Offshore Funds: Fleeing Risk

Our annual survey of the 500 largest offshore funds shows value investing has returned

The market rout that started in March, 2000, when the tech stock bubble burst, was a cyclical economic phenomenon. It was something investors understood. They knew they just had to be patient and stock prices would right themselves. Who knew the next market theme would be investing in the time of anthrax?

Since terrorists reduced two of the world's tallest buildings to piles of rubble, people who felt they had earned peace of mind by virtuously salting away money for retirement or their children's education suddenly saw financial security melt away. "For 20 years," says Jean-Marie Eveillard, New York-based manager of the SocGen International SICAV, "you had good news. And whenever there was bad news--the crash of '87 or the Russian crisis of 1998--it was over in a few months, when Mr. Greenspan stepped in." But in the past 18 months, he says, "we've had three blows, and each has had a lingering impact: First, the tech bubble burst. Two, the American economy weakened. And three, September 11."

For many, the response to these shocking developments is paralysis. Who can think about investing at a time like this? But once we face up to the responsibility again, the question becomes how far to retreat from risk to satisfy our cravings for security. Are blue chips safe enough? Bonds? What about gold? Fund managers say investors shouldn't lose courage--this crash, like others before it, is a buying opportunity. "Call us the king of clichés, but pessimism is our friend," says Edwin Walczak, manager of the Vontobel U.S. Value Equity B fund, the top performer in BusinessWeek's annual survey of offshore funds. It achieved a 17.89% rise for the 12-month period ended Oct. 1.

Long before September 11, investors were shunning risk. They wanted developed markets and established companies. Now in fashion is that old stalwart, value investing, which fell so badly out of favor during the tech boom. Value managers look for high-quality, undervalued stocks and hold them until other investors recognize their worth and drive the prices up.

The investing landscape that emerges from the ranking of the 500 largest offshore stock funds reflects the changed market psychology. Just making money for investors was an achievement. Only five funds out of 500 did so--and three were value funds. Second behind Vontobel's U.S. Value fund came Eveillard's SocGen fund, with a 6.01% gain. How did he achieve it? An eye for bargains, and patience: "We are value boys and girls," he says.

Predictably, the 20 worst performers were in technology. Their losses ranged between 68.46%, for the Schroder ISF Global Tech A fund, to 88.64%, for the Fleming U.S. Technology A Fund. No region escaped, but 6 of the 20 weakest performers specialized in growth companies in Europe, a latecomer to the New Economy party. This was a rude comedown from last year, when they held the winner's circle. The Fleming Frontier European Discovery Fund, a European microcap fund that was last year's top performer in the BusinessWeek survey, with a 155.72% rise, was down 57.5% this year.

Offshore funds are based outside the U.S., typically in tax havens such as Luxembourg or the Channel Islands. The fund companies can't market to U.S. residents, because the U.S. Securities & Exchange Commission doesn't regulate them, but their performance is a good proxy for trends in the U.S., since many companies run parallel U.S. funds with the same investing philosophy.

HOPE. Can fund managers see light at the end of this tunnel? Paradoxically, one glimmer of hope comes from the U.S., despite the unremittingly scary news. The aggressive monetary stimulus from the U.S. Federal Reserve, plus new defense spending, an airline bailout, and broad tax cuts approved before the attack, should help blunt the impact of anxiety and war on the U.S. economy. Stronger security measures and a sustained anti-terrorism campaign presumably will restore U.S. consumer confidence eventually, and values will rebound. Those expectations are the factors behind the relative strength of the broad U.S. market indices compared with those in Europe and elsewhere. The Standard & Poor's 500-stock index is down about 18% year-to-date, while Morgan Stanley Capital International's Europe, Australia, and Far East index has dropped 24%. Europe's economy and markets may bottom after the U.S. "Before the third quarter, there was a lot of complacency about Europe's ability to withstand a downturn," says Patrizio Merciai, chief strategist for Swiss bank Lombard Odier. Thus, stock prices didn't fall as fast as they had in the U.S.

Most emerging markets, already in trouble before September 11, are in free fall now. Even the most intrepid developing-market veterans are taking a defensive approach. J. Mark Mobius, who runs the $3 billion Templeton Emerging Markets Fund from Hong Kong, had already sold off "anything where we thought down the road there would be economic problems" after the Nasdaq crash in March, 2000. Among those sold were two Pakistani holdings. About one-quarter of the fund's assets are in cash, he says, vs. 5% a year ago. As for stocks, he's sticking to relatively safe bets like Mexican cement maker Cemex, which operates globally, and San Miguel Corp., Philippine beverage company.

Not all emerging-market bourses did badly in the last year. Some markets that are sheltered from the flows of global capital were sustained by their own internal dynamics. That accounts for the relative strength of the two emerging-market funds near the top of the BusinessWeek 500: the HSBC GIF Chinese Equity fund, which was 16th, with a 7.6% drop, and Fidelity Investment's Thailand fund, which lost 8.8% in the past 12 months, ranking it No. 21. "We have continued to visit all these small markets," says Keith R. Ferguson, Fidelity's chief investment officer for Southeast Asia. "There are still good-quality companies. There has been huge consolidation. For example, where there used to be dozens of property companies, now there are just a few. That gives them pricing power." Fund managers that stay engaged with these countries can find good buys, he says.

One Asian sector that has attracted investor interest in the past year is the Indian pharmaceutical industry. Several Indian drug companies make cheap generic versions of costly, life-saving drugs needed in developing countries. The bioterrorism attacks in the U.S. have put Dr. Reddy's Laboratories Ltd. and Ranbaxy Laboratories Ltd. in the spotlight because they can produce ciproflaxin, the anti-anthrax antibiotic.

Then there's Mexico, the strongest major economy in Latin America. Its bolsa is up over 5% in dollar terms this year. Although the U.S. slowdown will cut 2001 growth to 0.5%, from 6.9% in 2000, Mexico will benefit as soon as the U.S. recovers. Its auto parts makers particularly stand to benefit. Orders are down, but the companies tend to be lean, well-run, and resilient. Others, including Cemex and food group Grupo Bimbo, have held their own, while Wal-Mart de México has posted solid sales gains.

WEEDING OUT. In the major markets, one would think that after 18 months of sliding prices, bargains would be easy to find. But fund managers who did relatively well stress that it takes more than just crude bottom-fishing to make money in a market like this. Chris Complin, lead manager of the Fleming European Strategic Value A fund, starts by looking at the cheapest 30% of the market, then weeds out the "the serial underperformers." It's painstaking work. "We check out 2,000 stocks a day," he says. His fund, which ranked eighth, with a 4.68% decline, benefited from a rash of takeovers in Britain. Complin thinks the market will keep falling for a while. "A lot of tech stocks are going out of fashion, so they may eventually become value stocks," he says. "But right now, the majority of tech stocks are too expensive." Take Marconi, a British telecom equipment maker. "Marconi halved in price the day after [a] profit warning," he says. "But earnings were downgraded by 60%, so it was actually more expensive after the share price fell on a valuation basis." Marconi's American depository receipts sell for around $1 a share, a fraction of the $29 they fetched 12 months ago.

Amid the general market wreckage, there are some companies that have done well, especially in consumer products, says Felicity Smith, co-manager of the $900 million Morgan Stanley SICAV European Value Equity A fund, which was 24th in the BusinessWeek ranking, with a 10.11% decline. She points to Imperial Tobacco Group PLC (IMT ) and British American Tobacco (BTI ), which are up 27% and 28%, respectively, year-to-date. "[Both] have strong free cash flow generation, and we bought them when the market wasn't factoring that in," she says. Value managers typically prefer cash flow to earnings as a measure of the strength of the company's business, because it's easier to distort earnings with accounting tricks.

Smith says the market is at a turning point, and new sectors, including technology, are beginning to look appealing again. If a company's share price doesn't reflect its long-term potential, a bargain may lurk, she says. That may be the best philosophy for investing in the time of anthrax.

By Julia Lichtblau in New York, with Kerry Capell in London, Bruce Einhorn in Hong Kong, and Geri Smith in Mexico City

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