Currency risk and mega-cap investing

(October 2006) Market commentators have been calling for a U.S.-led economic downturn for nearly the entire length of the current recovery. The fact that it has not yet materialized should not be taken as a sign it won’t, but rather as a sign of the futility of timing the markets.

Whether it’s next month, next quarter or next year; eventually the markets will decline. Investors wanting to ride out that storm may be well-served parking some of their equity allocation in global large caps, according to Ian Riach, co-manager of the Bissett Multinational Growth fund.

“Large-cap companies tend to perform well when economic growth is slowing and the profit cycle is decelerating, which is the environment we’re in right now,” he says. “Investors tend to pay up a little higher for stability and dividends in times of lower growth.”

Small- and mid-cap stocks tend to out-perform in periods of strong economic growth, he adds, which has been the case in recent years. In comparison, large- and mega-cap stocks have performed rather poorly. The tables could soon be turned, however, and Riach says the rotation into large caps has been underway for the past 10 months.

The other major shift in Canada has been the trend toward moving more capital off-shore, following the removal of foreign property restrictions on registered investments. The Canadian retail investor has been repeatedly told that overweighting domestic equities results in overweighting the materials and financial sectors while missing out on sectors with better potential growth.

“It’s very difficult to find a large, stable, mature pharmaceutical or healthcare company in Canada,” says Riach. “It’s easy to find them in the United States and Europe. It gives you access to sectors that you might not necessarily get access to in Canada.”

But investing outside of Canada exposes the portfolio to currency risk. As the price of commodities — primarily oil — soared, the Canadian dollar was driven higher. Over the past three years this has wiped out much of the gains for Canadian investors holding American assets.

Riach’s fund illustrates this risk all too well, as it is available in both Canadian-dollar-denominated and U.S.-dollar-denominated units. The Canadian-denominated A-class units have earned investors a paltry compound annual growth rate of 2.8% over three years, while the U.S.-denominated A-class unit have earned a more respectable 9.49%. Both versions were launched November 2000.

“With the Canadian dollar rising for the last three years, it has really hurt the absolute returns of this fund,” he says. “It doesn’t really matter what the stocks are returning, [because] when you translate it back to Canadian dollars, you’re losing on the currency.”

Of course, that’s cold comfort to investors who have held onto the Canadian-dollar version of the fund — which accounts for 98% of holdings — for the past three years and seen little reward for their patience. But Riach thinks economic conditions are starting to shift in favour of global mega-cap stocks, which should boost his fund’s performance.

“The Canadian dollar has been riding the commodity wave here in Canada and I see that stabilizing a little bit,” he predicts. “The currency impact isn’t going to be as significant as it has been over the past three years and in fact it will probably start working in our favour in the short term.”

While Riach acknowledges the relative poor performance of his fund, he suggests that it is often measured against the wrong benchmarks. For example, Morningstar compares the fund to the MSCI World index, which tracks 23 major stock indices.

“We don’t mind being put up against other global investors as a peer group, but the index itself I don’t think is all that appropriate,” Riach says. “There are a lot of stocks and countries in that index that we won’t or can’t invest in. Our fund is a bit of a mixed bag, between a Morgan Stanley World benchmark and the S&P 500.”

Internally, his team judges their performance against the Dow Jones Global Titans and the S&P 500 index. His fund is also restricted to investing in stocks listed in North America, either as common shares or ADRs.

“We look at this fund as a proxy for getting your foreign exposure so you can get some U.S. names and some global names, like the [MSCI] World does, but it has some pretty significant weightings in Japan and also has ordinary shares in companies that we wouldn’t be able to access.”

The fact that almost all of the fund’s holdings are listed in the U.S. — and therefore denominated in U.S. dollars — partially explains its underperformance. Charting the fund against the S&P, as measured in Canadian dollars, shows a close correlation between the fund and the index.

Riach may have a point about the downside protection offered by global mega-cap stocks. In 2001 and 2002, the MSCI World (measured in $CAN) fell 11.4% and 20.4%, respectively. In the same periods, Bissett Multinational Growth fell 5.5% and 19.2%. The problem has been the gross underperformance since then.

“I think the investment process strayed for a little bit from the original discipline,” he says. “Over the last year or so we’ve restructured the fund fairly significantly to come back and focus on high quality dividend-paying companies. In the past there may have been a little more emphasis on growth-oriented factors.”

That return to discipline may now be paying off, as the Canadian-denominated A-class version of the fund has a one-year return of 6.16%. Factoring out currency, the U.S.-dollar-denominated A-class version has earned 10.43%. In terms of flows, the fund had been in net redemptions for about 18 months ending in June, when sales stabilized, turning net positive in September and October.

“The process is significantly tightened up, so from a micro standpoint I think investors are getting more of the typical Bissett approach to putting a portfolio together,” Riach notes. “They are getting very high-quality names that should provide very good risk-adjusted returns over the long run.”

Investment Process

In Riach’s investment process, the first screen selects stocks that trade either in the U.S. or Canada and meet the fund’s definition of “multinational” — companies that derive at least 25% of their revenues from outside of their home country.

This North American-listed rule has been in place since the fund’s inception, and was intended to minimize accessibility issues at the time. While this has precluded investment in a handful of stocks he liked — such as UK-listed banks Royal Bank of Scotland and HBOS — Riach says the rule generally allows him to buy almost any multinational he would want.

“It would have been nice to have those one or two names in the portfolio, but would they have really impacted the performance on the fund? I don’t think it would have been all that significant,” he says. “Because we hold a pretty well diversified portfolio, no name would get up above 5%.”

The next step is a quantitative analysis focusing on the firm’s dividend, taking into account both the current yield and track record of growth. The final stage examines the fundamentals, looking at profitability and the balance sheet to determine the sustainability of the dividend growth.

The sell discipline is essentially the reverse, although Riach says it is more common to trim a holding that has grown to exceed the desired allocation. Excess valuation is typically determined by comparing the price-to-earnings multiple to the historical average, although depending on the industry, other metrics may be more appropriate, such as price to cash-flow, or enterprise value to EBITDA.

“We don’t set specific price targets. We have targets in mind based on the financial models that we run, but those are dynamic,” he says. “We’ll look at the company’s growth rate relative to valuation and if we think that relationship is getting to the point where the valuation is too high, we’ll start taking the stock back.”

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

(10/20/06)