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Global Franchises - The low risk approach to diversifying overseas
Too much (local) knowledge can be dangerous
Sunday Business Post - December 26th 2010
by John Mattimoe, Senior Portfolio Manager, Appian Asset Management
The Irish equity market has been caught in the crossfire of the turmoil afflicting the Irish bond market. All Irish financial assets have been tarred with the same brush by international investors and there is little discrimination between quality assets and those that are genuinely toxic. In that context there now is, at best, major apathy towards Irish equities from institutional investors, and this indifference may well persist for as long as it takes Ireland to regain the confidence of the bond market - which is likely to be well along the four year plan to stabilise the public finances.
Consequently, those investors whose interest in equities has predominantly been in Irish stocks may now need to internationalise their investment universe. However, many such investors have shown reluctance over the years to diversify equity holding outside of Ireland. While this in part was due to the good returns generated by Irish equities in teh 1993-2006 period, it also reflects (i) a belief that local knowledge was an advantage in Irish equities, and (ii) concern that the risks associated with far away hills were not as manageable.
Looking at the first of these issues, we would challenge how valuable local knowledge has been. Indeed, sometimes being too close to the ground can be a distinct disadvantage - anyone who bought Irish banks shares because they heard someone from one of the banks in the pub at the weekend saying everything was grand and there was nothing to worry about can painfully testify to this. Also, many leading quoted Irish industrial companies, such as CRH, Ryanair, Aryzta, Kerry and DCC, have profitably diversified away from Ireland over the years, to the extent that in most cases, the proportion of their business in Ireland is 10% or less. In that context, Irish investors are not best placed for getting local knowledge about what is happening on the ground for these businesses in the US, Britain or continental Europe.
Risk analysis on potential equity investments is critical, and just because a stock might not be based in Ireland does not mean that a sound assessment cannot be made, particularly if basic principles are applied. Granted, it is easy to get excited and bamboozled in equal measures by exotic sounding opportunities. For example, emerging markets promise much in terms of economic growth potential, but the valuations of many equities in these areas already discount much of that potential, while a lot of potential investors are correct in wanting to satisfy themselves on concerns over corporate governance, accounting standards and market regulations before jumping into emerging markets.
However, keeping things simple and sticking to basic valuation principles is a sensible way to manage the risk of diversifying into overseas equities. An effective example of keeping it simple that we in Appian like is a portfolio of Global Franchise stocks - for illustration we have chosen the following half dozen: Coca Cola, Colgate Palmolive, Johnson & Johnson, Nestlé, Unilever and Wal-Mart. These are large, blue chip companies which offer defensive growth characteristics.
They are defensive because they have scale, strong and established brands, reasonable pricing dynamics, low costs and they serve markets which have robust demand characteristics - the demand for and the pricing and profitability of products like Coke, Nescafé and Persil tend to perform better than most products during downturns. These companies also have stronger balance sheets, with an average debt / equity ratio of 15%, nearly half that of the market average. Not only does this mean the financial risk wihin these stocks is lower, it enables them to better sustain dividend payouts, growth of dividend and investment back into their businesses.
The Global Franchises also offer growth characteristics by adding to their product range and expanding geographically. A product acquired or newly developed by a Global Franchise company can reap the benefits of their massive distribution capability - for example, Unilever recently acquired the producer of Alberto V05 hair-care products which were predominantly sold in the US and to a lesser extent in Europe, but Unilever can now use its network to develop markets for these products in Latin America and Asia. Geographic growth is being successfully pursued through the penetration of new markets. In particular these are mostly emerging markets where the Global Franchises will not only benefit from fast rates of population growth, but they will also prosper from growing demand for western and global brands as wealth levels rise. Indeed, we in Appian would argue that with the Global Franchises generating significant proportions of their business (nearly 50% in the case of Unilever) from emerging markets, that they represent a low risk way for western investors to get exposure to those markets.
Finally, the financial characteristics of the Global Franchises compare well against the broader market. At the time of writing, the weighted average 2011 price / earnings ratio of the six which we have highlighted is 14.5x, based on consensus forecasts. While this is slightly higher than the market average of 13.2x this premium is more than justified by the superior earnings growth record of the six Global Franchises. These, over the past decade, have grown earnings per share by 9% p.a. on average compared to just 2% for the market average. The average 2011 dividend yield of the six is an expected 2.9%, higher than the market average of 2.5%. To put that in context this 2.9% yield is similar to German 10 year bond yields and just below the US 10 year bond yield of 3.3%. This is attractive given these companies have delivered average dividend growth of 13% p.a. over the last ten years, a period where the market average has shown a decline of 3% p.a.
Based on these metrics, we would argue that Global Franchises offer a relatively low risk opportunity among international equities.
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