The T. Rowe Price International Discovery Fund (PRIDX ) recently opened to new investors following a three-year hiatus. The portfolio had to be closed in March, 2000, after its asset base grew to an unwieldy $1.4 billion following an outsize 155% gain the prior year.
Based in London, portfolio manager Justin Thomson searches the globe for high-growth, small-cap stocks that can deliver sustainable profits. Unlike many foreign stock managers, he won't hesitate to invest in emerging markets, although the bulk of his assets remain parked in Western Europe and Japan. Thomson has been managing the fund since August, 1998.
For the five years ended in May, the fund rose an average annualized 6.9%, vs. a loss of 4.1% for the average international stock fund. Year-to-date through the end of May, it has risen 16.6%, vs. 6.8% for the peer group. Based on risk and return characteristics over the last three years, S&P has an overall rank of 3 Stars on the portfolio.
Palash Ghosh of S&P's Fund Advisor recently spoke with Thomson about the fund's strategy. Edited excerpts from their conversation follow:
Q: The fund reopened to new investors on Mar. 31 after having been closed for three years. Could you discuss this?
A:We closed the fund to new investors in March, 2000, because net assets had ballooned up to about $1.4 billion. In the first quarter of that year alone, the fund took in $450 million of new cash. It proved difficult to get all that cash invested and to maintain our small-cap mandate. This coincided with the stock market bubble, when the market had got far too overheated.
Fast-forward three years, and market conditions have dramatically changed: depressed valuations and poor business outlooks. Our fund had suffered some cash outflows. It currently has net assets of about $425 million.
Q: What kind of stocks do you look for, and how do you select them?
A:We invest in fast-growing, small-cap companies among both developed and emerging countries. We will consider companies ranging in market-cap size from $100 million to $3 billion. Our median market cap typically falls between $550 million and $600 million.
We clearly have a growth bias. We focus on profitable companies that can sustain their profitability. We do our own fundamental research and conduct interviews with company managements. Regarding valuation, we seek to take advantage of market pricing inefficiencies.
Q: Is your investment process strictly bottom up?
A:Yes. For example, we currently have about 28% of our assets invested in Japan and Germany. From a top-down perspective, these are two economies that are struggling and wouldn't appear to be appealing places to invest. However, we're aware of certain macroeconomic trends that may influence our investment choices. For instance, in Japan, we're emphasizing companies serving the domestic sector, rather than exporters, reflecting our view of the relationship between the yen and U.S. dollar.
Q: The fund gained 155% in 1999, then had three straight years of declines. What drove the outstanding gains in 1999? Were you heavily invested in technology and telecom then?
A:Our performance was, indeed, driven primarily by technology and Internet stocks. With respect to the Internet, we typically stayed away from the pure plays. Instead, we invested in companies related to software services, infrastructure, and firms that stood to benefit from doing their business over the Web.
Our telecom exposure was principally focused on mobile telephony. There weren't all that many telecom equities available in the small-cap space. Our big run was also influenced by our holdings in Japan. In November, 1998, we doubled our weighting there. We caught it right as the government was pumping money into startup companies. It was a great environment for Japanese small-caps.
We sold off many of our tech holdings throughout 2000 and 2001, and we have struggled the past three calendar years.
Q: How many stocks do you typically keep in the portfolio?
A:Usually between 125 and 175. We have about 150 now. Our fund has a rather large mandate, and we have wide latitude in the kinds of companies in which we can invest. There are probably about 3,000 investible companies in our universe. Our experience has taught us that 150 provides us with sufficient diversification, as well as sufficient concentration, which allows us to run with our winners.
Q: What are your 10 largest holdings currently?
A:As of Mar. 31: Rapala VMC Corp., 2.4%; Galen Holdings (GALN ), 2.3%; JGC, 1.9%; Eidos, 1.8%; USS Co. Ltd., 1.7%; HDFC Bank Ltd., 1.6%; Topdanmark, 1.6%; Corporacion Mapfre, 1.5%; New Skies Satellites N.V. (NSK ), 1.4%; and Actelion, 1.3%.
Q: What are your top sectors?
A:As of Mar. 31: consumer discretionary, 26.2%; financials, 17.2%; industrials and business services, 14.3%; health care, 12.5%; information technology, 12%; consumer staples, 4.2%; telecommunication services, 4.1%; energy, 1.8%; and materials, 1.7%.
Q: Financials isn't a typical growth sector, yet it represents your second largest sector.
A:From time to time we buy stocks in sectors that are not usually categorized as a growth industry. Currently, we are bullish on insurance companies because the pricing cycle is very good, and stocks are attractively cheap. One of our top stocks is HDFC, a highly profitable and efficient Indian mortgage bank. Mortgage-banking services has enormous potential to grow in India. This represents a consumption play in India.
Q: What are your top regional sectors?
A:As of Mar. 31: Europe 47.7%; Pacific Rim 27.3%; Japan 18%; and the Middle East, 1%. On a country level, the top allocations are Japan, 18%; U.K., 15.4%; Germany, 8.4%; India, 4.6%; and Hong Kong, 4.4%.
Q: What do you make of the Japanese economy, which has been in a recession for at least the past decade?
A:We hold an eclectic mix of Japanese businesses. For example, we own USS, a wholesaler of second-hand cars, sort of a "dealers' dealer." They take no risk on their inventory, and their business is growing 25% annually, which is quite extraordinary given price deflation and lack of demand stimulus in Japan. We also have a number of mobile Internet connectivity companies, which provide services or technology for handsets.
Q: The emerging markets -- particularly Russia, Eastern Europe, and South Korea -- have performed very well the past few years. Are you investing there?
A:At any one time, our exposure to the emerging markets varies between 15% and 20%. We have recently been buying banks in Thailand, Taiwan-based manufacturing companies which are setting up in Mainland China (a huge engine of growth for Asia), and some domestic consumption plays in South Korea. We also hold significant positions in Malaysia and India.
India is a particularly exciting. When its economy links with the U.S. economy, a massive internal market opens up. India's consumer demand is huge, and their economy will benefit tremendously from the Internet (i.e., data processing and IT services). Indian companies can turn information around at a fraction of the cost of their counterparts in the U.S. and Europe. These Indian tech companies are highly profitable and, more importantly, profit-oriented.
Q: How often do you sell stocks?
A:We have a relatively moderate 90% annual turnover rate. Our sell process is rigorous and disciplined: We typically unload when a stock reaches our target price after a thorough review.
Q: Small and mid-cap stocks in Europe have been crushed by the bear market. Has this presented a great buying opportunity for you, or has it been difficult to find companies offering high-growth?
A:This has presented a fabulous buying opportunity for us. The general business cycle and the state of capital expenditures in Europe are currently weak. However, stock valuations have declined disproportionately, or more than the economies have dipped. European markets have overreacted to the dwindling business cycles.
This offers us great stock-buying choices. We especially like insurance, financial-services distribution, marketing research, oil services, and certain consumer stocks in Europe.