Richard Pell is no stranger to taking the road less traveled. For two years during the early 1980s, he made a living as a professional poker player. Before that, he worked as a private investigator in the San Francisco area following a
11/2-year stint as a law school student. He joined Julius Baer Investment Management in 1995, about 12 years after he got his first "real" job as a bond analyst for Bank of Tokyo.
Pell, co-manager of the $852 million Julius Baer International Fund, once again is treading on less traditional turf with his conviction that the emerging markets of Eastern Europe will outperform the moribund U.S. stock market in the years ahead. Stocks of companies in emerging markets-mainly Poland, Hungary, and the Czech Republic-make up 11% of fund assets, representing one of the highest allocations to that region of any foreign stock fund.
While that may not seem like much, the volatility of those stocks can pack a wallop. "The group has doubled since we began our buying in late 1999, and we think we can triple our money from current levels," says Pell. "Two years ago, you could buy every bank in Eastern Europe for under $10 billion. Now, you'd have to pay $20 billion. That's still cheap."
The key driver behind these stocks, most of them issued by banks such as Hungary's OTP Bank and Poland's Bank Pekao, center around plans by eastern European countries to join the European Union in 2004. This foray represents Pell's third convergence play since he began managing the fund in 1995. In 1996 and 1997, he reasoned that the introduction of the euro would prompt countries with high interest rates, gaping budget deficits and weak currencies to clean house to comply with treaty requirements. To capitalize on that conviction, he bought banking stocks in countries with beleaguered economies such as Spain, Italy, Portugal and Ireland. In 1998, he followed a similar course with Greek banks as that country prepared to join the EU. Both times, the strategy proved profitable.
The risks of this latest convergence play include political opposition in Western Europe that could delay the entry of eastern European countries into the EU, as well as a history of corruption in the region's banking industry. In the 1990s, bank managers, who were former state officials, bowed to political pressure by doling out loans to financially weak companies.
But Pell says that the banks are modernizing and improving disclosure and management practices. Some key Western institutions have been taking controlling stakes in some of these banks, bringing with them their capital and management expertise. "From a risk-reward perspective, the region, and the banks in particular, remain very attractive," he says.
Pell does not hold the same view for Japan, which represents 8% of fund assets. Many of the companies there remain heavily dependent on exports and on the struggling economies of the countries where they sell their wares. "In many ways, Sony is as much an American company as a Japanese one," he says. "The Japanese exporters are not a good way to diversify internationally."
Even companies less dependent on exports, he says, must grapple with Japan's struggling economy and a culture that still frowns upon cost-cutting layoffs and restructuring. "In Japan, management's idea of a layoff is moving someone to a subsidiary," he quips.
Although layoffs are all to familiar to many American workers, they are not enough to cure what Pell considers a troubled and still overvalued U.S. stock market. For one thing, Wall Street's earnings predictions are simply too optimistic. By his estimate, the Standard & Poor's 500 Index was selling in July at a still-high 28 times forward 12-month earnings. "U.S. stocks are not priced to return more than government bonds," he says. 'The equity risk premium has disappeared." Pell figures that the S&P 500 Index, hovering a bit over 900 in mid-July, "would be fairly valued somewhere in the 600 to 700 range."
Reflecting concerns about overvaluation in U.S. markets, Julius Baer Investment Management recommends that its privately managed accounts hold no more than 45% of their equity assets in domestic securities. In his personal account, Pell has trimmed his equity stake from a peak of 70% of his portfolio a few years ago to around 30% today. Over half of that decreased equity stake is in foreign securities.
In Pell's view, stocks of developed markets in western European countries represent a better value than those in the United States. The dividend yield of the Europe Stoxx index is 2.7%, compared with 1.6% for the S&P 500. The European index trades at a relatively reasonable 20 times earnings and sports a lower price-to-book ratio.
"You have to remember that the developed European markets lagged this country for most of the 1990s," says Pell. "While they are not particularly cheap, they are still cheaper than stocks in the U.S."
In emerging markets, Pell takes a top-down approach by zeroing in on primarily on local political and macroeconomic factors that promise to lift the entire economy and stock market. But when it comes to developed markets in western Europe, where the fund has 57% of its assets, he favors a sector-driven, bottom-up approach to stock picking. There, he looks for companies he considers undervalued in relation to their potential for earnings growth. They usually occupy a dominant niche or provide a high-demand product or service.
Recently, Pell has been buying stocks of Norwegian banks, which are transitioning to a public ownership structure that would enhance opportunities for mergers and acquisitions. The group boasts dividend yields in the 7% to 8% range, and some of the stocks trade at prices below book value.
A willingness to make decisive and sometimes sizable shifts in country, sector and market-cap allocation, and to hold large cash positions from time to time, has helped make Julius Baer International Equity Fund one of the leaders of the foreign-stock-fund pack. Its eclectic approach has also made it a strong, all-weather fund. It excelled in the late 1990s, when large-company growth stocks dominated, but it also has delivered strong returns in the more value-oriented environment of the last couple of years.
"Over its seven years with the current managers, the fund has outdone its average peer by a factor of almost three," says Thurman Smith, editor of Equity Fund Outlook, an investment newsletter. "Their aversion to high-priced stocks, the occasional cash cushion, and wide diversification have meant less volatility than the average diversified foreign stock fund."
Over the last few years, Pell and co-manager Rudolph-Riad Younes have decreased the fund's exposure to large-cap stocks and gravitated to mid-cap companies, which they define as between $1 billion and $10 billion. Currently, 32% of the fund's assets are in large-cap stocks, 39% in mid caps and 9% in smaller companies with market capitalizations of under $1 billion.
"Five years ago, larger companies accounted for three-quarters of the fund's assets," says Pell. "All other things being equal, that's where we prefer to be because those stocks are the most liquid." But its managers began a shift into small and mid-sized companies in late 1999 and early 2000 as large-cap valuations rose beyond Pell's comfort level. They also had concerns about the impact a weakening dollar would have on larger companies that relied heavily on export revenues. A stronger euro increases costs for these companies, making them "a bit less competitive" in Pell's view.
"Companies that depend mainly on domestic revenues won't be hurt as much by a weaker dollar as exporters, and we believe the dollar will continue to weaken over the next several years," he says. "Over the last three decades, we have found that major shifts in the dollar's strength against other currencies occur roughly every six to 10 years. Between 1995 and 2000, we saw a strong-dollar bull market. The current weakening is only 11/2 years old, so we have some time to go in this current cycle." Because small and mid-sized foreign companies with domestic revenues are more sensitive to local economies than global economic trends, they provide more efficient portfolio diversification than larger companies, he adds.
Pell isn't afraid to move into cash, which accounted for about 18% of assets in mid-July. He says the reason for the high cash stake has less to do with a lack of good investment ideas than a desire to cushion volatility in an uncertain stock market. On the equity side, he stays diversified by holding about 160 stocks and rarely investing more than 3% in each issue.
The fund uses hedging strategies sparingly. Between 1995 and 2000, when the dollar was strengthening, Pell did some hedging to protect fund profits. But with the greenback now in a declining mode, enhancing U.S. investors' foreign stock profits as gains convert to more dollars, the fund does not currently employ hedges.