Look Over There, but Beware

Investors have been flocking to foreign stocks, and for good reason. But there is also good reason to remain wary of overseas investments.

During the first 10 months of 2004, international funds had inflows of $83 billion, a record pace and more than double the figure for the year before, according to Financial Research Corp. Strong performance is attracting the cash. In 2004, foreign small/mid-value funds returned 25 percent and emerging-market funds delivered 23.7 percent, according to Morningstar. That looks rich compared to the Standard & Poor's 500 index, which climbed about 9 percent.

Though foreign shares can help to diversify portfolios, some advisors are wary of the sudden move abroad. International stocks can be volatile. After gaining 71 percent in 1999, emerging-market funds lost 30.3 percent the next year. The message is clear: Investors chasing hot performers now could be badly disappointed in a year or two. “Many people tend to buy foreign stocks high and then sell low,” cautions John Sterba, president of Investment Management Advisors, a registered investment advisor in New York.

When to Look Overseas

Should you avoid foreign shares until prices dip? Not necessarily. Calling the top is difficult. Investors who don't already hold foreign stocks should move gradually, slowly buying funds that can diversify a domestic-oriented portfolio. Sterba urges clients to put at least 30 percent of assets in foreign shares — and to hold that position for the long term.

To protect against the next downturn, avoid the hottest funds, cautions William Rocco, an analyst with Morningstar. Because overseas small value stocks and emerging markets have done the best in recent years, he suggests looking at funds in other areas. Top choices include funds that hold large-caps or growth shares. Conservative investors may prefer portfolios with limited exposure to the developing world.

A solid selection is Tweedy, Browne Global Value, which holds a mix that includes stocks of all sizes in the developed world. “Tweedy has done relatively poorly lately, but this is the kind of fund that will hold up when small stocks correct,” says Rocco.

Tweedy could prove particularly stable because the fund hedges its foreign currency exposure, to counter the impact of moves in the dollar. In recent years, the hedging has been a drawback. As the dollar has dropped, the value of foreign holdings has climbed for U.S. investors, a move that gave an extra boost to unhedged overseas funds. Eventually the dollar will revive, causing a headwind to slow the progress of foreign stocks. When that happens, Tweedy's hedging will produce some shelter from the storm. Rocco suggests holding Tweedy along with a fund that doesn't hedge. That way a foreign portfolio will be diversified by currency strategies.

Neuberger Berman International is a fund that usually is unhedged. Portfolio manager Benjamin Segal seeks growing companies selling at modest prices. Stocks with high annual earnings growth tend to carry steep prices, so Segal looks for companies growing at 5 percent to 15 percent annually. He buys high-quality businesses of all sizes with entrenched franchises. Such companies can thrive in downturns and have helped the fund achieve modest volatility. To limit risk, the fund keeps less than 10 percent of its assets in emerging markets.

The biggest Neuberger holding is Anglo Irish Bank, which has delivered steady results by focusing on a narrow group of customers — doctors, lawyers and other professionals. “The prototypical client is a dentist who wants a loan to buy his office,” says Segal. “These high-end customers are very good credit risks.”

Another fund with low volatility is Evergreen International Equity A. The fund limits risk by staying broadly diversified, keeping about half its assets in growth stocks and half in value. The resulting portfolio is labeled “foreign large blend” by Morningstar. Portfolio manager Gilman Gunn searches for growth stocks with steady track records. A top holding is Smith & Nephew, a British maker of hip and knee replacements. “They are one of the dominant companies in the field where demand is growing as the population ages,” says Gilman.

Evergreen exercises extra caution in the emerging markets, focusing on companies with secure niches. The fund currently has 5.5 percent of assets in emerging markets. A favorite holding is Korea Electric Power, the dominant electric producer in its market.

To limit losses, Gunn considers selling any stock after it has lost 20 percent in a 12-month period. “By selling losers quickly, you avoid getting caught with an Enron that looks cheap but will eventually collapse,” says Gunn.

Investors seeking a small growth specialist should consider Forward International Small Co. The fund aims to reduce risk by holding a mix of growth stocks. Portfolio manager Justin Hill divides the portfolio into several categories. At the riskiest end of the spectrum are emerging companies, fledglings with earnings growth rates of 20 percent. For more stability, the fund takes established companies whose growth has slowed. Hill also includes turnarounds, companies that seem poised to recover from temporary lulls.

One of the fund's successful turnaround plays has been Kidde, a British maker of equipment used for fire protection. Increased demand for smoke detectors has helped the earnings climb.

Hill argues that many foreign small growth stocks remain attractive. “With small-caps, you can put together a portfolio with an attractive valuation and much better growth than the overall market,” he says.

For a large value fund, try Causeway International Value, which focuses on blue-chips from the developed markets. Many holdings are cheap because they faced cyclical downturns or tough restructurings. “We want companies that can show sustainable growth, but we don't want to be caught paying a lot for them,” says portfolio manager James Doyle.

A big holding is Vodafone, the British wireless company that soared in the 1990s and then crashed along with its competitors. While the stock has dropped more than 75 percent from its highs, the company boasts a solid balance sheet and healthy profit margins.

Another favorite of Doyle's is Honda Motor. The Japanese giant has been expanding its market share in North America and turning a nice profit. That kind of solid performer should hold up for years and help Causeway deliver decent results, even when the hard times return and competitors sink into the cellar.

Good International Bets