Guide to Foreign Stock Investments

Many more stocks trade outside of the United States than within. Depending on which stock markets one includes or excludes and the criteria one uses to select stocks, the universe of available investments may be three or four times as large.

This guide is for people who are interested in the idea of investing in foreign stocks but are uncertain of how to proceed.

Table of Contents

Which Countries?
Choosing a Broker
What Types of Accounts
How to Find Foreign Stock Ideas
Researching Foreign Stocks
Trading Foreign Stocks
Foreign Currency Transactions and Exposures
Currency Exposure Management
Taxes and Paperwork

Which Countries?

The best stock foreign stock markets are the ones that are best positioned to help you meet your investment and financial objectives.  While there are many variables to consider, we would begin the process of investing in foreign stocks by focusing on three variables:  transaction costs, counterparty risk and regulatory risk.

TRANSACTION COSTS

Does foreign stock investing make sense for both short-term and long-term investors?  The cost of trading varies tremendously from market to market.  In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States.

If one is a momentum investor who expects to trade frequently, one will want to focus on the stock markets that have the lowest trading costs.  If one’s investment strategy focuses on undervalued stocks and one does not expect to trade frequently, higher trading costs may not represent a significant barrier to investing in a specific stock market.

The cost of trading varies tremendously from market to market.  In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States.  One typically finds low costs if the stock exchange is all-electronic and the settlement of trades is by book- entry only.

In other cases, the market structure may involve floor brokers and the exchange of physical stock certificates.  Trading such markets may cost much more than what one expects in the United States.

One must also consider the cost of converting currencies.  Currency conversion costs range from negligible to a multiple of the commissions one pays to trade a stock.

COUNTERPARTY RISK

Counterparty risk pertains to getting paid.  For example, one executes a trade to sell a stock at $50.00 per share.  One sends the shares to the buyer’s broker.  Do they send the cash immediately, or days later according to local business regulations?  Alternatively, one agrees to buy stock for $50.00 per share.  One sends the cash to the seller’s broker. Do they send back the shares immediately, or later?

What happens if the counterparty goes bankrupt after they have received the shares one sold, but before they have sent back the cash?

For the typical U.S.-based investor who uses a U.S.-registered broker to buy or sell U.S.-registered stocks, the U.S. regulatory and market structure reduces counterparty risk to the bare minimum.

One cannot assume the same if one invests in foreign stocks.  There may substantial delays between the movement of cash and the movement of shares.

Wealthier countries tend to have structures in place to reduce this type of counterparty risk.

REGULATORY RISK

Although far from perfect, the United States maintains a fairly rigorous regulatory structure for stocks.

The same cannot be said for other countries.  Foreign stock regulators may not have a well-developed regulatory structure to protect the interests of investors.

Where ample regulations exist, the funding to enforce the regulations may not.  If the foreign government does not provide adequate funding, there may not be a sufficient number of regulatory personnel to discourage unethical or criminal behavior.

One should also consider account insurance.  Brokerage accounts in the United States are insured against certain types of theft and similar losses by the broker.  A foreign broker may not protect the investor in that way.

POSSIBLE SOLUTIONS

In deciding what foreign stock markets in which to invest, one can design a due diligence process to bring some clarity to the issues of transaction costs, counterparty risk and regulatory risk.

Alternatively, one can limit oneself to trading only those markets that are available through a U.S.-registered broker.  Doing business with a U.S.-registered broker does not eliminate the need to do research on foreign markets.  But we believe doing so will narrow some of the risks because most reputable U.S.-registered brokers will have due diligence processes in place to protect their customers.

Choosing a Broker

One’s choice of a stock broker is an important consideration.  One should think about the range of offerings and the likely transaction costs.

RANGE OF OFFERINGS

No single broker offers access to the top 30 or 40 stock exchanges.  In the United States, the broadest offering covers stocks traded in 25 different foreign countries.  The least costly broker offers access to stocks traded in 15 foreign countries.

The U.S.-registered brokers offer access to almost all of the economically advanced countries.  They exclude certain important developed ones, notably Taiwan, South Korea and Israel.  They also exclude some less developed countries, such as Philippines, Thailand, Malaysia, Indonesia, Russia, Egypt and Hungary.  Some of these foreign markets may offer outstanding value or momentum stocks.

If one wants access to countries that are not available through a U.S.-registered broker, one must open an account with a foreign broker. Foreign brokers operate under a different regulatory scheme.  Investor protections may differ.

TRANSACTION COSTS

The cost of trading foreign stocks is higher than what one generally encounters trading U.S.-registered stocks in the United States.

The higher cost may simply reflect a higher cost of doing business that the broker passes on to the customer.  If the foreign stock market employs large numbers of people rather than relying on digital trading technology, trading costs will be high.  Similarly, if the local business practices require the recording of share ownership changes by exchanging physical stock certificates rather than electronic entries into the shareholder register, trading costs will be high.

Currency trading costs must be considered separately.  Foreign stock exchanges settle trades in their own currency.  For the U.S. investor to buy the foreign stock, one must come up with foreign currency either by converting U.S. Dollars into the foreign currency or by borrowing the foreign currency.  The cost of converting or borrowing ranges from de minimus to exorbitant, depending on the broker.

Certain types of investment strategies may become untenable in the face of high transaction costs.  In that case, a strategy focusing on undervalued stocks may be best.

Finally, due to burdensome U.S. financial regulations, many foreign brokers refuse to allow Americans to open financial accounts.

What Types of Accounts?

What type of account should one use to fund investments in foreign stocks?

Should one use personal funds or the funds in one’s retirement account? If one has a trust account, should one use it to make the investments?  What about another structure – perhaps a corporation, a partnership, a limited liability company or something similar?

As one can imagine, the answer depends on the circumstances and what kinds of costs and uncertainty one is willing to accommodate.  Most of the challenges relate to taxes and to tax paperwork in particular.

Based on our research, we believe using a personal account to invest in foreign stocks minimizes the tax and paperwork hassles.  If one chooses the countries carefully, the tax compliance obligations could be as little as filing an extra form or two with the Internal Revenue Service.

Trust accounts can be tricky.  The basic problem is one of legal status or lack thereof.  Many countries are unfamiliar with trusts and have made no accommodation for them in their tax laws.  Lack of status can create unpredictable tax results.  Specifically, in such countries the foreign tax authorities may assign the trust income to someone other than the trust – perhaps a beneficiary, but maybe not.  In addition, the tax paperwork requirements for a foreign trust may be more onerous than for a natural person.

Individual retirement accounts face many of the problems of trusts because individual retirement accounts are trusts, too.  See Section 408(a) of the Internal Revenue Code:  “… the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries …” [emphasis added].  In addition, foreign governments may or may not recognize the tax deferral features of a U.S. individual retirement account.  

Corporations, partnerships, LLCs and similar entities introduce another layer of complexity.  You may face additional filing requirements based on the specifics of the structure, perhaps so the foreign governments can track the income of the owners of the entity.

How to Find Foreign Stock Ideas

How does one find a list of stocks that might be worthy of further research?

If one has large amounts of money to spend, one can subscribe to an institutional-quality research database.  The cost of such databases likely exceeds the resources of most small institutions or individual investors.

A cost-free alternative is the global stock screener offered by the Financial Times.  FT offers some predefined screens plus the ability for one to create a custom screen.  While the FT screener offers relatively few variables on which to screen, they offer enough to reduce the research list down to dozens of stocks from tens of thousands.

In some countries – particularly the Anglophone ones in which investing in stocks is a popular past time – active discussion boards and chat rooms can provide investment ideas.

Stock exchanges sometimes provide financial information about the shares they trade.  They may offer a simple screener to identify the more promising potential investments.

Newsletters focusing on foreign stocks are rare.  We searched hard for them and came up with nothing that met our requirements.  To plug this hole, we stepped up and created our own.  We offer two newsletters, designed to meet different investment styles:

  • The Global Deep Value Letter which focuses on undervalued stocks with good quality.  This letter is designed for the classic “value” investor.
  • The Global Value-Momentum-Quality Letter.  As suggested by the title, this letter looks for stocks that are attractive on three metrics – value, momentum, and quality.  This letter is designed for “momentum” investors who want stocks that have performed well.  Because investors can get carried away on the upside, this letter includes value as a stock selection criteria.  The stocks in this portfolio are not as undervalued as the stocks in the Global Deep Value Letter, but they nonetheless seem undervalued to us.

Researching Foreign Stocks

Let’s imagine that one has a list of foreign undervalued stocks that appear to have some potential.  Some people will throw caution to the wind and just buy them.  But most people will want to do additional research.

In the United States, obtaining financial information about U.S.-registered stocks is not difficult.  One can start with a company’s website.  Most companies having securities traded by the public include an “investor relations” page on their websites.  The page usually includes information about the stock and copies of important corporate filings.

If a company’s investor relations outreach is insufficient or non-existent, one can turn to the Federal government.  The EDGAR system of the United States Securities and Exchange Commission warehouses an enormous number of corporate filings.  If one knows the name or the trading symbol, one can obtain an indexed listing of a company’s filings.

One can also go to websites like Yahoo! or Morningstar to find financial information about U.S.-registered stocks.

If one is investing in foreign stocks, the research process is similar.  Many foreign companies maintain an investor relations page on their website.  If the company website does not provide adequate information, one may be able to find official corporate filings online, possibly with the Ministry of Finance (or equivalent), the securities regulator or the stock exchange that makes a market in the stock.

One should expect that foreign websites and financial filings likely will be in a foreign language.  If one cannot read the foreign language, one can obtain a translation for free by using Google Translate.  Simply cut and paste the text into Google Translate.  Even better, Chrome Browser users can click on the translate button in the right corner of the browser’s address bar.

Undervalued Stocks

When one clicks on the icon, this will appear:

Undervalued stocks

The translation may be of mediocre quality, but one can get the gist of what the page says.

If does not want to bother with document translation, one can consider websites that aggregate information about global stock opportunities.  For example, the Financial Times website can be searched for detailed financial and other information on specific stocks.

Trading Foreign Stocks

While not difficult to master, the mechanics of trading foreign stocks are a little different than trading U.S. stocks.  People investing in foreign stocks should plan accordingly.

FOREIGN CURRENCY

The most obvious difference is that foreign stocks are priced in a foreign currency.  For countries with currencies that have little value per unit, one should expect to see stocks trading for very large amounts of currency.  In the U.S., it would be unusual to see a stock trading for more than $2,000 per share.  In contrast, many Japanese stocks trade for more than 2,000 Yen per share.  With an exchange rate of more than 100 Yen per U.S. dollar, a Yen price of 2,000 is the equivalent of less than US$20.00.

DIFFERENT TRADING HOURS

The U.S. stock markets are open from 9:30 AM to 4:00 PM – a full six and a half hours.  Other markets may be open for shorter periods of time or may have more than one session during the day.  For example, the Tokyo Stock Exchange has two 150-minute sessions, one in the morning and one in the afternoon with a one-hour break between the two.

TIME ZONE DIFFERENCES

If one lives on the East Coast of the United States, trading in Japan is about one-half of a day ahead.  Thus, to trade Tokyo on Monday morning, one trades in New York on Sunday evening.  To trade Tokyo on Friday morning, one trades in New York on Thursday evening.  The Tokyo market is closed for the weekend during Friday New York regular business hours.

Europe’s regular trading hours are the equivalent of early morning for East Coast United States investors.

SYMBOL DIFFERENCES

Countries may have different types of symbols for stocks.  In the U.S. we use the letters of the alphabet.  Many countries have adopted the same practice.  In Japan, the symbols are numbers – e.g., “6160” or “6161.” Other countries use a combination of letters and numbers.

MINIMUM SHARE LOTS

In the U.S. and in many other countries, the minimum trade size is one share.  Other countries may require minimum trades of one hundred or even one thousand shares.

Foreign Currency Transactions and Exposures

When one starts investing in foreign stocks, one must learn to work with foreign currencies.

Foreign currency is an issue not just in the buying and in the selling of foreign stocks. If the stock does not rise or fall but the currency moves, one’s net worth (expressed in U.S. Dollars) will move solely because of the movement of the currency.

If one opens an account with a brokerage firm like Interactive Brokers, one has three options for managing currency exposure:

  • Exchange currencies;
  • Borrow currencies;
  • Hedge currencies using futures.

EXCHANGE CURRENCIES

One can exchange currencies as part of one’s investment program.  This means if one needs Japanese Yen to settle a trade, one sells U.S. Dollars to buy Japanese Yen.

The sale of a Japanese stock will settle in Japanese Yen.  If one needs U.S. Dollars, one sells the Japanese Yen to buy the needed U.S. Dollars.

Interactive Brokers charges a commission every time it exchanges currencies.  The commission is small.

BORROW CURRENCIES

Companies like Interactive Brokers also provide foreign currency margin loans.  Instead of having to convert U.S. Dollars into Japanese Yen in order to settle the purchase of a Japanese stock, one simply borrows as many Yen as one needs to settle the trade.  When one sells the stock, the proceeds from the sale (in Japanese Yen) are used to pay down the Japanese Yen margin loan.

Margin loans are a natural currency hedge.  One owns a foreign currency asset (the foreign stock) and incurs an offsetting foreign currency liability (the margin loan).

The brokerage firm charges interest on outstanding loan balances.  One must maintain sufficient collateral to avoid margin calls.

HEDGE CURRENCIES USING FUTURES

One can use futures to hedge currency exposures.  When one enters into a futures contract, one agrees to receive or to deliver foreign currency at a specific time in the future.

If one has a long futures position, one agrees to receive the foreign currency.  Economically, this is equivalent to owning the foreign currency. If one has a short futures position, one agrees to deliver foreign currency. Economically, this is the equivalent of having borrowed the currency.

Generally, one may hedge the currency exposure of a foreign stock position by going short a foreign currency futures position.

Trading futures incurs commission costs.  One must maintain adequate collateral to avoid margin calls on the future position.

Currency Exposure Management

Ownership of a foreign stock does not require one to assume the risk of the foreign currency.  One can easily reduce or eliminate altogether the risk of owning the currency while preserving exposure to the performance of the foreign stock.

If the prospects for a currency look good, then one might consider having an unhedged position.  This means taking on the full exposure to the currency.  In contrast, if the prospects for a currency do not look good, one might consider hedging the risk.

How does one decide whether a currency has good or not good prospects? While one can never know for sure what will happen to the price of a currency, we look at three variables:  price trend, interest rates and purchasing power parity.

PRICE TREND

We believe that a trend in place may have a tendency to continue.  Thus, if the trend of a currency is upwards (meaning it is becoming more valuable over time), we assume that the odds may be a little better that the currency will become more valuable in the near term.  Contrariwise, if the trend of a currency is downwards (meaning has been losing value over time), we tend to think that it may continue to lose value.

INTEREST RATES

In our view, currencies with higher yielding short-term investment opportunities may be more attractive than currencies with lower yielding short-term investment opportunities.  By short-term investment opportunities, we mean the highest quality government short-term bills, notes or bonds available to investors.

In comparing yields, one must make appropriate adjustments for differences in credit risk.  Governments with speculative credit grades should yield more than investment grade governments.

One should also make adjustments for inflation rates.  The currencies of high inflation economies may lose value faster than the currencies of low inflation economies.  Consequently, one should consider looking at the real interest rate by deducting from the interest rate the rate of inflation.  Currencies with higher real interest rates may perform better than currencies with lower real interest rates.

PURCHASING POWER PARITY

Another approach is to consider what equivalent amounts of currency can buy in each country.  If US$ 100 buys a nice gift, does the same amount of money converted into Euros buy two nice gifts?  If yes, then owning Euros may be a better idea than owning U.S. Dollars.

Taxes and Paperwork

Investing in foreign stocks likely will create additional tax paperwork and – possibly – some new tax liabilities for the investor. The nature of one’s new compliance responsibilities depends in part on the countries in which one chooses to invest.  For a number of countries, the foreign individual investor faces a light incremental tax compliance burden.  For a few countries, the hassles are significant.

THE NATURE OF TAX COMPLIANCE

Tax compliance includes two distinct concepts:

  1. Paying the correct amount of tax, and
  2. Filing the correct income declaration forms.

In many countries, one must do both correctly.  One can be fined for not paying the tax.  Even if one has paid the correct amount of tax, one may still have to file forms declaring the income that gave rise to the tax.  A failure to declare income on the correct form may itself give rise to a fine. If unpaid the fine can compound over time.

FOREIGN TAX COMPLIANCE

In most cases, calculating and paying the foreign tax is the easy part. Frequently, the foreign governments tax only the income from one’s foreign stocks.  The tax likely will be withheld fully from the dividends.  The dividend payor remits the tax directly to the foreign government.  In many cases (but not all), capital gains are entirely exempt from foreign tax.

Filing the correct paperwork is less clear.  A number of governments do not want the foreign investor to file forms if the investor’s income tax liabilities have been covered through the divided withholding system.  The dividend payor already has provided the information to the government when the payor remitted the withholding.  For the taxpayer to submit an additional return would impose an unnecessary cost on the foreign government’s tax administration.

However, not all governments feel this way.  One must take care to understand what paperwork the various governments require.  A review of the details vastly exceeds the scope of this post.  My book covers this information for a large number of countries.

U.S. TAX COMPLIANCE

While foreign governments may impose a light or no tax on the income and capital gains of U.S. investors in foreign stocks, the U.S. taxing authorities will fully tax such earnings.

The tax code provides for tax credits to offset taxes paid to foreign governments.  Thus, it is highly likely that one will not have to pay duplicative taxes to the U.S. and to foreign governments.  One may have to file an additional form in order to claim the foreign tax credit.

In fulfilling one’s U.S. tax compliance responsibilities, one will also have to pay attention to FATCA and FBAR.  These forms are less about measuring and taxing income than making sure that the taxpayer is not hiding foreign income from the U.S. tax authorities.  One does not want to make mistakes with these forms … the fines for non-compliance can be astonishing.  FATCA and FBAR mostly (but not entirely) apply to people who have foreign financial accounts.  Depending on the types of securities in which one invests, carrying on one’s foreign investment activities through a U.S. brokerage account may relieve one of having to file FATCA and FBAR forms.

 

Some stocks we have recommended in the past

Normally, we reserve our recommendations for our paid newsletter subscribers and/or our free email list subscribers.  We wrote about the following stocks to give “window shoppers” a sense of the ideas we consider:

Nihon Kagaku Sangyo
Cooper-Standard
Murakami
Fukuvi Chemical Industry
Nippon Antenna

Four of the five stocks are in Japan.  We have no particular bias for or against Japanese stocks – it’s just a reflection of where we are finding opportunities at this time.  Incidentally, we think Japan is an interesting situation.

 

Inflation monitor as of 12/13/2016

This post reviews a wide range of market-based and statistically derived measures of inflation.

Our takeaway:  inflation is probably in the 1.5%-2.5% range with an upward bias.

Backward Looking Measures

Consumer Price Index (CPI) – changes

The CPI is calculated by the government.  More than a few investors view the index with a degree of skepticism.

CPI:  +1.64%

Median CPI:  +2.50%

Core CPI:  +2.17%

Sticky CPI:  +2.48%

Core PCE:  +2.15%

Producer Price Index (PPI) – changes

The PPI is calculated by the government.  Some investors regard it with suspicion:

Finished Goods:  -0.05%

Wages

Wages are very important because they account for such a large portion of the cost of goods and services.

Average hourly earnings:  +2.45%

An increase in average hourly earnings does not translate into an equal amount of inflation.  Increases in productivity can offset (entirely or partially) the inflationary effect of higher wages.

Billion Prices Project

The billion prices project estimates the annual rate of inflation by using prices posted by online merchants.

As of 9/15/2016, BPP estimates the U.S. inflation rate at about 0.4% per month, which is about 4.5-5.0% annualized.

Purchasing Manager’s Index

The Institute for Supply Management publishes the results of a monthly survey of their members, including a price diffusion index.  A diffusion index doesn’t tell us the rate of inflation, but rather what percentage of the survey respondents are seeing prices go up or down.

The survey results suggest no significant inflationary pressures.

Manufacturing Prices:  54.5

Services Prices:  56.3

FED REGIONAL MANUFACTURING SURVEYS

Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion Indices – past month

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

New York Prices Paid:  22.6

New York Prices Received:  4.7

Philadelphia Prices Paid:  7.0

Philadelphia Prices Received:  -3.7

Kansas City Raw Materials:  0.0

Kansas City Finished Goods:  -5.0

Dallas Raw Materials:  13.7

Dallas Finished Goods:  1.2

Estimated inflation – past month

Richmond Raw Materials:  1.17

Richmond Finished Goods:  0.64

Forward Looking Measures

Treasury Inflation Protected Securities

In addition to ordinary bonds, the U.S. Treasury issues inflation-protected securities (TIPS).  By comparing the yields, one can infer the inflation forecast of the capital markets.

Ordinarily one should assign high credibility to this type of information. However, caution may be appropriate given extensive central bank manipulation of the credit markets.

Five Year Forecast:  1.83% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  1.95% per annum (10Y Treasury Yield10Y TIPS Yield)

5-Year, 5-Year Forward Inflation Expectation Rate

Inflation expected from 5 years from now to 10 years from now:  +2.07%

Fed Regional Manufacturing Surveys

Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion indices – 6 month forward estimate

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

Kansas City Raw Materials:  19.0

Kansas City Finished Goods:  18.0

Dallas Raw Materials:  25.9

Dallas Finished Goods:  14.0

Estimated inflation – 6 month forward estimate

Richmond Raw Materials:  1.51

Richmond Finished Goods:  0.71

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.3

5-Year Expected Rate of Inflation:  +2.5

ECRI U.S. Future Inflation Gauge

ECRI +0.4

Trend-based indicators

Crude Oil:  Uptrend = inflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Uptrend = deflationary pressure

Nihon Kagaku Sangyo Co., Ltd. (TSE:4094) appears undervalued!

Summary points:

  • Industrial company focused on chemicals and building materials
  • Strong balance sheet, consistently profitable
  • The stock appears deeply undervalued.
  • 2.6% dividend yield

Nihon Kagaku Sangyo Co., Ltd. (TSE:4094) appears undervalued.

Nihon Kagaku Sangyo Co., Ltd., is an industrial company that has been in business for many decades. According to the company’s website, it has two business segments: Chemicals and Building Materials.

The Chemicals segment produces catalysts for a wide range of customers. It also produces. “chemicals for plating, coating materials, printing ink, electrical conductivity, ceramics and glass, and battery materials.”

The Building Materials segment builds on the company’s expertise in chemicals. In this segment, the company uses aluminum, steel and stainless steel to make products used in residential and commercial office construction.

The company’s businesses appear mature. Growth has been minimal over the past few years.

The balance sheet appears very strong. Cash is about 40% of total assets. The current ratio is nearly 5.4.

Cash from operations has averaged about 2,650 – 2,700 million Yen per year. With capital spending of 800-900 million Yen per year, free cash flow averages more than 1,800 million Yen per year. The company has 20.7 million shares outstanding. Therefore, free cash flow per share averages around 80 – 90 Yen.

On November 17, 2016, the stock traded at about 790 Yen. Cash per share is more than 680 Yen and net current assets per share is about 850 Yen per share. The stock trades for a little more than cash per share and it trades for less than net current assets per share.

Price-to-Free-Cash-Flow (P/FCF) is a little more than 9x. If one deducts cash per share from the stock price, P/FCF drops to only 1.3x.

The stock has no obvious catalyst to trigger a significant revaluation in the near term. In addition, Japan’s sub-par economic performance over the past decade or two is well known. However, change is afoot in Japan. The Stewardship Code of 2014 and the Corporate Governance Code of 2015 are encouraging Japanese companies to become more focused on improving shareholder returns. Management teams are increasingly accountable for taking proactive steps to improve returns. Major institutional shareholders are also increasingly accountable for exercising more vigorous oversight over the companies in which they invest.

With a strong balance sheet and a deeply undervalued stock, Nihon Kagaku Sangyo has some obvious opportunities to increase shareholder value:

  • A stock repurchase program
  • Recapitalizing the company
  • Selling the company to a strategic buyer

In increasing value for the shareholders, we would like to see management take advantage of the undervalued stock price. They could also simply increase the dividend – there is more than enough free cash flow to increase the payout by a significant amount.

By our calculations, pretax returns on net invested capital are in the high single digits. Based on these returns, we believe the company should minimize reinvestment in its core business, unless management can raise returns on capital. We think buying back stock at these levels is a better use of the shareholders’ money.

One can buy Nihon Kagaku Sangyo through a broker like Interactive Brokers.

Did you like this investment idea?  Click here to subscribe to our newsletters.

This article is information purposes only. It is not investment advice nor an offer of investment advice. The author does not currently have a position in the stock. Please d0 your own due diligence, as you bear the entire risk of your investment.

 

Investment Process

We believe that all investors should have an investment process in order to improve performance. Having an investment process can improve results for the following reasons:

  1. Focusing investor attention on the information that can improve returns.
  2. Risk control.
  3. More efficient use of time.
  4. Better control over the emotional effects of investing money.

An investment process consists of five parts:

  1. A universe
  2. Evaluation criteria
  3. Buy rules
  4. Sell rules
  5. Portfolio Construction Rules

Portability is the ultimate test of an investment process.  An investment process is portable if, when followed, it results in the same portfolio no matter who is using the process.  If one’s investment process is portable, then one can be certain that one actually has a well-articulated investment process.

On the other hand, if one’s investment “process” is not portable, the results vary according to who implements the process.  In this case, one may or may not actually have a real investment process.  Therefore, one may or may not obtain the performance benefits of having an investment process.

THE UNIVERSE

Defining the “universe” is the first step of creating an investment process.  The universe includes all of the opportunities that one could conceivably consider for investment.  It should be defined broadly.

An investment process for stocks could start with the membership of a broad-based index.  For example, one could define the domestic stock universe as the membership of the S&P 500 index.  Any stock in the S&P 500 is eligible for investment; any stock not included in the S&P 500 is not.

If one wants to cast a broader net, one could use the Russell 1000 membership as the universe.  Doing so would double the opportunity set compared to the S&P 500.  Or, one could choose the Russell 3000 and thereby expand the opportunity set six-fold compared to the S&P 500.
If one has the opportunity to invest in international stocks, one could consider a broad global index of stocks such as the MSCI All Country World Index (ACWI).

In general, one should opt for the universe that maximizes the opportunity set.  Why limit oneself?  But there may be reasons to consider narrowing the definition of the universe.  For example, one may want to avoid the following types of stocks:

  • Ones that are unavailable through your stock broker.  Such opportunities are unavailable unless one opens an account with a different stock broker who is willing to let the investor buy and sell such securities.
  • Ones that trade infrequently.  Infrequently traded stocks can be expensive to buy and sell.  The potential returns may not be justified in light of the high cost of trading.
  • Ones that do not pay a dividend.  The investor may have an income requirement that will not be met by stocks that don’t provide income.
  • Ones that are not included in a specific index, if it is important that one’s investment returns track that index over time.
  • Ones domiciled in a country that lacks long-term investment appeal in some way.

EVALUATION CRITERIA

Evaluation criteria are the second part of an investment process.  Unless one invests in every opportunity that comes along, everyone has some criteria for making buy and sell decisions.  The effectiveness of the criteria can range from substantial to non-existent to counterproductive.

For stocks, any of the following could be evaluation criteria, although not all are effective:

  • Dividend yield:  the actual dividend yield, a “flag” if the company pays any dividend, etc.
  • The total return of the stock over some period of time:  3 months, 6, months, 9 months, 12 months, 36 months, 60 months, etc.
  • Profitability:  return on equity, return on assets, gross profit return on assets, pretax return on assets, etc.
  • Earnings quality:  accruals as a percentage of assets, changes in days sales outstanding, changes in days inventory on hand, etc.
  • Growth:  sales growth, profit growth, asset growth over various periods of time (12 months, 24 months, 36 months, etc).
  • Insider transactions:  number of shares sold by insiders over the past three months (or 6 or 9 months), number of insiders selling shares, evidence of insider buying, etc.
  • Information about the Chief Executive Officer:  his age, where he went to college, the number of years he has been with the company, etc.
  • The industry in which the company competes:  oil and gas, retail, clothing, automobiles, etc.

For each criteria, one must decide what one considers attractive or unattractive.

  • In the case of dividend yield, a higher yield may be considered more attractive than a lower yield.
  • For insider transactions, evidence of insider buying could be more attractive than evidence of insider selling.
  • For industries, one would have to make a determination that some industries are better for investment than others.  Companies in those industries would be considered more attractive than companies in other industries.

Historically, not all evaluation criteria are effective at predicting what stocks will tend to do better.  We tend to favor criteria that focus on valuemomentum and quality – please see the hyperlinks for more information and for our reasoning.

BUY RULES

Buy rules are the third part of an investment process. Buy rules are the specific criteria that lead the investor actually to invest money at a specific point in time.

In many cases, the buy rules overlap significantly with the evaluation criteria.  For example, let’s imagine that one has a process for investing in stocks, and the evaluation criteria is a combination of valuemomentum and quality.  The evaluation procedure results in a ranking of all the stocks in the investable universe, in order of attractiveness.  One could have a single buy rule:  the portfolio invests in the top 50 ranked stocks.

While such a buy rule could suffice, in practice it overlooks a lot of important information.  For example, what happens if the 51st most attractive stock becomes the 50th most attractive stock?  Statistically speaking, the change in rank likely does not mean much in terms of expected returns.  However, a strict application of the “top 50” buy rule requires that one purchase the new stock at once.  What happens if the 100th rank stock suddenly becomes the 50th rank stock?  That change may be more meaningful and thus merit action.  Alternatively, the change may be the result of some temporary data or data processing problem.  Should one implement immediately, or is it better to wait for a period of time?

There are a wide range of potential buy rules that one could consider.  The following come to mind:

  • Does one execute the purchases on a specific day of the month or week?
  • Does one buy the entire position at once, or spread the purchases over a period of time?
  • Does one start with a small position and then add to it if the stock starts to advance?  Some investors call this practice “pyramiding.”
  • Does one start with a small position and then buy more if the stock declines?  This is called “averaging down.”
  • Does the purchase of the stock depend on some other variable?  For example, does one purchase only if the stock market (defined perhaps by the S&P 500) as a whole is above its 200-day moving average? Alternatively, for a stock that tends to be sensitive to changes in interest rates, does it one buy if interest rates are behaving in a certain way?

SELL RULES

Sell rules are the fourth part of an investment process. Sell rules are the specific criteria that cause the investor to sell a specific position at a point in time.

The sell rules may or may not bear any relation to the evaluation criteria or the buy rules.

For example, consider a process for investing in stocks, that uses as evaluation criteria valuemomentum and quality.  The evaluation procedure results in a ranking of all the stocks in the investable universe, in order of attractiveness.  The buy rule is simple: make sure the portfolio owns the top 50 stocks in equal dollar amounts (2% of portfolio value).
In this case, the sell rules would be simple: First, sell any stock that is no longer one the top 50 most attractive stocks. Second, for those stocks that are in the top 50 by the evaluation criteria, sell down to a 2% weight any stocks that have more than a 2% weight in the portfolio.

However, while simple these sell rules are incomplete. For example, how frequently does one implement the sell rules? Daily? Weekly? Monthly? Which day of the week or month? What time of day?

In addition, should one sell a stock if its rank slips from position #50 to position #51? From a statistical perspective, the expected returns may be the same. If so, is it worth the transaction costs to sell the stock?

The investor has many potential sell rules from which to choose.  The following come to mind:

  • When does one execute the sell transactions?
  • Does one sell all of a position at once, or spread the sale over a certain time interval?
  • Does one sell some of an investment that does well, so as to prevent any one position from becoming too big in the portfolio?
  • Does one sell a position if it falls by a certain amount, as in a “stop loss?”
  • Does one sell a position after a certain amount of time elapses?
  • Does continued ownership of the position depend on another variable? For example, does one sell the position if the stock market as a whole starts going down, or interest rates change in some way?

PORTFOLIO CONSTRUCTION RULES

Portfolio construction rules are the fifth part of an investment process. Portfolio construction determines how much money one puts into each investment. Portfolio construction does not answer the question “what?” but “how much?”

There are five basic approaches to portfolio construction: equal weight, return weight, risk parity, mean -variance and constrained.

  • Equal weight portfolio construction is self-explanatory: each opportunity receives an equal dollar investment. Thus, if one has forty investment opportunities, one invests an equal amount – 2.5% of the portfolio – in each opportunity. Equal weight has the advantage of simplicity. But it ignores some obvious considerations: for example, the opportunities may not have the same expected return or expected risk. Consequently, equal weighting may not create an optimal portfolio design.
  • Return weight means the opportunities that offer the highest expected returns receive the greatest monetary investment. For example, if stock A has twice the expected return of stock B, stock A could receive double the dollar investment of stock B. Alternatively, if the investment process invests in the top 50 stocks by return, one could give 50 units of capital to the most attractive stock, 49 units to the second most attractive stock, 48 units to the third, etc.
  • Risk parity means that lower risk opportunities receive more investment than higher risk opportunities. One risk parity approach is to scale the dollar investment in a specific opportunity as the inverse of expected volatility. Thus if stock A is expected to be twice as volatile as stock B, stock A receives half of the investment that stock B receives. If stock A has triple the expected volatility of stock B, stock A receivesone-third of the investment that stock B receives.
  • Mean-variance combines the return weighting and risk parity approaches, with the goal of maximizing the ratio of expected return to expected risk.
  • Constrained may include elements of equal weighting, return weighting and/or risk parity. But constrained also may require investments in specific opportunities in order to control perceived risk. For example, an investment process for stocks may include a portfolio construction rule that the portfolio is invested in all economic sectors at all times; or in large-, medium- and small-sized companies according to the weightings of such companies in a commonly used stock market index such as the Russell 3000; or in such a manner that the portfolio’s weighting in each stock varies by no more than one percentage point from the weight in a stock market index.