An Interview With Peter Spano, Portfolio Manager, Preferred International Value

    by Maria Crawford Scott


    CATEGORY: Foreign Stock

    PERFORMANCE* (as of 6/17/03):

      1Yr 3Yrs 5Yrs
    Fund -2.8 -3.0 2.1
    Category -2.9 -13.2 -2.4
    MSCIEAFE 0.4 -12.5 -3.3

    RISK: Average

    TOTAL ASSETS: (as of 5/31/03) $243 million

    CONTACT: Preferred Group 800/662-4769

    *Reported by Morningstar.

    Stock investors looking for a “zig” up to balance the U.S. market’s “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.
    Where does your approach start?
      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. We’re obviously most concerned with the stocks that are in our portfolio as well as stocks in the top two deciles because that’s 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 there’s anything else that might be interesting to add to our database.

      We don’t 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 they’re large caps, sometimes they’re mid caps. More recently we’ve started to find better values in the large caps versus the mid caps, but that wasn’t true a year ago.

    What are the screens that you use for the 450 stocks?
      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.

      We’re really bottom-up stock selectors—there are no preconceived ideas on country weightings or industry representations in the portfolio. Having said that, obviously we’re concerned with risk control. We are always adequately diversified by country and industry. That’s sort of an overlay, if you will, on a bottom-up stock selection process.

    Once a company passes your initial screens and makes it on your list, when does it turn into a purchase?
      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 it’s 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 haven’t made money for the fund. That’s a value trap that we don’t want to fall into.

      If we’ve checked a stock out fundamentally and we’re convinced that the numbers are good, then it’s 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 we’re 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.

    What are catalysts?
      Often they are fundamental issues. If it’s a retailer, perhaps we’ll 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 we’re really looking for is earnings growth on a longer-term basis—what’s 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.

    Do your initial screens tend to lead you to certain industries?
      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.

      That’s not the case in today’s 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. That’s where there’s been a lot of strong rebound in terms of price appreciation on a year-to-date basis.

      Typically, being value managers, it’s 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, that’s very limited representation there.

    Do you have a price-to-growth screen so that you’re not totally excluded from those areas?
      Yes. We’re 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 wouldn’t 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, we’ve been fairly successful over the last few years.
    You mentioned that you try to make sure that you’re diversified both by country and industry. How do you ensure that?
      One of our risk-control mechanisms here is that we don’t 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 wouldn’t want to have more than 32% in Japan. For industry weightings, we’re willing to go as much as 15% above the index weight.

      In addition, we don’t allow any one holding to become unduly overweighted in the portfolio. If it gets to be a 5% weighting in the portfolio, we’ll 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 don’t look at emerging markets as a diversifier, we look at them opportunistically. What we’ve 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 we’ve had zero in emerging markets, and right now we have about 6%.

    Do you find that industry diversification is becoming more important than country diversification in investing overseas?
      That’s a debatable point. I don’t think either has any advantage over the other—I think there’s 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.

    What would prompt you to sell a stock?
      Our sell discipline is very strong. We sell a stock for two reasons.

      The first we like to call a “good” reason: That’s when, over time, we’ve 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.

    What about selling on the downside?
      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, we’ve lost confidence in it—perhaps we’ve done a poor analysis job and now recognize that the company has stumbled or hasn’t 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, we’ll 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.
    What about currencies?
      We don’t 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 we’ve looked at, the long term seems to bear all of that out.

    What im pact has the euro had on the European markets—has it made analyses and company comparisons easier?
      Yes—there’s no question about that. It’s made it a lot easier for the companies that operate in the euro zone. They don’t have to deal with the currency risks. You’ve done away with 13 currencies.

      In addition, comparing companies is easier—the euro zone has certain accounting conventions now and there’s an international accounting standards board that’s similar to the FASB in the U.S. There’s 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 won’t need an FASB; it’ll 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 that’s 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. There’s 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. There’s a lot of leverage on the upside as we move ahead.

    Will they be able to do so—is the political structure such that they can restructure in a way that’s competitive to U.S. companies?
      Our response to that is very simple: If they don’t do it, they won’t be around. Going forward it’s going to be a situation where you’re going to have winners and losers. The enlightened companies recognize that and they’re doing something about it.

      But if you select the right companies, you’re 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 it’s going to be with the companies that we own.

→ Maria Crawford Scott