Fluctuating global fortunes

As financial markets dive, bankers and investors alike are wondering whether to rebalance and just how risk averse they should become.

The bad trip continues for major US markets and some emerging markets (EM), particularly in eastern Europe, as concerns grow about currencies and outlook.

Meanwhile, the economies of Brazil, Indonesia and Poland have all suffered from a collapse in currencies as worries of interest rates, inflation and the pace of growth forced a widening of bond spreads.

“Our analysts are cautious on emerging markets in the near term, given strong cyclical headwinds, for example, the uncertain outlook for US interest rates and potential dampening of US consumption due to higher interest rates and energy prices,” Putnam Global strategists say.

“Yet the longer-term structural fundamentals supporting these markets remain intact.”

The pricking of the EM balloon serves to reinforce the view that ‘bottom up’ approaches work best for funds and regional selections are best served through judicious stock picking.

Giving the signal

So faith holds strong for international equities and, perhaps surprisingly, for the US market too, given its resilience.

Mercer’s market valuation summary, as at March 31, 2006, switched its valuation signal for overseas shares from fair to between fair and undervalued. The quarterly valuations provide institutions and retail investors with guidance on asset classes.

Mercer says the switch was driven by their view of non-US shares — that is, Europe, Australasia and the Far East (EAFE) shares, as undervalued rather than fair to undervalued. On a value/growth preference, the Mercer view was neutral to growth.

Trailing price to earnings (PE) ratios for overseas shares are low compared to recent history, Mercer adds.

Russell’s chief investment officer Peter Gunning says institutional money managers were mostly bullish on international equities in their most recent outlook survey for the end of March, while the US and Japan investment managers were bullish on their own markets.

In the US, manager sentiment was bullish on large caps.

Rashmi Mehrotra, principal of Mercer Investment Consulting, adds that regional selection may still work for Asia (looking at the expected performance of the EAFE shares), but high conviction may have the best outcome.

The Mercer report adds: “Emerging markets have continued to perform strongly and appear broadly fair valued versus developed markets on fundamental valuation measures.”

Merger and acquisition activity in Europe is also described as “intense, indicating strong investment sentiment and that corporate restructuring is taking place”.

Mehrotra points to the recent trend for global managers to move towards high conviction funds.

Selecting the right strategy

Value, growth, core, concentrated, absolute return styles — what works best now?

As Robert Keavney, chief investment strategist of wealth advisory group Centric Wealth, says: “We use international funds and not regional funds; the managers move in and out, according to their criteria.

“At the end of the day, it comes down to picking stocks rather than regions and whether that’s built into prices.”

As to which style or strategy works best in the current environment, Keavney says people shouldn’t simplify the idea down to value versus growth style, adding “that’s just not our view”.

“Value and growth is one criteria but there’s half a dozen others too. It’s a broad church. For example, Platinum and PM Capital, which are prepared to short stocks and markets as well as go to cash,” he explains.

“Another differentiator in a value manager is, say, where Perpetual has quality filters so their process reduces the universe of stocks down to good quality and their attitude is that if a company is poor quality then it’s never bought.

“However, the Platinum attitude is that we’ll buy a lousy company as long as it’s not as lousy as the market suggests.

“Then you have a large versus small cap bias … so there’s criteria on management style other than value and growth,” Keavney adds.

The concentrated, high conviction portfolios, such as Lazard, may also vary depending upon the stock number.

Lazard has two different equity trusts — one with fewer and one with a wider portfolio.

“So if one stock does well or badly, it flows through to the unit price,” Keavney says.

On the other hand, Dimensional has several hundred stocks in the portfolio, so each individual stock is immaterial to the performance.

Taking a core approach

Newly-arrived US giant Putnam has launched two standalone products locally in May — an income fund and a global concentrated fund.

Director Peter Walsh says Putnam’s approach is based around a core style (neither value or growth), which has generally been around 4 per cent above the benchmark.

“The high tracking error approach means all the risk is in stock selection rather than in regional allocations. So it’s more pure in a sense. The buzz about benchmark unaware is fine, but the core funds are disciplined around qualitative and quantitative inputs. A stock may be included even if there’s not 100 per cent on signals. But concentrated portfolio selection is only about positive signals because there’s stronger conviction. With back testing, we can have confidence in the numbers,” Walsh says.

Steve Burgess, AXA’s general manager of wealth management, says international equity funds continue to shine for AXA.

Indeed, Alliance Bernstein, which manages the AXA Global Equity Value fund, won Money Management’s Fund Manager of the Year Award last year and remains in the top quartile.

“But there’s a feeling that the growth style is returning,” Burgess says, “and we’re seeing an increased interest into our growth fund, managed by Alliance Capital Management”.

“We’re in a strange position in that value and growth are both performing because the global economy has been performing well and you will get good stock picks coming through.

“One thing we’re looking at is a blended fund. Bernstein has a US equity blended fund, which has done well; the idea is to mitigate against the downsides of growth and value. We’ve put together an Australian equity blended fund but that’s as yet unlaunched.

“We also have a core fund managed by Rosenberg and launched a year ago as an all out quantitative manager with no style bias.”

Hedging your bets

Core funds tend to find their place in model portfolio designers or with multi managers because they cover off a base with quantitative-based securities.

“In our case, it’s only a year old, so it’s got to get some traction with researchers, but the institutions are interested in it.”

This year’s Money Management Fund Manager of the Year Awards international winner Credit Suisse’s range of international share funds offer hedging strategies from zero to 100 per cent. The International Shares Fund had a one-year return to April of 33.5 per cent and a three-year return of 15 per cent.

The five-year outcome was a small positive but, as head of international equities Russell Bye says, that was part of the review to the mean because in the later part of the last decade, shares went up in local currency terms as the Australian dollar went down while the technology sector zoomed up.

“In early 2000, it was harder for many managers to add value to the funds with alpha — the sharemarket went down in local currency terms while at the same time the Australian dollar rose. All up, this made international shares a difficult asset class,” Bye explains.

“Going forward, over the next couple of years we expect returns to be low double digits, which is closer to long-term trends. US dividends will increase at a greater rate from a lower base than Australia and a dollar risk on downside so it [international equities] will be a good asset class.”

Jumping on Japan

Putnam Global gave Money Management its assessment on the US outlook as well as other insights.

On a regional basis, it has underweighted the US in favour of Japan in the past quarter and beefed up on Asia Pacific.

“We continue to believe the global economy will experience a slower-growth environment. As such, our focus on companies with strong free cash flows and above-average growth prospects remains the same. This should result in consistent, dependable, and superior long-term performance for the portfolio,” Walsh says.

Newfound confidence in Japan’s economy after a 15-year stint out in the cold means Credit Suisse funds have been overweight on Japan in the past year and underweight on the US.

“The central bank will increase interest rates and that will be good for banks and will increase their profitability,” Bye says.

“Real estate is also rising and so is lending.

“Japan has had a crisis in the banking system and that’s now over.

“We’re overweight in financials in Europe and Japan; and material stocks and selectively in telecoms and underweight in consumer stocks.”

Zurich is also overweight Japan at 17.5 per cent against the average 12 per cent and has been for some time, according to Zurich’s director of investments Matt Drennan.

Drennan says Zurich is following two key Asian themes. Firstly, the greater China theme of high growth, high metal intensity and secondly, the turnaround of Japan through private sector growth and with that, the “dark side restructuring” of its companies.

“China will continue to be a dominant player driving world growth, which will have flow through to other economies; the trick is to get exposure to growth but not the underperforming stock market, whereas for Japanese companies the issue is different. If they want to survive, there’s no choice but to restructure,” he says.

The importance of stock picking

Drennan says these ideas guide stock selection in the fund and points to an example of two different businesses in the same sector — retailing group Daiei, which has a traditional view of its business and was overcapitalised with too many stores, $10 billion debt and is now in bankruptcy. Compare this to Seven & I, which owns the 7/11 chain of convenience stores. It leverages off the need for convenience in Japanese society and offers a home meal service and an e-commerce facility.

“These two companies stand in stark contrast and reflect the real generational change occurring in Japan, where you have an entrepreneurial culture emerging,” Drennan says.

Finalist in the international equities category of Fund Manager of the Year Awards 2006, Walter Scott & Partners is a boutique growth manager run from Edinburgh and distributed by Macquarie Bank.

Walter Scott picked energy, energy services and financial industries in its Japan selection. This fund had a much higher weighting on Asia ex-Japan too with around 10 per cent exposure against the MSCI weighting.

Despite its smaller analyst team and collegiate approach to selection, Lonsec recently gave Walter Scott a highly recommended grade, praising its intense evaluation process.

America and the three pillars

At the heart of most international equities portfolio is the fate of the US, which dominates.

Mercer’s valuation report says it expects US shares to continue to perform satisfactorily.

“Shares are not expensive, economic and earnings growth remain firm, but higher bond yields may impact sentiment.”

Many funds have ridden a return to ITT with strong results also coming from energy, healthcare and financials.

Frederic de Merode, senior strategist at Fidelity International, says when it comes to looking at the US market, it’s worth reminding ourselves of three main pillars supporting equity performance.

“The first is that performance follows earnings growth; the link to GDP growth, while important, is less strong.

“The second is the basic economic principle of supply and demand, which many commentators express in valuation terms.

“And the third is the power of innovation and how this gives companies or sectors — and ultimately a market — a particular edge over the competition.”

So how does the US stack up on each of these core measures?

“If one looks at recent earnings for the first quarter in the US, there is cause for cheer,” Merode says.

Evidence supporting this is the recent Bloomberg data on 353 of the 500 companies in the S&P 500 Composite Index reporting earnings by May 1, 2006.

Of these 353 companies, almost 70 per cent had reported better-than-expected earnings.

“Not bad for a year when many commentators are expecting a gradual slowdown,” Merode says.

On the second issue of supply and demand, the strong pick-up in mergers and acquisitions, share buy-backs, and quoted companies going private, has ensured that the supply of equity has fallen while demand has risen. This is also supportive for performance, he argues.

Leaders in innovation

On the third issue, a company like Google exemplifies for many, Merode says, the type of world-beating innovation that can revolutionise a whole industry — in this case the world of search engines and Internet advertising.

“The US continues to produce leaders in a highly competitive world, and this is perhaps the single most important reason not to ignore it in a diversified portfolio,” he adds.

Putnam Global also believes that the fundamentals for US corporations continue to be solidly supportive.

“Economic data released in April portrayed an economy that not only remains resilient, but whose leadership is shifting to the highly profitable corporate sector,” it says.

Consequently, Putnam’s market strategists expect the US stock market to become increasingly competitive with non-US stocks (excluding currency-translation effects) as the year progresses.

“Small-cap stocks finally stalled in April, perhaps beginning the shift to large-cap leadership that our asset-allocation team has long anticipated.

“As investors come to discover and reward the profitability of large companies, small caps, which the team now considers overvalued relative to large caps, should lag. The team expects the pace of equity-market appreciation to moderate, and market leadership to drift toward larger-cap, growth-oriented companies.”

Among sectors, Putnam’s largest overweights are financials, energy, capital goods, and health care.

“Our overweight to energy, with positions in exploration-and-production stocks as well as refiners, reflects our bullish view on oil prices,” Putnam Global strategists say.

“We believe health care should do well in a slower-growth environment; at the stock level, sentiment has been very negative for some time, which has created many attractive valuations among high-quality companies.

“Within capital goods, we are positive on the defence industry as we anticipate an increase in defence spending relative to GDP.”

Significant underweights for Putnam include consumer cyclicals, consumer staples, and basic materials. Slowing economic growth, tighter monetary policy, and declining leading economic indicators across the globe have historically been very negative for basic materials.

“We also believe that valuations in the sector are not especially attractive, given that peak commodity prices and surging Chinese demand are already built into investors’ expectations.”

An alternative benchmark

Paragem’s Ian Knox says he’s been conscious about how the MSCI tends to be heavily weighted to the US and that “maybe investors and advisers should consider tilting to a different benchmark”.

“The generational shift over the past three years suggests that China is opening up faster and the pace is sustained — same for India. Prior to that, there were sporadic bursts from emerging third world economies … but many smaller economies don’t have long-term structural shifts occurring,” Knox says.

“There’s more likely to be structural shifts in the US and arguably in Australia too, which will reconfirm the long held view that Australia is primarily a resources economy.”

Zurich’s Matt Drennan agrees that volatility in international markets has dropped as shares trend upward. While the Australian stock market “has been a dream” in recent years, international equities “look better from where we stand today based on a range of factors”, he adds.

Yet many investors have resisted these opportunities.

“Benchmark unaware managers are one solution to help clients return to this attractive sector,” Drennan says.