International Investing Doesn't Have to Be Scary

Earlier this year, I was in Omaha, Neb., for  Berkshire Hathaway's (BRK.B) annual meeting. While Morningstar has written extensively about the meeting, I wanted to take some of Buffett's comments and look at the international implications.

Buffett was asked about his investment in international large-cap company  PetroChina . The questioner had heard that Buffett only read the annual report and hadn't talked to management or others and wanted to know if that was correct. I think Buffett's answer provides some key insights to international investing.

Paraphrasing him, he said: The disclosure in the annual report was very good. It provided information on proven reserves, production rates, and lifting and other extraction costs. With this information I could compare PetroChina to other major oil companies that I am familiar with and value the company. My calculation said it was worth about $100 billion. When I looked at the market valuation and saw it was only $35 billion there was no need to go any further--it would have been a waste of my time--time that I should be using to buy the stock.

He went on to say that if the market valuation were $95 billion it would have been a different story, but the disparity was so big it didn't matter if his analysis was exactly right. You don't want to have to take your analysis out to three decimal places to justify your investment.

I want to highlight two comments. First, many international stocks can be compared to similar companies in the United States or elsewhere. Second, if the stock is mispriced sufficiently your analysis doesn't have to be completely accurate because you have built in a large margin of safety.

Foreign Stocks Aren't That Different
People have told me that investing internationally is just too risky. While there can be additional risks, many companies are in global industries and you can compare them relatively easily across countries. Buffett has shown us that one of these industries is oil. Another he discussed is pharmaceuticals. Let me provide an illustration of this principle from when I was running money in my previous job.

I used to attend a lot of conferences around the world that were sponsored by institutional brokers and would enable analysts to meet lots of management teams rather quickly over a few days. Other analysts were always amazed that not only was I a generalist in terms of sectors, but that I covered the whole world. Most covered only one or two sectors and then within a certain geography. However, to me it was an advantage, as I was familiar with companies all over the world and how valuations stacked up against each other. This allowed me to look for absolute value and not just value relative to other stocks in the same country or industry.

At one of these conferences in the Philippines, a company named Ionics Circuits presented. It was a contract manufacturing company, an industry that was doing very well at the time. Most businesses that sell electronics, both on a consumer and enterprise level, no longer actually manufacture their products. Instead, the production is outsourced to a contract manufacturer that specializes in manufacturing. This provides scale, which enables lower prices and frees up the name-brand company to focus on design and marketing. Many firms were just beginning to outsource their production in 1997, so business was booming.

At the time, most Philippine stocks were trading at very high multiples. This stock appeared cheap versus the Philippine market and it was the buzz of the conference. Most of the analysts there covered only Asian companies and some covered only Philippine ones. On the other hand, I knew I could buy another contract manufacturer, Accel in Mexico, for less than half the multiple of Ionics. When the Asian crises hit three months later, Ionics cratered, but because I was looking at absolute value and not just relative value, I hadn't bought it.

Since then, there has been significant consolidation in the industry. Because of the high prices paid for acquisitions and the manufacturing assets of other companies, the contract manufacturing industry's return on capital has dropped, and it has become much more competitive. Morningstar covers three contract manufacturers located outside the U.S.:  Celestica (CLS) in Canada,  Flextronics (FLEX) in Singapore, and  Nam Tai Electronics (NTE) in China. Currently, none of these stocks is trading below our Consider Buying price, but one contract manufacturer is trading in 5-star territory:  Jabil Circuits (JBL), which is based in the U.S.

So again, the important point is that many companies are in industries that can be compared worldwide. There is no reason to think that just because a firm is located outside the U.S. it is automatically riskier or more difficult to analyze.

 CRH 
One of my favorite examples is a stock that is rated 5 stars: CRH. It's a large producer of cement and aggregates--a business that is similar everywhere. The key to success is location. These are heavy products that are expensive to transport, so location near growth is important. Growth can come from housing or commercial construction or infrastructure projects. While CRH receives about 45% of its earnings before interest, taxes, depreciation, and amortization (EBITDA) from business in the U.S.--some of which is certainly being hurt by the current slowdown in construction--there are large parts in faster-growing parts of the world. Another 40% of EBITDA is in Western Europe, and 15% is in emerging markets. The firm showed particular strength in Eastern Europe in 2007. Last year, the firm also entered China and recently entered India with a 50/50 joint venture where it has an option to buy out its partner. These emerging markets will continue to grow even as housing markets in the U.S. and some European countries slow.

The firm is also the largest provider of asphalt in the U.S. and is a big beneficiary of the ongoing federal road projects here. It also owns a chain of home improvement stores in Europe similar to  Home Depot (HD) or  Lowe's (LOW) and is a large supplier of construction material in Europe. Overall I think its wide geographic diversification and the fact that it supplies product throughout the construction food chain will enable CRH to weather the current storm fairly well. The firm has grown revenues, earnings per share, and dividends per share every year since the 1992 recession, including from 2000 to 2003. Even in 1991 its growth dipped only slightly.

 Tomkins 
Another stock that is rated 5 stars is Tomkins, a supplier of auto parts and building products. These are businesses that are worldwide and currently being hit hard by the credit crises and housing slowdown. Auto parts and industrial represents 73% of sales, with building products the rest. About 63% of sales are in the U.S.

This is a firm I used to know very well. I have visited factories in Ohio and Michigan as well as corporate headquarters outside London. One of its businesses that I've always been impressed with is Gates, which dominates belts that engines turn to power cars. The auto business is about evenly split between parts for new cars and aftermarket parts. While the new car market is hurting, the replacement market will benefit as cars will need to be maintained as they are driven longer. The industrial side provides fluid power systems, power transmission systems, and oil and water pumps. These have benefited from the strength in oil and gas, mining, and agriculture. On the building products side, it focuses mostly on air systems components, bathroom fixtures (particularly high-end whirlpool-type bathtubs), and windows.

Tomkins is paying a high dividend and buying back stock, which signals that it thinks it has the financial wherewithal not only to survive the current environment, but also to thrive when conditions improve. I am watching both CRH and Tomkins as possible purchases for the Passport Portfolio. (For more on the Passport Portfolio, click here.)

Margin of Safety
Let us move on to the margin of safety. This is a major theme of Buffett's, which he took from his mentor Benjamin Graham (and which Morningstar has also taken as a core theme). Having a margin of safety can benefit you in two ways. If your analysis is correct and the firm performs as expected, eventually you will be doubly rewarded. First you will receive the implied long-term return required for that firm based on its cost of capital if it were trading at your fair value estimate. But if you buy below fair value, you will also pick up over time the discount it was trading at relative to its fair value. This is what happened with Buffett and PetroChina--in fact it did better than expected, gaining more than 600% in four years.

On the other hand, if your analysis turns out to be incorrect or events cause the business to not perform as expected, you have the cushion of the price you paid for the stock versus the new lower fair value. It is still too early to tell, but this may be the case with  Thomson . Despite my calculations that the firm was generating enough money to maintain the dividend, Thomson canceled the dividend to protect its cash. The good news is the stock barely budged, which suggests to me the stock is near the bottom and the sellers have all left. But if I'm wrong, we have such an exceptionally large margin of safety on this stock that the analyst's and my analysis could be off by quite a bit and we still should make good money over time, though it may take longer than I previously expected. Management stated that it is not looking to sell off any divisions, which in this market is the right decision. I hope that when conditions improve Thomson will look to dispose of some of its businesses, particularly the video production unit.

In closing, one other takeaway from the Berkshire meeting was Buffett's thoughts on currencies. He said (and I'm paraphrasing) that if he came from Mars with 1 million Mars dollars, he wouldn't put it all into U.S. dollars. He doesn't mind earnings overseas. I would agree, and it's another reason to hunt for great foreign stocks. While I'm no longer a dollar bear, I'm also not a dollar bull; I would prefer the diversification benefits of multiple currencies.

This is a revised version of an article that appeared in the June issue of Morningstar's InternationalInvestor newsletter.