Three International Fat Pitches

One of our favorite investing philosophies at Morningstar is the Fat-Pitch approach to stock investing. In a nutshell, the Fat-Pitch approach says that unlike baseball--in which a batter who just stands and watches three strikes go past will be called out--investors can stand and watch as many pitches as they want go by, waiting for an nice, easy, "fat" pitch before swinging away.

Fat Pitches Outside the United States
Given the sharp correction in international stocks--especially in emerging markets--since May, I'm seeing a few more good-looking pitches being thrown by the market. The number of 5-star stocks among Morningstar's international coverage rose from only four at the beginning of May to 18 on July 11. I've highlighted three of these "fat pitches" for you at the end of this article.

Batting in the international game can often be challenging. However, while it may require a little more patience and discipline--and the pitchers look very intimidating sometimes--I believe the Fat-Pitch method is a great way to approach investing in foreign stocks. Here's how I think of the five parts of the Fat-Pitch approach related to international investing:

1. Look for wide-moat companies.
By investing in international companies with moats, you place the odds in your favor that your investment will be worth more tomorrow than it is today.

In every issue of Morningstar StockInvestor, we highlight 25 of our favorite foreign firms with moats in the International Stalwarts list. Each Stalwart is a firm that I believe you could buy (at the right price) and sleep well at night.

While we prefer companies with wide moats, there are some great international narrow-moat firms that would make fine investments, in our opinion. For instance, there are several excellent narrow-moat emerging-markets companies--you'll find one such firm at the end of this article--but we believe that only one emerging-markets firm, Companhia de Bebidas  , or AmBev, has the staying power to qualify for a wide-moat rating.

2. Always, always have a margin of safety. (Amen and amen!)
Having a margin of safety protects you against the true risk of investing, which is paying more than a stock is worth and suffering a permanent loss of your capital. I believe nothing in international investing is more important than religiously adhering to this principle.

In general, the riskier the stock, the larger your margin of safety should be. Morningstar analysts consider several risk factors that are unique to non-U.S. firms. Red flags include shaky currency exchange rates, high inflation, political uncertainties, weak legal systems, and a country's disrespect for property rights.

Emerging-markets firms tend to be subject to more of these risks than those in developed markets, so our average emerging-markets stock has a higher risk rating and higher cost-of-equity estimate than the average firm in a developed economy. The higher the cost of equity, the more we discount future cash flows, resulting in lower fair value estimates.

Thus, when an international stock gets a 5-star Morningstar Rating for stocks, it's our stamp of approval that after accounting for all the various risks--including international-specific ones--we believe that the margin of safety is sufficient.

3. Don't be afraid to hold cash. (Cash is a valuable option to the international investor.)
Holding cash is like holding an option--the option to take advantage of volatility in the market. Since the value of an option rises when volatility increases, and international markets--especially emerging markets--are typically more volatile than the U.S. market, cash holdings are particularly valuable to international investors.

As a word of caution, holding cash when markets are irrationally high can often be psychologically painful. It's human nature to feel like you're missing out on all the fun, especially when you hear the popular press, market experts, and your friends and neighbors all joining in the revelry. However, if the market isn't throwing you any fat pitches, just hold on to your cash and wait until it does, because all parties have to end at some point. Just ask the speculators who were plowing money into emerging-markets stocks at the beginning of this year!

4. Don't be afraid to hold relatively few stocks. (But be careful about having too much concentration in emerging-markets stocks.)
I believe that holding a concentrated portfolio (few positions) is not to be feared; however, I do think Fat-Pitch investors should be careful about holding too great a concentration in emerging-markets stocks. Quite simply, because of the inherent uncertainty in developing economies, these firms have riskier long-term outlooks than those in developed markets. Case in point: As of July 11, there was no emerging-markets firm that held Morningstar's below-average risk rating.

Just think, investing is ultimately a game of probabilities, and in my view, emerging markets have a higher-than-average probability of an unforeseeable event occurring, which could destroy the ultimate value of your investments.

5. Don't trade very often. (But let volatility work to your advantage.)
Using the Fat-Pitch approach, you generally won't need to trade very often because you'll hold only companies with moats. Chances are high that a firm with an economic moat will become more valuable as time goes on. So these types of stocks are very appropriate for a buy-and-hold strategy because the odds are in your favor that your investment will increase in value over time.

I believe that this principle holds true in international investing, although you'll probably find yourself trading a bit more than normal if you're investing in emerging-markets stocks, which are often quite volatile. This volatility often results in relatively short holding periods because a stock can move quickly from very cheap to very expensive.

Let's Play Ball!
By following the Fat-Pitch approach, I believe international investors can significantly increase their odds of investment success. Given the recent volatility in international markets, I'm very optimistic that we'll all be seeing more fat pitches in the days to come.

Three Fat Pitches to Consider Today
These are three excellent international firms, with stock prices low enough to garner our 5-star rating as of July 11.

Cadbury Schweppes PLC (CSG)
Business Risk: Below Average
Economic Moat: Wide
Cadbury is one of the top manufacturers of confectionery products in the world. From the  Analyst Report: "Unlike its competitors, Cadbury now boasts strong brands in all confectionery segments: Cadbury in chocolate, Halls and Trebor in candy, and Trident and Dentyne in gum. In addition, the firm owns a slew of strong regional and local brands. It holds the number-one or -two confectionery position in 24 of the top 50 confectionery markets worldwide."

Novartis AG (NVS)
Business Risk: Below Average
Economic Moat: Wide
Novartis is one of the best pharmaceutical companies in the world, in our opinion. Excerpts from the  Analyst Report: "Novartis runs a tight ship and strives to minimize risk by pursuing a diversified stable of health-care businesses in branded pharmaceuticals, generics, and consumer health-care products. ... Returns on invested capital have averaged 25% during the last five years, nearly twice its cost of capital."

Fomento Economico Mexicano, or Femsa (FMX)
Business Risk: Below Average
Economic Moat: Narrow
Femsa is a dominant player in the Mexican carbonated soft drink and beer market, boasting well-established brands. The firm also owns one of the best bottlers in the world and a growing chain of convenience stores. From the  Analyst Report: "... it is the fragmented nature of the Mexican retail environment and the legality of tie-up arrangements with these smaller retailers that have allowed Femsa's operations to thrive, as they enable the company to dictate pricing and brand selection to mom-and-pop stores, in polar opposition to the consolidating American market. These arrangements have deterred market entry for decades and have allowed brand equity in Coca-Cola beverages and Femsa's beer to build to extremely high levels."