February 17, 2006

The Rewards of Going Global

Fund opportunities abound overseas.

U.S. investors voted with their feet in 2005, and global equity funds -- those that can invest in both domestic and foreign stocks -- won by a landslide. One could say the votes were bought: The average global equity fund returned 10.9% for the year, versus a 4.9% gain for the S&P 500. Flows into global stock funds were strong overall in 2005.

Among developed economies, Japan had the best performing stocks in 2005 in dollar terms, said Standard & Poor's equity market strategist Alexander Young. Japanese financial services stocks did particularly well in 2005, due to the anticipated reform of Japan's huge postal system, which actually serves as the world's biggest savings bank, with more than $3 trillion in assets.

The S&P Latin America 40 Index surged 50.2% in 2005, fuelled by the world's best-performing region. Gains were driven by the energy and materials sectors, which together constitute 40% of index. Young said that as a net exporter of oil and other industrial commodities, the region has been a prime beneficiary of the current commodity bull market. The index largely comprises companies based in Brazil (49% by market-cap weighting) and Mexico (38%), with Chile contributing 10%, and Argentina 3%.

In general, Standard & Poor's is bullish on stocks for 2006. "Equities are the asset class of choice" for the year, said Young. "While bond yields are higher in some of the emerging markets, we think they're low enough to make equities the more attractive place this year." Indeed, red-hot emerging market stocks, soaring on the insatiability of a commodity-hungry world, have been a compelling story.

Hitting the Jackpot

Investing heavily in the hottest markets, however, hasn't been a requirement for achieving high overall returns. The $281-million Polaris Global Value Fund (PGVFX) achieved "reasonably well diversified" returns in 2005, without favoring any particular geographic area, noted manager Bernard Horn. The fund has been a top performer in its category for both the three and five-year periods, and is ranked 4 Stars by Standard & Poor's.

An overweight position in materials probably contributed the most to the fund's 10.5% gain last year, Horn said, citing Impala Holdings Ltd. (based in South Africa), Showa Denko K.K. (Japan), and BHP Billiton Ltd ADR (BHP) (U.K.) as top contributors. Telecom services didn't do well because of concerns over competing internet services.

Another highly ranked portfolio is the $934-million Janus Orion Fund (JORNX). Portfolio manager Ron Sachs said that despite the mediocre gains of the S&P 500 last year, he achieved returns of about 20% on both his domestic and international holdings, partly because he doesn't follow a global benchmark. "I consider it a fund that goes wherever in the world the best risk/reward opportunities are," he said. The fund has also excelled over the three-year period.

Oakmark Global Fund/I (OAKGX), the number one fund inry its catego over the five-year period returning 18.0% annualized, benefited from U.S. stocks in 2005. Singled out, they gained roughly 11% for the year, bolstered by a 99% return on the fund's largest U.S. holding, Burlington Resources (BR), an independent oil and gas company in talks to be acquired by ConocoPhillips (COP). Euronext N.V., the holding company for European stock markets, was the strongest contributor to performance among non-U.S. companies. Clyde McGregor, the fund's manager, also cited solid results from Swiss financial services firm Julius Baer Holding Ltd. and Neopost SA, a French maker of mailing and shipping equipment, in a letter to shareholders.

Japan: Livedoor, Not A Trapdoor

Given the steep jump in Japanese stocks last year, Standard & Poor's expects to see profit taking, after which these equity markets should recover modest gains by the end of 2006. Although panic selling in the wake of the Livedoor scandal and investigation sent the Nikkei down in mid-January, even forcing the Tokyo Stock Exchange to briefly close, the index has since rebounded.

"We like Japan, but the pace of gains will have to slow," said Young. "It can't go up 25% a year." Standard & Poor's looks for 2% GDP growth in Japan in 2006 -- a lower rate than in the U.S., but still an improvement for that country. "They've flirted with recession for a long time," said Young. "The return of inflation will be a positive development by encouraging consumer spending, which we think has been missing from the economic picture."

Japan also boasts the fastest earnings growth in the developed world. Standard & Poor's projects 15% earnings growth in 2006 and an 8%-10% absolute return for the S&P Topix 150, which would make the index competitive versus U.S. stocks and fixed income. "Our forecast for a 2006 P/E ratio of about 19 is reasonable given the profit outlook," Young said. "These are not value stocks." Standard & Poor's is maintaining its overweight recommendation on Japan.

Young added that with China and the U.S. absorbing Japanese exports, largely information technology and industrials, Japan should do well as long as those nations continue to grow, as Standard & Poor's expects them to. Companies likely to benefit from this trade include Toyota (TM), Honda Motor ADR (HMC), Sony (SNE), Canon Inc ADR (CAJ), and Matsushita (MC). Products in demand could include iPods, game consoles, liquid crystal displays, televisions, and cars.

Emerging Markets: Continuing to Excel

"The best growth at a reasonable price is to be found in the emerging markets, where you have 15% earnings growth, just like in Japan, but multiples of only 10 or 11," said Young. "We're expecting another year of double-digit gains in earnings."

Young believes that Western investors don't keep enough money in emerging markets, which has recently been the best performing region in the world. Naturally, these stocks can be more volatile than those of developed markets, partly because they tend to be smaller-cap issues.

"One of the basic tenets of investing is higher return, higher risk," Young said. "When people are making 30% a year, they don't complain." He noted that while emerging markets fell 7% in October 2005, they have since rebounded. "We're recommending these things on a long-term basis for peoples' retirement," he added.

Standard & Poor's recommends an overweight position in emerging markets. Because these markets represent about 6% of global market cap in the S&P/Citigroup indices, we suggest that investors keep between 8% to 10% of their equity portfolio in the emerging markets.

Latin America: Bullish on Exports

Standard & Poor's outlook on Latin America is bullish, based on strong consensus earnings growth and attractive valuations. We expect the Latin America Index to gain 12% in 2006, due to a constructive macroeconomic backdrop of an expected 3.5% GDP growth and benign inflation. With earnings and the index moving up in tandem, Standard & Poor's doesn't foresee a rise in P/E ratios.

Like Japan, Latin America would suffer if either of its two primary export customers, U.S. and China, endured an economic slowdown. As noted, Standard & Poor's sees growth continuing in both nations. Though upcoming presidential elections in Brazil and Mexico may represent a wild card, Standard & Poor's believes that the key political parties are much more market-oriented than in the past, which should limit equity volatility regardless of outcome.

Sachs, who reported outstanding returns from Brazilian steel, iron ore, and basic materials companies, said he believes the risk of currency devaluation in the country is "mitigated" by the global demand for its basic materials. "If the currency goes down, their cost structure gets even lower," he said.

Asia-Pacific: Thriving in Japan's Shadow

The S&P Asia 50 Index, which comprises companies from Hong Kong (33%), Korea (32%), Taiwan (25%) and Singapore (10%), was up about 20.6% in 2005. These economies are largely export-driven and their outlook is influenced by currency fluctuations.

Standard & Poor's forecasts 6.1% growth in GDP for the region in 2006. Consensus estimates call for earnings growth of 13%; shares are now trading at about 12.4 times their projected 2006 earnings. "That is a low price for [such] high growth," Young said.

Standard & Poor's recommends overweighting of Pacific ex-Japan equities for 2006. The index's largest sectors, information technology and financials, should be held at marketweight, while materials should be underweight, due to industrial overcapacity in China that may limit commodity demand in 2006. Better growth prospects in consumer staples and utilities are also seen, and overweighting those sectors is recommended.

In terms of China, the nation's 2005 GDP was forecast to rise 9.3%, but Standard & Poor's projects that GDP growth will moderate to 8.8% in 2006, and maintains a cautious stance on the country given concerns on overcapacity and lower profit margins. We recommend underweighting the region in one's portfolio.

Europe: Weak Fundamentals Warrant Caution

In 2005, overall corporate earnings in Europe rose about 15%, while the S&P Europe 350 Index jumped 22.7% in euro terms. However, Standard & Poor's outlook for Europe in 2006 is cautious, based on the belief that the run-up in 2005 has discounted the good news for 2006. Standard & Poor'sEuropean strategist, Clive McDonnell, is looking for a year of consolidation.

The economy remains too dependent on exports and the business sector at the expense of new job creation, wage growth, and stronger earnings, Standard & Poor's believes. The continent also faces weak domestic demand on the heels of high unemployment, low wage growth, high taxes and susceptible consumer spending. Standard & Poor's sees a modest decline of 1% in the S&P Euro 350 Index in 2006 -- given a 3% dividend yield, the index would be slightly positive on a total return basis -- and expects earnings growth for the index to decelerate to 8% from about 20% in 2005.

Standard & Poor's recommends underweighting the region in one's portfolio, particularly in financials, the index's largest sector, due to concerns over higher interest rates and their negative impact on the mortgage lending and housing markets. "Cyclical sectors are at high valuations, justifying a more defensive stance," said Young.

Despite the outlook, fund managers have still been finding opportunities. The Polaris fund reported a number of winning stocks in the region in the industrial sector, the fund's second most important source of returns. Standouts included construction/services firms YIT-YHTYMA OYJ, Kone OYJ, and KCI Konecranes. In Norway, Horn singled out Cargotec, a spinoff of Kone.

At Janus Orion Fund, Sachs said Swiss pharmaceutical firm Roche Holding Ltd. was a top performer, along with Israel's Teva Pharmceutical Industries ADR (TEVA). Sachs said Turkey's integration into the E.U. has created a "lot of opportunity" as the nation has lowered interest rates and rapidly expanded its banking sector.

United States: Big Is Beautiful

For global equity funds that hold U.S. stocks, Standard & Poor's sees the potential for U.S. large-cap stocks to offer the best values in 2006. Young said he expects an 11% EPS gain for the S&P 500, and GDP growth of 3.4%, a rate that is "slowing, but still respectable." The S&P 500 is now trading at 14.8 times the P/E forecast for 2006. "This is relatively low," Young noted, "so there's still some value in the Citigroups (C), the GEs (GE), the Pfizers (PFE) of the world."

Below is a list of the best-performing global stock mutual funds for the one-, three-, and five year periods. In addition, we found two broader based exchange-traded funds that invest globally, the iShares S&P Global 100 Index Fund (IOO) and the streetTRACKS DJ Global Titans (DGT). Both hold stocks of very large multinational companies. As of the end of December, the iShares S&P Global 100 had roughly a 50/50 split between U.S and international stocks, while streetTRACKS DJ Global Titans had 63.4% of its assets in in the U.S., and 36.6% abroad. Both feature low expense ratios.

TOP PERFORMING GLOBAL EQUITY FUNDS FOR 1-YR.* PERIOD

FUND

Return (%)

3-Yr. Standard Deviation (%)

Expense Ratio

Merrill Lynch Global Value Fund/I (MAVLX)

+34.6

12.4

1.25

Scudder Global Fund/S (SCOBX)

+23.3

11.7

1.25

T Rowe Price Global Stock Fund (PRGSX)

+22.7

10.7

1.18

Janus Orion Fund (JORNX)

+20.9

13.4

1.01

Gartmore Worldwide Leaders/IS (GLLSX)

+19.1

12.4

1.64

Average Global Equity Fund

+10.9

10.6

1.64

TOP PERFORMING GLOBAL EQUITY FUNDS FOR 3-YR.* PERIOD

FUND

Annualized Return (%)

3-Yr. Standard Deviation (%)

Expense Ratio

Oppenheimer Global Opportunities/Y (OGIYX)

+34.4

19.6

0.82

Janus Contrarian Fund (JSVAX)

+29.7

13.8

0.93

Merrill Lynch Global Value Fund/I (MAVLX)

+29.1

12.4

1.25

Polaris Global Value Fund/Investor (PGVFX)

+26.2

12.1

1.48

Janus Orion Fund (JORNX)

+26.0

13.4

1.01

Average Global Equity Fund

+19.1

10.6

1.64

TOP PERFORMING GLOBAL EQUITY FUNDS FOR 5-YR.* PERIOD

FUND

Annualized Return (%)

3-Yr. Standard Deviation (%)

Expense Ratio

Oakmark Global Fund/I (OAKGX)

+18.0

14.1

1.20

Polaris Global Value Fund/Investor (PGVFX)

+16.3

12.1

1.48

Vanguard Global Equity (VHGEX)

+12.0

11.4

0.90

Van Kampen Global Franchise/A (VGFAX)

+11.6

9.4

1.28

Capital World Growth and Income Fund/A (CWGIX)

+10.9

9.8

0.77

Average Global Equity Fund

+2.5

10.6

1.64

InvestmentAdvisor.com has more mutual fund news from Standard & Poor's available here.
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