Photography by Hubie Frowein
John Reinsberg, managing director of the Lazard International Equity Fund, has the world in his pocket. Literally. The antique pocket globes Reinsberg collects were used by sailing masters of the past to navigate trade routes. To move past the shoals of international markets today, Reinsberg relies on a crew of 83 analysts and researchers around the world. They help pick value stocks for Lazard Freres & Co.'s 11 funds.
"We like to think of ourselves as stock jocks with green eyeshades," says Reinsberg. "We have CPAs on staff whose only job is to focus on local accounting practices. So when there's a change in German tax practices, we understand the implications for a firm's books. The accountants also look at pension funds and unexercised stock options. This allows us to have a much more intelligent conversation with management. "It also helps if you speak the language, and the members of Reinsberg's extended family of stockpickers are fluent in 20. They're on the ground in the United States, the United Kingdom, France, Germany, Japan, Austra-lia, and Egypt.
But Lazard's research machine can't take all the credit for the fund's 24% total return in 1999. "International investing outperformed the U.S. last year for the first time since 1994," Reinsberg crows. Japan thumbed its nose at its decade-long bear market with a stock market up 60%. And some European countries revived struggling economies with rallies in technology and telecom stocks. The average total return for a domestic mutual fund for 12 months was 22.6% compared to 32.1% for international funds, according to Morningstar.
Of course, many of the gains overseas last year came from emerging markets, which the International Equity Fund eschews. The fund's mandate to invest only in developed countries helps explain its ranking in the 73rd percentile of its international fund category.
"The Morningstar ranking includes funds that have 15% to 20% in emerging markets, which are up 66%," says Reinsberg. "Also, Morningstar doesn't divide its foreign stock category by large value, large growth, etc. So we are being compared to funds that have totally different disciplines." International Equity did outperform domestic large value funds by a wide margin.
Reinsberg expects his value fund to do better in flat and falling markets. "Although we participate in equity-led bull markets, don't expect us to lead during years of huge gain," he says. "That's why we are doing back flips over our performance in 1999."
Reinsberg comes by his international interests naturally. A child of European immigrants, his first language was German, and he has since added Spanish and French. He currently spends 30% of his time traveling. "In the past year, I've been to Europe many times and once to Japan and Australia. But I've found that managing a portfolio from 40,000 feet is impossible; I have to be at my desk most of the time."
Japanese stocks did extremely well last year, yet only 26% of your fund's assets are invested in Japan compared to 70% in Europe and the UK. Why haven't you invested more heavily in Japanese stocks to take advantage of that rally? Our process has historically been global. We're not looking at Japanese stocks against other Japanese stocks, or European stocks against other European stocks. We buy companies - wherever we find them - at very attractive valuations that will return something to the shareholder. For many years, we found Japanese companies selling a dollar bill for five dollars. Returns on equities were going down, and companies' management was clearly not shareholder-oriented. Their business model was flawed. In the early 1980s and very early '90s when Japan represented 50% or more of the EAFE index, we had zero holdings because we couldn't find anything to buy.
So do you plan to increase the fund's assets in Japan? We are finding some very interesting opportunities, but I haven't bought them yet. The recent rally in Japan was very much technology-oriented. However, we like railways and utilities. They're not the sexiest companies in the world, but they are solid. They have improving return profiles, and they are moving in the right direction.
The euro had a pretty disappointing performance against the dollar in 1999. How has that affected your fund's performance? You can look at the weak euro as a benefit - not in terms of currency exposure, but because it allows European countries to be even more globally competitive. A company in a marketplace that has a weak currency clearly has an advantage over its foreign competitors.
There are lots of examples of that in our portfolio. Siemens is one. It announced radical restructuring affecting over 30% of the company through either sell-offs or joint ventures. It also floated a company called Infineon, a semiconductor unit. All of a sudden, Siemens' stock went up 97%.
Does the predicted slew of European mergers and acquisitions present any buying opportunities? In late December, the German government announced a tax-reform package giving companies a one-time opportunity to sell off industrial holdings tax-free. German companies have an incredible network of connected holdings and cross ownership that goes back, in some cases, over 100 years. For example, Deutsche Bank owns 25% of Daimler-Chrysler. There is no great synergy between a commercial banking operation and an automobile maker, unless you put an ATM in the dashboard. A utility in Germany owns a construction company and a printing company. Again there is no synergy, so why do they hold these things?
These legacy holdings are going to give way to strategic holdings. That will fuel European merger and acquisition activity and put more pressure on management to make better decisions. If you sell off a business for 10 billion Deutsche marks, you now have that money burning a hole in your pocket. Those companies will have to re-deploy that money in their shareholders' best interest. This business model will create a massive shareholder revolution.
The rallies in Europe and Japan were propelled by technology, telecom, and media stocks. Yet only 6.6% of the fund's assets are in technology. I don't think it's fair to just look at technology and not combine it with telecom, because they are interrelated. The technology sector clearly produced some of the more extravagant returns - at exorbitant levels of valuation. There is, however, a global convergence between telecom and technology, driven by technology, that is breaking down geography and industry barriers. We own several telephone companies including Telefonica, Portugal Telecom, Nippon Telegraph & Telephone, NTT Mobile, and Tele Dan-mark. Telecom accounts for about 12% of the fund. But we can't find value in Nokia, which has become the largest company in Europe and the second largest company in the EAFE index. It sells at 170 times cash flow - a valuation that is pretty impossible to defend on any kind of fundamental basis. On top of that, you have M&A activity, which has compounded extreme valuations in companies like Vodaphone. This company is using its very highly valued stock to make a bid for Mannesmann, another very highly valued stock. We had that stock and clearly sold it too early. But we stuck to our value discipline.
So you're saying you can't find a lot of value in the technology stocks that are out there? Not today. However, we have benefited nicely from investing in companies not traditionally linked to technology but that are using technology to transform themselves.
For example? Well, Philips and Siemens are transforming themselves from conglomerates to technology-focused businesses. Sony is shedding its unprofitable businesses and focusing on electronics.
Are we going to see the same Internet explosion in Europe and Asia that we've seen in the U.S.? I think we've already seen part of it. Two of the top-performing companies in Japan this year were Softbank and Yahoo! Japan. But Softbank is the only large European or Japanese company I know that is Internet-related or an Internet provider.
Will you be looking at any Internet start-up companies? We are not a small-cap fund. Ours is a pure international equity developed-market portfolio. We don't invest in emerging markets, either. People say, "Wow, you don't own any emerging markets, what a mistake that has been." Wrong. That's not this portfolio's design.
This fund appeals to a more conservative investor. Yes. We are looking for companies that create value for the shareholders, and, as such, we ask two questions. One, what do we have to pay for the productive assets of companies? And two, what kind of financial-productivity returns are we getting from management?
Investors have been obsessed with blue chips, technology, and the Internet. Is an international fund a hard sell? No. As the world is globalized, investors and companies have globalized along with it. It's a dangerous strategy to have all your eggs in one basket, whether that basket happens to be the S&P 500 or U.S. technology companies. There is an equity mentality creeping into the rest of the world. We have seen massive restructuring programs in Japan. The recent one announced in Germany will clearly move to its European neighbors. If you look at the S&P 500, it was up 21% for the year. If you exclude technology, it was flat. Technology represents 25%. So what does that tell you? Minus that one sector, international equity markets drastically outperformed domestic markets.
How much does the U.S. market predict the performance of stock markets elsewhere in the world? If you take a historical look at international markets, you will see very different performance patterns. The U.S. has had very favorable economic conditions for some time. But a year ago, no one wanted to look at Japanese companies because industrial production and management was terrible. So how do you explain the fact that Japanese equities were up 60% this year, and the S&P 500 was up 21%? And how do you explain Belgium, which was down 5%, and Finland, which was up 200%? We don't spend much time analyzing how the world is linked. We just focus on stocks and on companies.
About 21% of the fund's assets are in United Kingdom stocks. Why is that such a favorite market? It's not. We really don't make market calls. While technology and wireless telecom were the darlings in the UK in 1999, many consumer-branded companies were discarded. I'm talking about companies like Unilever, Cadbury Schweppes, and Diageo, with strong track records and management teams and very attractive valuations. We love to invest in unloved companies with high ROEs and low price to cash flows. We have found these companies are unlikely to remain out of favor for too long.
With 83 people on the Lazard team, how do you pick the stocks? There are four parts to our research process. First is the quantitative analysis, which identifies the companies, what they do, and their valuations. Then we focus on security and sector valuation. This is pure analysis, where you generate and develop investment ideas. Through accounting validation and daily contact with companies, our analysts are asked to formulate opinions on every company and rank them. That is what the large team does. Then the three-member portfolio construction group evaluates the best ideas from our research team. We analyze tradeoffs, opportunity costs, risk, and, at the end of the day, pull the trigger. We also spend a lot of time on risk analysis, looking at what we own, what we don't own, and what provides, over the long term, the best risk-return profile.
You look first at the company and second, at what's going on in the country? We look first at the company. Second, the industry. And third, the country. And when I look at country, I'm evaluating geopolitical-economic risk. You need to be aware of a change in taxes or capital controls. What we don't do is try to guess what will happen to currency or interest rates. They are very difficult to guess, and it doesn't help you make money.
How do you deal with the corporate secretiveness that is prevalent in Asia when you research companies? As a result of the Asian crisis, there has been a new awareness of the shareholder as a useful means of providing capital. And if a company goes to the shareholder for money, it has to play by the shareholder's rules. That is a very different relationship than the previous one. But the secrecy wasn't only in Asia. European companies are the same. But that, too, may change.
How do you identify a value stock with potential for gain? A great example would be Broken Hill Proprietary in Australia. Half of the company is in oil, the other half in mining. BHP had a management team that was unresponsive to shareholders and changing market conditions. In March 1998, the CEO resigned. In November 1998, they appointed a new CEO, sold off operations, and drove their costs down in a big way. Did we know that oil prices were going to double over the past year? No. But the catalyst here was the new management team with a good record and the elimination of unprofitable assets. This year BHP was up 82%, but when we bought the stock, there was not a buy recommendation on the global Wall Street.
How long do you hold onto a stock waiting for it to turn around? Our portfolio turnover is about 30%. That implies, on average, we hold stocks for three years. BHP went down, but we added to it. Then things started happening. The same thing occurred with Siemens in Germany and Alcatel in France. You have to ask, what is this company worth? If you see a catalyst that will cause a reevaluation of the company, you have to give it some time.
Do you require these companies to grow at a certain rate every year? We're looking for companies with margin expansion rather than high growth rates. Many Japanese and European companies in the past year or two had extremely low returns on equity, which are now improving. I would rather own the cheap company that is going from 3% to 7%, with the catalyst in place to make that happen, versus the expensive company that has a 25% ROE. I always bet on the improving trend.
Give me an example of something you sold and something you bought recently and why. Westpac Banking in Australia is a stock we had bought at a very low valuation in 1994. It hit our valuation target, and we sold it after almost five years. A more interesting story is the two Japanese banks we bought last year: Industrial Bank of Japan and Fuji Bank. We bought IBJ because it was the first to accept the government bailout program. The company was admitting it had had problems in the past and it was focused on improving them. The same was true for Fuji Bank. They were selling at very cheap valuations, about one times book value. Book value for us is still the best determinant of financial stocks. In August, these two banks merged. And now they are joining Dai-ichi Kangyo to become the world's largest bank. Their net interest margins and spreads are rising, their costs are reduced, they have a cost income ratio of 50%, and deposits are beginning to flow in again, which reduces other more expensive funding. We are seeing substantial profit increases. In terms of performance, they did pretty well last year.
When have you simply guessed wrong about a company? The conglomerate British Tire did all the right things. It brought in new management and sold off assets. But the flaw was that business was still terrible. The company needed restructuring. After a rally, we sold it.
What is the prognosis for Europe and Japan and value investing? We are living through an extraordinary period of change in the business models in Europe and Japan. I think we will see more M&A activity, especially with the unwinding of cross shareholding and more emphasis on returns to shareholders by companies. One way companies do that is by focusing on their core activities and shedding non-core business, which is a value manager's dream. All this change is going to be extraordinarily powerful for value-oriented shareholders who are good at determining what a company's true value is.