Someone who reads my blog emailed me this question:
“Can you give your thoughts on looking at international markets now with the strength of the dollar. The pound has dropped so much as well as the euro against the dollar it seems to be a good opportunity. Many predicable consumer names are on sale even more so with the strength of the dollar.”
First, I should say that I am considering buying a U.K. stock right now. If I do, I will not hedge the currency risk. So, I would be happy to swap my U.S. dollars for British pounds right now. But, I would have to find the right stock – not just the right country – to invest in. For most people reading this, I think the country to focus on right now is the U.K. The currency is reasonable on a purchasing power parity basis because the U.S. dollar has been rising and because of the U.K.’s decision to leave the European Union. The business culture in the U.K. is good. There are U.K. companies that are comparable in quality to U.S. companies. So, I think the U.K. is the market to focus on right now. I would not buy a U.K. index fund or a basket of U.K. stocks. But, instead of just looking everywhere in the world for a good business at a good price – I would limit my search to the U.K. for now.
I always want to find more foreign stocks for my portfolio. I never have enough. I would like to be at least 50% invested in stocks outside the U.S. whenever possible. I have this hope that at least 50% of the stocks in my portfolio would be non-U.S. and at least 50% of the stocks in my portfolio would be micro-cap stocks. Big, U.S. stocks are rarely mispriced when the market is expensive. They can be excellent investments, but they are usually good buys when either the overall stock market is down or there is pessimism about their industry.
When I was writing the newsletter, we did pick some non-U.S. stocks. We picked Swatch (XSWX:UHRN, Financial) (a Swiss company), Ekornes (OSL:EKO, Financial) (a Norwegian company), Homeserve (LSE:HSV, Financial) (a U.K. company), Hunter Douglas (HDUGF, Financial) (a Dutch company) and Luxottica (LUX, Financial)(an Italian company). Now, the country designations I just gave are where those companies trade – not necessarily where they do a lot of business. For example, the U.S. is the single most important market for both Luxottica and Hunter Douglas. So, you can find companies listed in other countries that do a lot of business in the U.S. You can also find a lot of companies in the U.S. – especially predictable, consumer names – that do a lot of business in other countries. If these U.S. listed multinationals are not hedged, they will report higher earnings in U.S. dollars when the local currencies they operate in rise against the dollar. Currency moves can also affect competitiveness. But, this is not usually a big issue for the kinds of companies I am interested in. I tend not to look at businesses where price competition is a key concern. So, for example, we wrote about Swatch at a time when the Swiss franc was rising a lot against the dollar and therefore also against currencies in Asia – like the Hong Kong dollar and Chinese yuan – that are pegged either in a hard or soft way to track the dollar. In fact, because Chinese tourists buy a lot of Swiss watches when visiting the U.S., the combination of sales made in U.S. dollars, Hong Kong dollars and Chinese yuan was big. So, movements of the Swiss franc against the U.S. dollar cause a huge indirect lack of competitiveness for Swiss watchmakers. I am not sure this is important though. Almost all watches sold on the basis of price aren’t Swiss. And almost all Swiss watches are sold on some basis other than price. There are some brands – like the Swatch brand itself – that are obviously made less competitive in the U.S. by the rise in the Swiss franc versus the U.S. dollar. However, the Swatch brand and the U.S. market are small parts of Swatch’s earnings. The company earns a lot more selling luxury brands in China. But, it competes against other Swiss watchmakers. And those watchmakers also raise their prices in local currency terms when costs rise for them in Switzerland. So, that kind of company is not going to be affected the same way a maker of a product that competes on price with exports from other countries will be affected. This is why currency movements are complicated for investors in specific stocks.
Let’s take the examples of Luxottica and Hunter Douglas. Luxottica’s manufacturing costs are all in Italy. Likewise, Ekornes (they make Stressless recliners) has all its costs in Norway. But, a company like Hunter Douglas is different. Hunter Douglas is listed in the Netherlands. But, Hunter Douglas is really two companies. The Hunter Douglas brand manufactures and sells in the U.S. The Luxaflex brand manufactures and sells in Europe. The stock is listed in the Netherlands and reports its earnings in euros. However, most of the company’s sales and profits do not come in the form of euros. So, if you are an American investor interested in the Hunter Douglas brand, the complications here are that maybe 40% of the business is Luxaflex, which does business in euros. And then the other complication is that the stock is priced in euros even though much of the earning power originates in dollars. So, if the dollar rises against the euro, then next year’s expected earnings in euros will have risen. The stock price – in euros – may or may not rise by the correct amount when this happens. Very often it does not. The short-term movements in a stock listed in one country but generating a lot of earnings in other countries does not seem to be efficient to me. You could see this clearly when the Brexit vote happened. A lot of U.K. stocks dropped in price. That might seem to make sense at first. But, for a lot of companies – a stock price decline in British pounds does not make a lot of sense if it happens at the same time as a decline in the price of the pound versus other major currencies. A U.K. stock is not just falling in price. It is falling in price in a specific currency. So, if a company in the U.K. gets a decent amount of earnings from outside the U.K. and then its stock price drops in pounds at the same time the pound itself is dropping – you can see the problem. The stock is way over-reacting to the situation.
Some companies can suffer a lot from something like Brexit. Obviously, an importer that must compete with possible substitutes could be in real trouble. But, it is not always clear if there is a real substitute that would not also be increasing in price. For instance, use the example of Howden Joinery (LSE:HWDN, Financial). Howden Joinery serves trade account clients – builders – that install kitchens for U.K. homeowners. Unlike in the U.S., a U.K. company may be importing a fair amount of building material. However, Howden is not at any disadvantage compared to other importers. So, Brexit can hurt homeowners by making them less likely to want a new kitchen at the higher (due to pricier imports) cost of the kitchen and the lower confidence they may have in their economy. So, people may want to build fewer kitchens. And builders would then want to buy less from Howden. That is possible. Likely even. But, the decline in Howden stock after Brexit was big. And yet Howden is just a retailer – to trade accounts – in the U.K. So, its gross margin might be hurt for a time. But, Brexit should not do a lot to weaken Howdens’ competitive position inside the U.K.. It should just hurt all the companies selling to builders.
When doing the newsletter, we looked at Europe a lot and we did not see a lot of opportunities. We found more opportunities in the U.S. Even the European stocks we liked best – Hunter Douglas and Luxottica – do most of their business in the U.S. One reason for this is that Quan (my co-writer) and I use PPP (purchasing power parity). We are not thinking about whether a currency has dropped a lot over the last three months or three years. We are just worried where the currency is in terms of purchasing power parity, which is essentially the price at which you could buy equal amounts of stuff in the two places. You are probably most familiar with it in the form of the Big Mac Index. If a Big Mac costs $5 in the U.S. and $2.80 in China – then we can say that the Chinese currency is undervalued versus the U.S. currency in terms of purchasing power parity. There is an argument that higher income countries tend to be overvalued in terms of pure purchasing power parity and lower income countries tend to be undervalued in terms of pure purchasing power parity. So, maybe it is OK for Big Macs to cost more in the U.S. than in Mexico. And maybe you have to adjust for this income level difference. But that is tricky to do. It is tricky to disentangle a country’s lower income status from its government policies, ability to attract capital, etc. Most lower income countries are not attractive destinations for capital, have bad government policies for investors, etc. Most higher income countries are attractive destinations for capital, have good government policies for investors, etc. So, I think you can use purchasing power parity as you would use the discount to NAV on a closed-end investment fund. Some closed-end funds will – and should – always trade at a discount to NAV. Likewise, some countries have currencies that will – and should – always trade at a discount to purchasing power parity. For example, Quan (my newsletter co-writer) is from Vietnam. I am from the U.S. We have talked about the economies of those two countries many times before. To be honest, we have not come up with any reason why in the long-term Vietnam would be able to have a fully open trade and capital relationship with countries like the U.S. and not have capital leave it continuously. We would expect Vietnam to sometimes have a rising currency. In the long run, it would just be expected to continually devalue its currency. It would not be a one-time event. It would be something the country would be doing repeatedly.
I just do not see how the real returns on capital in Vietnam are going to be as high as the real returns on capital in the U.S. So, if someone in Vietnam could take their Vietnamese dong, exchange them for dollars at the official exchange rate and then invest all those dollars in U.S. stocks and keep them forever – they should. Now, they cannot do that because it is not allowed. But, you see my point. Vietnam may have a currency that is undervalued versus the U.S. dollar at this moment. But, the person holding U.S. dollars is always in a better situation going forward – he can use his dollars to buy assets that will have higher long-term real returns – than someone holding Vietnamese dong. This is true for a lot of developing countries. I do not know how their public companies can generate as high after-inflation returns on shareholder money as U.S. companies can. So, it does not make sense to “invest” in their currencies. It only makes sense to trade their currencies. Countries like the U.K., Switzerland, Sweden, Belgium and Germany have a lot of companies with long-term real returns on equity that come much closer to U.S. companies. It is reasonable to have little to no preference between holding a sampling of high-quality American, Swedish, Belgian, Swiss or British companies. When we move down the list to places like Germany, it gets a little tougher to say there is no long-term difference. There are plenty of smaller German companies that I think are fine, but giant German corporations do not have as good a long-term record as American companies. France and Japan are often considered comparable to the U.S. in terms of their development – but their business cultures are not comparable. French and Japanese companies do not earn as good real returns for their shareholders as American companies do. Now, if you can find a great family-owned company in any of these countries that is run along the lines you would want your American investments to be run – that is great. I like the way Hunter Douglas, Luxottica and Swatch are run. There are a couple Japanese companies that are run in a way I like. But, yes, there are plenty of countries in Europe that have good long-term records for return on equity. Public companies in Northern Europe – especially the U.K., Sweden, Belgium and the Netherlands – are good. Basically, the places where the industrial revolution started have still been – in the centuries that followed – good places to invest. However, there has not been a convergence of business culture between countries that came later to industrialization and those that started very early. We can see this a bit in the income levels of workers. A lot of countries that came later to industrialization have much lower GDP per hour worked (at PPP). And they have lower returns on equity. The real returns on equity of a country’s companies are critical. That is all you care about as a long-term investor. So, I would pay attention to what the very long-term history of real return on equity (ROE) has been in a country and I would pay attention to what purchasing power parity levels are now. But, I would not be excited by Mexico being cheap on a purchasing power parity basis versus the U.S. if I also knew that over the last 100 years Mexican companies have delivered much lower real returns on equity for their shareholders. Most of the countries I like best in terms of their public companies are the most expensive in terms of purchasing power parity. This has been true for several years.
Right now, I would say the U.K. is the most interesting place to look for ideas in terms of the combination of a reasonably low exchange rate relative to purchasing power parity levels and a good enough long-term history of delivering ROE for British shareholders. There are cheaper currencies, but right now I am not sure there is a better combination of a cheap currency and good companies than the U.K.
Disclosure: No positions.
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