American companies
Britain does have many world-leading companies that offer an alternative to their American counterparts. The one that stands above the rest in the high-technology field is semiconductor and software multinational ARM Holdings, which designs the microprocessors found in most of the world's mobile phones.

If you're looking for a pharmaceutical company to supplement or replace the likes of Pfizer, you may wish to consider GlaxoSmithKline or AstraZeneca. (Indeed, Britain's best-known large-cap investor, Neil Woodford, has placed large bets on the pharmaceutical sector of late. You can read which shares Neil Woodford favors now by downloading this free report: "8 Shares Held By Britain's Super Investor.")

But there are a few U.S. sectors that don't have any equivalent in Britain. For example, we don't have much of a railroad sector, because our trains haul passengers, rather than freight (trucks are more efficient for freight, as Britain is quite small), and thus we don't have any companies comparable to Union Pacific Corporation.

Big Beer
I'm a big fan of alcohol -- and not just as an investor! Brewing and distilling are two of the few recession-proof industries left, and unlike tobacco, sales of alcohol continue to grow in both the developed world and the emerging markets, though in some countries consumers are moving away from beer and toward wines and spirits.

If you want to invest in a brewer, you'll soon discover that the market is dominated by foreign companies, as 80% of the beer sold in America comes from breweries owned by Belgium's Anheuser-Busch InBev and Britain's SABMiller.

Actually, SABMiller is another "British" company which isn't very British, as it was formed in 2002 when South African Breweries bought the Miller Brewing Company from Altria Group.

Big Whisky
The world's biggest distiller is Britain's Diageo (NYS: DEO) , whose portfolio of brands includes such famous names as Johnnie Walker, Seagram's, and Smirnoff. Diageo also makes Guinness, the world's best-selling stout, which, in addition to being Ireland's national drink, is rather popular with American presidents.

While America is Diageo's largest market, accounting for many times the sales it makes within its home turf of Britain and Ireland, the group's fastest-expanding markets are in the developing world, where consumers' incomes continue to grow strongly.

Higher dividends
British companies generally pay larger dividends than American companies, with the current yield on the FTSE 100 being 3.8% compared to 2.4% on the S&P 500. This is because British tax law favors dividends, while American tax law encourages companies to distribute money to their shareholders via buybacks.

The key difference is that in America, dividends are taxed twice -- first by taxing the company's profits and then by taxing the investor, without allowing for the tax the company has already paid. In Britain, dividends come with a tax credit to represent the corporation tax paid and to ensure the payouts are not taxed twice.

No withholding tax
As a British investor who owns shares in 16 American and Canadian companies, I've become used to Uncle Sam and Johnny Canuck taking 15% of my dividends as withholding tax.

In contrast, the British government doesn't levy withholding taxes on dividends that are paid to foreign investors (except for 20% on those paid by real-estate investment trusts). As such, American shareholders in British companies will generally not have withholding tax deducted from their dividends.

Cheaper bosses
Company bosses in Britain are paid quite a bit less than those in America. You won't see British executives walking away with tens of millions of dollars in compensation for having ruined their companies. In Britain, they usually only get a few million!

However, we do occasionally see a fat-cat reward for failure. One of the biggest was the massive pension awarded to Fred "The Shred" Goodwin of Royal Bank of Scotland (NYS: RBS) when the bank's board of directors refused to fire him after the government effectively nationalized the bank in 2008. Four years later he became one of the very few people to have been stripped of his knighthood.

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At the time thisarticle was published Tony owns shares in BHP Billiton, Diageo, GlaxoSmithKline, Procter & Gamble, Unilever, Union Pacific Corporation, and Yum! Brands. The Motley Fool owns shares of Coca-Cola. Motley Fool newsletter serviceshave recommended buying shares of Unilever, Diageo, Vodafone Group Pl, Pfizer, Coca-Cola, and Procter & Gamble. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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