More value in Europe than Asia: Fund manager

(July 21, 2004) Investors seeking good value in today’s stock markets should cast an eye to Europe and the U.S., according to the manager of the AGF International Value Fund.

“After a number of years of global disappointment, of global recession, we really are in a period right now when everything is starting to move in the same direction,” says Ed Loeb, CFA, partner at Harris Associates and manager of the fund. “It looks like profits are going to be up in the U.S. for the second quarter by about 25 to 30%. We’re seeing a lot of strength in the U.S. but it’s really extended throughout the world more and more.”

The fund currently has no direct exposure to the Canadian economy at all, which Loeb says is not so much a call against our stock market, but simply a reflection that there are better deals to be found outside Canada.

He says profit growth in the U.S. has probably already peaked, but that this should not put investors off. Profits were coming off of such low levels that huge percentage gains were needed to reach normal levels and that 20% growth rates are obviously not sustainable. In 1993, profit growth rates peaked, yet the stock markets continued to move higher for the next six years.

“The issues that are the most exciting to us are really the highest quality businesses. Throughout the globe we have seen a compression of valuation. We really see very little difference between the valuations of low quality and high quality stocks. If we can find them when they’re facing short-term challenges then so much the better.”

As companies have recovered from the recent economic lows, they have used the opportunity to clean up their balance sheets and now corporate liquidity is seen at its best levels in “at least a decade.” Loeb says many companies are in a strong position to deploy their accumulated capital to increase spending, fund takeovers or increase their dividend.

If there is a downside, Loeb says it is that improved profits appear to be already priced into most stocks.

“The overall market is near fair value and I think that even though the market has not gone up much this year, it reflects the fact that earnings started to improve late last year and markets around the world rallied,” he says. “Now we’re maybe in a pause as earnings catch up to those stock prices.”

Harris’s value strategy has taken the fund to Europe in a big way, where it is relatively over-weighted when compared to the MSCI global index. Nearly 20% of assets are on the continent, with another 17% invested in the U.K.

Europe looks good to Loeb, because interest rates are stable and macroeconomic growth is speeding up. Things are improving on the microeconomic level as well, as reforms such as longer work weeks are being implemented. On the whole, he says Europe is undervalued.

Not so for Japan, however, which has seen the biggest stock market gains of the world’s major indices over the past six months. The country is “a question mark” to Loeb, as the economy heads into a cyclical recovery after a decade long recession. Deflation has stopped, but the country is still in need of structural reform, especially in its banking sector, where return on equity runs at about 5%.

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The Harris process

“We have always felt very strongly that fundamental bottom-up research is the foundation of investment success,” says Loeb.

The Harris office employs 18 unspecialized analysts working on the fund, which he says benefits the process because it allows more comparative analysis.

“As generalists, our analysts are able to compare companies across industries,” he says. “Our fear is that if we have only one technology analyst… they’d be narrowly focused on their own industry. They may miss opportunities to avoid one area and move the portfolio in another direction where there is a lot of value.”

Loeb says the key to value investing is finding companies trading at 60% of their intrinsic value. An important addition to this framework is the analysis of the business management, which he says must act as owners.

“I think the term ‘value investing’ is thrown around and maybe even confused from overuse in the world today,” says Loeb. “Our conception of value is understanding what a business would be worth to a rational person if they were going to buy the entire business outright for cash.”

The fund has suffered a mass exodus of capital since the departure of Brandes as manager in spring of 2002. The fund has dropped from about $7 billion at that time, to $4.9 billion today.

“We realized when we took on this portfolio assignment that this was a transition from another manager and that we always had to be prepared for cash out-flows,” says Loeb. “We did see some of that and we have seen a continuation of that in a modest way. I think it reflects a general concern about equities among the average Canadian investor.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/21/04)