Morningstar Advisor - Fall 2007 - 31

Companies in global industries such as oil, health care, and consumer staples get an especially big portion of their revenues from foreign sources, no matter where they’re headquartered. foreign funds are certainly giving investors exposure to the U.S. economy. It Still Pays to Travel If correlations between markets are high and companies more global, why bother with investing in international markets? First, even though we’ve seen correlations move higher in the past 20 years, global markets do not move in lockstep. In fact, in the past two years, correlations have come down a bit, as foreign-market returns have benefited from the weakening U.S. dollar. Also, exposure to different currencies provides diversification benefits—something that could continue to be a near- to medium-term benefit considering the United States’ trade and current account deficits. That’s certainly been the case recently. While the typical U.S. large-blend fund returned 11% over the past five years, for instance, the average foreign large-blend fund is up 17%. Moreover, there still are companies that aren’t influenced by the global economy as much as by their own local markets. In particular, foreign real estate stocks have been the subject of much attention, specifically for their diversification advantages. And some markets, like Japan’s, march largely to the beat of their own drummers. Second, globalization has created great investment opportunities on foreign soil. True, more U.S.-focused funds have increased their investment in foreign holdings, but they still tend to limit how much they can buy. There are enough companies domiciled outside the United States that deserve consideration to warrant a heftier exposure. Portfolio managers with whom we speak often highlight these companies, which they believe are among the best-managed in the world within any given industry. To exclude such stocks is a big opportunity cost for U.S. investors. Along similar lines, managers often find the most-compelling valuation opportunities Ryan McLean, Analyst SAO PAOLO Fortunately for investors, Chavez’s cries of “socialism or death!” have fallen on deaf ears in the region’s key markets. Most Latin American governments are quietly consolidating democracy, while businesses are going about making money. In the utilities space, privatization and regulatory reform have propelled the investment merits of some firms to the ranks of their global peers. I met with one such firm, CPFL Energia CPL, at its Sao Paolo office. Brazil’s largest privately owned utility operates distribution networks in the economically robust states of Sao Paulo and Rio Grande do Sul. Its natural monopoly status helps CPFL earn returns that exceed its cost of capital—a distinct achievement for a utility. Rising per-capita power consumption (currently one fifth of U.S. levels) and consistent rate increases are driving double-digit revenue growth. Another powerhouse is Enersis ENI, which operates in Chile and four other South American countries. We think Enersis’ low-cost hydroelectric assets give it an edge over competitors that rely more heavily on expensive thermal plants. Above-average business risk somewhat cools our enthusiasm for these firms, however. Both CPFL and Enersis are vulnerable to local currency depreciation, and nearly two thirds of the latter’s operating income is generated in less-stable markets, including Argentina and Peru. At their current 3- and 4-star prices (as of Oct. 12), shares in these firms are neither steep nor especially cheap. But Latin America’s volatile markets are known to serve up bargains from time to time, and at some point, price/fair value ratios are sure to fall. I also sat down with two utilities whose investment merits I found less convincing. Sabesp SBS, which distributes water and treats sewage in the Brazilian state of Sao Paulo, and Copel ELP, which distributes power in neighboring Paraná, possess inherently attractive business models. But we think these firms’ government owners place consumer interests ahead of minority shareholders’. The evidence lies in tariff increases that have barely kept pace with local prices. While populist pricing may be palatable in Brazil’s current (low) inflation environment, it could spell ruin if costs were to spike. In the meantime, artificially low tariffs are a drag on value creation. Dispatch From: Two Utilities Powerhouses MorningstarAdvisor.com 31

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Morningstar Advisor - Fall 2007

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