Non-US Stocks Appear to Offer Somewhat Greater Value

November 19th, 2010 by hackel Leave a reply »

What began as a study on sovereign risk (an important element in CT Capital LLC’s cost of capital model) turned in some interesting offshoots. The study was also undertaken because the CT Capital, equity portfolio has a larger than normal (14%) exposure to ADRs and we wanted to uncover the reason(s).

I studied the 970 non-banking foreign firms (outside the U.S. and Canada) which report to the Securities and Exchange Commission and have a minimum $25MM market capitalization; this group had a median market value of slightly over $1 billion, compared to the S&P Industrials $15.1 billion market capitalization.

It is currently not difficult to make the case that foreign firms offer more risk and value, in general, than does an investment in the S&P Industrials group of companies. The 970 company universe of such firms (those which CT Capital’s models were able to grab sufficient data) had a higher rate of growth in normalized free cash flow as well as a higher growth rate in sales.

In addition, the foreign group invests a greater percentage of their revenues into R&D. Hopefully, this does not translate into the U.S. becoming less competitive, as history would suggest. The U.S.  group, being composed of the S&P Industrials, a large stock index, includes many firms which derive a large to majority share of their cash flows from abroad, but even for those firms, R&D spending was found to be below the foreign group when compared to revenues. In technology, for instance, large US firms have had greater reliance on acquisitions rather than in-house product development, which has not been as true abroad. Either strategy is acceptable if the end result-higher free cash flows- come to be.

With the conversion of US GAAP and international accounting standards, I strongly suspect both investment advisory firms and “sell side” research departments will feel more comfortable increasing their coverage to include more foreign domiciled companies.

The lower average tax rate for the foreign group is unsurprising given the 35% U.S. statutory rate is higher than other developed countries and far higher than small countries-the smaller the country, the lower the rate. The magnitude of the gap, however, was surprising. I would question the cash tax rate for many of the non-US firms as more than half do not report the actual cash taxes paid. However, given the reported effective rate, it may not be far off from the table entry. Non-US firms often had large deviations from their U.S. counterparts, including Volkswagen (VLKAY.PK) (27.7%), Taiwan Semiconductor (TSM) (8.5% cash), Swiss Re (SWCEY.PK) (7.8% cash), and Garmin (GRMN) (8.2% cash). Other than autos, where both GM (GM) and Ford (F) will be near a zero cash rate, other U.S. industries tend to operate at a competitive disadvantage.  Many of the firms for which cash taxes were available are based in Bermuda, raising the possible effects of Congress closing that loophole resulting in higher cost of capital for those entities. Others were based in European countries which may be facing higher rates as their countries face credit issues.

The interest charge coverage in the table includes lease obligations and is a multiple of normalized free cash flows adjusted for balance sheet changes that pumped up reported free cash flows over the past three years.

The foreign group has a higher beta than the S&P, and that is reinforced with its higher cost of equity capital, although this is not the case for an important number of companies at the individual portfolio level, a point we make whenever possible. It is here good credit analysis can spot changes to a firm’s prospective stability of cash flows, thereby proving the analysts value.

Of interest is the foreign group has lower balance sheet leverage which is normally associated with a higher cost of capital. There were other factors at work, including tax rate volatility sovereign risk, and various stability metrics which raised the foreign group’s uncertainly of prospective cash flows relative to the U.S.. Interest rate coverage, considerably stronger for the S&P, has gotten progressively so during the past couple of years, relative to the non-U.S. group.

Both universes of companies appear historically undervalued, with the S&P selling at 18.5x normalized free cash flows and the foreign group at 17.5x. However, the pace of free cash flow growth of the foreign group in this period of otherwise sub-par revenue growth makes them attractive. This higher growth rate is due to: faster rate of growth in the countries where they are domiciled, greater exposure to emerging markets, product demand, and a lower tax rate. The foreign group has not been as diligent as the S&P companies in their cost controls.

While the S&P represents a less risky (defined as uncertainty of free cash flows) group, the foreign group appears to currently offer greater appreciation potential over the longer term. As we have seen this week, the ride there could be quite bumpy.

For additional information, including a complete discussion related to the analysis of credit quality and risk see Security Valuation and Risk Analysis, McGraw-Hill, 2010.

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Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).


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