Europe may still hold appeal as a vacation destination, but investing in the Continent is no leisurely pursuit. One country after another is facing a debt crisis and political upheaval. Despite a restructuring agreement reached in late June, many investors are still looking askance at the region, beleiving that indebtedness will lead to a long-term decline. Europe barely avoided recession in the first quarter, with growth flat, according to Eurostat, the statistics agency of the European Union. Nonetheless, 11 European countries have slipped into recession.
Yet Barnaby Wiener and Benjamin Stone, co-managers of the $4.8 billion MFS International Value Fund, continue swimming in these troubled waters. Despite the problems, the managers maintain a two-thirds allocation to Europe, and they have no plans to reduce.
To be sure, Wiener and Stone are not fond of the overleveraged, undercapitalized companies (read banks) that have been the scourge of European economies. Europe's fiscal problems are mammoth, they agree.
They still see plenty of stocks that defy the gloomy forecasts. Those businesses are well run and are able to withstand periodic shocks, thanks in large measure to their strong balance sheets. "The biggest chunk of our allocation is to high-quality businesses, many of which are global businesses that happen to be domiciled in Europe," Wiener explains. "Actually, we're not particularly exposed in Europe." The pair prefer companies that can take their operations wherever there's growth, whether in their home country or around the world.
The team's focus on quality has helped MFS International Value outshine its peers in the foreign large value category. Over the last three years, the fund is up 11% a year annualized, beating 96% of its competitors as of July 13, according to Morningstar. For the five-year period, the fund is down 1.6% a year annualized, besting 98% of its peers.
Many of the companies with the characteristics Wiener and Stone like are in the consumer staples area, like Nestle, the world's largest packaged food operator. About 45% of the Swiss-based food giant's revenues come from emerging markets, where consumers are increasingly willing to pay up for brand-name foods. "They are not dependent on the overleveraged developed market consumer," Wiener notes.
On the other hand, Nestle's diversified revenue streams around the world provide a buffer. "If something happens in China or Brazil, it doesn't derail Nestle, Wiener notes.
Nestle recently acquired Pfizer's infant nutrition division as a way to compete even more in emerging markets. First-quarter sales rose 7.2% on organic growth and much of the gain came from emerging markets. Nestle's stock has struggled this year, however, as consumers in developed markets have pull backed. The company's shares are down 0.9% through July 13, versus a 5.3% gain for the S&P 500.
Heineken, the world's third largest brewer, similarly experienced a revenue increase in its most recent quarter, thanks to growth in the consuming class in emerging economies, especially eastern Europe and the Middle East. Shares of the Amsterdam-based brewer have risen 12% since the beginning of the year.
THE VALUE OF QUALITY
To find 90 or so companies for their portfolio, Wiener and Stone seek out enduring brands and strong financials. Then they overlay a valuation analysis. They are not deep value investors, interested only in companies selling at rock-bottom prices, because those valuations often spell trouble. "We will pay out for quality and sustainable cash flow," Wiener says. "We don't pay out for growth.
That's why, even though the consumer staples companies have run up in recent years, the fund still owns them. On the other hand, less reliable players should sell at lower multiples, they say.
That strategy helps the fund hold up well in downturns. In 2008, for example, the fund fell 31.9%, considerably better than the 43.4% decline posted by the MSCI EAFE index, and placed in the top 4% for its category.
Sizzling markets are more challenging, however. According to Morningstar, MFS International Value outperformed its category peers in 80% of down markets, but only 40% of up markets. Over long periods, that's an advantage, Stone says. "If you protect capital on the downside, that's very positive when it comes to compounding returns," he says.
The skippers spend a lot of time analyzing downside risk, mainly operational risk. "We avoid areas of the economy where you've seen a bubble, like areas of the financial world," Stone adds. "That's where you tend to see your biggest downside."
Wiener and Stone place a premium on balance sheet strength. "Everyone looks at earnings, but I can get you any earnings you want," Wiener says. Balance sheets can tell the story of a company with financial wherewithal to operate in different climates. "If you want to endure a shock, a year of no profit or losses, then you need a balance sheet," he says.
FOND OF JAPAN
The managers go out on a limb with their fondness for Japan. More than a quarter of the fund's assets are invested there, compared with just 17% of competitors' portfolios on average. "What attracts us to Japan is valuation," Wiener says.
Two decades of stagnation have created a cheap market. Japan now trades at a price-to-book ratio of 1.4, compared with 2.2 for the S&P 500. Japan has caught more than a few investors in its value trap over the years, however, and the MFS managers are aware of the perils.
They believe that things are on the upswing in Japan and think that Japanese firms haven't gotten credit for substantially improving profitability over the last decade. Some of the positive signs are dividend increases, improving margins and share buybacks. More than anything, there has been a corporate shift toward greater shareholder friendliness.
Wiener likes KDDI, a Japanese telecommunications company. The second largest telecom in Japan, KDDI increased revenues 4% in 2011, on the strength of sales of the iPhone. KDDI's subscriber base has risen in recent quarters as it introduced new smartphones in its lineup. Shares of KDDI are up 2.4% this year through July 13.
The managers also like Lawson, a convenience store operator that is looking to expand into China. The chain took advantage of Japan's deflation to lower costs while raising prices. Shares of the stock were up 36.6% for the 12 months ended July 16.
AREAS OF FAVOR
Another favorite area for the fund is pharmaceuticals. One reason is the predictability of cash flows. Despite concerns about how drug makers will fare once the health care law takes full effect in the U.S., the managers believe the sector is still a reliable one. "People were worried about those risks in 1995 when Hillary Clinton was talking about health care reform," Wiener notes. But companies like GlaxoSmithKline, Roche and Bayer have the pipelines and low patent expiration risks to be able to withstand any pressure on pricing the new law may bring.
The duo is also interested in German real estate, which they say is undervalued but on the rise. "It's one of the few assets classes in the world that haven't seen a bubble," Stone says. The fund has invested in two residential property owners, Deutsche Wohnen and GSW.
Stone points to the low rate of property ownership in cities like Berlin, despite significant rates of immigration. "Vacancy rates are coming down and the value is significantly below new construction costs," he says.
Ilana Polyak, a Financial Planning contributing writer, has also written for The New York Times, Money and Kiplinger's.
MFS Intl. Value Fund
Credentials: Masters in history, Oxford University
Experience: Portfolio manager, MFS Intl. Value, 2009 to present; Merrill Lynch equity research analyst; Credit Lyonnais equity research analyst; British Army captain
Fund inception: Oct. 1995
Style: Foreign large value
AUM: $5.6 billion
3-year performance as of July 13, 2012: 11.04%
5-year performance as of July 13, 2012: -1.63%
Expense ratio: 1.28%
Front load: 5.75%
Min. investment: $1,000
Alpha: 5.58 vs. MSCI EAFE
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