Mining the Silver Lining

Offshore fund managers find plenty of thriving consumer stocks despite sluggish growth in Western Europe and the U.S.

It sometimes seems that today's markets are governed by Murphy's Law. Just about anything that can go wrong is going wrong, as nearly every day brings news of another corporate scandal, another negative economic indicator, another terrorist attack. "The market psychology has gone from being overly sanguine about growth to overly cautious," says Ed Burke, manager of Invesco U.K. Equity Core Fund. "But there are signs that the pessimism is overdone."

Indeed, the results of BusinessWeek's annual survey of the 500 biggest offshore funds show that, in spite of all the gloom and doom, it's possible to play the market and win. This year's survey stands in stark contrast to last year's, when only a handful of offshore funds made money. This time, all the top 20 funds on our list posted double-digit gains. Benefiting from all the uncertainty, the No. 1 fund was Merrill Lynch Investment Managers World Gold Fund, up 78.3% for the 12-month period ended Sept. 30. The benchmark MSCI World Index, by contrast, was down 28.4%. "In these turbulent markets, investors want safe havens," says Graham Birch, the Gold Fund's manager.

With the global economy showing few signs of picking up, investor caution is understandable. Morgan Stanley forecasts that U.S. growth will be a measly 2.4% this year and 3% next year, with Europe expanding by only 0.9% this year and 2.7% next. And Japan remains in the doldrums.

Our data on the 500 biggest offshore funds was gathered by Standard & Poor's, which, like BusinessWeek, is a division of The McGraw-Hill Companies. Offshore funds are domiciled outside the U.S., mainly in tax havens such as Luxembourg and the Channel Islands. Because the U.S. Securities & Exchange Commission doesn't regulate these funds, offshore-fund companies are not allowed to market them to U.S. residents. The performance of offshore funds, however, is a good barometer of global market trends.

And what this year's survey shows is that things aren't quite as bad as the headlines suggest. To be sure, capital spending by U.S. and European companies is at a standstill, and there's no consensus on when it will resume. But, buoyed by low interest rates, consumers have kept Western economies moving, especially the U.S. Home refinancing has provided consumers with new money to spend even as the value of their mutual funds plummets. And the new credit-card and installment-plan cultures of Eastern Europe and Asia have kept consumer spending expanding at a sizzling rate.

Western Europe, however, can't shake off its sluggishness. The biggest concern there remains Germany. Lackluster economic growth and a precipitous fall in the stock market have hammered German banks. Weakened balance sheets means more banks are calling in loans and curbing new lending. "The underperformance of the German economy is acting as a substantial drag on the rest of Europe," says Invesco GT Continental Europe fund manager Alister Hibbert.

But despite Germany's problems, there are some good investment opportunities there and elsewhere in Europe. "We're bullish about the outlook for Western Europe," says Henning Gebhardt, head of large caps at DWS, Germany's largest mutual-fund manager. "Valuations are very low, and that makes this an interesting entry point for long-term investors." Indeed, many fund managers reckon that the European market, outside of Germany, has just about hit bottom. They expect European funds to post modestly positive returns in the coming year. But managers underline "modest" and say investors should have realistic expectations. "In this kind of low-inflation environment, growth is hard to come by," says Invesco's Burke.

Of course, the outlook for some European sectors is worse than others. For the third year running, technology and telecom funds have taken a beating. Nearly all of the 20 worst-performing funds in our survey are tech funds. European tech funds were especially hard hit. Walter Holick, senior portfolio manager and head of the tech team at DWS, sees no evidence of an upturn in tech spending among global corporations, and expects many tech funds to close down. "If your company isn't doing well, you can work another year with your old laptop," he says. The industries favored by European fund managers are those that benefit from consumer--not corporate--spending. They are investing in beaten-down sectors such as financial services, retail, pharmaceuticals, and construction. Other favorites include food and tobacco.

Meanwhile, funds have instituted a notable shift in strategy. After the introduction of the euro in 2000, money managers increasingly looked at stocks on a pan-European basis, focusing on industries, not countries. After all, Europe was now one market. But in the past year, fund managers say, European economies, and industries, have been diverging, not converging. So while Germany and Italy languish with little or no growth and almost zero inflation, Spain, Ireland, and some of Scandinavia are going strong.

Then there's Britain. Thanks in large part to its position outside the euro zone, Britain is doing better than most of its neighbors. The fact that London controls its own monetary policy gives it invaluable flexibility as the world's large economies sputter. The government's policy of pushing up spending to stimulate the economy is fueling strong consumer demand, says Graham Seeker, an economist at Morgan Stanley in London. The extra spending will add an estimated 1.25 percentage points to gross-domestic-product growth on average this year and next.

Here's a surprising British stock pick: After shunning telecom and technology stocks during much of the last decade, Invesco's Burke is buying shares in British Telecom. In the past year, the company has slashed its debt, improved its balance sheet, brought in new management, and refocused on its domestic market. "I wouldn't have touched the stock a few years ago, but now it looks cheap," he says. Burke also likes British insurer Legal & General, which makes up about 3.5% of his $163 million fund. Unlike many other European insurers, Legal & General has no solvency worries, and it has consistently produced higher earnings each year.

But the best bet in Europe is still the so-called convergence play. As 10 Eastern European countries move toward membership in the European Union, their economies and companies are emulating EU standards. That's one reason why half of the top 20 funds in BusinessWeek's survey are focused on Eastern Europe. This year's No. 3 fund, Griffin East European Fund, was up 57.4% for the year ended Sept. 30. Griffin and other Eastern Europe funds have benefited by crossing over into Russia, where rising oil and gas prices, a jump in consumer spending, and improvements in corporate governance under the stabilizing regime of President Vladimir V. Putin have pushed the market way up. In the year ended Sept. 30, the Russian market rose 26% in dollar terms. The big oil companies led the way, with the share prices of Sibneft and Yukos jumping 284% and 188%, respectively. Both of these companies have sharply boosted output by investing in high-tech production techniques.

Strong consumer demand gave several Asian markets a boost last year. South Korea, Thailand, and China have emerged from the crisis of 1997-98 stronger than before. Indeed, seven of this year's top 20 offshore funds specialize in these three countries. The real star was South Korea, considered the model for Asian economic and corporate restructuring. Its economy is expected to grow by more than 6% this year, buoyed by robust domestic consumption. After the Asian turmoil, Seoul forced banks to cut back their loans to the industrial conglomerates. The South Korean government has also spent $120 billion in the course of the past four years recapitalizing banks and buying bad loans. As a result, well-capitalized banks sharply increased consumer credit. "Easy credit helped fuel domestic consumption that's gaining importance in the economy," says Kang Shin Woo, chief investment officer at Good Morning Investment Trust Management Co. "Suddenly, companies relying on local demand look more attractive."

Take Shinsegae Co., a retailer running department stores and discount outlets. Its shares nearly doubled, to $147, in the year ended Sept. 30. Another fund-manager favorite, Lotte Chilsung Beverage Co., saw its stock almost triple, to $576 a share, in the same period. This year's second-best-performing offshore fund, the Jardine Fleming Korea Fund, likes Samsung Electronics. The world's largest memory chipmaker, Samsung has recently emerged as the world's No. 3 mobile-phone maker, too. While other chipmakers are suffering from the information-technology slump, Samsung recorded a net profit of $3.08 billion in the first six months of this year, up 80% from the same period in 2001.

Fund managers are also bullish on Thailand. Its economy posted 5% annual growth in the third quarter, helped along by a strong housing market and, again, exploding consumer credit. Hot markets such as Thailand and Russia proved to some fortunate investors that double-digit returns are still possible. But cautious fund managers aren't taking any chances. They reckon, in the words of investors such as Invesco's Burke, that "the key to making money going forward is not to be too ambitious." It's a lesson most investors have already learned.

By Kerry Capell in London, with David Fairlamb in Frankfurt, Christopher Condon in Budapest, Frederik Balfour in Hong Kong, and Moon Ihlwan in Seoul

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