Justin Thomson, lead manager of T. Rowe Price International Discovery Fund (PRIDX), has generated stellar returns with a strategy that outsiders say combines a rare knack for balancing boldness in security selection, with safety in allocation. The fund’s returns have handily bested the average of small- and mid-cap international growth stock funds and the MSCI ACWI ex-USA Index over the last 1-, 5-, 10- and 15-year periods, according to Morningstar.
At times the fund is overweighted in various countries and sectors, but it doesn’t seek an overweighting. Years ago (Thomson took over the fund in 1998), it was more concentrated, but he came to view that strategy as too risky.
Thomson discussed these and other issues in a recent interview.
WealthManagement.com: What do you think accounts for the stellar performance of your fund over the past 19 years?
Justin Thomson: To perform well long term, you have to think in terms of a long period rather than a long series of quarters. You have to see performance over a long cycle. That sounds easy, but it may mean periods of underperformance. In addition, while I’m the lead portfolio manager, make sure you surround yourself with great people. I believe I have good people on my team.
WM: Morningstar Analyst Bill Rocco says your investment strategy combines boldness and tameness. Can you elaborate on that?
JT: The boldness comes in security selection. That’s where we take risk. Buying small-cap stocks in international markets is risky, and you should take your risk at the stock selection level. The portfolio structure level is where risk is mitigated.
We have some biases on countries and sectors, but we aren’t trying to achieve overweighting there. We try to outperform by maximizing security selection and minimizing sector and sovereign risk.
Currencies also are important. When we consider investing in a country or currency that’s weak, the hurdle rate for going into that market is higher to compensate. We have the ability to hedge our currency exposure, but we tend not to, because I’m an equity guy. We try to diversify our currency risk instead.
WM: Can you talk about the fact that your market-cap is smaller than your peers?
JT: We’ve run the fund with a median market cap of $2 billion over many years. Clients hire us because they like international small cap. To be true to that remit, we have managed the statistic effectively.
As we have grown assets, it’s harder to keep the number down. We will let a company run as it goes over $5 billion and $10 billion. That growth is what we’re trying to achieve. But we always have to find the next multi-year winners.
WM: What's your approach to emerging markets?
JT: The key issue is what are you investing for there? It’s long-term growth, the emerging middle class and massive growth in consumption. The most interesting area of the market is consumption, particularly Internet plays and services, particularly healthcare, education, travel and leisure. Those are all areas where growth and spending are happening year in and year out. To get that you need to invest in small-cap stocks.
WM: Can you explain your approach to countries and sectors?
JT: We try to be diversified, but we have biases. At the country level, China and India are where we see the deepest pool of securities. Both have extremely large domestic markets, of course. Small emerging markets have country risk.
In terms of sectors, we have tilted toward traditional growth sectors: consumer, information technology and healthcare. We have tended to tilt toward resources and banks and away from regulated businesses such as utilities.
WM: Can you flesh out those sectors a bit for us?
JT: As for resources, T. Rowe Price is bearish on oil prices. We tend not to invest in junior miners, where information flows are very local, so we don’t have an information edge. Plus, they tend to perform in short bursts. We like compounding over long periods of time.
We shy away from regulated businesses because we like higher returns than are allowed in them. As for banks, we selectively invest in them—in emerging markets. In developed markets, Japan and Europe are structurally uninteresting. Their banking industry isn’t consolidating like regional banks in the U.S.
WM: What is your approach to valuations?
JT: Part of what we do is take multiple risk—valuation risk. If we are looking three or five years out, sometimes we are prepared to pay up. Valuation matters, it just matters more at some times in companies’ life cycles than others.
WM: Can you explain the large number of holdings in your fund?
JT: The number of names—200 to 220—has been consistent over many years. In businesses we’re comfortable with and where we get to know management, we’re prepared to build our positions to 1 to 2 percent. But at the same time we’re creating new positions. We move gradually. We start small and move higher, as the position goes up.
WM: What are the most important elements of your investment philosophy?
JT: First is having an information edge, which means rigorous analysis. You need good people for that. Second is the advantage of time, having a higher-than-average time horizon.
WM: Has your investment philosophy changed over the years?
JT: Yes, your philosophy is always colored by your own history. To be an effective portfolio manager, you need to be a continuous student of the business, and you need to understand your own strengths and weaknesses and keep working on your weaknesses.
When I took on this fund in 1998, I was 30. I was bold, thinking you only take small-cap positions in five sectors: technology, media, telecoms, support services and biotechnology. So the portfolio had a very big bias. The fund was very strong in 1999, but with hindsight, that was more about generating beta than alpha. I have moderated since then to not load up on sectors.
Stylistcally, where we’ve increased our positions in the fund is in high-quality growth stocks. Growth can be 5 to 10 percent. It doesn’t have to be off the charts. It’s persistence of growth that’s important.
