Japan Blooms Again?

The free-cash flow of some Japanese companies appeals to Bernard Horn of Polaris Capital Management

For the first time in 10 years, Japan is suddenly becoming a place to invest. So says Bernard R. Horn, Jr., president and portfolio manager of Polaris Capital Management, who runs the Polaris Global Value Fund (PGVFX ) and the Quant Foreign Value Fund (QFVOX ). Both funds are up about 30% so far this year. Horn says one of his main focuses in selecting stocks is free-cash flow, and by that indicator some Japanese companies are attractive again. He singles out utilities as an industry with value in Japan. Other Asian countries he likes are Korea and Malaysia, the latter because it benefited from companies fleeing the SARS epidemic in China. Other foreign industries Horn likes now include homebuilding in Britain and paper in Scandinavia.

As a safeguard against the use of his international funds as a vehicle for market-timers -- an abuse cited by New York Attorney General Eliot Spitzer in his investigation of trading scandals -- Horn says both of his funds may impose a redemption fee on shareholders (see BW Online, 9/22/03, "A Primer on the Mutual-Fund Scandal").

These were a few of the points Horn made in an investing chat presented Sept. 18 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Amey Stone. Edited excerpts follow. A complete transcript is available on AOL at keyword: BW Talk.

Q: Bernie, we picked a great day to talk about the market, with such a good burst in the indexes. Do you expect the momentum to build?

A:

I think the U.S. market has had a very strong performance this year to date. And we think that the large-cap U.S. stocks are a bit overvalued, especially compared to the rest of the world. So we're actually decreasing our weighting in the U.S. market in favor of Asia and Europe. We have been quite heavily invested in emerging markets for the last five years.

But we're now beginning to find better values in the more developed markets, especially Japan. This is the first time in almost a decade that we're seeing good companies with strong free-cash flow in Japan. Free-cash flow is one of the most important metrics we use to determine where the most undervalued companies in the world are. Concentrating on free-cash flow has preserved an awful lot of value for shareholders in the last five years. It's one reason why both of the mutual funds we run are up about 30% in 2003 (year to date).

Q: It seems like Japan's markets have been an important story in the past few days. Can you update us on what's happening there and the impact on the U.S.?

A:

Sure. The Japanese stocks have been more prevalent in our screens this year than in the last 10 years. In fact, I just returned from a trip to Japan to interview about 10 companies that look attractive. This is the first time in many years where we're seeing Japanese companies actually generate free-cash flow.... While the economy there still has many challenges as a result of competition from China, there are still good world-class Japanese companies that are good investments.

Q: Which Asian markets do you see for a major rebound? What countries in Europe?

A:

We think Korea continues to be well-positioned for strong growth, based on good relationships with Chinese companies and exposure to growth in the Chinese economy. And they have world-class companies like Samsung Electronics (SSNLF ) that have weathered the tech downturn very well.

The other economy, as I said earlier, that we're beginning to get more excited about is Japan. But [there], it's very important to be careful about the stocks one invests in. For instance, in Japan we have been doing a lot of work on utilities, which many investors will avoid in a growing market because they tend to lag. But in the case of Japan, we think there are some very unusual opportunities. Utilities can also be helpful if the markets become more volatile.

The other markets we're looking at are places like Malaysia, which already have good manufacturing industries. They seem to be experiencing an uptick in business as a result of the needs for global companies to diversify away from China after the SARS epidemic.

In Europe, we continue to like Britain and Scandinavia. In Britain we are very excited about the homebuilders, and we have owned these companies for over five years -- more or less doubled our money in all of them, yet they're still a good value.

In Scandinavia (Norway, Finland, and Sweden), we like paper companies. We like these companies because of their strong cash generation that enabled these companies to build large, efficient machines that are very cost-competitive in today's market. The big question is how will paper demand increase as the economy grows?

Q: Bernie, you manage the Polaris Global Value Fund (PGVFX ) and the Quant Foreign Value Fund (QFVOX ). First, a basic question -- the distinction between "global" and "foreign"? And how have the funds' performances been, beyond the year-to-date numbers you cited?

A:

Global funds by definition can invest anywhere in the world. International or foreign funds invest outside the U.S., or more generally, the investor's home country. The Polaris Global Value Fund also was up 3.8% in 2002 when our competitors in the index were down about 20%, and has made money in the last three and five years -- which we're extremely proud of, given how difficult the markets were. It has a 5-star rating from Morningstar.

QFVOX also made money last year, and the last three and five years. It currently has a 4-star overall rating, and a 5-star three-year rating from Morningstar.

The other point we like to make about the funds is that their risks relative to their benchmarks and the U.S. market are reasonably low. So the betas are in the 0.7 range. Because we are very deep value managers, our portfolios tend not to track the overall indexes because the indexes tend to be dominated by stocks that performed best over the last three years or so. I hope that's helpful.

Q: Thanks to an investigation of mutual-fund trading practices launched two weeks ago by New York Attorney General Eliot Spitzer, a lot of attention has been paid to international funds and the potential for market timers to hurt the returns experienced by long-term shareholders. Have you seen that activity in your fund?

A:

We have always been aware that market timers tend to use international funds and global funds, and we have seen some of that activity in our funds. We absolutely do not like that activity because of its effect on long-term shareholders. So what we have done to discourage this behavior was to add a redemption fee to those shareholders who withdraw their funds within 180 days -- that applies to PGVFX. QFVOX also has a redemption fee. So this has certainly reduced the market-timing activity in the funds.

Q: Can you give some specific stock names? What are your funds' top holdings?

A:

We tend to invest in a portfolio of equally weighted securities. Our top holdings tend to be those stocks that have done well and become a higher portion of the portfolio. Some of the stocks we like now include Parmalat (it's an Italian company that makes ultra-high-temperature milk and has diversified into food). Another company would include Kone (Finland), which makes elevators and escalators.

One of our favorite U.S. companies is Anthem (ATH ), in health care. We think Anthem will be one of the biggest health-care providers in the next 10 years. Among U.S. banks, we like Webster Financial (WBS ) and Banknorth (BNK ). In the U.K. homebuilding area, we like Barratt Development. Those are five of our favorites.

Q: You haven't mentioned any tech stocks that I recall. What's your opinion on the sector? Both here and abroad?

A:

Well, we do have some tech stocks in the portfolio. However, they aren't our best values. We do like companies that have diversified product lines, such as Samsung, which I mentioned earlier. ASM Pacific Technology (ASMVF ) in Hong Kong is another. The reason we like ASM is because of all the new technology capacity being built in Asia. ASM sells a variety of equipment to make chip sets and test chips. So as long as tomorrow's economy consumes more chips than today, and those chips are smaller and fast, ASM will continue to do good business.

Q: Do you also try to profit in your fund from currency moves? Or do you hedge those effects out of the portfolio?

A:

The currency changes do affect our returns, and that depends on which currencies we are invested in and how they move against the dollar. For several years the dollar was relatively strong against the euro, for instance, so we had currency losses in our European portfolio. We don't hedge our currency exposure for a couple of reasons. The first is that it's very costly. The second is that it's quite difficult to get it right. Thirdly, we actually build into our valuation analysis of companies a measure to compensate us for expected currency losses. We think that's another method which has helped us preserve capital in volatile times.

Q: In the last three years how much has your fund exceeded the Standard & Poor's 500?

A:

PGVFX (as of June 30) was up 6.53%. The MSCI World Index was down 12.95%. The S&P 500 was down 11.2%. If you look at the QFVOX fund over the last three years, the fund was up 1.28%, and its benchmark, the MSCI EAFE Index, was down 13.27%. So the margin of outperformance has been quite large for the last three years.

Q: In allocating assets for a long-term investor, how much would you put into stocks -- and how much of that into global/foreign?

A:

It's very dependent on the investor's tolerance for risk. For our younger clients we recommend a higher proportion of investments in stocks. And we do feel strongly that global funds should be a core holding for investors.

Edited by Jack Dierdorff

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