Peter Spano of Preferred International Value Fund

S&P Rank: 5 StarsUndervalued Stocks Trump Merely Inexpensive Ones

Quick Take: Peter Spano draws a distinction between statistically inexpensive stocks and those that are undervalued. The latter appear to have the potential to appreciate, because a catalyst is at work, he explains. Those are the ones that Spano wants in the Preferred International Value Fund (PFIFX), which he manages.

In picking stocks, Spano trawls among financially sound companies with little debt. He focuses primarily on large ones in developed countries, but can invest up to 10% of the fund's assets in emerging markets.

Spano has overseen the portfolio since 1992, and was joined by James Chaney two years ago. Their fund was up 8.4% this year through October, versus a gain of 6.5% for the average international stock fund. For the five years ended last month, Preferred International Value rose 5.8%, on average, versus a loss of 0.8% for similar funds.

The $667-million portfolio closed to new investors on Oct. 29 to keep its assets from reaching the point where they could hurt its performance. However, it remains open to current shareholders.

The Full Interview:

A stock won't catch Peter Spano's eye just because it's cheap.

His interest is piqued when he sees a catalyst, like a new product or a restructuring, that's likely to transform undervalued shares into overvalued ones he can sell profitably.

To pick stocks for the Preferred International Value Fund, Spano hunts for those priced low relative to a company's earnings, book value and cash flow over the last three to five years, and based on profit growth projected over five years. He wants equities that are inexpensive compared to their own history and the overall market. Stocks are ranked every three months.

"Really, what we're asking ourselves is what are we going to be paying for companies today that are going to have excellent earnings five years from now," says Spano.

Aside from valuations, Spano scans for companies with strong balance sheets and cash flow, little debt, and improving profit margins. The fund leans towards large companies in developed countries.

Spano is willing to put up to 10% of the fund's assets into emerging markets, however. He describes these investments as "world class" companies that "just happen to have the wrong address, if you will."

Companies don't have to be market leaders or buy back their shares to get admitted to the fund, but those that do carry added attraction for him.

About 50 stocks make their way into the portfolio. Spano believes that number provides adequate diversity while enabling winners to make significant contributions to the fund's performance.

In the second quarter this year, he invested in Bridgestone Corp., the big Japanese tire and rubber products manufacturer. He sees the company as well positioned to benefit from rising demand for those goods. Bridgestone also looks because of its 20% share of the worldwide tire market, Spano says.

Another stock that entered the fund in the second quarter is RAS, an Italian financial services company that is one of the country's largest insurers. The company features an "extensive distribution network," and a growing international presence, according to Spano. He also applauds its management team.

The fund's country weights are a result of Spano's individual stock picks. At the end of September approximately 16% of its holdings were based in the United Kingdom, including its No. 1 stock, Vodafone Group PLC, which provides mobile telecommunications services.

Spano bought the company about two years ago, when telecom stocks were depressed, because its shares struck him as compellingly priced. They still do, he says. The stock had risen to the top of the portfolio because it appreciated, he says.

When he initially invested in Vodafone, it was the leading player in its field, and appeared positioned to increase its market share by "taking advantage of weak competitors," Spano says. "That's exactly what it has done," he adds. As a result, it has exposure just about everywhere in the world, he says. Looking ahead, he thinks Vodafone will generate good earnings growth.

Another U.K.-based company, drug maker GlaxoSmithKline, held third place in the portfolio at the end of the third quarter. Spano took a stake in the company early this year, when, he says, its shares had gotten beaten to their lowest level in years, despite what one of the fund's analysts considered an "impressive" group of developmental drugs. Spano likes the company's global footprint, too.

The fund, Spano says, got a boost in the third quarter from its energy stocks, including Petroleo Brasileiro S.A. ADS (PBR), a Brazilian oil company that he says has done "exceptionally well" for him. Another gainer cited by Spano is Milan-based Saipem S.p.A., which provides drilling and construction services to oil and natural gas companies.

When it comes to selling, Spano will unload a company if its stock starts getting pricey while its financial fundamentals turn sour.

For example, he eliminated Akzo Nobel from the fund in the third quarter this year when it appeared the Dutch chemical and drug manufacturer's pharmaceuticals division wouldn't be able to develop any drugs that would fatten its bottom line.

"It had been in the portfolio for quite some time, and I think we were probably more than patient with it, in hindsight maybe a little bit too patient in holding it as long as we did," Spano says of Akzo.

As a rule, Spano is not quick to banish a stock. That's demonstrated by the fund's turnover rate, which measured 30.6% last year, compared to 88.1% for its peers.

Contact Bob Keane with questions or comments at: .

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