World of trouble

The global downturn has hit U.S.-based international funds. Holding up best: small caps and value.

The global downturn has hit U.S.-based international funds. Holding up best: small caps and value.

By Constance Gustke
October 2001
Institutional Investor Magazine

For Americans, a year abroad is thought to be enriching. But not if they’re investors and it has been a year like this one. Hammered by a strong dollar and weak global markets, most U.S.-based international stock funds have been floundering. The reason: Diversity hasn’t delivered. Unfortunately, the world turns out to be more integrated than ever at a time when Europe, Japan and the U.S. are simultaneously in the doldrums, or in “synchronous” decline in economese.

Following slight gains in 2000, U.S. international funds as a group sank nearly 19.3 percent through August in dollar terms, reports research firm Morningstar. This compares with a decline of 7.6 percent for the Standard & Poor’s 500 index and 14 percent for the MSCI Europe, Australasia and Far East index. “This year the markets are more difficult, because all developed markets have followed the U.S. market,” says Morningstar analyst Gabriel Presler.

So international funds are typically holding 7 to 10 percent of their assets in cash. Even economies that seemed robust this spring, such as those of France, Germany and Italy, are now struggling. Only a few markets worldwide - notably, Russia (up 45 percent in dollars through August), Thailand (up 23 percent) and Indonesia (up 11 percent) - have bucked the trend.

Small-cap international stocks are bearing up a bit better than large-cap, although they, too, declined 7 percent on average in the year through July. It’s easier to find value with small caps, says Margaret Naylor, portfolio manager of the Morgan Stanley International Small Cap Fund, because analysts don’t do that much research on international small caps, making for tremendous price inefficiencies. Adds Joseph Leung, portfolio manager of the Barr Rosen Institutional International Small Cap fund, “Small caps are becoming more undervalued.”

Among large-cap funds, value investing is king. At Morgan Stanley Dominic Caldecott, chief investment officer of the firm’s Institutional International Equity Portfolio Fund, says valuations are returning to “a reasonable level” after the bursting of the tech bubble. In these tough times Caldecott is stressing companies with “resilient cash flow,” such as tobacco and confectionery concerns.

Memphis, Tennessee-based Longleaf Partners scours Europe and Asia looking for midsize companies that the firm judges to be severely undervalued. Currently, most investments are in food staples like brewery Molson Cos. Last year the Longleaf Partners International Fund returned 26 percent, and this year through August it was up 15 percent.

Old-fashioned defensive stocks are also back in style. David Mannheim, manager of the large-cap MFS Institutional International Equity Fund, is adding food companies, such as Nestl,, along with pharmaceuticals and banks to his portfolio. That should help counter the fund’s 12.3 percent slide this year through August.

What about the battered tech sector? Mannheim is betting on cellular companies like Vodafone Group to revive. And Morgan Stanley’s Caldecott has invested in - of all things - semiconductor stocks in Japan and South Korea. “We’re finding high-quality companies with high returns,” he says.

So will big international stocks recover soon? Probably not. They tend to lag the U.S. market by six months, and international companies’ earnings estimates, says Caldecott, are “probably too high for next year.”

For now, small may be better. “International small caps will finally get the attention they deserve,” contends Barr Rosen’s Leung. “They will outperform international large caps.”