Use this screen to find overlooked small- and mid-cap international stocks.
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
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.
Bonavista Energy is an independent oil and gas producer that operates solely in the Western Canadian Sedimentary Basin. Its strategy of acquiring and developing acreage positions with a focus on increasing drilling location inventory has provided consistent production and reserve growth. We think the company’s asset portfolio will continue its steady production growth and emerging plays will benefit from tuck-in acquisitions.
Cellcom is Israel’s largest telecommunication provider by customer base and commands just over a third of market share, competing with Partner PTNR and Pelephone—each of whom hold just under a third of the market. High barriers to entry have allowed Cellcom, Partner, and Pelephone to sustain net incomes in excess of 15% of sales, which has caused the government to intervene, acting as an advocate for customers. Therefore, we believe that Cellcom will continue to lead the lucrative telecom industry, but at substantially lower operating margins.
Given Imaging has pioneered an entirely new way to diagnose various gastrointestinal conditions with its camera capsules that traverse the GI tract. Building on its core of internally developed products, Given has also expanded with strategic purchases during the past few years. The firm now enjoys a growing portfolio of GI-focused diagnostic tools. In August, however, we put Given under review as we reassessed our estimates for one of its products, PillCam COLON.
Leveraging its global scale, ICON has risen to the top ranks of the contract research industry. Despite recent near-term earnings pressure, favorable industry dynamics should continue to drive strong growth for ICON. We think that ICON is well positioned to benefit from drugmakers’ increasing use of contract research organizations for clinical trial work. In addition to drastically reducing trial costs and development time, CROs allow drugmakers to shift to a variable cost structure, concentrate on core competencies, and better adapt to regulatory changes. Consequently, we project the $20 billion market for contract research services will expand 50% during the next five years. We believe ICON’s global presence and broad suite of services earn it an economic moat within this burgeoning industry.
Portugal Telecom is the incumbent telecom operator in Portugal. Despite its status as the largest operator in Portugal, PT has seen its revenues decline. Since the firm was forced to spin off its cable television service in 2008, PT has seen increased competition for fixed-line and broadband customers from ZON and from Vodafone VOD. As these rivals have added bundles, it has also pressured pricing on the wireless side. PT has fought back by pushing fiber further out in its network, increasing broadband speeds, and offering its own pay-television services through fiber, Internet protocol, and satellite systems. It has attracted 1.1 million customers in four years. Because of high programming costs, this business is losing money. But we expect the high quality of its content and the ability to bundle the service with PT’s other offerings will allow the firm to continue to add television customers, making the business profitable in another year or so.
Peyto Exploration & Development
Peyto Exploration is our favorite pure-play natural gas producer in the Canadian energy sector. The firm adheres to a contrarian business strategy and exhibits extremely solid fundamentals. We like Peyto’s demonstrated ability to create value for investors through superior economics and tactical thinking, rather than hyping unproven, undeveloped acreage in the next big play. Operating exclusively in the Deep Basin region of Alberta for 13 years, Peyto’s extensive knowledge of the area’s geology has allowed the company to cherry-pick its acreage positions. With its adoption of horizontal drilling in 2010, we think Peyto is positioned for a multiyear period of production growth in the range of 20% to 30% annually.
Although steel and energy are both cyclical sectors, Vallourec is enjoying a secular growth trend. The depletion of oil and gas wells, the world’s growing need for energy, and the increasing tendency for new wells to be drilled in harsher environments that require premium oil country tubular goods are all drivers of demand for the company’s products. More than half of Vallourec’s sales are to the oil and gas E&P sector. The only other end market that constitutes more than 10% of sales is power generation, where Vallourec provides tubular products for thermal and nuclear power plants. Vallourec’s business originated in France, but through numerous acquisitions and joint ventures, the conglomerate now commands a leading presence in North and South America.