When Value Can Be a Trap
Pamela Holding brings a debt analyst's training to the search for undervalued stocks. Four years after joining Putnam Investments in 1995, first as a high-yield bond analyst and then as a fixed-income research manager, Holding moved to London to oversee European equities research. In 2001, she returned to the States as co-manager of the Putnam International Growth & Income Fund/A (PNGAX), becoming lead manager in July, 2004. Holding says she continues to draw on her fixed-income experience in evaluating potential stock positions, particularly if the company is under a cloud.
In recent years, the $825-million fund's performance has closely matched that of its benchmark, the S&P/Citigroup PMI World Ex-U.S. Value Index, while slightly outpacing its international equity peers. For the one-year period through Jan. 31, the fund rose 23.8%, vs. a 25.4% gain by the index and a 24.4% advance by the peer group. For the three-year period, the fund gained 28.1% (annualized), vs. a 31.0% rise by the index and a 26.3% return for the peer group. Over the five-year period, the fund gained 6.9%, compared with returns of 9.2% and 4.9% for the index and peer group, respectively.
The fund carries a 1.38% expense ratio, compared with similar funds' 1.54% average. The fund's 128 holdings turn over at a rate of 62.4%, compared with a 67.4% rate for the peers. It also closely matches with peers in terms of volatility, with a standard deviation of 11.07, vs. other funds' 11.68 average. Based on risk and return characteristics, Standard & Poor's gives the fund its second highest ranking of 4 Stars.
As of Jan. 31, the fund's largest percentage of assets were invested in Japan (29%), with Britain (14.6%), France (10.1%), Switzerland (6.9%), and Germany (6.6%) rounding out the top five. Top industry sectors as of that date consisted of financials (36.8%) and consumer cyclicals (13.3%).
As of Dec. 31, 2005, the fund's top individual holdings comprised HSBC Holdings (3.3%), CS Group (2.6%), Royal Bank of Scotland (2.4%), BNP Paribas (2.3%) and Barclays (2.2%).
Carol A. Wood, a reporter for Standard & Poor's Fund Advisor, recently spoke with Holding about her investing strategy. Edited excerpts from their conversation follow:
How would you describe your investment philosophy?
This is a large-cap, international, developed-market value fund -- stocks must have attractive valuations. There also must be some sort of change factor to unlock that value for the shareholder. The real investment philosophy is cheapness and change. What we don't want to do is to buy "value traps" -- stocks that look cheap but which never return cash to shareholders. Overall, this fund focuses on well-known mid- and large-cap stocks with good liquidity, offering reasonably safe exposure to international markets and generally good long-term returns.
We try to take advantage of market mispricing. For example, if a company comes out with some sort of accounting scandal -- say it owes back taxes and the stock takes a 10% hit -- we'll immediately analyze how much the news will affect earnings and valuation, and if the market is overreacting.
We also will buy growth stocks if they look cheap relative to their sector or to their own trading history. Ericsson (ERICY), for example, was traditionally considered a growth stock. In 2002-03, the market was expecting it to go out of business. It didn't, and we picked up a nice position, which we've since sold.
We definitely can go outside the benchmark for our universe of stocks. For example, some of our best ideas in the past few years have come out of Brazil, where we have employed a top-down theme. Though we're traditionally bottom-up stock-pickers, we saw significant economic improvement in the country, which was paying down its external debt. We played it through the banking sector, buying Banco Itau HoldingFinanceira ADS (ITU) and Unibanco Banc/Unibanco (UBB) at the end of 2003. They have been extremely good stocks for the portfolio.
What's your strategy?
We use a quantitative model to screen a universe of roughly 1,200 stocks, ranking their attractiveness based largely on valuation. We also include earnings valuation and momentum factors to help us time our buy and sell decisions. Since we have a larger cap bias, we generally limit this universe to stocks with $1 billion of free-float market cap and above.
After the model is run, our analyst team uses a valuation tool to derive a fair value for all stocks in the universe. They also run bull/bear scenarios to project what the valuations would be if everything goes right for this company, or if everything goes wrong.
The global equity research team comprises more than 40 analysts who cover roughly 80% of international market cap. In addition, we have specialty research teams in emerging-, small- and mid-cap markets helping us find interesting ideas.
Portfolio decisions are made by me, a fundamental manager, and Darren Jaroch, who is quantitative. We focus on stocks that are most attractive from a quantitative perspective and that are supported by our analysts' valuation work. We also look at risk characteristics of the portfolio -- any external factors that may affect the stock, such as regulatory or legal issues. An analyst and a junior analyst help us quickly pick up stocks not covered by the research team.
What are your sell criteria?
Once a stock appreciates to its fair value, there has to be a very good reason for us to hold it. It can be momentum-related, as we don't want to sell too early. Another trigger for selling is a change in management philosophy or strategy. If a thesis on which we based our purchase somehow changes, or is negatively affected by regulation or law, we will re-evaluate and sometimes sell it.
Your literature says you look to benefit from privatization and deregulation. How so?
In many cases, we're able to get companies with dominant market share at attractive valuations because they haven't been run that well.
An example is Hellenic Telecommunications (OTE), which we bought in October, 2004. Owned by the Greek government, it was hugely bloated in terms of personnel. Once it started to privatize, it brought in a professional management team who understood the operating characteristics required by a telecom company. The stock price was trading at a very attractive valuation because the company was operating well below some of its peers.
Where have you done well recently, and not so well?
We were hurt at the end of last year by an underweight stake in Japanese financials. We saw better opportunities buying banks in Brazil, Korea, and Europe. But Japanese banks made a significant move at the end of the last quarter. We've had strong performance in Korea and Taiwan, and very good stock selection in Europe, in communications, basic materials, and financials sectors.
A couple of consumer cyclical stocks really hurt us last year. Renault was one, but we consider it to be a long-term holding, and an attractively valued company going through positive change. They have come out with a car that costs €5,000, which are selling extremely well in Eastern Europe.
Are you following the sector weights of your benchmark?
Absolutely. We don't tend to stray too far from benchmark sector weights.
This year, we've witnessed more significant valuation discrepancies, and we've tended to be a little further away in some sectors. We're 4% underweight in financials, because we think Japanese and Australian financials are relatively expensive. We're 3% underweight in consumer staples because we can't find a lot of good value ideas within the sector. We're 3% overweight in consumer cyclicals, with names like Renault and Adidas, which have been very good stocks over the long term for the portfolio.
We were overweight in Continental Europe for all of last year, on the premise that stocks had the potential to benefit from corporate restructuring, even without a lot of economic growth.
Japan has the additional benefit of having companies that are restructuring, and which are starting to return their massive cash balances to shareholders.
How much of the fund is invested in the emerging markets?
It typically ranges from 4% to 8%. As of December 31, 2005, it was at 8.7%, with 3.1% in Brazil, 4.1% in Korea, 0.9% in South Africa, and 0.6% in Taiwan.
Are there any areas or sectors that you avoid?
No, in general, we'll look at anything. Right now, we don't think utility stocks are attractive, and unlike many value funds, we have been underweight in the telecom sector. That was a very good decision for 2005.
While Australia and Canada are resource-based economies that were strong performers last year, we think they also look expensive. China is an important theme in fund, but it's hard to find good value ideas going directly into China. We play it through peripheral ideas -- European luxury goods, industrial machinery, and natural resources.
What's your outlook for various global markets? We're still extremely bullish on international markets. Valuations overseas, especially in Europe and Asia, are attractive, and many stocks in the emerging markets still trade at only single-digit p-e ratios. The U.S. looks expensive relative to international stocks.
With China, Japan, and Korea creating their own consumer spending cycles, we think we will see a de-coupling from the U.S. Based on the growth in China, we think a lot of the Asian economies could continue to grow at a nice pace despite what happens in the U.S.
With the Fed raising interest rates, the dollar has been very strong in the past year. But as the tightening cycle ends, investors will focus on structural issues facing the U.S. economy, and the dollar could weaken again. That could create a tailwind for international markets.
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