Mexican cement manufacturers. Japanese shipping companies. Pulp-and-paper makers. Dull as dishwater to most investors.
"People don't like them. They have low expectations for them," says Bernard R Horn, head of Polaris Capital Management, with $1.8 billion under management. But such unglamorous businesses have handsomely rewarded Horn's shareholders.
His $400 million Polaris Global Value Fund has returned an annualised 17.7 per cent in the past five years, far outpacing the Morgan Stanley Capital World Index's 6 per cent.
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From his office in Boston, Horn scours the globe, from Scandinavia to Mexico, in search of dull stocks that happen to be cheap. The first thing he looks for in a company is not net earnings but free cash flow, which he defines as cash flow from operations minus maintenance-level cap-ex.
"It's useless to use net profits to compare companies globally," he says, as the figures can be easily manipulated or affected by local accounting and tax rules. A software company, for instance, could capitalise or expense the cost of software development, while steel companies' tax rates could vary based on the country in which they operate. But, says Horn, "There's either cash, or there isn't."
Though Horn is a self-described "cash-flow junkie," there is no good database, he says, that allows comparison between a company's free cash flow and that of its peers. Since companies don't break out maintenance cap-ex from expansion, he frequently has to estimate it. As a proxy, he suggests using the readily available ratio of price to the sum of net income and depreciation. (We'll do that for the ratios in this article, which are based on Horn's analysis as of Apr. 30.)
Horn begins with a universe of 24,000 companies in 50 countries, which he boils down to a 500-strong set of companies that look most promising by his cash-flow criteria. He then looks at those in more detail, often making visits.
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He typically holds 75 companies in his fund. In recent years he has found more value outside the US than in it. Only a third of the Polaris Global Value Fund's portfolio is in US stocks. Apart from 4 per cent in cash, the rest is in non-US equities, such as BHP Billiton , an Australian metals and minerals company that would be his largest holding had the recent UnitedHealth Group acquisition of Pacificare not rolled two of his holdings into one that was larger.
Most of the foreign companies in which he invests--increasingly, these days, Japanese telecom and shipping companies--are not traded in the U.S., even as American Depositary Receipts. Ambitious investors can get their brokers to buy on overseas bourses. But from here on we'll focus on the more accessible foreign stocks, ones with ADRs.
One Horn favors is Cemex, a $15 billion cement business headquartered in Monterrey, Mexico. The world's third-largest cement company, with operations in 50 countries, it is a big player in Mexico and other emerging markets, where construction is on the rise, and increasingly in the booming regions of the southwestern and southeastern US, where a shortage of cement needed for rebuilding after last year's hurricanes has helped pushed up prices. Cemex trades at 7.2 times, versus 10 times for construction materials companies.
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Horn likes SK Telecom, which holds the dominant position in the South Korean telecommunications market. That is not a huge market, but it happens to be a world leader in demand for mobile and broadband. Every new technology--such as Melon, which lets users listen to digital music on MP3 phones--means a new revenue stream for the $10 billion (2005 sales) company. It trades at 6.4 times net plus depreciation, compared with 6.9 times for the average wireless carrier.
Horn is cautious on Europe, but he sees a handful of companies worth a second look. Solvay, an $11 billion Belgian health care/chemicals/plastics concern, plans to expand in Asia; it trades at a multiple of 6.7 times, compared with 13.1 times net plus depreciation for its peer group. "It's a health care company at a chemical company multiple," says Horn.
ABN Amro, the Dutch bank that is one of the 25 largest in the world, with $1.2 trillion in assets, also appeals to Horn. ABN Amro, which in the U.S. owns the Midwest midmarket bank LaSalle, is fast expanding its retail footprint in Europe; in April it agreed to buy Banca Antonveneta of Italy for $9.2 billion. The stock is cheap because investors don't like acquirers, since acquirers pay premiums to get other companies. Not to worry, says Horn. ABN Amro, with an efficiency ratio of 69 per cent, looks to have some tempting fat to cut, and bank consolidation worldwide is so powerful that someday this acquirer could itself be bought up at a premium.
Ireland's CRH is another cement-and-aggregates producer Horn likes. Management at the $18 billion group, he says, pours above-average profits out of the mundane ready-mix concrete business. Half of CRH's sales come from the Americas, where it is benefiting from the reconstruction frenzy in southern states. At ten times cash flow, CRH trades at the same multiple as its peer group.
Overcapacity has weighed down European pulp-and-paper stocks. But in January some of Europe's largest paper companies said that they would close 10 per cent of their factories to more closely align supply with demand. One firm that stands out is UPM Kymmene, of Finland, with $11 billion in sales; its multiple is 7.
Marathon Oil, a medium-size oil explorer and (in the Midwest) large-scale oil refiner also catches Horn's bargain-hunting eye. Its multiple is 6.4, against 9.3 for the sector.
