Frequent Fliers

Morningstar

Andrew Foster is used to spending hours on a plane as he searches the globe for stocks he believes are undervalued. A recent 10-day trip spanned more than 15,000 miles as he visited with more than a dozen management teams in Mumbai and Hong Kong. Only a typhoon kept him from traveling to mainland China. Such due-diligence trips are routine for Foster, who launched emerging-markets fund Seafarer Overseas Growth & Income (SFGIX) in 2012 after almost a decade of successfully guiding offerings at Matthews International Capital, the parent firm for the Matthews Asia funds.

"You want to make sure reality matches your analysis," Foster says. "It's worth the trip if you come back with one good idea."

Foster and peers such as Ralf Scherschmidt of Oberweis International Opportunities (OBIOX) and Henrik Strabo of Rainier International Discovery (RISAX) are part of a cadre of managers running small funds that are trying to keep pace with their bigger brethren in Morningstar's international fund categories. Their funds may not have the long performance records of, say, Gold-rated Oakmark International (OAKIX). But the managers have proven themselves at their current funds and previous charges. Indeed, the Seafarer and Rainier funds were in the top quintile of their respective peer groups in 2013, while Oberweis International Opportunities' 55% gain last year was tops in the foreign small/mid-growth category.

These managers, though, have their work cut out for them. The old adage is that investors should pay up for international managers because they can exploit local market inefficiencies. A good manager with analysts on the ground can find attractive stocks long before others do. To that end, J.P. Morgan has an annual research budget that surpasses $100 million. T. Rowe Price has 12 experienced analysts that just focus on the Middle East and Africa. By comparison, Scherschmidt has four analysts--for the entire globe.

Another obstacle to contend with is a series of index mutual funds and exchange-traded funds that allow advisors to get more focused coverage to a certain region or country and different-sized companies within those areas. For example, Vanguard FTSE Emerging Markets (VWO) and iShares MSCI Emerging Markets (EEM), two of the five largest ETFs, hold a combined $97 billion of total assets. Investors can also purchase international ETFs that focus on emerging-markets small caps, dividend payers, and bonds. Emerging-markets factor-based ETFs are also emerging. Active managers must duel with these funds for assets.

"There is a value-add for sure for [an active manager], especially in a market that is hard to focus in on," says Dave Stock, chief investment officer of Rainsberger Wealth Advisors in Colorado Springs, Colo. Stock uses a mix of active funds, index funds, and ETFs in his practice. "At some point we are vehicle-agnostic," he says. "But it's a good overlay to have some active management."

Foster, Scherschmidt, and Strabo must also navigate a shifting international investing landscape. Emerging markets were key performance drivers the past decade as demand for commodities and infrastructure projects led to robust economic growth.

Now, though, bellwethers such as China and Brazil are expected to grow 7.7% and 2.4%, respectively in 2013, below the levels that made them darlings in the 2000s. Concerns about the Federal Reserve ending its tapering policy have also weighed on these markets. The average diversified emerging-markets fund was flat in 2013, and India equity funds were down a staggering 11%. Meanwhile, Japan has jumped as economic reforms have taken hold. The average Japan stock fund was up 26% last year.

Here's a look at how each of these managers tackle the challenges of investing internationally--with resources reflective of their small asset bases.

Oberweis International Opportunities: Exploiting Earnings Surprises
Scherschmidt welcomes competition. That's because he thinks they often get things wrong. So much so that he incorporates into his stock-picking strategy what is called "post-earnings-announcement drift." Research has shown that share prices are slow to react when companies announce surprise earnings. One explanation is that instead of analysts updating their valuation models based on the new information, they cling to their original theses, not wanting to be the first one to say a company is in turnaround mode. As a result, the stock price eventually "drifts" toward a higher price over weeks or months.

"The analysts don't understand the company," he says. "That's when we go in."

The phenomenon doesn't get arbitraged away, he says, because there will always be people who are more concerned with keeping their jobs than sticking their necks out.

"A lot of firms are unwilling to jump into a stock they think may be overvalued," says Stock, who has put some of his clients in the Oberweis fund. "They have a hard time buying it even when it breaks out to a new high."

An earnings surprise isn't the only detail Scherschmidt and team analyze. They also evaluate companies on data points that fall into three buckets: business fundamentals, valuation, and catalysts. In short, Scherschmidt wants to own companies with growing profit margins and market shares and an attractive valuation relative to his perception of their intrinsic value. The portfolio will typically consistent of 50 to 90 companies in developed international countries that have market capitalizations between $100 million and $5 billion. Last summer, that process led him to Alcatel Lucent (ALU), the French telecom equipment maker. Scherschmidt says the firm lost market share over the past few years as competitors marketed better products. But, he adds, a new CEO appointed earlier this year is shuttering or selling off non-core businesses, paying down debt and refinancing other liabilities, leading to cost savings that could easily top $1 billion. (Earnings have already started to improve.) He's also been adding to Japanese auto-parts makers.

"People stopped buying new cars [in the downturn], but at some point those cars get old," Scherschmidt says. "They have to be replaced or repaired."

Scherschmidt helped launch the Oberweis fund in early 2007, just as the financial crisis was taking hold. The fund's five-year performance attribution shows Scherschmidt has been able to add value compared with his foreign small/mid-growth category counterparts in most sectors, especially energy and industrials. The fund's top performers during that time were GungHo Online Entertainment, a Japanese video game company, and Ashtead, a U.K.-based heavy equipment rental firm.

However, Scherschmidt does have one glaring blemish on his record. The fund dropped a staggering 60.5% in 2008, which put it near the bottom of the foreign small/mid-growth category rankings. Scherschmidt got caught holding a large chunk of industrials that underperformed that year. While the loss didn't shake Scherschmidt's conviction in his stock-picking process, he did take steps to better manage risk in the portfolio. For example, he now uses a tool provided by Empirical Research Partners that measures the fund's risk across sectors, countries, valuations, and individual stocks. While the fund has beaten the peer group average every year since then, its overall Morningstar Risk rating remains high.

The fund could also stand to improve when it comes to fees. It's 1.6% annual expense ratio is slightly higher than the 1.55% average for the foreign small/mid-growth category. The fund's 280% turnover is also a concern, since such churn can lead to higher trading costs.

Scherschmidt says most of the turnover is the result of taking profits and losses. In addition, Scherschmidt, who has as much as $500,000 of his own money in the fund, tries to manage the trading in a way that minimizes taxes. Indeed, the fund's tax-adjusted returns are some of the best in the category.

Rainier International Discovery: A Smart Call
Earlier last year, Strabo got a little uncomfortable. He had overweighted the fund toward emerging markets. But he grew concerned about slowing economic growth, current account deficits, higher inflation, and rising interest rates in some of those countries. He decided to pull back, cutting the fund's exposure to 16% of assets from as much as 30%.

"It was the biggest change in the portfolio since the inception," he says.

The timing worked in his favor. When the Federal Reserve announced in June that it may begin tapering its stimulus program by the end of 2013, emerging-markets stocks sold off. The fund, which has gained a strong 33% in 2013, was mostly insulated from the drop. Strabo since began adding to blue-chip emerging-markets stocks that he felt were oversold.

When making this call, Strabo relied on past experience. Although the Rainier fund is less than 2 years old, he's been investing in international stocks for more than two decades. Most of his experience stems from his time at American Century, where he was the firm's chief investment officer of international equities and manager of funds such as American Century International Discovery (ACIDX) and American Century International Growth (TWGAX). During his tenure at International Discovery, which ran from 1994 to 2002, the fund gained an annualized 12.5% versus 2% for the MSCI EAFE Index. He guided International Growth to an annualized gain of 8.3% between 1993 and 2005. That tally beat the index by two annualized percentage points.

At his current charge, Strabo looks to build a portfolio of stocks with market capitalizations that are less than $5 billion. Strabo is benchmark aware, staying within reach of the MSCI ACWI ex-U.S. Small Cap Index in most cases, but venturing from that bogy when his team's bottom-up research gives him conviction in a certain stock, sector, or country. He emphasizes quality companies with attractive valuations, strong management, and performance drivers that can propel earnings. He tries to control risk by keeping the portfolio diversified with between 60 and 120 stocks and across regions and by trimming positions as they exceed or fall short of his expectations.

The fund's positive 2013 performance was largely due to top holdings such as Pigeon Corp. and Wirecard. Germany-based Wirecard does payment processing over mobile devices. Strabo likes the firm because it has a strong presence in both developed and emerging markets and continues to develop new client relationships. The stock was up almost 50% in 2013. Pigeon, a South Korean maker of household products, was up about 150% last year.

Another top performer was KakaKu.com, a Japanese price comparison website for shoppers. Strabo has also been dipping into frontier markets, too. A recent purchase was Kolao Holdings, a conglomerate that gives the fund exposure to fast-growing Laos. (The Asian Development Bank estimates the country's economy will grow 7.7% in 2014.)

"We want to invest in companies that are good at what they do," he says. "They have dominant market positions and good products and services. Yet they are small enough to see a clear path to wealth creation."

Strabo is supported by two experienced analysts. But he can also tap the research conducted by Rainier's eight-person domestic team and a small two-person fixed-income team. In total, the firm runs almost $11 billion.

Seafarer Overseas Growth & Income: Starting From Scratch
Foster knows what it's like to have a plenty of resources at his disposal. As a portfolio manager at Matthews Asia funds in the 2000s, he could lean on about a dozen portfolio managers and analysts. Now, though, he has just two associate portfolio managers to split the research duties with. And that's the way he likes it. To Foster, having an army of analysts on the ground in local markets is overrated.

"Boots on the ground sounds wonderful," he says. "But if you are in the local market every day you can fool yourself into thinking you know more than you actually do."

Foster's goal is to use a combination of stocks, preferreds, and convertible bonds in order to build a portfolio that can generate capital appreciation and current income. He largely avoids making top-down decisions based on macroeconomic trends. Instead, he favors picking emerging-markets stocks with attractive valuations and consistent cash flows that can be used to pay dividends. He keeps the fund diversified across sectors and regions. But holding just 41 positions, the fund is a bit concentrated. Indeed, 35% of assets are in its top 10 holdings.

Lately, Foster has been focusing some of his research efforts on the traditional BRIC countries--Brazil, Russia, India, and China-- but especially Brazil. These countries were under-represented when Foster launched the fund because he had valuation and currency concerns. Now, slowing growth in China has spilled over into Brazil, a chief trading partner. Foster says the dips in the BRICs have presented an opening. He is leaning more toward service-oriented firms. He recently initiated a position in Valid, a Brazilian company that manufactures credit cards and cellular phone cards and prints driver's licenses and corporate photo IDs. Another holding is Odontoprev, which specializes in dental benefits.

"The hot market is actually going to be the market within the hot market," he says. "The real frontier is the services sectors in these countries. It's reminiscent of the U.S. in the 1940s. And those domestic sectors are undervalued in a lot of countries."

There is ample reason to buy into what Foster is saying. As a key manager on the teams running Matthews Asia Dividend (MAPIX), Matthews Asian Growth & Income (MACSX), and Matthews India (MINDX), he helped post performance throughout the 2000s that easily outpaced the MSCI EAFE Index.

In the early going at Seafarer, Foster has been able to add value compared with peers in most sectors. NTT DoCoMo (DCM) and Malaysia glovemaker Hartalega were two of the fund's top performers the last year. Gains from those stocks, though, were somewhat washed out by Latin America holdings such as Chile-based SQM, which produces specialty chemicals. Its shares fell on weak exports. That stock is no longer in the portfolio. Foster, though, has largely been sticking by his positions, as evidence by the fund's 39% turnover (versus 72% for the category average). And he thinks the consumer-oriented names in the portfolio will pan out over the long haul.

He adds a word of caution for emerging-markets investors: "You have to analyze the control party," he says. "In most cases, the company has a person or entity behind the scenes that sets the agenda. It is essential to know their intentions."

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