This is the letter we wrote to our clients in the first quarter of 2011. It discusses the importance of international investing and our purchase of a UK retailer, Halfords PLC. If you want to read a shorter version, I’ve turned it into an article that was published in the June issue of Institutional Investor, and also, it was part of my presentation at VALUEx Vail 2011.
While attending the Berkshire Hathaway annual meeting I had the tremendous pleasure (for the second year in a row) to participate in the Value Investing Panel at Creighton University, joined by Whitney Tilson and two other value investors. Ben Claremon, an owner of Inoculated Investor blog, took detailed notes.
I was on BNN (the Canadian version of CNBC) discussing sideways markets, in the company of two great Jeffs: Jeff Saut, Chief Investment Strategist of Raymond James, and Jeff Hirsch of Stock Trader’s Almanac. (there are three segments.)
Finally, Dan Anglin took detailed notes of Jim Chanos’ terrific presentation/”dessert lecture” at VALUEx Vail 2011.
Finding Investment Treasures in International Markets
Simply stated, stocks should compete against each other for a place in your portfolio. The larger the pool of stocks you can choose from, the higher the bar—the opportunity cost—that a new stock has to overcome to make it into the portfolio. International stocks need not be seen merely as a necessary evil for diversification—they should contribute in a real way to raising that bar, as they increase the quality of the investment pool. You don’t need to become the Indiana Jones of international investing by diving into developing countries like Zimbabwe or Afghanistan [or Russia] where the rule of law is still in its infancy. Start with the developed countries that are in your comfort zone and then tiptoe out from there.
Quality, Valuation, and Growth – these are the three attributes (dimensions) that we seek for companies in our portfolios.
A Quality company will have long-term-oriented, shareholder-friendly management, a competitive advantage that will protect the company’s future cash flows from competitors, a high return on capital, a strong balance sheet, and the business will have a high recurrence of revenue, which will result in stable cash flows.
In the Growth dimension we are not just looking for earnings growth but also seek stocks that pay high dividends. Though stock price movements are responsible for all daily headlines, dividends were responsible for half of the returns from stocks over the last 100-plus years. Dividends are extremely important in sideways markets, as in the past they were responsible for over 90% of the returns for investors. Dividends are also important for another reason: they usually improve a company’s quality by lessening the chances of capital misallocation. Canceled or missed dividends are mayhem for a company’s management and its stock. Management will cancel its country club membership before it suspends a dividend. A significant dividend creates another fixed cost, therefore it imposes thriftiness on the company’s operation and often keeps management from doing something dumb with the company’s cash flows.
It is easy to find companies that meet our Quality and Growth criteria in any market environment, but for these companies to be good stocks they need to meet the third very important criterion – Valuation. A stock needs to trade at a discount to its fair value, or in other words it needs to have a margin of safety. It is almost impossible to find a company that flawlessly meets Quality, Valuation, and Growth requirements (though we try). However, with weakness in one dimension we always look for offsetting strength in the others. For instance, if a company has volatile (cyclical) cash flows, we require an extra strong balance sheet – no debt, and a lot of cash. Or, if a company lacks in the Growth dimension, we require a much higher margin of safety.
The US market overall is not cheap, and we expect it to get cheaper over time. Stock selection is further complicated by the adjustments we make due to the headwinds we see in the US and global economies (we’ve communicated to you about them over the years about positioning your portfolio to avoid them). Here is our solution to the problem: fish in a bigger pond. Don’t limit your stock selection only to the US stock market but look in other countries, i.e., democracies that have stable political systems, the rule of law, and financial statements that are prepared in a way we can understand them and written in English (okay, British is as far as we’ll deviate). International investing is not new to us here at IMA; a third of our portfolio today is invested in foreign companies that trade in the US and are known as ADRs (American Depositary Receipts). Their original (ordinary) shares are listed on foreign exchanges. A US-based bank buys and holds foreign shares and creates a dollar-denominated equivalent that trades on US exchanges. (BP, Total, Vodafone, and National Grid are all ADRs.) Though ADRs reduce trading complexity, they only marginally increase our pond, since only limited numbers of very large foreign companies are traded as ADRs.
From this point forward we’ll also be buying ordinary shares of companies listed on foreign exchanges. The bigger pond may change our daily routines a little due to the time differences –we’ll have to place trades early in the morning – but this should allow us to maximize each Quality, Valuation and Growth dimension, which hopefully will increase risk-adjusted return. Buying stocks on foreign exchanges will increase transaction costs compared to US-listed counterparts. We have found that it may cost roughly an extra 1% in total (in and out of the trade) to own foreign as opposed to domestic stocks. Since we don’t trade a lot, this cost should not have a significant impact on returns in the long run. By buying foreign-listed stocks we are not abandoning our principles; quite the opposite: we get the opportunity to maximize Quality, Valuation, and Growth.
The first, inaugural foreign stock listed on a foreign exchange to make it into your portfolio is Halfords PLC (symbol HFD on the London Stock Exchange). HFD is a 109-year-old company in the UK. HFD has 480 auto parts/bicycle stores in England and the Republic of Ireland. It has sales of about £800 million ($1.3 billion) and a market capitalization of about £800 million. About 60% of HFD’s sales come from auto-related products (windshield blades, car batteries, brakes, stereos, etc.) and the rest comes from bicycle sales (it is the largest bicycle retailer in the UK). A significant portion of HFD’s sales come from its own private brands.
In 2010 HFD bought the largest independent auto service company in the UK, which has about £80 in sales. Let’s take a look at HFD through the Quality, Valuation, and Growth lenses, and you’ll see why we believe it is a stock worthy of your portfolio.
This is a business with a high return on capital: return on equity is pushing 30% and return on capital has improved over time. Management has done a terrific job managing the business, return on equity, profit margins, free cash flows are up, and net debt is down. The company is also a good steward of capital: it raised its dividend in April; after a significant stock decline (it missed an earnings forecast due to extremely cold winter in the UK) it announced a buyback of 9% of its outstanding shares; and finally, the latest acquisition to its auto service business was made at a very reasonable price and makes sense. HFD has stable cash flows and a decent balance sheet – it can pay off all of its net debt in a bit more than a year if it chooses to do so.
HFD’s auto service business, with 220 shops, will be an important source of growth. Until 2003 British law prohibited non-dealer auto repair shops from servicing cars that were still under manufacturer warranty – it voided the warranty. Though the law has now changed, most consumers are not aware of that. HFD has rebranded its auto service stations to Halfords and just started a national campaign to alert consumers that they can save a lot of money (usually 30-40%) by servicing their cars at Halfords shops. In addition, HFD will begin opening about 30 new service stations a year. Auto service will likely contribute a few percentage points of growth a year. Same-store sales in retail stores (which in England are called like-for-like sales) will add another few percentage points. HFD will also continue to buy back stock; this should add 3-5% to earnings growth. Finally, HFD pays an almost 6% dividend, which will likely rise over time with earnings.
This is a very cheap stock. HFD generates about £100 of free cash flows, giving a very modest 8x free-cash-flow multiple. Comparable companies in the United States with a fraction of the dividend yield and a similar growth profile trade at close to double HFD’s valuation.
As you can see HFD fulfills our Quality, Valuation, and Growth criteria with flying colors.
Lost (and Found) in Translation
One final but an important issue we need to address is currency. Portfolios of stocks will always have exposure to currency fluctuations, it is unavoidable. US-based companies have currency exposure on two fronts: first, from sales overseas – for instance, 65% of HP’s sales come from outside the US. In the case of HP, a strong dollar would hurt its earnings. And second, there is exposure from purchasing goods outside the US. For instance, all of Walgreen’s and CVS’s earnings come from the US; however, a weaker dollar will decrease their purchasing power, making their foreign purchases more expensive. If they can pass cost increases to customers then they are fine, if not they’ll have a problem.
When it comes to foreign-listed stocks, we are exposed to the two currency risks noted above, plus an additional one: the risk that the dollar will appreciate significantly against the currency in which ordinary shares are traded, and in the translation into US dollars we’ll get fewer of them. Take HFD, for instance: since all of its sales occur in the UK, a strong dollar against the pound would hurt our returns.
Currencies are a guessing game and we rarely have a strong opinion about their long-term direction (the Japanese yen being an exception – it makes little sense for the yen to be close to multi-decade highs while Japan has the worst debt profile in the developed world, is trapped in ultra-low interest rates, and has a rapidly aging population). However the British pound doesn’t scare us. In fact, we like it slightly more than the euro. Britain is not on the hook for the bailout of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) from the massive debts they’ve accumulated. The British government is embracing austerity (at least for now), while our government is in “easing” mode (the Fed may decide to let quantitative easing expire in June; however, we get the feeling the Fed might embark on QE3, 4, 5 6 if the stock market meaningfully declines). The UK has as much debt-to-GDP as the US, which is not good; but in today’s post-Great Recession world, currencies are priced on a “less-bad” basis. The UK and its currency are, in our estimation, doing as badly or maybe even a little less badly than the US.
We’ll watch carefully the geographic and currency exposures in our portfolio. Overall currency movements should cancel out in the longer run and should not significantly add or subtract from returns.
Finally, we want to make two more important points: (1) this excursion into foreign markets is NOT a deviation from our Active Value Investing process; we are just extending the universe of stocks we look at to increase reward and minimize risk of stocks in the portfolio. (2) Our core portfolio will still likely be dominated by “made in America” stocks.
Copyright Vitaliy N. Katsenelson 2011. This article may be republished only in its entirety and without modifications.