1 Promising and 1 Not-So-Promising Stock

Are you top-down or bottoms-up?

That's not a question of how I go about getting dressed in the morning, but rather a question our Motley Fool Global Gains research team gets frequently about how we go about identifying promising international investment opportunities. Bottoms-up means we'd go hunting for well-run, compellingly valued businesses and buy them irrespective of the broader trends in the market in which they operate. Top-down means we'd focus on finding a promising country or macro trend and buy a variety of companies -- irrespective of their individual merits -- with exposure to that theme.

So which is our tack? Frankly, we aspire to do both. That can mean we work bottom-top, which means we go looking for well-run, compellingly valued businesses and then verify that they're benefiting from -- and not being challenged by -- broader global economic trends. Or it can mean we work top-bottom, which means we identify a short list of companies in an attractive market and then try to figure out which one specifically is the best bet.

A case study of bottom-top
Take, for example, the case of China Security & Surveillance Technology (NYSE: CSR), a company I mentioned recently that could be hurt by a bursting Chinese real estate bubble. This raised a few eyebrows since CSST is the business of manufacturing, selling, and installing security systems for Chinese government clients a part of that country's Safe City Initiative -- a priority for the country given the government's focus on "social harmony" that's only been heightened by the recent spate of school stabbings there.

And CSST has been very successful in this line of business. Sales are up more than 50% annually over the trailing three-year period and profits are up nearly 40%. Given those growth rates, the tacit government support, and market opportunity in China, CSST stock looks like a real bottoms up bargain at less than 1 times sales and a little more than 5 times EBITDA.

But is it?
There is, however, a problem with having the Chinese government as your main customer: It's very slow to pay. China Security's days sales outstanding (DSOs) now number more than 140 and its cash conversion cycle is almost 170 days long! This is a problem for a company pursuing rapid growth because the longer working capital is tied up in receivables, the less money the company has to reinvest in new inventory. China Security, of course, realizes this and has adapted by beginning to factor its receivables. This means that CSST sells the right to collect the receivable to a bank at a slight discount to its fair value in order to get its money back more quickly. Since the Chinese government is considered creditworthy and the Chinese banks are owned by the government, they're generally more than happy to take on this transaction and earn the slight profit for them that it entails. Win-win, right?

If you've been following China's banking sector, however, you know that the recent pace of lending has been rapid, that non-performing loans appear to be increasing, and that the country's regulator recently asked banks to stress test for a 50% to 60% decline in housing prices. What this indicates to us from a top-down level is that China's banks could soon run low on capital in a way that reduces their ability to, among other things, buy receivables from CSST. This could put CSST in a capital crunch that could cause it to either raise additional capital from investors or severely curtail its growth -- neither being an attractive option for current investors.

As a result, we're steering clear of CSST for the time being. While it looks like an attractive bottoms-up opportunity, the broader economic trends in China could prove to be a serious challenge for its business model. That's what we're talking about when we say we work bottom-top.

A case study of top-bottom
One of the ways we work top-bottom is by keeping track of the relative valuations in the world's markets. Here's how that list for the Big 6 Global Markets looks today:

Source: Motley Fool Global Gains research.

Based on these data, you might be prompted to go looking for ideas in either Europe or India -- which is precisely what we've been prompted to do. Yet just because it's cheap doesn't mean I want to own Europe en masse. Companies such as Allied Irish Banks (NYSE: AIB) and France Telecom (NYSE: FTE), for example, look fairly troubled given their concentrated exposure to the region. Yet as I went through a roster of European names, I came upon Covidien (NYSE: COV), a Dublin-based manufacturer of medical devices and other health-care supplies.

Now, we all know about the economic troubles in Ireland, but a closer look at Covidien reveals that the company gets less than 25% of its sales from Europe. Add to that a durable business that's earning better than 20% operating margins and double-digit returns on equity, and you have an intriguing investment opportunity. Although I found the company looking top-down, a bottoms-up analysis is what confirms it to be an interesting idea.

Put your shirt on first one day
Although it's easy to fall into a pattern of being either a top-down or bottoms-up investor, our experience investing at Motley Fool Global Gains has taught us that the approaches work best in tandem. This is particularly true when it comes to investing globally since country forces can have significant positive or negative impacts on either well- or poorly run businesses.

The best scenario, of course, is to buy a great business in a great market, and you won't know if you're doing that unless you endeavor to look at both.

Get Tim Hanson's Global View column every Thursday on Fool.com, or by following him on Twitter.