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Portfolio > Portfolio Construction

First Among Equals

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There has been a great deal of discussion lately about the importance of a higher allocation to international securities. A larger participation in international assets may make sense when you think that, as of the end of 2006, the U.S. portion of world market cap was 43%, according to Morningstar. Overseas operations accounted for 48% of the operating revenues of the S&P 500. The World Bank’s GDP forecast projects 2007 and 2008 GDP in developing countries to be about triple the GDP for the U.S. That said, not everyone wants to have an all-equity allocation to international.

One fund that can provide “best-of-breed” portions of international equity as well as fixed income is the $280 million Ivy International Balanced Fund, (IVBAX). Templeton Investment Counsel is sub-advisor to the fund, and, E. Tucker Scott, based in Geneva, Switzerland, runs the equity portfolio, while Michael Hasenstab runs the fixed income portfolio.

The fund has a long record of solid performance, with average annual total returns of 9.36% for the 10 years ended April 30, versus 9.17% for its peer group of hybrid global funds; 15.74% compared with a peer group average of 11.24% for five years; and 16.81% as opposed to 13.80% for three years, according to Standard & Poor’s. S&P ranks the fund three stars overall, with a 10-year style rank of three stars; five-year rank of five stars; three-year rank of three stars; and one-year rank of five stars.

Scott spoke with Investment Advisor by telephone from Geneva in April.

How much money do you manage overall?

Round numbers about $8 billion; [in this fund] $280 million.

What’s your benchmark?

Because this account is normally it is 65% equity and 35% fixed [income], we’ve created our own customized benchmark, which uses the MSCI All Country (Ex U.S.) because we don’t invest in U.S. securities, for 60%, and [for the other] 40%, the J.P. Morgan Non U.S. Government Bond Index.

What’s your investment process for the fund?

I co-manage this [fund]. I manage the equity portion of the fund, and a fellow by the name of Michael Hasenstab manages the fixed-income portion. I manage the equity side as if it were a normal equity portfolio that I’m managing day to day. We are value oriented, our marketing people use the term “core value” I think that’s descriptively correct, in the sense that we’re not deep-value people, and when growth becomes cheap in the market–as I think it is today–then we’re able to buy companies that might not traditionally be labeled as value stocks.

We have a low turnover, it’s typically 20% to 25% per year, so we really do what we say we do, and that is we’re long-term investors and we tend to hold securities until we think that they are fully valued. We don’t want to eat up our returns in trading too much.

How do you select the companies you buy for the fund?

I operate as part of a team, I think we’re 34 people today, located around the world but very much part of a seamless organization. We’re primarily a research organization. I’m a portfolio manager, with oversight over a number of portfolios, but with regard to the value that I’m providing to the entire group–and this works in both directions–we all have research responsibilities. What I mean by that is, I follow forest products and paper on a global basis; commercial services; and within those industries it’s my responsibility to be aware of which companies are getting close to the parameters that we’re looking for, and then recommending those to the group. Then all portfolios’ [managers] consider buying the stock that I’m recommending. It really is a group effort.

So how do I go ahead and make decisions on the fund? It really is a bottom-up process in the sense that the analysts, wherever they’re finding value–no matter what country or what industry–go onto what we call our bargain list, which is our stocks that we believe are the most undervalued that we can find in the world–and that’s where I go when I want to add a new security to the portfolio. I’ll look across there and try to find the ones that make the most sense to me.

How does volatility in oil or resources around the world make a difference in your investment process?

Well, our whole approach to valuation revolves around the idea of normalization, so when it comes to commodities, especially, we think in the long run that’s a very sound process to take. You need to think about the incremental cost of adding capacity, and that tends to, over time, be roughly where the commodity price should settle out. So if you get a big disconnect, i.e. the commodity price is selling well above the cost at capacity–and I’m talking about a unit of capacity here–then people will add capacity because it’s very profitable to do so. Conversely, when the commodity price is well under that, they are not going to add capacity, so you have this self-correcting mechanism, which, over time, works. So volatility, to the extent that it’s influencing asset prices above or below what we think is justified by our normalization analysis, provides us opportunities to buy or sell. But, it really doesn’t impact per se how we view the world–commodity prices are going to fluctuate and they’re very hard to predict in the short run, but in the long run you have pretty good ability to predict where they’re going to average out.

So you don’t let that noise affect you?

Exactly. If anything it’s just going to provide more opportunities to buy or sell at advantageous prices, the way we view the world.

What about interest rates or currency fluctuations–how do they affect what you’re doing?

Well, certainly the way we approach valuation is on a company-by-company basis. So these are inputs that go into the company analysis, and in many cases, certainly with regard to currencies, when we’re dealing with a multi-national organization they’ve already matched up their currency exposures, usually, as well as they can, and then it’s really an issue of a translation effect as opposed to a real mismatch in the currency where you can get some big changes in the value of the company based on that, so you want to make sure that the company is well-matched. In that case then, the currency is not going to be that big of an issue. Conversely, I follow the paper business. Currencies are a very important part of the analysis that I do on paper companies. The Canadian paper producers have been getting killed because the Canadian dollar has gotten expensive, so I need to take a view on that. The way I do that is by, typically, looking at where it’s traded historically; I look at purchasing power parity; and I make my best estimate–and it’s just that, I don’t have any special insights into currencies. I’m just using a common sense, long-term, value-focused way to project them and when I do that, in those cases where it is important, and as I say that’s a minority of cases, that’s how we approach currencies. We don’t hedge currencies on top of our portfolios; we try to take it into account at the company level.

Would you talk about some of the larger holdings or something that surprised you with how well it’s done?

We’ve had good success with two companies in Europe, which are leading wind turbine manufacturers. One is called Vestas [Wind Systems], that’s in Denmark, and the other one is Gamesa, and that’s in Spain. We bought both of these stocks three- to four-years ago, when they were pretty badly beaten-up, and the thesis on both was that wind was a secular growth business, and that the economics were now at such a level that they were competitive with fossil fuel energy production, and that the politics were lining up behind wind as a very strong secular theme. Neither company was particularly profitable at the time but when we did our normalization analysis and wanted to figure out how much growth we thought we should pay for, we thought they were exceptionally cheap. That has, indeed, come to pass; those stocks–Vestas is up about 10 times from its lows, and Gamesa up not quite that much but, again, a very significant gain. Those are an instance where those stocks fell out of favor, the long-term fund fundamentals were there; the short-term fundamentals were not; but an instance where we’ve made a lot of money for our clients in those two stocks–which we still hold in the portfolio, although they’re no longer cheap, I would argue.

But maybe not fully valued?

Exactly. Getting close–we’ve reduced our positions but we’re not out completely.

Is there something that didn’t work out they way your thesis expected?

One of the stocks which has been a disappointment has been Rentokil in the U.K., in which we have a small position in the portfolio but it has not been a success. They’re a diversified services company; they wash uniforms, clean bathrooms, spray for rats–they do all kinds of stuff like that. The core issue there was, it was in retrospect what they term a value trap, where the stock got cheap, it looked cheap on P/E, on dividend yield, on a number of different metrics, but what the market had correct and what we had incorrect was that the profit was unsustainably high at that point, and indeed operating margins have gone from 19% down to 12% in the span of three years. We have not been able to get out in front of that and accurately predict that that trend was going to continue and be as extreme as it has been, and the stock has done nothing while the markets have gone up 50%. Poor forecasting.

Do you have a sell discipline?

Both the buy and the sell recommendations from the analysts and also from the portfolio managers’ actual executing the orders, it’s really fundamentally-based on our estimates for fair value for these companies. We’re looking to buy things 40% cheaper than what we think they’re worth, and we’re selling them for what they’re worth or hopefully even more than what they’re worth. If you think for a moment that the market is fairly valued but there are certain securities that are undervalued or overvalued, which I think is probably true, we’re buying the ones that are extremely cheap, and selling them when they kind of get back to average, so we’re trying not to hold the securities–which almost by definition is half the market–where they are overvalued. Our sell discipline is to recognize that we’ve reached fair value, in many cases that’s happening concurrently with fundamentals improving and people getting more positive on the outlook for these companies. When it goes onto what we call the source-of-funds list–not a sell list–the thinking there is that you don’t have to get out of these stocks right when they go onto the sell list, but use this as a source of funds when you’ve got a better opportunity to go into, and that’s really the value-based sell discipline that we have.

So when it tips the scales there and you’ve got something better to put the money into that’s when you’d make those moves?

Exactly. And remember, too, with the turnover at 20%, 25% per year, this is not a churn-and-burn type of portfolio; we’re really not moving it over too much.

Let’s talk about the fixed-income side of the fund [managed by Hasenstab].

I’m in touch with [Hasenstab] on a fairly regular basis. He’s more macro-oriented, he’s going to take into account views on interest rates and currencies; it’s more central to his decision-making. Today he’s got relatively short duration so he’s not optimistic that we’re going to see massive declines in long-term interest rates, and because there are flat to inverted yield curves around the world today, you are getting paid to sit on cash or short-term instruments. We don’t have any interest-rate exposure in Japan, but we do have a meaningful exposure to the yen, and other than that, the overweights would tend to be in peripheral Europe and some of the non-dollar block currencies in Eastern Europe.

Who would benefit from having a fund like this?

I think a lot of folks who don’t have a lot of international in their portfolio. The typical–if that’s the right word–but it’s not the only [person], but somebody that perhaps has a decent, diversified portfolio, wants to get a little more international exposure and perhaps is more interested in having a balanced exposure without having to fiddle around with a number of different funds. [With] this one, you know what you’re getting; it’s a proven long-term track record, with a strong equity and fixed-income component. We try not to deviate too much from a 65%-35% split, so if equities should drop down to 60% or up to 70%, I will work with Michael to rebalance the portfolio. It’s basically a one-stop-shop for international diversification, so one decision and you’ve got it.

What would be the benefit to advisors to have that all in one fund rather than pick a couple of best-of-breed funds?

I guess it would come down to simplicity, first of all, and for certain size portfolios maybe that’s a little more realistic, Second, you can look at the equity side and the fixed side and we do have best-of-breed on both sides. The Templeton Global Bond Fund, which Michael Hasenstab runs, you can look at that performance–he’s top-decile all the way back; and on the equity side, certainly over the longer time periods, we have very competitive performance. It was a good year, last year, but 2005 was a little rough, so some of the shorter-term numbers are good, but they’re not great. So we do have best-of-breed on both sides; why complicate things when you can keep it simple? You get the asset allocation built-in, you get some modest rebalancing of the portfolio, which happens inside the fund as opposed to having your advisor or somebody else do it outside. It’s a simple, self-contained little diversifying instrument for somebody.

A lot of people are advocating a larger allocation to international. If you were allocating for an individual is there a percentage that you would put into international?

This gets right to the personal nature of the recommendation–I’ll speak for myself, I have about 40% is non-U.S. assets that I keep in my own [portfolio] and that seems like reasonable amount. That’s just one example. If you look at the academic work that’s been done, using what in my view might be some questionable assumptions about the nature of the world, they come up with an optimal portfolio of roughly 40% international equities and 60% domestic if its an all-equity portfolio. That’s the academic answer–if you want to maximize your risk-adjusted returns, that’s what you do.

What else do advisors need to know about the fund?

On the equity side and on the bond side we have longstanding processes and philosophies, which have been operating under the Templeton name for decades, so we’re not a flash in the pan, we’ve been around before, we believe we have commonsense approaches to investment which work–they don’t always work, and they can be out of favor–but because we’ve been in business for a long time, and we have a brand name that out clients understand, they understand the way we approach investment, we can stick with it, and even through he tough times stick to our guns.

E-mail Senior Editor Kathleen M. McBride at [email protected].


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