Talk about a Catch-22 for Canadian investors. Two years after Ottawa nixed foreign limits in registered retirement savings plans, our commodity-fuelled dollar is flying higher than ever and there's a fire-sale on U.S. equities. Problem is, the fire is still raging as subprime infernos blow sparks toward the rest of the U.S. economy, and we don't know how long the commodity boom can keep our loonie flapping.
It may be time to step back and do what value investors have always done: Think long term and cast your net far for bargains. The world outside the U.S. (yes, there is such a world) has been relatively insulated from the subprime mess as the European economy grows at a healthy clip, and emerging markets in Asia, South America and Eastern Europe steam ahead. Right now, average price-to-earnings multiples on major global indexes like the S&P 500 and MSCI EAFE are in the teens - good hunting for value investors.
Value investing takes time but over the past decade international equity funds that have incorporated a value style have been the best performers.
At the top is the CIBC International Small Companies Fund with an average return of 11.1 per cent each year for the past 10 years. In comparison, the average international equity fund returned 4.7 per cent and the benchmark MSCI EAFE Index returned 5.4 per cent over the same period.
The fund is managed on behalf of CIBC Securities Inc. by Geneva-based Pictet International Management. Senior investment manager Justin Hill says the objective is simple. "We would like to see a price-to-earnings ratio less than that of the market, and growth more than that of the market."
Mr. Hill says 90 per cent of a stock's selection is measured from the bottom up through a specific company's financial statements. The remaining 10 per cent is determined by outside, or top down, considerations in the broader market that could create long-term growth potential.
Value investors don't normally target specific sectors or regions but nearly one-third of the CIBC International Small Companies Fund's $176-million in assets is invested in the industrials sector. The next largest sector is financials with a 14-per-cent stake. Mr. Hill says his team has discovered undervalued regional Japanese banks with no exposure to global credit markets. "They tend to be very, very conservatively run," he says.
Normally small caps get walloped by broad market turmoil but Mr. Hill says their lack of diversity has actually insulated them from the global credit storm. "The good thing about small caps is they tend to stick to their mission," he says. "I think there will be more unpleasant stories coming out of the woodwork for months to come. ... We would like to think our strategy will outperform throughout the cycle."
The second top-performing international equity fund over the past 10 years is the AGF International Stock Class Fund with an average annual return of 10 per cent. Rory Flynn co-manages the fund with John Arnold from AGF International Advisors in Dublin, Ireland.
Mr. Flynn says the $1.8-billion fund has turned out strong and steady returns over the past decade by limiting the portfolio to fewer than 50 stocks and maintaining an average holding period of 10 years.
AGF imposes a "30/30/30" value filter that only accepts a stock trading at least 30 per cent below its 18-month high, a P/E ratio 30 per cent below the market, and a 30 per cent higher dividend than the market. The stock is sold when it approaches the market P/E. "We use the same value mandate across the board," he says.
That value mandate has led AGF right back to global financials like BNP Paribas of France - hard hit by its exposure to the U.S. subprime market and currently trading at a P/E of about eight times with a yield of 5.2 per cent. "Unless something very strange happens, BNP will be growing earnings and increasing dividends," he says.
For similar reasons, 60 per cent of the AGF International Stock Class Fund is in the hard-hit financial sector. The 49 stocks have an average P/E of 12.4 and an average dividend yield of 3.8 per cent. "To make current valuations fair you have to have something horrible happen," he says.
The $400-million Mawer World Investment Fund, managed by Calgary-based Mawer Investment Management Ltd., is the third best-performing international equity fund over the past 10 years with an average annual return of 8.5 per cent. Manager Gerald Cooper-Key says his investment style is predominantly value with an element of growth. "Generally, we have been insensitive to index weights and have preferred to build our portfolio stock by stock," he says.
Mr. Cooper-Key says he has reduced his weighting in financials to 21 per cent from 28 per cent - holding on to non-bank financials such as insurance companies. "Our banks are diversified and perhaps less at risk from the U.S. subprime mess," he says.
Some of the value sectors on his radar screen include infrastructure, materials and environmental industry, and he singles out South Korean stocks as "reasonably valued."
"Ongoing growth in Asia and elsewhere may help to alleviate some of the pressures emanating from the U.S.," he says.
All Canadian-denominated funds that purchase securities in foreign denominations have lost value due to the strong loonie and international equity funds are no exception. To put it into context, the MSCI EAFE is up 11.4 per cent in U.S. dollars this year but down 7 per cent in Canadian dollars. That could work as a further benefit to international equity investors if the Canadian dollar declines.
© 2007 The Globe and Mail. All rights reserved.
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