The Pox Americana Casts a Pall

But a few offshore performers show surprising strength

The U.S. economy continues to recover. Japan has finally struggled out of recession, and its exports have surged. Asia is showing resilience, and China is turning into a powerful engine of growth for the entire region. So why did only 72 of the 500 biggest funds outside the U.S. and tracked by BusinessWeek make money in the second quarter? Because global recovery means nothing when global fear has taken hold. The accounting scandals and bankruptcy filings in the U.S. have cast a pall over the planet's markets. European bourses have been especially hard-hit: After five years of investing heavily in the U.S., the top European multinationals are widely exposed to the vicissitudes of American markets, and so are their stocks.

The sickening effect of Pox Americana has been felt in Asian markets, too. While still ahead for the year, they saw their powerful first-quarter gains erode as their own currencies strengthened against the dollar. Eastern European funds, the other strong-performing sector in the first quarter, beat a partial retreat as well, influenced by the downturn in Western European stocks.

It hasn't been this dark for global markets in many years. Indeed, it's amazing that any funds showed positive returns. Even more surprising is the sector that did best: small-cap funds in Japan. Among the top 25 performers in the second quarter, 21 were Japanese funds, and most were invested in small and midsize companies. That's a huge reversal for these Japan funds, none of which made positive returns overall for the past 12 months. Two European funds, one Thai, and one Asian fund rounded out the top 25.

Offshore funds, typically based in tax havens such as Luxembourg, aren't permitted to market to Americans because the Securities & Exchange Commission doesn't regulate them and because they don't file reports with the SEC. But many U.S. institutional and retail investors pour money into them anyway, as do other savers around the world. This means offshore funds reflect the collective judgment of fund managers and other investors worldwide. BusinessWeek's survey, drawing on data from Standard & Poor's Fund Services (which, like BusinessWeek, is a unit of The McGraw-Hill Companies), tracks the performance in dollar terms of the 500 biggest offshore funds. (A complete list is available at

What lies behind the dramatic rise of Japanese small-cap funds? For one thing, they have been down for such a long time that there was plenty of upside. And small companies are not as weighed down as big Japanese companies with large payrolls and overleveraged balance sheets. Thus, with signs that the economy may finally be on the mend--Japan's GDP grew at a brisk annualized 5.7% in the first quarter--small-cap stocks have been the first to bolt out of the gate. "We are talking pre-bubble market valuations," says David Scott, senior portfolio manager at J.P. Morgan Fleming Asset Management (Japan) Ltd., whose JF Japan Small Cap fund was the best-performing of the 500 funds. "This is a massively over-sold market".

HSBC Securities Japan small-cap specialist Minoru Tayama likes Uniden Corp., whose exports of mobile phones to the U.S. are booming. The company is forecasting a 50% jump in units shipped there this year, and although the stock is up 59%, to $6.80 a share, Tayama says it could go as high as $8.60. Another of his small-cap favorites is Fujimi Inc., a supplier of polishing materials for silicon wafers and hard disks to Intel Corp. (INTC ) and other chipmakers. Despite getting battered by the high-tech meltdown in 2000 and 2001, Fujimi continues to dominate this niche business in Japan and the U.S. The stock currently trades at $24, up from its post-September 11 low of $14.70.

Outside Japan, the best-performing country fund was Fidelity Investment's $293 million Fidelity Funds Thailand. Ranked sixth with a 10.56% return in the quarter, the fund has delivered a huge 40.58% in the past 12 months. Teera Chanpongsang, the fund's manager since 1998, shrewdly bet on Thailand's domestic economy, not its export sector. Consensus forecasts for GDP growth in Thailand have recently been revised from 2.7% to 3.9% on the back of strong consumer demand for credit, automobiles, and housing.

Asia and Japan are not the only locales where values can be found. Hunting down undervalued companies lies behind the success of the $476 million Nordea 1, SICAV European Value Fund, which was up 5.17% on the quarter and 11.96% over 12 months. Fund manager Tom Stubbe Olsen's search for value has now led him to look at sectors with free cash flow that most people won't touch, like media, technology, and even telecoms.

Olsen is a brave man. This quarter's tables are littered with the hulks of technology, biotechnology, and telecom funds. The worst delivered buzz cuts of up to 37.09% over the quarter, and 65.15% for the year.

Where to scout out winners in the months ahead? Salomon Smith Barney's Asian Equities Strategist Ajay Kapur suggests stocks in Japan and Southeast Asia still look cheap: They are selling at a 40% price-to-book discount compared with the U.S. In Europe, Umberto Colli, a finance director at Bancaperta in Italy, which manages the Julius Baer Italian Stock Fund B, says his focus on value helped him deliver 4.86% returns in the first quarter. What about those glory days of double-digit returns? Not a chance, says Colli. "It will be harder and harder to explain to our clients we are outperforming--and losing their money," he says. If Colli is right, investors may soon conclude that the mattress fund is the best fund of all.

By Frederik Balfour in Hong Kong, with Brian Bremner in Tokyo and David Fairlamb in Frankfurt

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