The Rewards of Going Global

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.