Tag Archives: america

Foreign Stock Exposure: How Much Is Enough?

Summary Over the long haul, the inclusion of foreign stocks in an equity portfolio can reduce risk. Since the subprime crisis, foreign stocks have been a drag on portfolio performance. Foreign stocks today offer better value that American stocks. Portfolios can capture most of the diversification benefit of foreign stocks with weights in the 20% to 40% range. The American stock market has been one of the world’s premier performers since the subprime crisis. Since the end of first quarter 2009, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) has returned nearly 175% while the V anguard FTSE All-World ex-US ETF (NYSEARCA: VEU ) has lagged far behind with a total return of 83%. With that kind of recent performance, it’s easy to forget that there are opportunities in foreign capital markets as well. In terms of market capitalization, US stocks comprise about 50% of the world’s total. An important question for investors to consider is how much of their own portfolios should be deployed in foreign stocks. Here, we’ll review some of the key issues surrounding equity investment overseas. The Basis for International Diversification Portfolio management has long been guided by the principal of diversification. Holding a broad swath of assets cancels out much of the risk attributable to company-specific fortunes. Don’t put all your eggs in one basket, or country. It makes sense, then, for investors to take advantage of the growth opportunities available to public companies overseas. There are some caveats. Not all markets are created equal. Many foreign markets trade much more thinly and are less transparent than American stock exchanges. Most of our own consumption is denominated in dollars as well, making US companies especially suitable for holding. Two key questions loom. What is the “foreign market” and how much of it should a prudent investor put in their portfolio? What is the World Stock Market? At year end 2014, the aggregate market capitalization of the world’s stock markets was over $60 trillion. A significant fraction of this stock is not actually tradable because it is closely held by governments, company founders, or certain institutions. About $44.1 trillion is considered available for trade. This stock is often referred to as free float in the press. Most major stock indices only account for this free floating stock when they assign weights to companies. The influence of American stocks in the world market has varied over time. Just after the devastation of World War II, America was about the only place to trade stocks. By the late 1980s, over 70% of the world’s stock was outside the US. That period coincided with a great bull market in Japanese equities. For most of the past twenty years, the US market has hovered about where it is, at or near half the world’s free float. The very largest private corporations are American. Nine of the top ten stocks are headquartered in USA. There are some huge companies overseas but much of their ownership remains in government hands and not part of the free float. For example, only about 30% of the stock in mainland Chinese companies is tradable. In the United States, over 90% of outstanding stock is freely available. For the purposes of our discussion, we’ll break down foreign stocks into two segments: developed markets and emerging markets. Foreign countries fall into one of these two categories. As the name implies, developed markets are characterized by high incomes, stable political institutions, and a transparent stock exchange mechanism. Think Western Europe and Japan. Emerging markets have lower national incomes with evolving political and economic institutions. They are typically characterized by high economic growth rates. Here is a recent breakdown of the major categories of stock market weight according to Dimensional Fund Advisors. (click to enlarge) Benefits to Foreign Stock Ownership? The benefits of diversification are typically measured in reduced portfolio risk. Risk is often referred to as volatility – the level of variability in portfolio returns over time. Investors naturally prefer less volatility. The historical record of domestic and foreign equity returns to date reveals some pitfalls. Stock markets have tended to move together or correlate more closely in recent years. When highly correlated assets combine, overall risk remains relatively intact. Not good if you’re building an investment portfolio. In fact, foreign stocks have offered no risk reduction since the subprime crisis in 2008. Their volatility has been high and overall returns have been low. US stocks have been among the world’s best performers in the last six years. Despite these disclaimers, the long term data still show that foreign stocks reduce risk by a measurable amount in investment portfolios. Investors can capture most of the benefit of foreign diversification with portfolio weights well short of the 50% market cap representation of non-USA stocks. Recent research from the Vanguard Group suggests that most of the risk reduction available with international diversification can be captured with a 20% to 40% weighting to foreign stocks. The chart below reveals that most of the benefits can be achieved with comparatively shallow exposure to markets outside the US. The line on the chart below represents overall change in the risk level of an all stock portfolio as foreign stocks are added. The highlighted green range covers the lowest risk mixture of foreign and domestic stocks. (click to enlarge) The scale of the risk reduction is highly sensitive to the measurement period. The charted depicted takes the long view – reviewing stock market returns from 1970 the present. If we exclude first twenty years of the series, the benefits are considerably less. While the theory supporting foreign stock diversification is strong, the actual data is more cautionary. Reliable stock return data for the universe of foreign stocks is considerably shorter than US stock returns. When does a foreign stock market become viable enough to be included in any index? A statistically reliable record is still under construction. Prudence suggests that investors use foreign stocks, but underweight them relative to their representation in the capital markets. The evolution of overseas stock markets and modern investment products has made foreign investing cheaper and easier. Twenty years ago, the only entrance to foreign markets for retail investors was through individual stocks or expensive mutual funds. Today, there are a number of indexed exchange-traded funds (ETFs) and mutual funds that provide broad exposure to foreign equities at low cost. You can invest in the entire foreign market or a relevant subset. Some key foreign stock ETFs include VEU, the Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ), the iShares MSCI EAFE ETF ( EFA), and the Vanguard FTSE Emerging Markets ETF ( VWO). Special Considerations with Foreign Investing For many years, researchers have consistently found that American stocks with prices that are low relative to fundamental measures like earnings and revenue generate superior returns. This phenomenon has been dubbed the “Value Effect.” Consequently, many investment professionals overweight low priced stocks to capture additional returns. One might reasonably ask whether this value effect extends to foreign markets. The data thus far confirms that value stocks outperform their peers overseas as well. Over the last 25 years, foreign “value” stocks have generated an annual return premium of almost 3% annually. While foreign stock databases are newer than their American counterparts, every indication suggests that a value effect is worldwide. Another issue to consider with foreign equities is their overall ability to improve portfolio returns. In other words, do foreign stocks outperform US stocks? The jury is still out. The number of data points is still too small. Using 1970 as a starting point, foreign stocks have lagged American equities by about one percent annually. However, during the first couple of decades of this period, there was very little emerging market participation in the foreign stock data. Stock returns in these developing economies have been good. With all the changes in the composition of foreign stock indices, comparison of US and foreign stock market returns remains difficult. While there is evidence that the inclusion of foreign stocks can reduce risk in the long term, the historical record of foreign stocks as short term “crisis insurance” is poor. That is, stocks from all countries tend to move together (and downward) in times of economic dislocation. The meltdown in 2008 is only the most recent case in point. There are other examples. Foreign stocks fell hard during the dotcom bust in 2001-02 and during the stock market’s crash in 1987. International diversification is a long term phenomenon. It will not insulate an investment portfolio from a recession or an international crisis. Participation in world markets will most likely smooth returns over long periods of time. That’s a useful if unspectacular outcome. Do Foreign Stocks offer Good Value Now The historical record indicates that both US and foreign stocks perform well when they trade at low valuations. But how do those valuations look now? Obviously there are many ways to measure value. One of the metrics that has gained a lot of traction in the press is Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE ratio). It measures the price of a stock against its trailing 10 years of inflation-adjusted earnings. The principle behind the extended lookback is that a 10 year perspective smoothes the otherwise wild swings in the P/E ratio attributable to the economic cycle. Shiller’s model predicts that stocks perform better over a five year horizon when they start from a low CAPE ratio. With that in mind, we looked at the US market and compared it with major foreign equity indices. There were stark contrasts in relative value as measure by CAPE. The US large cap market currently has a CAPE ratio that is more than 50% above its median. Both the developed foreign market (EAFE) and the emerging markets (EM) have CAPE ratios well below their medians. In fact, emerging markets are trading as low as they ever have in their relatively brief history. I do not claim that foreign stocks are about take off and leave the S&P 500 behind. However, the data suggests that the both the principles of diversification and value call for a strong commitment to foreign stocks. (click to enlarge)

Southern Company – Rising Infrastructure Assets But Look Out For Some Challenging Quarters

Summary Southern Company is one of the largest utilities in America. Will grow to #2 spot by customer count after the AGL Resources purchase. Southern announced its plan to acquire AGL Resources for $8B cash – fueled by debt and equity issuance. The company is a dividend contender having raised dividends for 15 consecutive years; 5-yr dividend CAGR is 3.7% and Chowder Rule is 8.56. The Southern Company (NYSE: SO ) is one of the largest utilities company in America. The company serves more than 4.4 million customers and has approximately 46,000 megawatts of generating capacity serving the Southeast through its subsidiaries. Subsidiaries include electric utilities in four states – Alabama Power, Georgia Power, Gulf Power, and Mississippi Power; a growing, competitive generation company – Southern Power; a licensed operator of three nuclear generating plants – Southern Nuclear; and fiber optics and wireless communications – Southern Telecom and SouthernLINC Wireless, respectively. (Source: September 2015 Southern Company Overview Presentation ) In August 2015, Southern Company announced that it will be acquiring AGL Resources Inc. (NYSE: GAS ) in an $8B cash deal. This combined company will shift Southern from being an electric-only utility company to an electric-and-gas utility company. The customer base is expected to double with this move and pushes Southern to become the second largest utility company in America (by customer count), if the deal is approved. Corporate Profile (from Yahoo Finance) The Southern Company, together with its subsidiaries, operates as a public electric utility company. It is involved in the generation, transmission, and distribution of electricity through coal, nuclear, oil and gas, and hydro resources in the states of Alabama, Georgia, Florida, and Mississippi. The company also constructs, acquires, owns, and manages generation assets, including renewable energy projects. As of December 31, 2014, it operated 33 hydroelectric generating stations, 33 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 9 solar facilities, 1 biomass facility, and 1 landfill gas facility. The company also provides digital wireless communications services with various communication options, including push to talk, cellular service, text messaging, wireless Internet access, and wireless data; and wholesale fiber optic solutions to telecommunication providers in the Southeast. The Southern Company was founded in 1945 and is headquartered in Atlanta, Georgia. A Closer Look The Southern Company has remained focused as an electric utility company through the years. The company has remained a heavy user of dirty fuels such as coal (accounts up to 42%) for its power generation over the years, but has started transitioning to cleaner resources including natural gas, solar and wind. This move will also be welcomed as the company aligns itself with the US government mandate targeting power plants to cut carbon emissions by 32% (by 2030) on the 2005 levels. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) Acquisition of AGL Resources Inc. In August 2015, Southern Company announced a plan to acquire AGL Resources Inc. for about $8B in cash, fortifying SO’s assets with the natural gas infrastructure. AGL Resources distributes gas in Georgia, Illinois, Virginia, New Jersey, Florida, Tennessee and Maryland. Southern Co. owns utilities in Georgia, Alabama, Florida and Mississippi. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) This move lowers SO’s dependence on power generation and pushes SO to the #2 spot in the utility sector by customer count after Exelon Corp. (NYSE: EXC ). The combined company will operate 200,000 miles of electric lines and 80,000 miles of gas pipelines. The deal is expected to close in the second half of 2016. Southern Company will be issuing $3B in new stock and also tapping into the debt markets to finance the merger. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) The deal is expected to raise the long-term EPS growth rates by 4-5%. In addition, the dividend growth is expected to rise faster than current rates. Dividend Stock Analysis Financials Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations. (click to enlarge) (Source: Created by author. Data from Morningstar) (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The utility industry is resilient and has seen a slow and steady rise over the years. Revenues and earnings are fairly constant with year-over-year growth ranging between -0.3% to +0.15%. The debt load is also stable and SO enjoys a ‘A-‘ credit rating from S&P. SO has a debt/equity of 1.36 and a current ratio of 0.80. Those numbers can be expected to change significantly over the course of next year or two as the AGL purchase moves closer to closing. Dividends and Payout Ratios Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: Utility companies are slow and steady growers and are perfectly suited for long-term dividend investors. Southern Company is a Dividend Contender having raised dividends consecutively for 15 years. The 1-, 3-, 5-, and 10-year dividend CAGRs are 3.5%, 3.6%, 3.7%, and 39% respectively. Coupled with a current dividend yield of 4.86%, SO has a Chowder Rule number of 8.56. The current payout ratio is 89%. Outstanding Shares Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The number of shares have risen steadily over the years and are expected to rise more as the company intends to issue $3B of new equity to finance the AGL deal – approx 66M new shares based on current price, an increase in the number of outstanding shares by ~7%. Book Value and Book Value Growth Expected: Growing book value per share. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The book value is a bright spot in the company’s financials. The book value has steadily increased over the years maintaining a nice upward trajectory, although we can expect this to stumble when more debt and shares are issued in the coming years. Valuation To determine the valuation, I use the Graham Number, average price-to-earnings, average yield, average price-to-sales, and discounted cash flow. For details on the methodology, click here . The Graham Number for SO with a book value per share of $22.22 and TTM EPS of $2.35 is $34.28. Based on the last closing price, the stock is currently 30% overvalued. SO’s 5-year average P/E is 18.92, and the 10-year average P/E is 17.80. Based on the analyst earnings estimate of $2.94, we get a fair value of $55.62 (based on the 5-year average) and $52.33 (based on the 10-year average). SO’s average yield over the past five years was 4.60% and over the past 10 years was 4.61%. Based on the current annual payout of $2.17, that gives us a fair value of $47.17 and $47.07 over the 5- and 10-year periods, respectively. The average 5-year P/S is 2.16 and average 10-year P/S is 2.0. Revenue estimates for next year stand at $21.18 per share, giving a fair value of $45.74 and $42.35 based on 5- and 10-year averages, respectively. The consensus from analysts is that earnings will rise at 3.58% per year over the next five years. If we take a more conservative number at 3%, running the three-stage DCF analysis with an 8% discount rate (expected rate of return), we get a fair price of $36.73. The following charts from F.A.S.T. Graphs provide a perspective on the valuation of SO. (click to enlarge) (Source: F.A.S.T. Graphs ) The chart above shows that SO is slightly undervalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be 2.75%. (click to enlarge) (Source: F.A.S.T. Graphs ) Conclusion Electric utilities in general have seen slower sales industry-wide amid a combination of energy conservation, energy efficiency and shift towards independent power generation/natural gas usage. Coupled with the new regulations from the US government to reduce carbon emissions, electric utilities have started focusing a shift away from dirty fuels such as coal. Southern Company still relies heavily on coal, but has started focusing on cleaner energy alternatives to meet the target. In a move to diversify and fortify its assets, the company is moving to acquire AGL Resources Inc. in a deal financed by new share and debt issuance. While this is good for the overall company’s business, in the short term (over the course of next few quarters/years) some balance sheet damage can be expected as the company takes on more debt and investors see share dilution. An added risk for investors is the potential rise of interest rates by the US Fed. Bond substitutes such as utility stocks suffer the most in rising rate environments. Based on the metrics discussed above, if we give equal weight to all metrics, we get a fair value of $45.31. Full Disclosure: None. My full list of holdings is available here .