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Don't Overpay for Foreign Exposure

Jason Stipp
Heather Brilliant, CFA

Jason Stipp: I'm Jason Stipp for Morningstar. We're well into third-quarter earnings season and a few interesting trends have emerged but what devaluations look like? We're checking in today with Morningstar global director of equity research Heather Brilliant to get some insights on how stocks are priced.

Thanks for joining me, Heather.

Heather Brilliant: Thanks for having me, Jason.

Stipp: We've noticed a few things about earnings so far. I did a video with Bob Johnson, our director of economic analysis, and he talked a lot about some decoupling that he's seeing between U.S.-focused businesses and businesses that have international exposure. International exposure has meant weakness in a number of areas, including currency effects for some companies, and U.S. exposure they've held up a little bit better. So, I'm wondering, how are the valuations looking? Are the U.S.-focused companies priced as if they are doing a little bit better, and how about the international exposure? I know this is hard to get a handle on, but what have you found when you look at that?

Brilliant: So, when we took a look at the data, we were actually surprised to find that companies with more of their revenue coming from outside North America are trading at a slight premium to companies where their revenue primarily comes from within North America. And this data is actually really hard to come by. So we had to compile our own database of where the revenue is coming from for all the companies that we cover and try to analyze it, so we could get a sense of where the valuations come out. And we found that the companies focused outside of North America from a revenue perspective are trading at about 96% of fair value versus about 93% for those focused within North America.

Stipp: It's possible if you're looking for individual opportunities, you may find that this could be a factor at a company-by-company level perhaps. What are you looking at when you are trying to get a handle on whether a certain discount for international exposure is enough to consider a company that has a lot of overseas sales?

Brilliant: I think right now we see a lot more opportunity within the U.S. economy. So, personally what I have been saying is that we really would like to find companies that are highly exposed outside the U.S. to be trading at a little bit more of a discount than ones that are more exposed to the U.S. when we're trying to make that final investment decision or recommendation. So, that's really where we've come out on it. If a company is highly exposed to Europe, we'd rather be more confident in where its future prospects are going as opposed to a company that might be more exposed to the U.S.

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Stipp: So international exposure may give some discount to some companies, but that uncertainty about some of those markets probably demands a bigger discount, generally speaking anyway?

Brilliant: Yes.

Stipp: Some other trends that we've noticed are sector-by-sector trends. So, when I looked at the trailing month, which encompasses a lot of the earning season so far, a couple of laggards sort of popped out and that may or may not necessarily be earnings-related, but energy was one of those. Energy stocks have lagged some of the other sectors of the market. What are you seeing there, and have your fair value estimates on energy stocks come down at all recently?

Brilliant: We haven't seen a lot of movement in our energy fair values, but we have also seen that movement downward in the stock prices. I think it's due to a couple of factors. First of all, the oil price has come down a little bit, so that tends to correlate to energy stocks not trading as strongly. Another factor is that some of the oil-services and oil majors companies have been reporting pretty weak earnings over the third quarter. So, while we don't usually think that a poor single quarter is any reason to change our fair values--so we've been leaving our fair values--we certainly have seen that weakness, and the market has been recognizing it.

Stipp: You mentioned there was another trend in the division between oil and natural gas and some of the fundamentals that we're seeing there. How is that affecting some of the performance and potential for stocks in the energy sector?

Brilliant: We have been seeing on the margin some firming within the natural gas space. And so we look for things like whether companies are investing more and developing natural gas fields as opposed to oil fields, and we're starting to see on the margin less investment going into natural gas. So, we believe that's a really good sign that the natural gas price will start to stabilize and improve from here.

Stipp: Tech is another area that's disappointed a lot of investors, and we've had some bad tech earnings out there already. We still have some yet to come. What are some of the factors behind tech, and tech having sold off I think the most of all the sectors over the last month seems to be hurting the most from the market's perspective. Are you seeing the same?

Brilliant: Well, we have not been wholesale downgrading our fair values in tech either, so I would say we're seeing incrementally more opportunity within tech. Generally speaking a lot of these large-cap tech companies have quite a lot of exposure to Europe, and so as the European economy has been very weak, tech can be one of those areas that companies can cut back on for a little while. But overall we don't expect this to fundamentally affect the long-term position of really well-positioned companies in terms of fundamentals like EMC or Oracle or Cisco, even for example.

Stipp: So, if you're going to go in and try to do some bargain-hunting in tech, which has sold off a bit over the last month, you want to look for some of those traits. Do you have any other specific ideas that your analysts are taking a look at now, good fundamentals and maybe a depressed stock price?

Brilliant: Well my colleague in the tech sector, Grady Burkett, mentioned a couple of weeks ago in his earnings video that F5 looks like a pretty interesting opportunity. F5 is actually one of those companies that almost never trades at a discount to what we think it's worth because the market really recognizes what a high-quality business it is. And it had a pretty weak third quarter, and the market really punished them for it. So now you can buy it for about a 20% discount to our fair value.

Stipp: It's an interesting one to take a look at. My last question for you, just broadly this earnings season feels like a disappointment after a string of earning seasons that probably exceeded expectations throughout the recovery. What's your general sense on the sentiment of this earnings season, and why are folks kind of down on corporate earnings right now? What's disappointing them?

Brilliant: I think there is a lot of concern in the market right now that as we're starting to see margins either stabilize or even contract a little bit that perhaps this is the end of the great operating margin boom that we've seen over the last several quarters, and you know then people start to worry that maybe this means that margins are going to start reverting to levels that we have been benefiting from and start to go back to a more normalized rate that you might have seen even 30 to 40 years ago.

But overall, we don't agree with that. I mean we think that there is certainly the possibility that margins are going to stabilize around these levels, and on an individual company basis of course you'll see some weakness. But generally speaking, we really believe that a lot has changed in the economy over the last 40 years. And to say that we're necessarily going to go back to the types of profit margins that businesses could earn in that period, we don't think is a valid overall generalization.

Stipp: So it sounds like a market that's generally fairly valued. There are still some opportunities there and no reason to think that earnings margins potentially will collapse in the quarters ahead?

Brilliant: Absolutely.

Stipp: All right, Heather, thanks for joining me and for the insights.

Brilliant: Thanks very much, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.