Core Diversification

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.

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.