Saturday, November 10, 2012

Buy American pays off as euro crisis flares

Earlier in the year, when markets overseas and at home were hopping, technology and consumer staples stocks topped the new high list every day. Yet now that overseas markets are in turmoil, the new highs are going primarily to utilities, telecoms and real estate trusts. Why?

You might imagine that the difference is between high-beta and low-beta, or between high-growth and value. But the reality is quite different, according to a neat study this month by Bespoke Investment Group analysts.

It turns out that the primary factor distinguishing May and June winners from early year winners is the percentage of business generated overseas. The more international a company's business, the more investors are punishing it. So much for globalism, right?

Bespoke looked at international revenue exposure by sectors in Russell 1000 companies. Four sectors have above average (69.3%) domestic revenue exposure, led by telecom services and utilities, where domestic revenues make up 95%+ of the average company's revenue. The two other sectors with above average domestic revenue exposure are financials (84.7%) and consumer discretionary (75.8%).

On the other side of the spectrum, technology has the lowest percentage of domestic revenues as a percent of total (45.4%), according to the Bespoke analysis, and it is the only sector where the average company generates less than half of its revenue in the United States. Other sectors with below average domestic revenue exposure are materials (53.8%), consumer staples (63.4%), and industrials (63.9%).

Finally, health care (66.8%) and energy (69.2%) both technically have below average domestic revenue exposure, but they are both within 300 basis points of the average.

While U.S. stocks are often grouped as a single asset class, the analysts observe, within the S&P 500 there are big differences between companies over just how "American" they are. And this year the differences are a key factor driving stock price differentials.

For instance, Coca-Cola KO , McDonald'sMCD , and HeinzHNZ are often thought of as being the ultimate American companies. Yet all three generate less than half of their revenues in the United States.

Taking these differences in revenue exposure into account, Bespoke created two baskets of S&P 500 companies based on their revenue exposure and calculated their performance over the last 12 months. The first basket contained the 121 companies in the S&P 500 that generate 100% of their revenues in the U.S. (domestics), while the other basket contains the 122 companies in the benchmark index that generate less than half of their revenues in the U.S. (internationals).

It turned out that the basket of domestics was up 1.4% over the last year, while the internationals� basket (blue line) has dropped 8.5%. Furthermore, the basket of internationals really began to underperform in early April just as issues in Europe came to a head and the Euro began to collapse, the analysts note.

It makes sense now to favor domestic-based companies over companies with greater international exposure. However, the spread between the two baskets has widened to such an extremes that, in the short term, there may be a mean-regression move in which stocks with international exposure temporarily outperform.

So what might work among very, very domestic companies that are under the radar? How about looking at some of the closed end investment firms that focus on generating lofty income by investing in small to medium-sized U.S. companies through the extension of secured loans, mezzanine loans, and equity.

Consider Solar Capital Ltd. SLRC , which despite its name has nothing to do with solar energy.

/quotes/zigman/116711/quotes/nls/slrc SLRC 21.50, -0.13, -0.60%

It is essentially a publicly traded private equity firm. Michael Gross has served as chief executive and chairman since 2007 and has over 20 years of experience in private equity and mezzanine lending.

He formerly was founder and president of Apollo Investment Co.AINV , in addition to co-founding Apollo ManagementAPO � in 1990.

Solar Capital is treated as a business development company, or BDC, and is formatted as a regulated investment company. That means, for tax purposes, the firm is required to payout at least 90% of its taxable income in the form of dividends, just like a real estate trust. That's great for investors, as the current dividend yield is a whopping 11%. Additionally, the structure provides for several risk safeguards including a 1:1 max debt-to-equity leverage ratio, and a limit of no more than 25% of total assets in any one issuer.

The firm's portfolio consists of $20 million to $100 million investments in a wide variety of industries including aerospace, health care, beverage, food, finance, automotive and several others. Very diverse. Because most of the investments are private, one of the biggest concerns for BDCs can often be the difficulty in getting a true valuation of their portfolios.

Well, researchers at Citigroup point out that Solar Capital overcomes this obstacle by utilizing independent third-party valuation firms to conduct quarterly appraisals and review the company's own preliminary valuations. The board of directors then determines a fair value for each investment based on the input from the investment advisor and the valuation firms. The company also constantly monitors its portfolio of investments and ranks the holdings by credit quality as it looks to control risks and mitigate any losses.

Solar Capital grew total revenues by 11% last year while net investment income grew 19% from a year ago on just over $1 billion in total assets. Just over 7% of the investments are equity, with the remaining 93% consisting of senior secured loans and subordinated debt.

The company's shares are up about 18% since going public in February 2010, and flat thus far this year. There's certainly plenty of room for share appreciation, but the hefty dividend is the star of this show; in total return it's up 6.5% this year. The ability to participate in the private equity markets by buying shares of a business development company like Solar Capital is an attractive opportunity for income-seeking investors who want to stay strictly domestic.

Jon Markman owns a long position in Solar Capital.

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