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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.

Morningstar Rating for Stocks >= 4 stars

In December, only 19 companies passed the screen. By far the toughest hurdle is the last one--valuation. Only three foreign companies earned 5-star ratings: France Telecom FTE, Novartis NVS, and UTi Worldwide UTIW. Below, we highlight five of the narrow-moat firms that passed the screen. The Uncertainty rating gives investors an idea of how tightly we feel we can bound our fair value estimate for the firms.

Huaneng Power International HNP
Economic Moat: Narrow
Fair Value Estimate: $33 per ADR
Uncertainty: High
Historically, robust economic expansion and an aggressive acquisition strategy have fueled rapid growth at Huaneng Power International, China's largest independent electricity producer. Although demand for electricity has taken a hit from the global recession, the country's long-term growth prospects remain robust. Huaneng possesses two key strengths, in our view. The first is the attractiveness of its service territory. The firm's power plants serve the more developed eastern portion of China, where electricity demand is consistently stronger than in other regions. The second is the firm's protection from competition. Obtaining approval to build--and sometimes, even, to acquire--a power plant in China has traditionally been an onerous process. But Huaneng's relationships with the central and local governments have helped shield its 34 power plants from significant competition.

Guangshen Railway GSH
Economic Moat: Narrow
Fair Value Estimate: $24 per ADR
Uncertainty: Medium
GR focuses more on passenger transit (57% of revenue in 2008) than freight transport. Owning the only railway connecting mainland China and Hong Kong, GR's railway network covers the Pearl River Delta (the economic hub in south China), a strong environment for steady growth. We think it is unlikely that the Chinese government will allow another railroad to be built and compete with GR, given its ownership stake in the rail. As another avenue for growth, in 2007 GR acquired the operating assets of Guangzhou-Pingshi Railway, the southernmost section of the Beijing-Guangzhou Railway. We expect GR to purchase more high-quality assets from its parent company in the future.

Economic Moat: Narrow
Fair Value Estimate: $32 per ADR
Uncertainty: High
Rexam operates in an industry prone to commodity pricing and intense competition. To protect itself, the firm strives to be the lowest-cost manufacturer in its markets, has technologically advanced innovations, and embeds itself deeply into customers' supply chains. Rexam focuses on continually driving costs out of its manufacturing processes. Lean manufacturing principles, which aim to drive out every input cost nonessential to the finished product, are incorporated and refined at every facility. Plants then document and share their best practices across the entire network in formal forums. Strict adherence to such practices, along with the scale of its raw material procurement, has enabled Rexam to attain low-cost producer status, alleviating competitive pricing threats.

Rio Tinto RTP
Economic Moat: Narrow
Fair Value Estimate: $289 per ADR
Uncertainty: Medium
Rio Tinto is a top-tier global miner along with BHP Billiton BHP, Brazil's Vale VALE, and United Kingdom-based Anglo American AAUKY. A world-class asset base and capable management make Rio one of the few miners to earn more than its cost of capital through the commodity cycle. Geographic and product diversification give Rio relatively stable cash flows and lower operating risk than many of its mining peers. Most revenue comes from the relative safe havens of Australia, North America, and Europe, though operations span six continents. Through selective acquisitions and grass-roots exploration, Rio has assembled a large portfolio of long-lived, low-cost assets.

Toyota Motor TM
Economic Moat: Narrow
Fair Value Estimate: $113 per ADR
Uncertainty: High
Although earnings will suffer this fiscal year, the world's largest automaker is one of the best-positioned in the industry.

Product is what drives consumer demand for Toyota vehicles, with the firm's sales increasing at a 5.6% compound annual rate since fiscal 2001. Toyota's strength is simple--it makes many types of quality vehicles that people want to buy. Expanding production to growing emerging markets, as the firm did with the Corolla in Brazil in March 2008 and the Camry in Russia in 2007, will further boost sales and mitigate the severe downturn in U.S. auto sales. Using a full product lineup to meet demand all over the world has paid off.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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