Vanguard International Growth is looking to emerging markets for growth.
For Virginie Maisonneuve, China is more than a
country with a burgeoning economy and red-hot stock market. "I consider
China a passion," says the 42-year-old manager of the Vanguard
International Growth Fund.
If the 97% rise in China's most widely traded stocks
last year is any indication, a lot of investors share those warm
feelings. But Maisonneuve's interest began back when a mysterious veil
of secrecy still shrouded the country. As a young child growing up in
France during the 1970s, she knew that she would "always be associated
with China in some way." She fulfilled that premonition in the
mid-1980s when she attended an intensive Chinese foreign language
institute, and later began her career as a consultant with the French
Ministry of Foreign Affairs in China. Her two adopted daughters are
Chinese.
In the fund, Maisonneuve's positive feelings about
the country's investment potential translates into investments in its
stocks, such as cell phone maker China Unicom, as well as stocks of
other emerging market countries such as Indonesia, Russia, India and
Brazil. Altogether, emerging market stocks account for roughly 13% of
the $15.3 billion fund's assets. The allocation was up to 20% in
September, but Maisonneuve and co-manager Matthew Dobbs decided to take
some profits and trimmed the allocation late in the year.
Those profits came after a severe plunge in May and
June as foreign investors, concerned about rising interest rates, fled
emerging markets and prompted a decline of 25% in the Morgan Stanley
Capital International Emerging Markets in just over a month. That index
later rallied and ended the year nearly 30% higher. For investors
willing to ride out such volatility, Maisonneuve considers emerging
markets the "best place to find new investment opportunities that have
growth potential and are attractively valued."
Despite that conviction, those markets are not the
centerpiece of International Growth's carefully controlled, risk-averse
portfolio. Established Europe accounts for 60% of assets, and the
Pacific Rim another 25%. Two countries, the U.K. and Japan, account for
nearly 44%. There are no big individual stock bets here, with 140
stocks in the portfolio and the ten largest holdings weighing in at 18%
of assets. To help control risk the fund is usually not less than
half-weighted, or more than one-and-one-half times weighted, the "major
components" of its benchmark, the MSCI EAFE Index. A major component is
any region, sector or country with a 20% weight or more.
Maisonneuve's employer, London-based Schroder
Investment Management, advises roughly two-thirds of the fund, with
James Anderson at Baillie Gifford Overseas in Scotland stewarding the
rest. She took over as manager after the 2005 retirement of Richard
Foulkes, the former vice chairman of Schroder. Like her predecessor,
she favors a value-conscious, growth-at-a-reasonable-price style.
Baillie Gifford employs a more classic growth strategy by looking for
stocks with above-average earnings and cash flow and the potential for
positive earnings surprises.
It's hard to say whose side is doing better, since Vanguard does not
disclose separate returns for each firm's assets under management. A
Morningstar report on the fund notes that Maisonneuve has "thus far
been able to fill the shoes of her predecessor," while James Anderson
"assembled a strong track record at the U.K.-based fund Baillie Gifford
International." However, it also goes on to say that the latter firm
"has a mediocre record on a mutual fund it runs for Guardian, though
that fund is pricier and has a narrower mandate than this one."
Maisonneuve reserves comment, saying only that the two firms have
complementary styles that mesh "with a lot of harmony and cohesion."
For its sleeve of the portfolio, the Schroder
investment team uses fundamental analysis to rank stocks from "one,"
which is a strong buy, to "four," a strong sell. They also consider
macroeconomic factors, including oil prices and interest rates, as well
as local and regional conditions. Business and consumer trends in the
U.S. come into play for companies with a large consumer base in this
country, such French dairy and beverage firm Danone.
Long-term core holdings make up about 70% of the 70
to 90 names in the portfolio and typically stay in the fund for several
years. The rest of the portfolio consists of "opportunistic"
investments with timely themes that have a shorter holding period.
Over the last few years, cyclical stocks in
economically sensitive areas such as energy and materials have
dominated the opportunistic side. But Maisonneuve contends that at this
point in the economic cycle those sectors are more vulnerable than
growth stocks. "We believe that market leadership has shifted to favor
quality growth investing and we are refocusing the portfolio
accordingly," she says. "We've sold some of our industrial holdings,
and to be fair we may have gotten out a bit too early. But they were
getting close to their fair market value and we think there are better
opportunities elsewhere."
The fund's more defensive leanings toward companies
with steady earnings growth is in response to the delicate balancing
act many of the world's economies are performing, she says. Her firm is
looking for deceleration in global gross domestic product from 3.5% in
2006 to 2.9% this year. Potential economic stumbling blocks over the
next year include decreasing property values, higher oil prices,
slowing consumer demand and continued tension in the Middle East. "I'm
also worried about the consensus view that oil prices will go down. We
need to keep in mind that demand for oil in China will double over the
next ten years. By the end of this year the country will still only
have one month of oil reserves." If oil stocks continue to drop, she
says, she may step in as a buyer.
Counterbalancing those concerns is the support
provided by the money from the Middle East, China, and Russia flowing
into everything from property to brand-name shoes. "I live in London
and I can tell you that the property market here is not supported by
the British, but by wealthy investors from the Middle East and Russia,"
she says. "The liquidity coming from these emerging markets is
sustaining demand."
Like the world's economies, financial markets are
searching for balance as well. "Valuations are not stretched, but we
need to keep an eye on profit growth," she cautions. "We've had some
amazing earnings growth over the last three or four years, but pricing
power is not all that great and wage growth is tame. Investors are
going to react sharply to earnings surprises, and we are likely to see
more volatility in the world's financial markets this year than we did
in 2006."
Maisonneuve is looking to a number of consumer
staples stocks to add some ballast to the portfolio. One of them,
Danone, is launching higher-calcium products that should boost sales
and is well-positioned to benefit from a stable business in the U.S.
and Europe and growth in developing markets. U.K. retailer Tesco, which
offers a broad range of products, is a core holding with a growing
online business in its home country as well as Eastern Europe and
China. Another U.K. core holding, Burberry, makes luxury handbags,
coats and other apparel. A new CEO came over from another well-known
clothing label and is looking to expand the company's presence in the
U.S. accessories market.
Two banks in Europe have also caught her eye. One of
them, Societe General, is expanding its niche from the French market
into nearby Eastern Europe with mutual fund and insurance products that
many consumers are buying online. Italy's San Paolo Bank has a valuable
insurance franchise that the market is not recognizing.
For Vanguard fans, the question is whether to go
with actively managed International Growth or another all-in-one
international offering that includes emerging markets, Vanguard Total
International Stock Index. Both have low expense ratios-0.55% for
International Growth and 0.32% for Total International Stock Index.
Both are about as volatile as the MSCI World Index Ex USA, which
includes both established an emerging markets. Total International,
which combines the firm's European, Pacific and Emerging Markets stock
index funds, is classified as a foreign large blend fund, while
International Growth falls into the foreign large growth category. The
turnover rate for International Growth is 45%, compared to 2.1% for
Vanguard Total International Stock Index.
In terms of pretax performance the index fund holds
a slight edge over the one- and three-year periods, and a 2.3
percentage point lead over the five years ending December 31. On an
after-tax basis, Total International's and International Growth's
respective returns were 26.04% and 23.43% over one year, 20.4% and
18.69% over three years, 15.51% and 12.92% over five years and 7.14%
and 7.07% over ten years.
It's hard raising a bar you've set yourself, but
that is what Vanguard faces when it comes to measuring the performance
of its actively managed funds against its passive index offerings. For
International Growth and many funds sponsored by Vanguard and other
fund firms, beating those bogeys, especially on an after-tax basis,
remains a challenge.