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Fair Winds from the East

Foreign small-cap stocks enjoyed tremendous returns last year, so not surprisingly, Oppenheimer International Small Company Fund (OSMAX) flourished. The $267-million portfolio skyrocketed 94% for the 12-month period through January, while the average international equity fund gained 45.1%. For the three-year period, the fund rose 11.6% annualized, vs. a 2.8% drop by the peer group.

Over the past few years, the fund has been significantly overhauled. Rohit Sah, who was formerly part of the fund's four-member management team, became the sole portfolio manager in January. Portfolio changes in recent years include cutting a high weighting in health care and boosting holdings in Japan.

While the fund has a somewhat higher beta and standard deviation than its peer group, its turnover has fallen noticeably in recent years. Turnover dropped from 280% in 1999, to a modest 53% last year owing to the fund's management changes.

In October, 2003, Standard & Poor's raised its ranking for the fund to 5 Stars from 3 Stars. Palash R. Ghosh of S&P's Fund Advisor recently spoke with Sah about the fund's strategy. Edited excerpts from their conversation follow:

Q: What kind of stocks do you look for?

A: We like companies with high sales growth and high operating margins. We also like companies in new industries, such as the wireless cell-phone data-services industry, which is forecast to grow very strongly. We look for companies in industries undergoing significant structural change due to deregulation. For example, the global textile industry is poised for big changes because of commitments by Western Europe and the U.S. to phase out textile import quotas in 2005.

We screen for companies which will benefit from long-term growth trends and which can typically deliver annual sales growth of at least 15%. In addition, we look for companies with attractive operating margins and high returns on capital. Our stock selection process is strictly bottom-up and includes company visits.

Q: How do you define small-cap?

A: The fund's prospectus defines small caps as below $2.5 billion in market cap. The median market cap of the fund is currently about $550 million. Once a company's market cap reaches the $2.5 billion level, it automatically becomes a sell candidate. When we sell depends on whether we feel the stock has reached fair value.

Q: Can you discuss the recent history of the fund's management?

A: In January, I became the sole portfolio manager, but the fund's investment objective didn't change. Nick Horsley, the fund's original manager, left Oppenheimer in 1999. At that time, the fund adopted a quantitative, model-driven portfolio using computers. That strategy failed because small-caps require bottom-up analysis, meeting with managements and qualitative judgments about sectors.

In December, 2000, the fund was taken over by four managers -- Frank Jennings, Rajiv Bhaman, George Evans, and myself -- each running 25% of the fund. Then the portfolio was significantly overhauled. Subsequently, we fine-tuned the fund by reducing a high weighting in health-care stocks and adding to exposure in Japan.

Q: How did you perform against your benchmark last year?

A: In 2003, the fund gained 85.1%, vs. a 62% return by our benchmark, the MSCI World (ex-U.S.) Small Cap Index. Our performance came from holdings in all of our sector positions and most of our country weightings.

The fund was buoyed by significant exposure to Japan and India -- these markets surged in 2003 -- and holdings in the telecom services and Internet sectors. Of course, we were helped by the tailwinds of the global bull market, which was particularly helpful for international small-cap stocks.

Q: What are your largest holdings?

A: As of Jan. 31, the fund's top holdings were: Index Corp., 5%; Song Networks Holding, 4.4%; e.Biscom, 3.2%; ComfortDelGro Corp., 3%; Leopalace21 Corp., 2.8%; Neowiz Corp., 2.7%; iTouch, 2.6%; Arvind Mills, 2.5%; Cosel Co., 2.4%; and SFCG Co., 2.4%.

The top 10 stocks represented 30% of the fund's total assets. We currently have about 55 stocks, so the portfolio is relatively concentrated. We like to keep meaningful weightings in our favorite holdings. In the past, we've had as many as 70 stocks in the fund. Our portfolio is invested in more than 18 countries and most major industries, providing significant diversification.

Q: Can you discuss two of your top holdings?

A: ITouch is a British wireless data service provider, operating primarily in the U.K. and Spain. They provide wireless with downloadable data and the ability to take photographs. The stock is cheap because the market underestimates the potential growth of these technologies.

Arvind Mills is a textile company, based in Ahmedabad, India. They should benefit tremendously next year when the U.S. and Western Europe eliminate textile-import quotas. Arvind recently switched from being a family-run enterprise to a more professionally managed firm, and their customers include Levi Strauss and Wal-Mart Stores (WMT).

Q: What are your largest sectors?

A: As of January 31, 2004, the fund's top sectors were information technology, 18.6%; financials, 15.5%; industrials, 14.3%; consumer discretionary, 12.4%; telecommunication services, 12.3%; consumer staples, 6.7%; health care, 6.4%; materials, 4.5%; and energy, 1.8%.

Q: What are the top regions and the top countries in the fund?

A: By region, as of Jan. 31: Europe, 29.4%; Japan, 27.5%; Asia, excluding Japan, 26.4%; U.S./Canada, 10.5%; Latin America, 4.8%; and Emerging Europe, 1.5%.

By individual country: Japan, 27.5%; India, 10.9%; Great Britain, 8.4%; Sweden, 6.9%; Canada, 6.2%; South Korea, 5.5%; Germany, 4.6%; U.S., 4.3%; Italy, 3.9%; Hong Kong, 3.7%.

We typically do not try to match the allocations of our benchmark. Our exposure to emerging markets has historically ranged from 20% to 30%.

Q: What's your outlook for Japan?

A: The outlook for Japan is quite positive -- the one negative is the way their central bank and government manipulate their currency. This massive intervention will create serious problems in the future for Japan.

For the past few years, Japanese companies have been paying down debt, cutting costs, and restructuring their balance sheets. Going forward, they're favorably positioned as the global economy recovers.

Q: What's your outlook for India, another significant part of your fund?

A: I'm very optimistic on India -- I see it as a multi-year bull market. The Indian economy is taking off and the government is doing all the right things. Like their Japanese peers, Indian corporations restructured their balance sheets, retrenched their work force, and are increasing labor productivity and improving product quality. Global outsourcing offers high growth potential for many major Indian companies.

The two biggest risks in India are largely political. Indian politicians may seek to block or slow further industry privatization, and continuing tensions with neighboring Pakistan may worsen.

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