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Amid Turmoil, Don’t Discount Foreign Equities

Use this screen to find overlooked small- and mid-cap international stocks.

Morningstar Analysts, 10/19/2012

This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

Uncertainty in Europe has understandably led many U.S. investors toward domestic stocks. We believe, however, that there is still value to be discovered in international equities, especially smaller names that often get overlooked. With the U.S. economy deleveraging in the next few years and developing countries taking the spotlight in economic growth, investors would be remiss in not taking advantage of the opportunity to invest in international markets. Even so, we aim to look for international stocks that are relatively stable and can survive any impending economic instability. 

Domestic = No

Many investors’ portfolios are overconcentrated with domestic stocks because of a combination of familiarity bias and the current economic climate. It is important, however, to not overlook value within international stocks. Although Morningstar Principia cannot select particular countries, we can search for nondomestic companies. 

And Market Cap < 58

Because our goal is to look for international equities that might not be receiving as much attention owing to fears relating to investing internationally, we also want to filter out large-cap companies who receive significant attention from both analysts and investors regardless of the economic situation. We will look for companies whose market capitalizations are less than $5 billion. This allows us to look for small- and mid-cap international companies. 

And (Economic Moat = Wide
Or Economic Moat = Narrow)

The ultimate indication of a good business, however, is the ability for the business to reinvest its earnings in growing shareholder value. To that end, we want to still look for companies who have some or many competitive advantages over their competitors. Morningstar analysts use the economic moat rating to describe the ability of a business to earn returns on capital of more than their cost of capital. With five sources of a moat—intangibles, cost advantage, switching costs, network effect, and efficient scale—and a narrow or wide rating to describe the length of such advantages, international companies with moats will provide us with the sustainable value generation that we desire.

And Price/Fair Value < 0.75

Finally, we wish to look for companies that are inexpensive compared with their fair value. Morningstar analysts provide a fair value estimate to gauge what they believe to be the intrinsic value of the company based on a discounted cash flow valuation. With this screen, we are looking for companies that are trading at a 25% discount to their estimated intrinsic value, which gives us a significant margin of safety. We ran our screen using Principia in August. Here are seven results.

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