An individual investor from France sent me an email about finding great small cap stocks in other countries:
“These kind of stocks are I think virtually impossible to find for a non-local investor. I would be delighted for instance to find some German small caps but I don't even know where to start…”
Maybe an example will help.
Let’s put aside the language difference. And just focus on the foreign stock part of the problem.
I’m from the United States. In my entire life, I’ve spent all of 15 days in the United Kingdom. My knowledge of the country is limited to cultural exports from the BBC – half of them sitcoms – and whatever I can glean from the Financial Times and The Economist.
The point is: I know nothing about the United Kingdom.
Like any investor looking at foreign stocks, I’m starting from a position of complete ignorance.
So here’s how I started looking for stocks over there.
I went through the A’s and B’s and found 13 potentially promising companies:
These stocks may or may not be good buys at these prices. I was just looking for potentially promising companies – regardless of price.
That’s how I start looking for stocks in another country. I’m only interested in good businesses I think I can understand. There are always plenty of cheap, mediocre businesses over here in the U.S. There’s no reason to hunt for them overseas. So the bar is a little higher with a foreign stock. Anything that isn’t a good business I throw out right away.
In this case, I used the following steps to find potentially promising companies:
1. I clicked on the “fundamentals” tab in the LSE page for each stock and scrolled down to the return on invested capital. I looked for a positive number that had been in the double-digits each year. Ideally, the company tended to have 20%+ returns on invested capital for the last few years.
2. I looked up the companies that passed step #1 over at Bloomberg. I read Bloomberg’s business description. If it sounded like a business I couldn’t understand (for example, it was a tech company or investment bank) I threw it out. If it sounded like a business that had the potential to earn very high returns on capital (for example, it monitors volume on beer lines) I moved on to step #3.
3. I opened the annual report and found the cash flow statement. I checked to see if cash flow from operations exceeded capital spending in each of the last couple years. In other words, I checked to make sure the company had positive free cash flow.
4. Finally, for any companies that made it this far, I created a folder on my computer’s desktop and placed all the PDFs of the company’s past annual reports in that folder.
That’s as far as the search part of stock picking goes. After that, you start studying individual companies. That means reading the annual reports. I like to start with the oldest report first and read my way up to the present day.
The next step after that is appraising the company. Appraisal is the Ben Graham and Warren Buffett approach. For details on how Ben Graham appraised a stock, read the 1949 edition of The Intelligent Investor.
For details on how Warren Buffett appraises a stock, watch this video.
Ideally, you want to find a good business first. Then, you want to appraise the value of the business without seeing the stock price. Once you’ve decided what you think the business is worth, you check the stock price. Then you decide whether or not to buy the stock.
If you do it in any other order, you risk biasing yourself.
My usual rule of thumb for appraisals is that a stock should trade at 10 times normal EBIT (Earnings Before Interest & Taxes) and 15 times normal free cash flow. For a consumer products company like Kimberly-Clark (KMB) or an advertising conglomerate like Omnicom (OMC) normal earnings are pretty much synonymous with last year's EBIT and free cash flow. For everybody else, I take the 10-year average real (inflation adjusted) EBIT and free cash flow.
If a foreign stock's price is at least 25% below the value you appraised it at, and you love the business, you should think about buying it.
If it fails either the love test or the 25% off test, don't waste any more time on it.
Warren Buffett often says he found the best bargains in his career early on just by reading through the Moody's Manuals starting with the A's. He also said he turned a lot of pages in those days.
People tend to forget that second part. It isn't hard for foreigners to work their way through the London Stock Exchange or any other market. It just takes a long time.
But it's doable. Say you have 5 hours a week to spend on investing. Set aside 2 of those hours to spend working your way through the LSE (or another foreign exchange) starting with the A's. Use the quick step-by-step approach I talked about in this post. You'll find those 2 hours a week are the most efficient use of your investing time in terms of good ideas produced. Your creative output will blossom when you start studying stocks you've never heard talked about on CNBC.
Having to form your own opinions from scratch does wonders for investment analysis. One of Warren Buffett's greatest investment moments was finding PetroChina when nobody in the U.S. was talking about that stock. And one of Ben Graham's greatest investment moments was finding the government report on Northern Pipeline that showed the cash assets it hid from investors.
That kind of searching from scratch puts you in the best mindset to value a stock objectively.
In my experience, going through a list of stocks from A to Z is one of the most profitable uses of time you can make.
I've only found 3 dependable ways for turning up great stock ideas:
- Going through a list of stocks from A to Z
- Reading value investing blogs
- Direct, personal experience with the company
All 3 methods take a lot of time. And a lot of sifting.
But start with the 25 stocks Richard Beddard lists on this page and the 13 stocks I mentioned above. That's 38 U.K. stocks right there. Richard Beddard's 25 are better than the 13 I listed above in terms of price. But it won't hurt to study the 13 stocks I mentioned in this post.
I've often found that my best investments come from stocks I study and pass on (because of price) only to buy the same stock some 4 or 5 years later when it has its Salad Oil Scandal moment.