Could this be the year that international funds lead the way? Some analysts and money managers think so. But don't bet your clients' ranch on the overseas markets.
Overseas stocks have underperformed U.S. stocks for more than a decade, but the tables are turning. Money managers believe terrific bargains are overseas. Stock valuations are low, and corporate earnings are growing faster than U.S. stocks. The weakening dollar makes non-dollar investing rewarding at a time when the U.S. financial reporting scandal is spooking investors at home and abroad. So we could be in for a long period of foreign stock outperformance.
One harbinger of good things to come is overseas corporate profitability. The return on equity (ROE) of foreign companies is gaining ground on their U.S. counterparts. In the 1990s, the ROE on the S&P 500 was as high as 17%, but has dropped to 13.9%, according to McGraw-Hill data. By contrast, the ROE on the MSCI EAFE index is 12.9%, up from 11% several years ago.
The financial markets are sensitive to this trend. As of June 30, emerging market stock funds were up an average of 3.64%. The average foreign stock fund was down 1.14%, according to Morningstar Inc., Chicago. By contrast, the S&P 500 is down 13.78%.
Ronald Welburn, investment strategist with Merrill Lynch Private Investors, Plainsboro, N.J., is optimistic about some overseas markets. "We believe that we are in the early stages of a synchronized global economic recovery," Welburn says. "The same economic and financial forces that are aiding the United States are helping the rest of the world. These include lower interest rates, falling energy prices and inventory rebuilding."
The Asian stock markets, including Japan, are the most attractive, he says. This region has lower cost, higher productivity and higher savings rates than Europe and Latin America. Europe still has too much government bureaucracy, which slows business decision-making. Productivity is lower in Europe than in other parts of the world. And in Latin America, there are growing political and social problems.
Despite the optimistic outlook, the International Monetary Fund has serious concerns about the global economy in the aftermath of the terrorist attacks last September 11. The IMF's recent report, World Economic Outlook: The Global Economy After September 11, cites the risks:
Economic growth in the United States may be slower than expected due to overinvestment, a high level of consumer debt and the declining value of the dollar, according to the report.
Access to capital in the emerging markets depends on the economic growth of industrial nations.
Slowing growth and a future flight to quality in the financial markets would put pressure on the corporate and financial sectors of the world's economy.
Contagion is another issue. The IMF's data show high cross correlations exist for both loan and asset prices. In bad times, individual country returns tend to move more in tandem than in positive times.
More terrorist attacks also could pose majors risks to the global economy. A 2001 study by Alberto Abadie and Javier Gardeazabal for the National Bureau for Economic Research in Cambridge, Mass., says future terrorist attacks will have a noticeable impact on productivity. They argue it would be similar to the effects of the oil crisis in the 1970s, creating uncertainty and high business transaction costs.
Fund managers are the first to say that the foreign markets are volatile. Nevertheless, they believe the fundamentals point to a long-term rebound.
"I am a firm believer in the regression to the mean," says Betsy Palmer, associate portfolio manager of MFS' International New Discovery Fund, which is up 5.23% through mid-year. "We are coming off a period where international stocks drastically underperformed the U.S. markets. The price-to-cash flow, price-to-earnings and price-to-book ratios are 70% to 75% of U.S. stocks."
Christopher Olson, co-manager of the Acorn Foreign Forty Fund, which is down 2.15% this year as of June 30, agrees, particularly in the small-cap sector. He calls the current period the "90s reversal syndrome." He expects investment dollars to move into the foreign markets, driving up stock prices of companies that represent growth at reasonable prices.
"Everything that did well in the last decade will trail the averages for the next decade," Olson says. "That puts small companies on top. The world's markets have been strong since September (2001). Small stocks have outperformed large-cap stocks in every market this year."
Olson favors property, basic materials and consumer companies that will benefit from the economic recovery. He sees strong earnings growth in Ireland, the United Kingdom and Switzerland. His typical holdings have strong balance sheets, low debt and strong cash flow to support dividends. Two stocks he favors are Anglo Irish Bank and Irish Life and Permanent. These stocks are a play on the strong housing market and favorable demographics in Ireland and the United Kingdom. The stocks sport price-to-earnings ratios of just eight times earnings, while earnings are growing more than 20% annually.
Palmer also favors small-cap and mid-cap stocks-particularly in Europe. European stocks make up half of the fund's portfolio. The International New Discovery Fund is loaded with natural resources and basic materials stocks, such as Talisman Energy, Canada; Anglo Irish Bank, Ireland; Reckitt Benckiser, United Kingdom; Television Francaise, France; and VNU, the large Dutch publishing company.
Christopher Anderson, manager of the T. Rowe Price Emerging Markets Fund, says he is also buying growth at attractive prices in the large- and mid-cap sectors. For the first six months of the year, the fund was up 2.7%. The average holding of the fund is growing earnings at 26%. He owns firms with strong balance sheets including Wal-Mart de Mexico, South Korea's Kookmin Bank and Samsung Electronics, and Taiwan Semiconductor Manufacturing.
"Last October, emerging markets were at 15-year lows relative to the S&P 500," Anderson says. "Corporate governance has improved, and a lot of structural reforms have come out of the concerns over the crisis of a few years ago."
Trade flows between developing and emerging markets have picked up dramatically over the past year, he says. The fund is 53% invested in the Pacific, excluding Japan; 23% in Latin America; 12% in Europe; 12% in the Middle East and the rest in Eastern Europe. The fund is up3% this year as of June 21.
"The Pacific region appears to be the most geared to the economic up cycle," Anderson says. "Malaysia and Thailand, Indonesia and the Philippines are rebounding. Property prices are rising, and banking systems are improving."
Paul Matthews, manager of the Matthews Pacific Tiger Fund, up 15.7% over the past 18 months ending June 30, is cautiously optimistic about the Asian markets.
"I believe the upturn in the Asian markets has long-term legs. Prices could pull back. However, we have had a good run over the past 12 months," Matthews says. "But good performance hasn't been uniform across the region. South Korea, Indonesia and Thailand have performed well. China and Southeast Asia haven't done as well. The markets are very volatile and will continue to be so."
Matthews maintains he's more bullish on China than Japan. Japan is slow in making economic reforms. Meanwhile, China's domestic housing market is growing, and its economy is growing at 7%.
The average Japan stock fund is up 11%. However, those returns may be short-lived. At the end of May, Moody's Investors Service lowered its rating by two notches to A2 and Aa3 for yen-denominated domestic securities issued or guaranteed by the government of Japan. Japan's bonds are now rated lower than bonds issued by Botswana and Estonia, due to current and anticipated economic policies that will not solve Japan's domestic debt problems.
Matthews' Pacific Tiger Fund is broadly diversified in mid-cap stocks, excluding Japan. Consumer stocks are his biggest industry bet. The fund's largest holdings, which are growing market share, include: Huaneng Power in China; Hong Kong Electric; Giordano International, the largest retailer in Asia; and Nogshim, a Korean noodle manufacturer. The fund is up 8% this year as of June 21.
"Individual balance sheets are strong," Matthews says. "There is a growth in mortgage, credit cards and personal loans. Asians are also buying more imported autos."
Although the European markets are not setting the world on fire, Stan Pearson, co-manager of the Pioneer Europe Fund, thinks long term. His fund is down 7% this year as of June 30. But he is buying large well-managed companies, with strong balance sheets and cash generating potential, on price declines.
Pearson put all the fund's cash to work after last year's September 11 terrorist attacks. He snapped up some great values such as ENI, an Italian oil company; Munich Reinsurance, a large German insurance company; BNP Paribas, a large French bank; and Wolseley, a United Kingdom food and products company that does half its business in the United States. Overall, he stresses that the global economic slowdown did not hurt European markets as badly as other markets. There were fewer cuts in capital expenditures than in the United States. There were fewer companies in the hard-hit technology sector and fewer bankruptcies. Plus, high levels of consumer and corporate debt do not burden Europe. Pension reform and tax reform continue to move forward. And mergers and acquisitions remain strong.
"The supply and demand for equities look good," Pearson says. "Over the last five years, the equity markets have deepened, and on the demand side, people will be investing in their pension funds."
On the negative side, he says, "companies have problems with productivity and labor costs need to be readjusted." But his greatest concern is a rapidly falling dollar.
"It would unsettle the markets," Pearson says. "Imports would pour into Europe, domestic industries would suffer and labor costs would be high."