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 (PDF link).
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 – you can find them here (PDF link).
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