ICON International Equity Fund manager eyes a move toward defensive industries.

    Over the last three years, ICON International Equity Fund manager Scott Snyder has made stocks in economically sensitive cyclical industries the cornerstone of the fund's portfolio. Investor concerns about the economy, rising oil prices and war made them a bargain when he began buying them, while a surge of investor interest gave them a boost over the last few years.
    This year started out with a continuation of that trend as economically sensitive sectors and industries that benefit from growing economies, including energy, materials, construction and industrials, led the way with returns of 10% or more by the end of the first quarter. "Defensive" sectors that investors turn to in more uncertain times, such as consumer staples, healthcare and utilities, barely budged during the period.
    But over the last few months the 27-year-old Snyder has watched the market shift toward defensive industries that have held up better during downturns. "One of the most telling signs we've seen recently has been the emergence of stocks in more defensive industries that have been out of favor for several years," he says. "The question is whether that recent strength is a true theme reversal or a head fake."
    The possible market mood swing could make a big difference in the way the portfolio looks a few months from now. ICON International Equity Fund's investment strategy centers around buying underpriced industries that are just beginning to show market leadership. That leadership can last for several quarters, or several years. With the correlation among international markets so synchronized over the last few years, those industry themes transcend country borders and are common to the firm's domestic and international portfolios.
    By stressing industry exposure and holding a wide sampling of stocks within those industries, Snyder and his team reduce the company-specific risk associated with individual securities. The fund holds 125 stocks, each accounting for a small percentage of the portfolio. Financials comprise the largest sector, followed by industrials, materials, consumer discretionary and information technology.
    Shifts in industry themes over the last few years reflect the longer-term nature of these rotations, which often occur in times of high volatility or at market bottoms. In 2001 consumer, industrial and cyclical industries usurped recession-proof stalwarts such as food and consumer staples as market leaders. For eight months in 2002 and early 2003, leadership was absent as the market drifted. In late March 2003, the fund began to rotate into cyclical and economically sensitive issues that have historically tended to lead during economic recoveries.
    For most of the last few years an emphasis on cyclical stocks during an economic recovery, plus a valuation tilt toward mid-cap stocks, boosted returns relative to both its competitors and foreign stock benchmarks. In 2005, a total return of 31% for the I-shares class beat its competitors in Morningstar's foreign small-/mid-cap value category by 12.5%, and the MSCI EAFE by 17.3%.
    But 2006 got off to a slow start, as the fund's dominant industry themes suffered amid fears of rising interest rates and a slowing economy. As of early June returns were flat, leaving the fund in the bottom 2% of its group year-to-date.
    Despite a slowdown in cyclical stocks and revived interest in defensive industries, Snyder says it's too early to abandon the former group. "They haven't run out of gas, but they have shown some signs of weakness. We're keeping a close eye on them," he says.
    According to the firm's calculations, many long-time favorite industries continue to sell below fair value. Financials, for example, sell at an average discount of 25% discount, meaning that the group has room for 25% upside growth from prevailing levels. Metals and mining companies, where Snyder sees "tremendous growth and tremendous bargains," are selling at a discount of around 35%.
    Overall, says Snyder, U.S. stocks were trading at a 16% discount in early June, while international securities traded at a discount of 27%, on average. The deepest discounts over the last three years have been in the Asia Pacific region, where discounts average 34%.
    "Economic growth in many parts of Asia has been more lackluster than the rest of the world, so those stocks haven't seen the upside over the last five years that many other regions have enjoyed," he says. "That makes for better bargains and more upside potential. While both Asia and Europe offer better value than the U.S., Asia appears most attractive, especially issues in the industrial sector." The fund has remained actively overweight the benchmark throughout the year in the Asia-Pacific region due to more favorable valuations relative to other areas.  
    By Snyder's estimate, Japanese stocks are selling at a whopping 49% discount to fair value, largely because they had been depressed for so long. The market lost 80% of its value between its 1989 peak and the beginning of 2003. The tide started to turn in 2003 and 2004, when stocks ended in positive territory, and Japan was among the best-performing established markets in 2005. Company profits are up after years of restructuring, and consumer confidence is on the rise.
    Yet the Japanese economy also shows signs of strain. The country depends heavily on exports to the U.S., leaving it vulnerable to an economic slowdown here. A growing budget deficit threatens economic recovery. And Japanese stocks retreated this year, reaching a six-month low in early June. Even though investors remain cautious, Snyder believes Japanese stocks offer "tremendous, broad bargains and great upside potential."
    Although international markets experienced a drop in late May and early June, as the U.S. market did, Snyder does not believe the downturn marks the beginning of a bear market.
    "When most markets behave similarly, experience suggests this reflects investor emotions. A move based on fundamentals would show some unique behaviors country by country," he says. "And the long-anticipated drop in longer-term bond yields adds questions to the validity of the latest inflation concerns."
Looking For Bargains
    To calculate whether or not a stock or industry is selling at a discount to intrinsic value, Snyder uses an unusual measure called a value-to-price ratio. A modified version of Benjamin Graham's "Central Value Formula" equation, it  is supposed to provide a better snapshot of valuation than a price-earnings ratio because it considers the effects of historical and projected earnings, projected growth, risk and interest rate opportunity costs. The valuation equation uses average earnings per share, future earnings growth estimates and beta, as well as the prevailing triple-A bond yield, as a yardstick for opportunity cost. It projects earnings growth into the future, then discounts those projections back to their present value. The value derived from that equation is then divided by price to calculate a value-to-price ratio for 147 different industries.
    Snyder identifies stocks and industries within market sectors that are beating the broader market, and favors companies with high cash flow and low debt. He rotates among undervalued and overvalued securities and industries by buying those he thinks are undervalued while selling those that are overpriced. If an industry drops into the bottom 10% of the value-to-price rankings, or poor performance drags it into the bottom 20% in terms of relative strength, he generally will sell.
    A relative strength reading above 1.0 means that an industry is stronger than the broad market over the previous 26 weeks, while a reading below that level means it is weaker. The gauge is different from momentum because it does not require that an industry move higher; the industry simply needs to be stronger than the market.
    "A value analysis may lead to buying stocks before they are ready to move," he says. "By focusing on underpriced securities and industries that are already demonstrating market leadership, we can avoid getting in too early." Favorite holdings include Vallourec S.A., a French steel and alloy tubing manufacturer supplying the oil and gas industries; USG People N.V., a temporary staffing firm based in the Netherlands with operations across Western Europe; and Hopson Development Holdings, a Hong Kong company that develops, manages and invests in properties in China.
    He places no restrictions on market capitalization or traditional value and growth characteristics. "We'll look at any and all-sized companies," he says. "One year we may be categorized as a mid-cap value fund, and another we may be a large-cap fund. We just go where we see the best undervalued opportunities."
    Currently, the fund's emphasis is in the mid-cap range. But Snyder says that if the defensive stock theme has legs he will probably migrate the fund toward larger companies that dominate those types of industries.