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Foreign Stocks: Think Selection, not 'Spice'

We use our moats and star ratings to find attractive stocks outside the United States.

Haywood Kelly, 03/23/2010

If you're like me, you cringe just a bit when you hear a phrase like "foreign stocks can add spice to a portfolio." The phrase suggests that foreign stocks are always good to sprinkle in a portfolio. The truth isn't so simple. An investment is only good when it offers an attractive risk/reward trade-off--when it's cheap, in other words. If it's not, the spice can end up ruining the dish.

I began my investing career as an analyst covering Japanese stocks near the peak of the Nikkei bubble, and I learned the hard way that spicy foreign stocks can cause indigestion for a long time after swallowing. It was popular in those days to draw efficient frontiers showing the benefits of adding Japanese stocks to a U.S. portfolio. Unfortunately, those efficient frontiers assumed that past returns would repeat themselves, which is never the case in reality. Yes, Japanese stocks trading at 60 times earnings diversified a portfolio. Did they improve portfolios? Hardly.

Instead of spice, think selection. That's the real reason to look at foreign stocks. By broadening the investable universe to include foreign stocks, you increase the chances of uncovering attractive businesses at good prices that can become long-term portfolio holdings. As Morningstar has expanded its equity coverage list to include more non-U.S. companies, we've found hundreds of wonderful businesses based overseas. Consistent with our methodology, we only recommend the stocks of these businesses when they look cheap relative to the cash we think the firms can generate.

For this issue's stock screen, we'll focus on these companies that are based outside of the United States. Morningstar collects data on thousands of non-U.S. companies, including companies based on both developed and emerging markets.

Foreign = Yes

Next, we eliminate companies that lack an economic moat. An economic moat is some kind of competitive advantage that allows a company to earn high profits for an extended period--and not have those profits competed away by new or existing products from competitors. Across our entire coverage list, we rate 946 companies as having an economic moat--either wide or narrow--and of those, 246 are non-U.S. firms.

And Economic Moat > Narrow

Finally, we turn to valuation. Given the performance of global stock markets in 2009--which ranged from good to great--it's tough to find bargains. We don't have many 5-star stocks right now, either here or abroad. For our screen, we look for a current Morningstar Rating of 4 stars or better. As a reminder, the star rating depends on our analysts' estimates of fair value for each stock. A rating of 5 stars means we think the stock trades at a significant discount to our fair value estimate and offers a comfortable margin of safety in case our fair value estimate turns out to be wrong; a rating of 4 stars means we think the stock is undervalued, just not enough to offer a comfortable margin of safety.

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