Money Floods Foreign Stock Funds

Nothing could stop the torrent.

Stock markets around the world soared in 2005, pumped by record amounts of new cash moving into international equity funds. Led once again by the vibrant emerging markets, foreign issues overcame a tidal wave of challenges, including record high oil prices, rising U.S. interest rates, terrorist attacks, continued unrest in the Middle East, and unprecedented natural disasters.

Apart from the commodity-rich emerging markets, the other big story in global equities was Japan, which appears to have shaken off the cobwebs of a 15-year bear market. Mutual funds and exchange-traded funds investing in Japan soared in 2005. Overall, the average international equity fund gained 17.7% for the year, while the average global equity fund, which has the latitude to invest in both U.S. and foreign stocks, rose an impressive 10.5%. In comparison, the S&P 500 climbed 5.8%.*

Not surprisingly, U.S. fund investors caught the foreign bug and found better bets abroad. According to Emerging Portfolio Fund Research Inc. (EPFR), dedicated emerging market equity funds received $16.1 billion in net inflows through mid-December, beating the record $14.4 billion established in 2003. Investors placed $3.9 billion of new money into Latin American equity funds by mid-December, compared with just $97.8 million in 2004, and $436 million in 2003. Another $7.1 billion flowed into Asia (ex-Japan) equity funds in 2005, the most since the $7.3 billion recorded in 2003.

EPFR’s data also indicated that 2005 was the second best year of inflows for Japan and global equity funds, and the worst year for flows into U.S. and Europe equity funds in this decade. Currently, iShares MSCI EAFE Index Trust (EFA) and iShares MSCI Japan Index Fund (EWJ) are among the five largest exchange-traded funds, with $21.7 billion and $11.6 billion in assets, respectively, as of theend of November, according to Standard & Poor’s data.

Emerging Markets: Still A Good Buy

Thomas A. Mengel, portfolio manager of the $57-million Ivy International Value Fund/A (IVIAX), attributes the surge in emerging markets primarily to continuing robust energy and commodity prices, although it varies by region. “The biggest commodity-driven market has been Russia, whose economy is heavily linked to the price of oil,” he said. “However, another major commodity play, Brazil, has a more diversified economy. For instance, it boasts a strong banking sector, and the country’s overall economic growth has been good.”

Ron Holt, president and managing director of global research of Hansberger Global Investors and portfolio manager of the $229-million Harris Insight International Fund/N (HILAX), likes the emerging markets due to better fundamentals, attractive valuations, the development of a huge domestic demand base in China and India, and the long-term structural shift from the developed world to the emerging markets.

Despite handsome gains, the emerging markets still remain relatively cheap on multiples. According to S&P/Citigroup Global Equity Indices, such developed markets as Austria, France, Japan and Britain are trading at 12-month trailing P/E’s of 21.8, 22.7, 26.8 and 22.2, respectively. By comparison, red-hot emerging markets like Argentina (12.8), Brazil (7.8), India (15.1), Mexico (7.8) and Russia (11.6) remain veritable bargains. As a whole, the emerging markets are trading at a P/E of 12.3, versus 18.1 for the Eurozone and 20.9 for the U.S.**

Nicholas Kaiser, president of Saturna Capital Corp., which oversees the Sextant and Amana funds, said that in the emerging markets “sound businesses with reasonable fundamentals are still available. The large increases in cyclical earnings make many companies even cheaper on a price-to-earnings basis.”

The U.S. dollar, which has undergone a broad rally against major currencies this year, has played a large role in the fortunes of foreign markets, particularly exporters in Asia and the developing world. However, Asian nations are trading more with each other and gradually becoming less dependent on selling their wares to the U.S., somewhat softening the negative impact of the stronger dollar.

Kaiser is not overly concerned about the dollar. “Rising domestic interest rates boosted the U.S. dollar in 2005,” he explained. “As there is little chance for falling U.S. interest rates in 2006 the dollar will remain strong. A collapse is highly unlikely, as a strong U.S. economy will improve the federal financial picture while also supporting imports from emerging markets.”

Japan: New Engine, Sleeker Design

Japanese markets are bursting at the seams with optimism, buoyed by meaningful corporate restructuring, an improving domestic economy and the recent election victory of reform-minded Prime Minister Junichiro Koizumi and the Liberal Democratic Party.

“Japan made good progress on clearing up its bank debt problems in 2005,” said Kaiser. “They voted to privatize the postal banking system, showing that the financial drags of many years standing can be removed and the need for governmental policy to fight deflation has evaporated.” Kaiser said he expects the Japanese recovery to continue for at least another six months, with the Nikkei rising 20% over that period.

Mengel also believes Japan’s economic revival is sustainable. “Japan is coming out of deflation, which is very good for domestic consumption,” he said. “Japanese companies are also increasingly profitable.”