Mutual Funds

Nine Reasons to Invest Abroad

Europe's cheap stocks and China's rapid growth may entice you to head overseas. Here are six top no-load foreign-stock funds that will make the trip a little easier.

By Steven Goldberg, Contributing Columnist

From Kiplinger's Personal Finance magazine, August 2004

International funds--do you own any? Perhaps you need motivation, so try this: European stocks are notably cheap today, whereas U.S. stocks are not. On the other side of the globe, China is growing at a breakneck pace and lifting economies and stock prices across Asia -- even Japan seems to be awakening from 15 years of economic lethargy. And owning funds that invest in Europe and Asia is a terrific way to diversify and smooth out the ups and downs of your investments.

Those are three reasons to invest overseas. Want more? The other six are the international funds in which we have the highest degree of confidence.

Before we tell you more about them, consider the case for investing overseas. China is now the world's manufacturing epicenter. Its economy is growing at a rate of 10% per year. Raw materials from countries such as Australia and New Zealand feed its factories, and companies in other Asian nations sell their goods to a growing and acquisitive Chinese consumer class. With many of its 1.3 billion people migrating from farms to factories, China seems destined to grow faster than the developed world indefinitely.

Ironically, one of the main reasons for the volatility of Asia's stock markets is that China may be growing too quickly. Because such rapid economic growth often leads to dangerously high inflation, the Chinese government is trying to slow growth to 7% or 8% a year. What often happens in such circumstances is that policymakers hit the brakes too hard, choking, instead of slowing, the economy. The forces driving China's growth are so powerful, however, that any interruption is likely to be only a relatively brief -- albeit painful -- blip in the long-term trend.

The picture in Europe is less rosy. Much of Western Europe, except England, clings stubbornly to costly labor, pension and welfare systems. These factors make companies reluctant to hire workers and result in anemic growth. "Those 35-hour workweeks and five weeks off in the summer are not realistic," says David Herro, co-manager of Oakmark International fund.

Still, Europe is home to many world-class companies, such as BMW and Volkswagen. These companies stand to benefit from cheap labor from Eastern European countries, eight of which just joined the European Union.

Foreign stocks, in general, are cheap. Morgan Stanley's Europe, Australasian and Far East (EAFE) index, a broad-based measure of foreign stocks, sells at 15 times estimated 2004 profits. Since 1970, EAFE's median price-earnings ratio is 23. Compare that with a P/E of 18 today for U.S. stocks, as measured by Standard & Poor's 500-stock index.

The easiest way to invest overseas is through funds. Here we identify the six best no-load foreign-stock funds. Our picks have produced consistent, above-average returns; charge modest fees; and are run by talented, experienced managers (who often have conflicting views about foreign markets). Consider buying two funds -- one that focuses on large companies and one that invests in smaller ones. Long-term investors can justify placing a fourth of their stock investments in overseas funds.

Growth maven

Mark Yockey had a rare off year in 2003 -- at least relative to other overseas fund managers. The problem? Some of the financial and consumer stocks he owned failed to take off because the economic recovery was slow to arrive. But Yockey remained patient with those stocks, and Artisan International, the fund he's run since its inception in late 1995, is slightly ahead of the pack in 2004. Over the past five years, Artisan ranked among the top 20% of diversified foreign funds -- a fine showing given that the large, high-quality companies Yockey prefers have generally been out of favor in recent years. Artisan has returned an annualized 6% over the past five years, while the EAFE index returned an annualized 1% (all returns are to June 1).

Yockey is increasingly finding his kind of stocks in Asia, especially Japan. Like the managers of most large-company-oriented international funds, Yockey, 48, invests mostly in Europe. But the San Francisco-based manager recently doubled his fund's stake in Japan, to 18% of its $10 billion in assets. "This is the first time in 15 years that Japan is actually starting to make some progress," he says. He particularly likes Honda (symbol HMC) and brokerage Nomura (NMR). He considers Honda to be one of the world's best-run carmakers and says that Nomura will benefit from a rising Tokyo stock market. (Note: We list symbols for foreign stocks that trade actively in the U.S. as American depositary receipts.)

In Europe, Yockey owns a slew of media stocks. "The nice thing about media companies is that they don't have to make huge capital expenditures," he says. So, as companies attract additional customers and advertisers, the increased revenues drop almost straight to the bottom line. Yockey's favorites include satellite broadcaster British Sky Broadcasting (BSY) and ITV, another British broadcaster.

Strength in numbers

At last count, Fidelity Diversified International owned 392 stocks -- too many for most mortals to track. But Fidelity has 93 analysts assigned to its foreign-stock funds, which, including those run for non-U.S. investors, contain $236 billion in assets. That gives Boston-based manager Bill Bower an edge over his competitors. "About 95% of the stocks that go into the fund come from ideas that are generated by our internal research," he says.

That advantage has translated into superior performance. Diversified International returned an annualized 8% since Bower took over the reins three years ago, putting it in the top 10% of diversified overseas funds. And before that, Bower chalked up solid numbers for three years at Fidelity International Growth & Income.

Bower looks for stocks that he thinks will provide superior performance over the next two or three years. He prefers growing companies with stocks that sell at reasonable prices. And although he focuses on individual stocks rather than making bets on countries or sectors, he is bullish on health care, particularly the beaten-down stocks of European drug and medical-equipment companies. Bower, 37, won't discuss individual stocks, but two of the fund's biggest holdings are pharmaceutical giants GlaxoSmithKline (GSK) and Novartis (NVS).

Bower is looking past the short-term question marks in Asia: "Over the next three to five years, India, China and South Korea will be some of the fastest-growing countries in the world." He's high on natural-resources companies, which are helping to fuel those Asian economies.

Hard to pin down

We've become believers in Richard Pell and Rudolph-Riad Younes. In the nine years that the pair have run Julius Baer International Equity, in only one year has the fund finished in the bottom half of its category. Over the past five years, it was in the top 10% of diversified overseas funds, having gained an annualized 11%.

Pell and Younes are hard to pin down. Most superior managers adhere to a strict stock-picking discipline: They'll invest either in undervalued stocks or in fast-growing companies with share prices that make bargain hunters cringe. And most first-class managers focus on finding attractive stocks rather than trying to forecast the economy, currencies or industry sectors.

But Pell and Younes are different. They've filled their fund with bargain-priced stocks and with higher-priced shares of fast-growing companies. And they make economic predictions and calls on various markets, as well as pick stocks. "To ignore the economic picture is to use only half your brain," says Younes (who won't give his age; Pell is 49). Switching metaphors, he adds, "We are freestyle swimmers. The fastest way to swim is freestyle, and we swim very fast."

Lately, the duo have been swimming away from Asia. "A slowdown in China will mean a slowdown in the rest of Asia," Younes warns. So, he and Pell have cut back on companies in emerging markets that supply commodities to China. They've also trimmed their holdings in Japan.

Europe is more to their taste. Unlike the U.S., which is running a huge budget deficit and has high consumer debt, Western Europe is relatively staid, says Younes. Economic growth in Europe, he figures, will pick up -- eventually. "We love Europe," he says. "Once the economies improve, you could have long, sustainable gains." One of his favorite stocks is Vodafone (VOD), which Younes calls "the world's cheapest cell-phone company." Younes and Pell are also enthusiastic about Eastern Europe, having invested 15% of their fund's assets in companies based there (that figure includes investments in Turkey). They figure that the region will benefit from the European Union.

Bargain hunters

When stocks go in one direction, David Herro's and Michael Welsh's emotions often go the other. They're contrarian thinkers.

By that, we mean that Herro, 43, and Welsh, 41, who co-manage Oakmark International, hunt for good companies whose share prices are beaten down because the stocks are out of favor with most investors. Like Pell and Younes, the Oakmark pair currently love European stocks (which make up 75% of the fund's assets). Many European companies that do business worldwide are taking advantage of opportunities in developing economies. "They're building new plants in Eastern Europe and Asia," says Herro. "No one is building a thing in Western Europe." Like Fidelity's Bower, the Oakmark managers' favorite drug stocks include GlaxoSmithKline and Novartis.

Herro agrees that China is a key factor driving global growth, but says Chinese stocks don't hold much allure for him and his partner. Says Herro: "The companies are badly run, and it's a very competitive place."

Oakmark hasn't finished below average among other foreign-stock funds in any calendar year since 1998. That's partly because undervalued stocks have been in vogue most of that period. But the fund's longer-term record is impressive, too. Its 9% annualized return over the past five years puts it in the top 10% of its category.

Small-firm specialist

Because few professional investors spend a lot of time researching small foreign-based companies, those stocks are often in the bargain bin. So it makes sense to invest a portion -- though not the heart -- of your overseas money in a fund that focuses on small, foreign companies.

Founded in 1988, T. Rowe Price International Discovery is the oldest small-company overseas fund. Over the past five years, it ranked in the top 20% of the category, returning an annualized 14%. Still, you shouldn't expect a smooth ride with Discovery. It gained 48% in the past 12 months, but it lost 63% during the 2000-02 bear market.

A team of veterans runs Discovery. Although he's only 36, lead manager Justin Thomson has more than a decade of experience in his region (Europe). So do his three co-managers. Thomson is based in London, and his three co-managers are based in Hong Kong, Singapore and Tokyo. They spend some time predicting the economies of various countries and regions. But they focus mainly on picking stocks -- with the help of 18 T. Rowe Price foreign analysts. Like most T. Rowe Price managers, they seek stocks of growing companies but won't pay high prices for them. "We like to buy small stocks before they're discovered," Thomson says.

Thomson believes Japan is finally on the mend. "Japan has been restructuring gently" for many years, he says. The fund has nearly a fourth of its assets in Japanese companies, mainly those that sell to consumers, who are increasing their spending.

Discovery has another 22% of its assets in other Asian countries, although it has only 2% in China. Thomson doubts that China can slow down its economy without harmful effects. "I think it will be a hard landing," he says, and that will have a negative impact on other Asian economies. But long term, he's convinced that both China and India will grow rapidly, boosting the entire region.

Cheapskate disciple

Like T. Rowe Price International Discovery, Third Avenue International Value focuses on small companies. But unlike Discovery, which specializes in growing companies, Third Avenue is concerned more with identifying bargains. Manager Amit Wadhwaney is a disciple of Third Avenue founder Marty Whitman, whose mantra is "safe and cheap."

At first blush, the fund -- less than three years old -- seems too new to recommend. But it ranked in the top 30% of all small-company overseas funds in 2002 and 2003. And at age 50, Wadhwaney is no neophyte. He has researched stocks for Third Avenue since 1990, concentrating on foreign companies most of that time.

Wadhwaney ignores the big picture. Instead, he looks for stocks selling at steep discounts to the value of their assets, after subtracting their liabilities. "We don't make any economic prognostications," says Wadhwaney. "We pick each stock on its own individual merits." He demonstrates confidence, however, in the stocks he does buy. The fund owns only 37 stocks, including oil-service companies in Norway and mining companies in Canada.

Fording Canadian Coal Trust (FDG) is a classic Third Avenue stock. The company mines metallurgical coal, which is used in steel production. It's one of the biggest players in an industry that has seen consolidation and many departures. That enables Fording to raise prices, Wadhwaney says. Moreover, the stock yields a juicy 7.5%.

About 35% of Third Avenue's assets are in cash. That's because, Wadhwaney says, most stocks are too expensive. He sniffs at "this China madness." But as Asian shares retreated a bit recently, some stocks are becoming more attractive, Wadhwaney says.

--Reporter: Elizabeth Kountze

International Funds: Our six favorite no-load choices

Our picks among diversified overseas funds represent a mix of funds that buy growth stocks and those that specialize in cheap stocks. Two of the funds focus on small-company stocks.

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