Globalization is blurring geographical boundaries, resulting in a convergence of company valuations and stock markets around the world. So, where do clients get the diversification needed to minimize risk and enhance returns?

Part of the answer is to add asset classes such as real estate and alternative investments. But inves-tors should also be paying attention to sector diversification. Sectors frequently have very different returns, both compared with other sectors and with country indices.

You need to look no further than Toyota Motor Corp. as an example. Analysis by Charles Burbeck, head of global equities at HSBC Halbis Partners in London, shows that from 1992 to 2004, Toyota’s stock generally followed the ups and downs of General Motors Corp. stock, and was not at all like the Japanese Topix index, which was flat to down.

That isn’t surprising. With 66% of Toyota’s sales in foreign markets, the company is clearly much more dependent on what’s happening in auto markets around the world than to what’s happening in Japan. By contrast, in 1994, only 31% of its sales were overseas; in 1987, 90% of its sales were in Japan.

Toyota’s globalization mirrors what has happened to many companies. The 50 biggest public companies in 2006 had average foreign sales of 43% that year, vs 24% in 1987. Burbeck says this is a trend that has come from both organic growth and acquisitions.

That’s not to say that there isn’t still a need for geographical diversification, but that is less important than the sector mix. Burbeck calculates that only about 10% of large companies’ stock performance can be explained by conditions in the country in which the firm is located, while 20% is due to what’s happening in the sector. The remaining 70% is explained by company-specific factors. But that isn’t new — picking the right stocks in a geographical area or sector has always been key to getting the best returns.

Burbeck believes that this concept presents opportunities because most investors haven’t started focusing on sectors and, as a result, aren’t taking advantage of trends and valuations that favour particular companies within a sector.

He also points out that a look at the five-year returns in the Morgan Stanley composite index shows that best returns in the worst-performing sectors match those in the bottom quartile of most of the best-performing sectors. For Burbeck, this means that you don’t have to make sector bets but should instead just pick the best companies in each sector.

For Canadians, sector diversification means going global because most Canadian public companies are in either the resources or the financial services sectors, which together account for about 75% of the S&P/TSX composite index. But that doesn’t mean advisors wouldn’t suggest Canadian companies in sectors other than resources and financials, or that some investments won’t be in companies that aren’t affected by global sector developments.

Globalization isn’t universal. Lots of companies, particularly small ones, sell only in their home markets — in which case, local economic conditions can be the driving factor in performance. These include regulated utilities and telecoms, real estate firms solely focused on the home market, some health-care providers and a lot of small companies with domestic franchises.

A major Canadian example is Shoppers Drug Mart Corp. It operates only in Canada and is not affected by conditions in the U.S. or elsewhere, except to the extent that it might borrow operating techniques from firms in other countries. In fact, Shoppers doesn’t borrow as much from foreign peers than those firms borrow from Shoppers, which is considered a leader in many drug-store innovations.

Another example is Canadian Tire Corp. Ltd. Even though it does compete against U.S.-based Home Depot Inc. in the Canadian market, Canadian Tire has a very strong domestic franchise and adequate product differentiation, which makes what’s happening in the Canadian economy more important to Canadian Tire than what Home Depot is doing.

But that isn’t the case for Loblaw Cos. Ltd., Metro. Inc. or Sobey’s Inc. for the most part. Competition from U.S.-based Wal-Mart Stores Inc. and Costco Wholesale Corp. is having a big impact on consumer behaviour.

Furthermore, there are sectors in which even those that operate only locally are affected by global sector trends. This includes resources and financial services firms.

Resources have always been global because, even if they don’t sell overseas, prices are determined on the world market.

@page_break@Financial services companies, particularly banks and those providing investment advice and products, have, however, become more global in recent years because of the ease with which funds can be moved around the world.

As a result, what’s happening elsewhere can affect them as much as — and often more than — what’s occurring at home, even if their clients are all domestic.

This is certainly the case with the current global credit crunch, which started in the U.S. but quickly spread. It has resulted in the repricing of products, even when a given institution was not directly involved in the short-term commercial paper turmoil.

Globalization has also produced opportunities to buy assets those most affected by the mess had needed to unload.

The globalization implicit in financial services makes the globalization trend among the 50 biggest companies even more pronounced. The 16 financial services institutions among the top 50 had average foreign sales of only 21%. Foreign sales for the other 34 companies averaged 54%. Seven of the 34 were energy companies, with the rest divided among a variety of sectors. The only companies less than 54% were Wal-Mart (22%), Time Warner Inc. (19%), plus three U.S. telecoms. IE