Emerging markets have been stealing the headlines lately, and it's easy to see why. Over the last five years, stocks in developing countries were up 12.9% annually, while domestic stocks, at least as measured by the S&P 500, gained only 2.3% as of Dec. 31.

More important for investors, the growth rates of emerging markets surged ahead of mature economies. China's gross domestic product grew by 10.3% in 2010, while Brazil clocked in at a 7.5% rate. The United States, meanwhile, turned in a tepid 2.7% rate, while the European Union's GDP increased by an even more paltry 1.7%.

But all that growth and impressive stock performance has come at a cost, namely higher valuations and higher inflation rates in emerging markets. "When those governments start hiking interest rates, there's very little investors can do," says Peter Baughan, one of the managers of the Harding Loevner Global Equity fund. Investors like Baughan have concluded that the United States, even with its stubbornly high unemployment rate and lukewarm economic rebound, offers better value today, largely because that market has been so cool in recent years.

By constantly looking for undervalued geographies and sectors, Harding Loevner Global has carved out an impressive record. Over the last three years through Feb. 11, the fund is up 4.4% a year, besting 86% of other funds in the world stock category, according to Morningstar. Over the last three years, the fund is up 6.1% a year, in the category's top 10%.

 

LEAVING THEM IN THE DUST

Harding Loevner, based in Somerville, N.J., was born when Daniel Harding and David Loevner left Rockefeller & Co., the wealthy family's private investment office, in 1989. They spent 12 years there diversifying the group's investments into Europe and Asia. Baughan, a former colleague from Rockefeller, joined in 1997.

From the beginning, the firm established international, global and multi-asset investment strategies, adding emerging markets in 1998. The mutual funds mirror the institutional investments, which have the lion's share of the firm's assets. While the Global Equity fund has just $174 million in assets, there is $4 billion on the institutional side.

Harding Loevner's investment process aims to identify "thoroughbreds," Baughan explains. These are defined as businesses with such strong long-term growth prospects that they leave all others in the dust.

From its universe of close to 600 stocks, the managers winnow down their picks to about 50 issues. They are looking for companies that display quality characteristics, like return on capital, return on assets, return on equity, leverage and profit margins that are in excess of the market. In tandem, Harding Loevner looks for growth measurements, such as trailing earnings, actual earnings and dividend growth rates that are well above average.

The team does not screen for price-to-earnings or other ratios used to determine value like price-to-sales or price-to-book. Instead, they perform a discounted cash flow analysis to come up with their estimate of fair value. "There is nothing predictive about a company's quality or structure that can be gleaned by its P/E," Baughan believes.

The result of this process is a portfolio with enviable characteristics. For example, the average earnings growth is 10%, compared with 4.3% for the MSCI All Country World (ACW) Index, the fund's benchmark. The fund's return on equity is 15.2%, while the MSCI ACW's is 12.1%.

 

THE RIGHT SECTORS

While the process is bottom up, security selection carries industry and geographical biases, however. "We can identify a thoroughbred business, but we believe that they only operate in industry structures that allow it," Baughan says.

For example, during the financial meltdown of 2007 and 2008, Harding Loevner began shifting away from financial services and consumer discretionary companies. They thought many of the stocks in those sectors were expensive, especially as economies around the world looked poised for downturns.

"We didn't like the valuations of the consumer discretionary sector and thought that the consumer around the world was overleveraged," Baughan says. Of course, by the end of the 2008 and early 2009, those stocks were hammered, just as Harding Loevner had reduced its exposure.

Now, however, the fund is beginning to like those same industries. The managers believe that financial services-now at 14% of fund assets, up from 7% at the end of 2008-and consumer discretionary categories are the way to play the economic rebound.

"What's going on in U.S. financials is much more positive than I've seen in a long time," Baughan says. What's more, Baughan likes that financials can achieve growth within their own borders.

The managers have set their sights on JP Morgan Chase and Wells Fargo, two of the biggest U.S. banks. JPMorgan Chase is seeing fewer credit losses, leading to significant earnings power. In 2010, the bank's net income rose 48%. The stock is up 17.7% over the past 12 months.

Wells Fargo's loan portfolio is also improving, with better charge-off rates. The bank had net income of $3.4 billion in the fourth quarter of 2010, up 21% from the year before. The stock is up 22.2% over the last 12 months.

Baughan says global consumers are making a comeback, and their tastes are expensive. There are several ways to tap into this spending appetite.

One is Coach, the luxury leather goods seller. Harding Loevner began to buy the stock in late 2008, and it's been one of the fund's best performers since. Baughan likes that Coach has brand dominance in the United States, Japan and China and is making inroads into Europe. "It's got a track record of brand innovation that is globally competitive," Baughan explains. The stock is up 65% over the past 12 months.

Then there's Li & Fung, a Hong Kong firm that provides supply chain logistics management for retailers around the world. The company is the largest supplier to Walmart and Kohl's. Now Li & Fund is focusing on Chinese retailers, Baughan reports. The stock was up 10.6% in 2011 through Feb. 10.

 

TECHNOLOGY WORKHORSES

Technology reigns as the fund's biggest sector, overweight at 24% of assets (the managers only allow sector weightings to reach 25%). "Technology has the best combination of earnings growth and balance sheet strength," Baughan says.

He believes that the global economic recovery will bring forth a new wave of technology products. And that means that data storage will be key as more systems use cloud computing. In this area Baughan likes EMC, Oracle and Teradata, which focuses on data warehousing.

Beyond computing, Baughan points to Dassault Systemes, a French firm that provides 3D computer-assisted design software used in automobiles, medical equipment and consumer goods. Dassault's operating margin is 20%, and the share price rose 34.6% in 2010.

Another pick is Fanuc Systems, a Japanese company that has seen fast growth in China for its robotics business. As it is, more than half of the world's computerized tools use Fanuc's products, including those at Toyota and General Motors. The strategy is paying off, at least in the short term. The stock was up 52.4% in the past 12 months.

With a knack for choosing the right sectors and the right countries, Harding Loevner Global and its thoroughbreds are a good bet to dominate the investing racetrack for the near future. With their selection process working smoothly, Baughan and his team will no doubt be adding to their stable of companies.

 

Ilana Polyak is a regular contributor to Financial Planning.

 

 

Peter Baughan

Harding Loevner Global Equity

 

Age: 49

 

Credentials:

B.A., political science, University of North Carolina, Chapel Hill

 

Experience: Portfolio manager, Harding Loevner Global Equity (1997-present); investment analyst, Rockefeller & Co. (1988-1997); distressed debt manager, Chase Manhattan Bank (1983-1988)

 

Ticker: HLMGX

 

Inception of fund: January 1996

 

Style: World stock

 

Assets under management:

$174.4 million

 

Three-year performance as of Feb. 11, 2011: 4.4%

 

Five-year performance as of Feb. 11, 2011: 6.1%

 

Expense ratio: 1.17%

 

Front load: None

 

Minimum investment:

$5,000

 

Alpha:

3.27% vs. MSCI All Country World