Company location overrated when it comes to stock analysis
A company's location is no guarantee of good governance, and emerging markets are home to some of the best and most overlooked stocks, according to two of the great minds in international investing.
A company's location is no guarantee of good governance, and emerging markets are home to some of the best and most overlooked stocks, according to two of the great minds in international investing.
Addressing the 30th Morningstar Investment Conference in Chicago last week, Diana Strandberg, director of international equity at Dodge & Cox, and David Herro, chief investment officer of international equities at Oakmark, said analysing a company involved looking beyond where it was located.
"Domicile doesn't tell much about risk and opportunity," said Strandberg, who manages funds rated Gold by Morningstar. "We’ve seen some of the best corporate governance in Brazil, and been disappointed in The Netherlands."
It was a sentiment echoed by Herro, who manages Oakmark International, rated Gold by Morningstar. Location is "overrated" in his eyes when it comes to analysis.
"Japan is ground zero of poor corporate governance," he told the conference. "We tell them that we are investing people’s savings and we have a responsibility to earn a return through our investments, and they should be working to generate earnings!
"We are not a big fan of certain countries, particularly Russia," said Herro. "We can deal with economic instability, but rule of law and ownership rights must be there. That said, domicile is one of the most overrated factors … companies based in Europe make their money all over the world."
Domicile doesn’t dominate analysis
Strandberg said Dodge & Cox instead focused on global scope of a business and where it earns and owes money. In line with this, Morningstar is developing geosegmenting analysis of portfolios, measuring geographic exposure on the sources of underlying companies' revenues, not the countries in which they are headquartered.
As well as location, Strandberg said macroeconomics could also sometimes obscure opportunity. She cited the case of Brazil where concerns about the possible election of a candidate are knocking down stock prices.
Election jitters are weighing on stock prices in Brazil
Sao Paulo-based bank Itau Unibanco remains one of the best-run banks in the world, she said, with strong fundamentals and priced at about 10 times earnings, with a 5 to 6 per cent dividend yield.
Similarly, while Herro is cautious about China because of government intervention in corporate affairs, he holds Chinese tech giant Baidu, which is growing strongly and is a leader in artificial intelligence. The hurdle is higher for such companies, though.
"When we look at a company based in China or Brazil, or any unstable environment, we require a higher rate of return," Herro said. "With Google, the cost of equity is 9 per cent or 10 per cent. For Baidu, it’s 14 per cent."
Overlooked opportunities
Both Strandberg and Herro also own Naspers, a South African multinational internet and media group that owns about a third of Chinese internet giant Tencent. Strandberg has owned it for 10 years, while Herro recently added a position.
"We've been fans of Tencent for a long time; it is perhaps the best internet property in the world. Naspers was up significantly last year, but the underlying value of Tencent increased even more so, so the value gap was strong,” said Herro. "And the rest of Naspers isn't so bad, either."
"The market cap of Naspers is $100 billion," noted Strandberg, "while the market cap of its stake in Tencent is $150 billion. So the market is valuing the rest of an unparalleled array of holdings at -$40 billion. We think it is worth $20 to $30 billion. We've been trimming back over the past year or so, however, as the valuation has risen."
"That's who we've been buying it from!" Herro quipped.
On the other hand, Herro sold his stake in Japanese conglomerate Honda, while Strandberg remains positive on the company. Herro believes the core auto business is underperforming compared to peers. Strandberg pointed to the strength of Honda's motorcycle business, with operating margins in the low teens, and believes that scepticism is priced into the stock.
They agreed that corporate governance is an issue for Honda and other companies in Japan, pointing to companies' tendencies to stockpile cash.
"We are underweight in Japan largely because of capital allocation," said Strandberg. "We write letters to boards and engage with management in a friendly way to try to improve capital allocation and have seen modest success."
Filtering out background noise
Asked about the effect on portfolios of global ructions such as Brexit and trade wars, Strandberg and Herro said it was crucial to block out the noise and focus on a company's intrinsic worth.
"You have to look company by company," said Strandberg. "We pay attention to the macro, but we view it through the lens of what's priced into valuation. Banks are down 30 to 40 per cent, almost at financial-crisis levels.
"But their fundamentals are vastly stronger, their asset quality is better, earnings are going up. Higher interest rates would be fantastic, but our investment thesis doesn't rely on interest rates. Macro concerns are obscuring improving fundamentals."
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Laura Lallos is a senior analyst covering equity strategies on Morningstar’s manager research team and managing editor of Morningstar® FundInvestorSM, a monthly newsletter.
Lex Hall is a Morningstar content editor, based in Sydney;
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