An Interview With Peter Spano, Portfolio Manager, Preferred International Value
by Maria Crawford Scott
Stock investors looking for a zig up to balance the U.S. markets zag down have not found it overseas over the past few years. For the past decade, the international markets have tended to follow the U.S. with a short lag. On the other hand, with the U.S. market already on the rebound, the international markets present opportunities to investors willing to expand their horizons overseas.
One international fund that has done well relative to other funds in its category—and relative to the EAFE international index—is the Preferred International Value Fund. The fund has a four-star Morningstar rating, and is among the top 25% of all foreign stock funds for the last three-year and five-year periods.
In early June, portfolio manager Peter F. Spano discussed the management of the fund with Maria Crawford Scott.
What is the investment objective and basic approach of the fund?
Our basic objective is long-term capital appreciation, and we use a value style of management.
We have an active database with about 450 stocks that we rank by decile. The top two deciles, which would be approximately 90 stocks, would be potential buy candidates, and the lowest ranked deciles, nine and 10, would be potential sale candidates.
These are the stocks that we monitor on a regular basis. Were obviously most concerned with the stocks that are in our portfolio as well as stocks in the top two deciles because thats where the candidates are.
In addition, every quarter we screen about 2,500 stocks from a list that is well represented by industry and country just to see if theres anything else that might be interesting to add to our database.
We dont have any market-cap bias, although the average market cap we have now is about $7 billion. We tend to go where the best opportunities are—sometimes theyre large caps, sometimes theyre mid caps. More recently weve started to find better values in the large caps versus the mid caps, but that wasnt true a year ago.
We look at things like price-earnings ratio, price-to-book value, yield, long-term earnings growth, price to cash flow, earnings momentum, and the like. And we judge each stock relative to all of the stocks in the universe.
Were really bottom-up stock selectors—there are no preconceived ideas on country weightings or industry representations in the portfolio. Having said that, obviously were concerned with risk control. We are always adequately diversified by country and industry. Thats sort of an overlay, if you will, on a bottom-up stock selection process.
The rankings basically point out to us that a stock perhaps looks statistically cheap or statistically rich. Then it is up to us, as analysts, to determinewhether that statistically inexpensive stock is truly undervalued. If in fact its just inexpensive and not truly undervalued, then three or four years from now we may be sitting with that same stock that still looks inexpensive, but we havent made money for the fund. Thats a value trap that we dont want to fall into.
If weve checked a stock out fundamentally and were convinced that the numbers are good, then its a question of timing. Usually we will monitor the stock for weeks or even months before we step up to the plate. And that is usually a function of market dynamics—what were seeing out there in terms of the appetite for particular stocks.
Many value managers, particularly deep value managers, tend to get into stocks too early. We would rather monitor a stock on our radar screen than put it in our portfolio and watch it do nothing for two years simply because it looks cheap. Instead, we move in when we think there are catalysts ready to kick in.
Often they are fundamental issues. If its a retailer, perhaps well wait until we see an improvement in consumer confidence and early indications that consumer spending is picking up.
But, whatever the catalyst is on a shorter-term basis, what were really looking for is earnings growth on a longer-term basis—whats going to cause that to happen? Is it a new product, or a new management team that really seems to have costs under control and has started to raise profit margins? There are a whole host of factors that play into this.
Right now there are no industries or countries that pop off our screens as being significantly undervalued. There are points in time in the market when various sectors, or perhaps even particular countries, are just totally bombed out and there are lots of opportunities there.
Thats not the case in todays market, although we are finding some opportunities in the more economically sensitive areas and those companies that offer more operating leverage.
Certainly since the beginning of the year, most of the action has been in technology and telecommunications—areas that have been hurt significantly over the last few years up until the beginning of this year. Thats where theres been a lot of strong rebound in terms of price appreciation on a year-to-date basis.
Typically, being value managers, its difficult for us to find opportunities in those areas. But having said that, we do have some exposure in telecommunications and limited exposure to technology, which we bought early on. So they have helped us. But again, thats very limited representation there.
Yes. Were really relative value managers, if you will, as opposed to deep value. By way of explanation, if in fact you went back to the early part of 1998, we ended up buying some telecommunications and also had some limited exposure to technology stocks. These are stocks we had purchased at very depressed price levels. A number of deep value managers probably would not have bought those stocks simply because they tend to be dogmatic—perhaps they wouldnt pay more than seven times earnings or five times cash flow. We would if, in fact, the earnings growth was there. On a relative value basis, weve been fairly successful over the last few years.
One of our risk-control mechanisms here is that we dont want to be more than 10% above the EAFE index weight of a particular country. In other words, if the index is 22% for Japan, we wouldnt want to have more than 32% in Japan. For industry weightings, were willing to go as much as 15% above the index weight.
In addition, we dont allow any one holding to become unduly overweighted in the portfolio. If it gets to be a 5% weighting in the portfolio, well cut it back.
We also are willing to expose up to 10% of the portfolio assets in the emerging markets/developing markets if in fact we can find opportunities there. We dont look at emerging markets as a diversifier, we look at them opportunistically. What weve done there is to cherry-pick universal companies that just happen to have the wrong address, if you will. There have been points in time when weve had zero in emerging markets, and right now we have about 6%.
Thats a debatable point. I dont think either has any advantage over the other—I think theres a need to be well diversified from both points of view.
In emerging markets, the country factor tends to be more important than it might be in a developed market, simply because the level of political risk in a place like Brazil or Argentina is a lot greater than it would be in the UK or Switzerland.
Our sell discipline is very strong. We sell a stock for two reasons.
The first we like to call a good reason: Thats when, over time, weve made money in a stock, and it is clearly not only expensive but, more importantly, truly overvalued. In that case, we tend to ease out of it—not sell all of it at one time, but just sell it into the marketplace. The ideal situation would be lots of buyers, the stock has been discovered and is in demand, and we can take our time selling it over a period of time. It could take weeks or a month by design.
Let me give you a good example. Back in early 2000, we owned British Telecom. You may recall that back then everybody had to have telecommunications stocks—that was just about at the peak of technology, telecom and media stocks. We had owned British Telecom for about two and a half years, had made a lot of money on it, and it was now a nine- or 10-decile stock—statistically it was rich. There was nothing fundamentally wrong with the company; the fundamentals at that time still looked pretty good. But consensus earnings growth numbers were rising to the mid-teens and we thought that was ludicrous. However, we also recognized that there was a very strong appetite for telecom stocks out there. We started very slowly selling that stock over a period of months until we exited. There was no compelling reason to sell it all in a day or two—it just made sense and it was prudent for us because of the dynamics of the marketplace at that particular point in time to take our time in selling it.
The other reason we would sell is if something has fundamentally gone wrong within the company. Even though it may not be ranked as a sale statistically, weve lost confidence in it—perhaps weve done a poor analysis job and now recognize that the company has stumbled or hasnt delivered what they and we expected. In that particular situation, we want to get out of that stock as fast as we can—if we can sell it all in one day, well do that. Once we lose confidence in something, we think it makes sense to get out of it, even if it means taking a loss.
We dont hedge currencies—we never have. We view currencies as a diversifier. Currencies are figured into the earnings estimates we come up with. Sometimes the currencies are going to hit the earnings in a positive way and sometimes a negative way and that all ultimately comes out in the analysis.
Having said that, we also know that on a longer-term basis, currency factors do wash out. On a short-term basis, they clearly have a lot of impact. But according to empirical studies weve looked at, the long term seems to bear all of that out.
Yes—theres no question about that. Its made it a lot easier for the companies that operate in the euro zone. They dont have to deal with the currency risks. Youve done away with 13 currencies.
In addition, comparing companies is easier—the euro zone has certain accounting conventions now and theres an international accounting standards board thats similar to the FASB in the U.S. Theres more standardization—the ISB, the international group, and the FASB work together very well. There may even be a point in time, down the road, when we wont need an FASB; itll just be ISB, period.
Many U.S.-based investors became disillusioned with international funds over the past five years because they followed the U.S. markets so closely—diversifying into those markets did not lower their risk. Do you think international markets have changed or were investors expecting too much from them?
All the empirical studies continue to show that adding international stocks to a portfolio does reduce risk. At one point, diversifying overseas was also significantly adding return as well as reducing risk. The return issue has come under some question in the last few years for a whole bunch of reasons, but thats not indicative of what may be happening going forward.
If you look at valuations today in foreign markets, and certainly the stocks we look at, there are much better opportunities overseas in terms of valuation relative to the U.S. market. Theres a lot more restructuring that needs to take place in companies overseas that are probably, on average, five years behind the U.S. in that respect. Theres a lot of leverage on the upside as we move ahead.
Our response to that is very simple: If they dont do it, they wont be around. Going forward its going to be a situation where youre going to have winners and losers. The enlightened companies recognize that and theyre doing something about it.
But if you select the right companies, youre going to make good money. There are a lot of very fine companies outside the U.S. Certainly, on average, the U.S. companies have clearly been the leaders and—deservedly—have seen their stock prices improve and their earnings multiples go higher than some of their competitors overseas. We think a lot of that is going to change going forward and hopefully its going to be with the companies that we own.