From the October 2006 issue of Investment Advisor • Subscribe!

Core Diversification

Fund gives managers freedom to find value worldwide (An abbreviated version of this article appeared in the print edition of Investment Advisor, October 2006)

Advisors use many techniques to make clients' portfolios geographically and industrially diverse, from including international funds along with U.S. mutual funds, to selecting a group of ETFs that cover indexes around the world. But if an advisor doesn't want to select and monitor a group of individual stocks from the U.S. and abroad, how can they prevent the unintended consequence of over- or underweighting certain geographic regions or industries?

One solution may be to have one manager keep an eye on the whole planet by investing in a global fund that searches for the "best values and the cheapest cash flows in the world," according to Polaris Capital Management President and CIO Bernard Horn, the portfolio manager of the $495 million, no-load, Polaris Global Value Fund (PGVFX). Along with Vice President, and Assistant Portfolio Manager Sumanta Biswas, Horn believes that a global fund can be appropriate as a core holding: "A global manager is responsible for making the decisions as to where one should invest in the world, that that process, if it's done well, leads to a very diversified and risk-optimized core of someone's portfolio."

The fund has an overall four-star ranking from Standard & Poor's, with five stars for its five-year ranking; four stars for the three-year ranking, and three stars for the one-year ranking. The fund has achieved five-year annualized total returns of 17.84% versus 8.42% for the S&P/Citigroup PMI World Index; and three-year annualized returns of 20.00% versus 17.20% for the index, as of August 31.

How much money do you manage at Polaris Capital?

BH Just over $2 billion at Polaris overall, and just under $500 million in the Global Value Fund.

How is the fund different from others in the global sector?

BH It definitely is positioned as a deep value fund, and I think what is most different between what we do, from perhaps the rest of the market, is that we tend to be very absolute value oriented, and in that search for value we will tend to go wherever we find the most undervalued companies in the world. As such, it might mean that we will be away from the index, sometimes by quite a substantial margin, and that's not atypical of what we're seeing right now in the fund. For instance right now we have one of the lowest weightings we've ever had in the U.S., which is about 35%; in recent times we've had zero weighting in Japan but recently we've gone up to about a 10% or 12% weighting in Japan.

What's your investment process for Global Value?

SB We start out with an investment set of around 24,000 companies, across 50 different countries in the S&P database, and then we use a lot of parameters to screen out companies that you wouldn't necessarily be interested in. It's a very effective process actually--in a couple of days we're down from 24,000 companies to 400 and we will use different parameters. [For instance] we are interested in companies with only positive cash flow from operations, then [we'll see] if those cash flows are priced to give us our required rate-of-return or not. After all those parameters it boils down to a few hundred companies.

Then we would take these companies and do a thorough, fundamental, basic Graham & Dodd analysis; very exhaustive financial models, company management contacts, traveling all around the world kicking the tires, talking to suppliers, customers, and also getting down to the shop floor and seeing where the cash flows are really generated. Basically, 28 days a month is all this dirty stuff: kicking the tires--basic Graham and Dodd analysis--it's financial modeling; it's company management contact, you know--talking to management in the office, traveling--doing site visits; triangulating from different meetings, talking to suppliers, customers, competitors, and everything else--all this is 28 days. Then basically forming a portfolio of anywhere between 50 to 80 stocks. That's how we go about it.

How often are you on the road to see these companies?

BH Probably a good 25% of the time, anyway--but our company contacts are also heavily supplemented by what we see coming through Boston. Boston is a particularly good place to be located just because there are so many managers here that companies kind of come through here.1006MFS-chart3.jpg1006MFS-chart2.jpg

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It looks like you have a fairly low turnover in your portfolio?

BH Yes, and that's true for a number of reasons. One, we just tend to buy and hold, and the kind of inefficiencies that our process uncovers tend to be those that take a few years, three to five years, to mature. Sometimes it's shorter than that--if there's a catalyst like a takeover or a management does something somewhat rapidly. For all practical purposes, if you think about what we do, back in the days when people were kind of enamored with tech stocks and dotcoms, the market was very hot on those, people were chasing those and they were completely ignoring things like natural resource companies, or emerging markets. Those are the kind of things that we bought and it took some time--here we are six or seven years later--and now natural resource stocks are actually somewhat popular. So it tends to take that long for not only the market to come around on some of these sectors, but also, once the companies are doing well, they tend to do well for a while, and as a result the valuations can continue to go up as the cash flow of the underlying companies improves.

And that low turnover helps to keep your expenses low?

BH Absolutely. Trading costs, fund expenses, as well as it tends to be very tax-efficient.

SB And that might also be an answer to the first question: "How can the fund be a bit different from the rest?" Looking at long-term rather than absolute short-term--every quarter or so; not just looking at the next-quarter results, but trying to understand a company in the long term, too.

How have the gyrations in oil markets affected the fund?

BH We're certainly aware that higher oil prices are affecting companies in a couple of ways: one, obviously if you're producing oil you're getting a higher price for your product, and it's favorably affecting all the oil-producing companies, and also the oil-producing countries. Of course, on the other side of the coin, if a company is using oil or oil-related products in their cost of production, it's obviously squeezing margins, and that's something that we obviously take into consideration--not just oil but certainly all the other things. But clearly if you think about all the haves and the have-nots in global economy, the countries that have oil are clearly generating extraordinary cash flow these days, and the cash flow that's going into countries like Saudi Arabia, Egypt--even small countries like Qatar, and United Arab Emirates, Russia, Norway, and so forth, those countries are experiencing tremendous investment booms and tremendous increases in the liquidity in their economies. On the other hand, those countries that are very large consumers of oil are experiencing the opposite. They're seeing cash drained out of those economies--and of course, the U.S. is one of those.

Is that one of the reasons why your allocation to the U.S. is a little bit lower than normal?

BH Not so much related to that as it is that the U.S. has so grossly outperformed everything else over the last 10 to 15 years that the valuations of U.S. companies are extraordinarily high relative to what we can find elsewhere.

How do you cope with currency fluctuations outside of the U.S.?

SB A couple of ways: the first step of our process is actually where we discount our estimated free-cash-flow with the companies, with a discount rate--that's our required rate-of-return, which has three parts. One of the parts is the real government bond yield of that country.

BH It's just an additional return that we need to compensate us for the potential devaluation of the currency in those countries where the risk is highest.

SB The next would be when we look at a company, then we would look at its transaction exposure, meaning if its revenues are in a depreciating currency and its costs are in an appreciating currency then, of course, it's not good. That's at the company level where we'd take a deep look and see if it would work in their favor or not and then take it from there.

What about interest rate fluctuation as rates have gone back to normal in the U.S.--has that made big difference for you?

BH Actually it's been a bit of a drag, we have a bunch on investments in U.S. banks, and as the yield curve has flattened--what you said is that rates have gone back to normal--and real rates have gone back to normal in the sense that it now costs borrowers, after inflation, something to borrow money. Whereas when the Fed had interest rates down to .5% to 1%, interest rates were actually negative, in real terms, in the U.S. So, yes the real bond rates, or the real interest rates in the U.S have gone back to something that resembles normalcy, but the yield curve has considerably flattened. For some banks that has been a problem, for other banks it's actually helped them. So it has had a bit of a drag on our performance but we think, though, that as the loan books of banks re-price in the second half of 2006--that is, when the annual variable rate mortgages or the rates on commercial loans adjust upward as a result of higher interest rates in the economy--then that will start to increase the net interest margin in banks and that will start to help. But we do think that the presence of positive, real rates-of-interest in the economy is fundamentally a better stabilizing effect, and it creates less excess in the general economy.

So long-term that's a plus?

BH We think so.

Can you talk about some of your largest holdings?

BH Well we generally equally-weight all of our portfolio securities and as a result there isn't a tremendous difference between our largest holding and our smallest holding. Some of the larger weightings [as of June 30] are in companies like WESCO [International, Inc., U.S.] (WCC) but again, we're talking about a company that is 1.5% of the portfolio; some of the smaller weightings are 1.25%, so it's really only about 25 basis points difference. WESCO is a U.S. company that provides distribution of electrical products to everybody from utilities to manufacturers around the country. They have had quite a tremendous performance because this is a relatively low-margin business but management have done a phenomenal job squeezing costs out of the entire logistics and supply chain, from their vendors out to their customers, so it's created very strong increase in their cash flow over the last five years, and we've been fortunate to have benefited from that. United Health (UNH) is another company that we have a larger weighting on. The primary reason for that is that we owned Pacific Healthcare and [United Health] took over Pacific Healthcare and we wound up with a bigger holding.

We've got a couple of Japanese companies that were added recently, in the end of the first quarter and beginning of the second quarter and they actually performed quite nicely since then, and as a result they've become a slightly [larger] weighting in the portfolio.

Is there something that you've bought that hasn't yet worked out the way you had hoped?

BH We should probably talk a little bit about the paper companies. We've owned them for a little while, it's not something that we've just recently purchased; but we've noticed that the paper industry has seen an increase in capacity around the world, primarily as new capacity has been built in Asia, and specifically, China. The combination of that new capacity plus the fact that the dollar has weakened against the euro has stopped the flow of paper from Europe to the U.S., and backed up supply in Europe a little bit. The combination of those two things has held price increases back in the paper business, and so it's a sector where we were hoping that we would see better capacity utilization by this time; it hasn't happened and so pricing has been off. The demand is actually reasonably good, it's increasing well, but not strong enough to keep up with the capacity additions that have been hurting the industry.

Where would this fund fit in an individual's portfolio?

BH I'd probably make the bold statement that we think that investors should consider global funds as the core piece of their portfolio, that because a global manager is responsible for making the decisions as to where one should invest in the world, that that process, if it's done well, leads to a very diversified and risk-optimized core of someone's portfolio. I've been preaching this for about 25 years so I'm not sure it's going to happen by the time I retire, but we strongly believe that, and we think it's a trend that we're starting to see some movement toward, but obviously it has a tremendous way to go--if it ever happens.

We do think that one of the other ways of investing globally is for someone to have a domestic portfolio, and then they kind of bolt onto that an international portfolio, and while that's global it may suffer from the unintended consequence that if the two portfolio managers, that is the domestic manager and international manager, tend to overweight similar sectors or the management of those two portfolios isn't coordinated, you could end up having excess risk or a concentration where, in fact, what you're trying to achieve by investing globally is lower risk.

Better to have one "eye" on the entire world?

BH Exactly. And then if you want to specialize or overweight certain sectors, you can do so around that global core, but we think a global strategy is a good base for a core.

What else do advisors need to know about the fund?

BH It's not going to be a fund for every season. One, it's not a currency play, and two, because we follow a very strict discipline of searching for the best values and the cheapest cash flows in the world, it means that at times we're not going to be invested in a similar way to the way the index is constructed. Just like right now we're very underweight in the U.S component of our portfolio, it's about 35%; yet as a part of the World Index it's closer to 55%, so as a result, if one part of that index performs a little bit better than the way we're weighted, from time to time, it might mean that we'll lag. But, we've been making those kinds of benchmark decisions for decades, and we're used to doing it; we do it simply because we know we can find better returns away from where the index might be heavily weighted.

The second thing is that many people have been talking about, and we've read a lot about, Warren Buffett, who has made a huge bet against the U.S. dollar, and that a lot of people look to global funds as a way to "play" the impending decline of the U.S. dollar. We would not advise people to buy a global or international fund thinking that they are going to get a currency play--this is a strategic decision to create a better-optimized portfolio with respect to risk and return.

For the Global Value Fund is it just the two of you making the decisions or are there more people on your team?

BH Well, there are five of us on this portfolio; I make the final decisions, but Sumanta's been a very strong assistant portfolio manager, with us about 4 1/2 years.

Do you own this fund in your personal portfolio?

BH Virtually all my liquid net worth is invested in the funds that we run. We run three mutual funds, and one private sector fund.

SB Same here, most of my wealth is also in the funds.

What do you do to unwind when you're not managing the funds?

BH I like to sail from time to time. I play a lot of handball and of course like fly fishing. Usually when I'm on vacation I get a little chance to do it--I have a nice, very compact seven-piece fly rod that fits in a carry-on--if I'm going to a place where I'm going to have a little extra time--doesn't often happen but...

SB I like swimming, chess, trekking--trekking is the first one--I've done a lot in India; I haven't had much chance to do it here; one of the portfolio managers down the hall (at a different company) is just back from Kilimanjaro and after hearing his stories, it's pretty enticing--pretty exciting stuff.

Staff Editor Kathleen M. McBride, a former stockbroker and bond trader, can be reached at kmcbride@investmentadvisor.com.

About the Managers

Bernard R. Horn, Jr., is president and portfolio manager of Polaris Capital Management, the investment company he founded in 1995. He manages about $2 billion in three mutual funds (Polaris Global Value Fund, Quant Foreign Value Fund, and Allegiant International Value Fund), and in separately managed accounts, and pension money.

Horn holds a BS in business administration from Northeastern University, and earned a management MS from the Alfred P. Sloan School of Management at M.I.T. where he was advised by Nobel Laureate Robert Merton, and the late Fischer Black. He sails, plays handball, and enjoys fly fishing to unwind.

Sumanta Biswas, is VP and assistant portfolio manager, with day-to-day responsibility for the Polaris' Global Valuation Model, and fundamental and quantitative analysis of investment opportunities for the funds. He has been with Polaris Capital since 2002.

He earned the CFA designation, and a diploma in business finance from the Institute of Chartered Financial Analysts of India. He holds an undergrad degree from North Bengal University, a Calcutta University (India) MBA, and a Boston College MS in finance. To relax, Biswas treks, swims, and plays chess.

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