Recently, I had been reading through Tweedy Browne's explanation of what has historically generated excellent investment returns for 20th century investors (you can read it yourself by clicking here), and I came across this gem of a passage that partially explained what can make international investing so lucrative:
"For companies domiciled outside the United States, Tweedy, Browne has frequently observed depreciation policies that result in larger depreciation expenses, and lower earnings, than would be the case if the same company prepared its financial statements in accordance with U.S. generally accepted accounting principles. The Swiss company, Nestle (OTCPK:NSRGY), for example, reports as an asset on its balance sheet the estimated current cost to replace its property, plant and equipment. This is a significantly larger figure than the historical cost figure which would be required under U.S. generally accepted accounting principles ("GAAP"), and results in higher depreciation charges versus U.S. GAAP. Cash flow analysis and comparison to companies in the same industry will frequently suggest "hidden value" in the form of understated earnings and/or assets that have been written off to amounts which are significantly less than true realizable values."
The best source of "hidden value" courtesy of understated earnings that I can find in the market right now comes from international firms BP (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.B). Both firms seem cheap right now on a P/E basis, and they appear attractive based on the current yields that they offer. BP is trading at a little over 11x earnings and Shell Oil is trading at a little under 8x earnings, and they both offer dividend investors nice starting yields over 5% that is especially appealing because the dividends are well supported by profits and have reasonable chances of growing each year.
But what really caught my attention about these companies is that they seem even more attractive on a cash flow per share basis. Because both companies have been coping with one-time items that have brought down earnings, the profit-generating capacity of both these firms is quite understated when looking at the cash flows per share. BP is slated to generate $9.55 per share in cash flow this year, and Shell Oil is slated to generate $13.20 in cash flow per share this year. BP appears to be earning under $4 per share, and Shell Oil appears to be earning around $8.50 per share. This high discrepancy between earnings per share and cash flow per share is not adequately realized in the current share price, and that is why I believe that both companies currently offer a source of hidden value for investors today.
However, there are some important risks that you need to keep in mind. Although Shell Oil and BP have been "Americanized" multinationals in the sense that they have adopted certain traditions that are typical of American firms (i.e. they pay quarterly dividends unlike the annual dividend that you see at international conglomerates like Nestle and Anheuser-Busch (NYSE:BUD) ), it could be useful to keep this old Wall Street maxim in mind: international companies are quicker to raise their dividends in good times, and quicker to cut them in bad times, compared to their American peers. If the economy fell apart and we saw something worse than the 2008-2009 crisis affect the oil industry, I'd rather own Exxon (NYSE:XOM) and Chevron (NYSE:CVX), especially compared to BP (in fact, BP's ability to recover from the spill disaster would be severely undermined if oil prices fell sharply).
Additionally, there are some company specific reasons that can explain why both BP and Shell Oil seem undervalued right now. In BP's case, there is the risk that ongoing litigation will cost the company more than it has set aside to pay for the Gulf spill. Additionally, it only replaced its reserves at about 80% in 2012, and anything under a 100% rate signals depletion and is something to monitor. In Shell's case, the large natural gas holdings in the United States have placed a serious drag on the business due to the current low market prices for natural gas. Likewise, Shell has been enduring 5% annual field depletion since 2009, and this explains why the company is only growing annual production at a 1-3% clip (this risk has largely been offset by the higher prices over the past three years).
Shell and BP are both attractive at the surface level because they offer 5% starting yields (something that is particularly attractive in this environment), and their P/E ratios seem attractive, especially in a world where the S&P 500 is trading at 18x earnings. But these international investments are both interesting because earnings are likely understated at both firms due to one-time items that hide the long-term earnings power of both companies. The higher cash flow per share indicates that these companies may be trading at cheaper prices than the prevailing market prices currently reflect, and should provide high current and future income to dividend investors, barring a steep decline in oil prices over the coming few years.