The Investment Checklist

by Michael Shearn

  What Are the Risks to a Company’s Foreign Earnings?

  Foreign earnings are impacted by many factors that are often outside of the control of the business. These include country risks (the political and social climate as well as local customs and regulation), and currency fluctuations. In other words, there is a risk that a business will lose money in a foreign market due to external factors. Let’s take a closer look at each type of risk.

  Country Risks

  You need to understand the risks of doing business in each of the countries where a business earns more than 10 percent of its revenue. For example, Brazil has a complicated tax code and archaic employment laws. (The cost of hiring someone is usually about 100 percent of that person’s base salary, per month, in addition to the base salary.) Apple does not have any stores in Brazil, even though Brazil is one of the fastest-growing consumer markets in the world: When CEO Steve Jobs was asked why he did not operate in Brazil, he said the “crazy, super-high tax policies” were too much for his company.9

  Be careful extrapolating the past success of a business in a foreign market into the future. You need to consider that the government policies for foreign investment can easily change. Many foreign businesses operating in China have had high revenue growth in that market. When China first began to open its economy to foreign businesses, it needed foreign capital, so it encouraged multinationals to do business in the country with many incentives and benefits. As China’s reliance on foreign capital has decreased, it is imposing tougher rules on multinationals. Some business executives have suggested that the Chinese government is reassessing its long-standing emphasis on opening its economy to foreign business and is instead favoring state-owned enterprises (SOEs). By instituting tougher government policies and regulations for multinationals, the Chinese government is intensifying domestic competition.

  For example, state-run media in China reported that the government plans to increase the market share for domestic car manufacturers to more than 50 percent of passenger vehicles by 2015, from 44 percent in 2009. This will hurt non-domestic carmakers, such as Volkswagen AG and General Motors, who have benefited from the growth in demand for cars in China and have reported high revenue growth rates there in the past.10

  Another example of Chinese protectionism is in the wind-turbine industry. Although foreign technology in wind turbines is superior, foreign market share has dropped from 75 percent in 2004 to 14 percent in 2009, with no foreign turbine maker winning a national bidding project since 2005.11

  There are many resources you can use to understand the difficulties of doing business in specific foreign markets. You can often learn more about the risks of operating in a particular country through the World Bank, which publishes a Doing Business Report, which ranks countries according to the ease of doing business in them. Brazil, for example, ranked 127 out of 183 countries in 2009.

  You can also use resources such as Business Monitor International’s (BMI) Country Risk Reports to get an understanding of the business environment for a particular country. These typically cover political and macroeconomic issues and industry and operational risks in each country.

  Currency Risks

  One risk to international earnings is changes in the currency rate. For example, if you have a plant in Canada that manufactures a product and sells it to the United States, then the costs for the plant are in Canadian dollars and sales are in U.S. dollars. If the U.S. dollar depreciates against the Canadian dollar, the margins of the business will decrease because each dollar is now worth less when converted to Canadian currency.

  Most businesses protect their exposure to changes in currencies by hedging, which allows a business to lock in predetermined foreign-exchange prices for future costs or revenues. The forward contract (where companies can lock in an exchange rate ahead of time) is the most common type of tool used to reduce the impact of currency fluctuations. You need to determine how a business protects itself against currency changes and how it hedges. The notes to the financial filings will often reveal how a business hedges its currencies. You can also read articles about how the business hedges its currency.

  For example, by reading an article, my firm learned that Lincoln Electric (a manufacturer and reseller of welding and cutting products worldwide) has a policy in place whereby it hedges at least half of its exposure to another currency once that exposure exceeds a predefined threshold.12 By learning more about how a business hedges its currencies, you can measure the amount of exposure it has to currency movements.

  Many times, a business will disclose the exposure it has to various currencies. For example, Louis Vuitton Moët Hennessy (LVMH, which makes and sells luxury goods and spirits) breaks out its sources of revenue denominated in foreign currency in its 2009 annual report:

  Euro 30 percent

  U.S. dollar 27 percent

  Other currencies 28 percent

  Yen 10 percent

  Hong Kong dollar 5 percent

  Even though LVMH hedges most of its currency exposure, this information may give you additional insights.

  Most businesses will report the impact of changes in currency in their public filings. Most of the time, the impact is low due to hedging. For example, watchmaker Swatch Group’s 2009 annual report shows that foreign currencies negatively impacted sales by Swiss Franc (CHF) 105 million or −1.8 percent, mainly in the second half of 2009.

  If a business reinvests the revenue it earns in a foreign country back in the same currency, then it will not need to hedge. This is often referred to as a natural hedge. For example, Brookfield Asset Management (a global asset manager focused on property, renewable power, and infrastructure assets) does not hedge its exposure to currencies because it often reinvests the money it earns from foreign countries back into the same country. This reduces its exposure to currency movements.

  Key Points to Keep in Mind

  Understand How the Business Makes Money

  If you can’t understand how a business makes money, then you should not invest in it.

  You will gain a deeper understanding of a business if you learn how the business has evolved over time.

  If you are having a difficult time understanding a business, ask what the customer’s world would look like without its products or services.

  To simplify a business description, find an analogy that best explains how the business operates.

  Evaluate Current and Potential Foreign Markets

  When a business first enters a foreign market, it often experiences high initial revenue growth rates. Projecting such growth into the future is usually a mistake because new markets will, of course, stabilize at some point.

  A management team that is committed to a foreign market invests for the long term, adapts its products to the specific tastes of that market by investing in R&D, and assigns a specific regional manager to emerging markets.

  A management team needs to be prepared to commit enough resources in order to sustain growth in a foreign market.

  1. Standard & Poor’s Capital IQ.

  2. VCA Antech 2008 10-K.

  3. Ball, Deborah. “Slow and Steady Is Winning the Race and Driving Nestlé.” Wall Street Journal, September 25, 2002.

  4. Gunther, Marc. “The World’s New Economic Landscape.” Fortune, July 26, 2010, pp. 81–82.

  5. Arndt, Michael. “Urban Outfitters’ Grow-Slow Strategy.” BusinessWeek, March 1, 2010, p. 56.

  6. Gunther, “Economic Landscape,” pp. 81–82.

  7. Boyle, Matthew. “Wal-Mart’s Painful Lessons.” BusinessWeek Online, October 14, 2009.

  8. Mijuk, Goran. “Nestlé Bets on Emerging Markets.” Wall Street Journal, June 22, 2010.

  9. Bevins, Vincent. “Working to a Different Beat.” Financial Times, December 16, 2010.

  10. Browne, Andrew, and Jason Dean. “Business Sours on China: Foreign Executives Say Beijing Creates Fresh Barriers; Broadsides, Patent Rules.” Wall Street Journal, March 17, 2010.

  11. “Pernici
ous Innovation?” China Economic Review, September 2010, p. 10.

  12. Kroll, Karen M. “Currency Risk: To Hedge or Hedge Not?” Business Finance, June 2007, pp. 35–39.

  CHAPTER 3

  Understanding the Business—from the Customer Perspective

  Customers are the lifeblood of a business. In fact, the quality of a business is determined by the quality of its customers. At the end of the day, they are the stakeholders who determine the fate of a business. If customers are not satisfied with a business, they will eventually find alternatives, or an entrepreneur will create an alternative if one does not exist. The more you can understand a business from the customer’s perspective, the better position you will be in to value that business, because satisfied customers are the best predictor of future earnings for a business. As Dave and Sherry Gold, co-founders of dollar store retailer 99 Cent Only Stores, often say, “The customer is CEO.”

  One of the main pitfalls in researching a business is viewing the business from your own perspective, instead of viewing the business from the customer’s perspective. This is one of the areas where investors make the most mistakes. Most investors allow their personal likes and dislikes to influence their analysis of a business. If you really like Nike tennis shoes, for example, then you will look at Nike’s business in a more favorable light. Try to disregard how you feel about a business: What you personally like is irrelevant to investing.

  To begin thinking like the customers and to understand how they interact with the product or service on a day-to-day basis, you need to interview real customers. You need to determine why they shop at a business or use its services and, most important, if they will continue to buy products and services from the business.

  For example, when I first researched 99 Cent Only Stores, I paid for the items of more than 50 customers in order to solicit their feedback on why they shopped at the store. 99 Cent Only Stores carries a variety of items, but it’s really more of a grocery store. It often sells brand-name products that it can obtain at discount prices because manufacturers discontinue certain products, change labels, or make other changes that make an older version of the product obsolete. For example, they might sell candy bars that have movie advertising or tie-ins: The candy bar is still good, but the movie is no longer playing in theaters. My goal was to understand how customers made the decision to shop at 99 Cent Only Stores, rather than trying to guess why they shopped at the store.

  As part of my research, I visited 120 out of the 150 total stores. It took about four months, as I ended up visiting about 10 stores each day in California, Nevada, Texas, and Arizona. Because the stores tend to be fairly close together, it was reasonably easy to visit so many locations. Although I didn’t interview customers at every store I visited, I did take the time to speak with as many as five or 10 each day.

  First, I picked store locations that represented different ethnicities and economic groups, to make sure I was interviewing a diverse and complete customer base. Once in the stores, I looked for people purchasing more than 20 items, which indicated to me that they shopped at the store frequently. Then I approached them and told them that I was researching how customers shopped at 99 Cent Only Stores and that if they agreed to a short interview about their purchases, then I would buy 10 items for them. I was looking for any patterns in their responses about why and how often they shopped at the store. I also asked them what would change their opinion about shopping there.

  I learned that most customers shopped at the store because they could buy smaller package sizes and thus increase the variety of their grocery purchases. These customers were on a tight budget, so if they shopped regularly in grocery stores or other retailers, they would be forced to buy fewer items to meet their budget. By shopping at 99 Cent Only Stores, they were able to stretch their budgets. This information helped me understand the true competitive advantage of 99 Cent Only Stores. Once I understood the competitive advantage, I could then carefully monitor any threats to that advantage, such as competitors offering smaller packaging sizes or the company offering less variety.

  Interestingly, Wall Street analysts spend very little time viewing the business from the customer’s perspective. More time is spent constructing detailed financial models and talking to the management team than trying to understand the business from the customer’s viewpoint. The main reason for this is that it takes a lot of time to locate and interview customers, whereas most management teams are readily accessible to Wall Street analysts.

  7. Who is the core customer of the business?

  You need to determine who the core customer of the business is. Many times, a small percentage of customers will represent a large percentage of revenues for a business. For example, the management team at Whole Foods Market used to disclose that it believed 75 percent of purchases were made by 25 percent of the customers who shopped exclusively at the store. My firm conducted its own due diligence by speaking with customers, suppliers, customer demographic information services, and competitors, and we learned that this was generally true. This information helped us continue to buy more stock in Whole Foods Market when the economy entered into a recession in 2007 and the stock price dropped from $37 per share at the beginning of 2008 to as low as $8 per share in November 2008.

  At the time, many other investors believed that Whole Foods Market was a high-priced grocer and that its customers would abandon the store in search of lower prices. However, because my firm had taken the time to understand the core customer of the business, we believed these loyal customers who shopped exclusively at Whole Foods Market would not move to competitors, but instead they might simply decrease the number of items they purchased. Within a year, we got confirmation of this, as Whole Foods Market disclosed that sales had not dropped as much as investors had anticipated, and the stock price recovered to more than $30 per share. By identifying the core customer of a business, you will be able to gain an in-depth understanding of a business, and you will be in a position to carefully monitor customer trends.

  As you begin to learn more about the business’s core customers, you want to understand how the business caters to them or whether it attempts to cater to too many types of customers. For example, electronics retailer Best Buy attempts to figure out which customers make them the most money and then segments them. It has names for each type of customer, such as “Barry,” an affluent tech enthusiast, and “Buzz,” a young gadget fiend. By segmenting its customers into different categories, Best Buy is able to tailor its inventory to a particular location based on the composition of customer types in that area. For example, to attract Barry, Best Buy has created a separate department for home-theater systems that has specialists who can answer most questions on the products. Best Buy also trains its employees to recognize these customers so that the employees can encourage them to spend more at the store or come back more often.1

  Paccar is a manufacturer of heavy trucks that is a great example of a company that has built its product around its core customer, the owner operator. Owner operators buy the truck they drive and spend most of their time in it. They work for themselves, either contracting directly with shippers or subcontracting with big truck companies. Owner operators care about quality first, and want amenities, such as noise-proofed sleeper cabins with luxury-grade bedding and interiors. They also want the truck to look sharp, and Paccar makes its Peterbilt and Kenworth brand trucks with exterior features to please this customer. Paccar also backs up the driver with service features, such as roadside assistance and a quick spare parts network. Because owner operators want this level of quality and service, they are less price sensitive, and they will pay 10 percent more for these brands.

  In comparison, Paccar’s competitors sell to large truck-leasing businesses or customers that operate large fleets. Because these customers buy in bulk, they can negotiate lower prices. By choosing a customer base that is more fragmented and discerning, Paccar avoids selling its trucks at a lower price, which allows it to earn high
er profits compared to its competitors.2

  8. Is the customer base concentrated or diversified?

  A business that earns its revenues from a diversified customer base has less risk than one with a concentrated customer base. If a business is dependent on few customers, then these customers can influence the price a business charges for its goods or services, and the loss of one customer can have severe financial consequences.

  For example, there are thousands of auto suppliers, yet only a couple dozen giant automakers. Therefore, if even the most diversified auto supplier lost a couple of automaker clients, it would be difficult to make up this business elsewhere, as there are only so many giant automakers. The auto supplier might either go bankrupt or lose a significant amount of its revenues.

  If a business has revenues from one customer that exceed 10 percent of total revenues, then the amount of revenues from each of these customers must be disclosed in the 10-K as well as the name of the customer. For example, the June 30, 2010 10-K for American Woodmark, a cabinet manufacturer states:

  During the last fiscal year, American Woodmark had two primary customers, The Home Depot and Lowe’s Companies, Inc., which together accounted for approximately 71 percent of the Company’s sales in its fiscal year ended April 30, 2010. The loss of either customer would have a material adverse effect on the Company.