Baptism by fire: Despite volatility, International Growth Fund manager celebrates three-year anniversary with solid results
Chace Brundige, CFA
Senior Vice President,
Waddell & Reed International Growth Fund – February 2012
International financial markets have been in the doldrums for much of the past three years, sliding under the weight of an epic global recession, morose economic and business outlooks for most economies and companies, political and social unrest in many corners of the world and several horrific natural disasters. Coincidentally, those were the same three years during which veteran large-cap, domestic-growth fund manager Chace Brundige, CFA, staged his debut in international investing. Brundige, who has more than 17 years of industry experience, took the management reins of the Waddell & Reed Advisors International Growth Fund on January 1, 2009, and never looked back. In his role as manager, Brundige oversees day-to-day management of the Fund’s more than $450 million in assets (and a total of more than $900 million in the international growth style), selecting investments in companies doing business in diverse markets around the globe. As the Fund marks its three-year anniversary under his tutelage, Brundige discusses his transition to international investing, the challenges and intricacies of global stock picking and his unique approach to finding and owning the world’s most successful companies.
1) It’s been three years since you moved from swimming in domestic waters to managing the international-only Advisors International Growth Fund. What was that transition like, and what adjustments did you make in how you look at the world and how you invest?
The largest difference has been dealing in a much broader universe, with an infinitely larger number of opportunities. I inherited an international-only growth portfolio when I had been working on the domestic-only growth team for a number of years – so there was a lot to learn just to understand the holdings already in the Fund, let alone the entire investable universe. There are so many more factors associated with international investing; the role of government bodies (executive, legislative and judicial) come into play, monetary and fiscal policies must be considered, different country domiciles and end markets have effects, and we have to know how currency movements affect not only a stock denominated in another currency but also how they can help or hurt a company, depending on how much of its business is import- or export-driven. It’s a whole different ball game.
2) Describe your investment philosophy for managing Advisors International Growth Fund.
Our investment philosophy is based on the idea that for a company to grow over many years with attractive margins and returns, it must do something its competitors cannot effectively replicate. That’s what we look for. We want to invest in leading, high-quality international companies with sustainable competitive advantages, and we want to buy them when long-term fundamentals are under-appreciated. In other words, we want to get good stocks at attractive prices. Possessing a competitive advantage is key because it leads to the sustainability of growth, and that sustainability leads to the long-term outperformance we seek.
Also key to our philosophy is that we like to maintain a more concentrated portfolio by investing in the companies in which we have the highest convictions, which enables us to know the companies really well. Ideally, we would like to hold these securities for roughly three to five years, but the recent market environment has shifted our investment horizon closer to two to three years, on average.
3) How do you identify companies with sustainable competitive advantages?
A firm’s competitive advantage can come from a variety of sources, including but not limited to brand equity, cost structure, intellectual property and distribution channels. Screening for good margins and returns, along with strong capital management and quality of earnings, allows us to look at a very large universe and get an initial indication as to whether a company possesses the characteristics we look for. Then we begin to ask several fundamental questions: Does the company have an edge over competitors? What is the source of that edge? Is it sustainable and leverageable? Do potential substitutes exist? If the source is government-enabled, is that enabling policy likely to continue or strengthen?
At any point in time, the majority of the Fund’s assets will be invested in long-term holdings chosen for inclusion in the portfolio at a fundamental level. These types of companies have what we believe to be a long-term, sustainable competitive advantage with superior margins and returns. We believe many other investors underestimate the longevity of these companies and their end markets are continuing to grow. A good example is Fresenius SE (2.6 percent of assets at 12/31/2011), a German health care company. It is a leading competitor in dialysis services and equipment, generic injectable drugs, and acquirer of German hospitals. We feel the market underestimates the longevity of three key tailwinds: changes in global diet leading to greater demand for dialysis; tighter regulation of injectable drugs narrowing the competitive landscape; and a push for efficiency in German health care through hospital privatization. We view Fresenius SE as a key long-term holding.
A still-large portion of the portfolio, though to a lesser extent, is made up of companies we plan to hold over the medium term. The sustainability of the companies’ competitive advantage is not necessarily clear, but there is some catalyst improving fundamentals in the meantime. The companies that meet these criteria often are growing market share and have above-average margins and/or returns. Valuation becomes more of a factor with these medium-term holdings, so we typically use price targeting to determine weightings. For example, we purchased Taiwanese handset maker HTC when we believed the company garnered an edge in producing and selling Google Android-based handsets. We also believed that edge was temporary and thus sold the stock after it had rallied significantly and consensus sentiment was running very high. Since then, Samsung has become a dominant competitor and market share gainer in the segment and HTC’s stock has suffered largely as a result.
The smallest segment of the Fund is typically invested in stocks we intend to hold for a relatively short period of time. Valuation is generally the key driver here, which often arises from top-down, sector or country-specific situations or trends. These companies generally possess at least some edge over the competition, though the key driver is typically valuation due to what we believe is a market misperception or lack of appreciation.
While the Fund’s country and sector weightings are largely a result of our bottom-up security selection, in most environments we take macro factors into consideration so that we can mitigate some type of risk, i.e., currency, government, environment, geographic and economic. We also may opportunistically exploit top-down situations and trends when we see them.
We typically invest in stocks at a beginning weight between 0.5 percent and 1.5 percent of net assets. As we become more comfortable with a given company and its growth prospects and our conviction deepens, we continue to build the position. The resulting portfolio is typically comprised of 50-75 securities, spread across many countries and regions (with a focus in developed markets) and encompasses nearly all sectors.
4) Who helps you identify and keep up-to-date on your holdings? What kind of research can you access?
The international trading day is very long. A couple hours after the
U.S. closes, Australia and then Asia begin the next day’s trading. Each night and early morning is spent monitoring new events as they develop in those markets, with a focus on key changes, in preparation for our daily morning meeting. The investment management team meets daily for our Morning Meeting
at 8:45. Almost all of the firm’s 30 portfolio managers, nine assistant portfolio managers, 24 research analysts, three economists and research directors, along with our president, chief investment officer and chief executive officer gather to share various economic, monetary, political, industry and company trends and issues. The information derived from this meeting is key for me in developing views on and monitoring the changing macroeconomic environment, evolving sector-specific conditions, and individual firm concerns or opportunities. Given the depth and breadth of the information shared at this daily meeting, it is an essential part of my investment process.
Most of our equity analysts are assigned along specific industry lines globally, and in addition to contributing in the daily Morning Meeting, they make timely investment recommendations (both buy and sell) which are reviewed at a separate weekly meeting, which, again, includes almost all of the investment management team.
I also work closely with the firm’s other international portfolio managers to generate and share best ideas gathered individually or through formal meetings with the analysts.
Other than the intelligence gathered from our investment division as a whole, we use everything from research reports and conference calls to on-site meetings and travel to help with analysis. I travel globally to visit the management of companies in which I am interested or am considering for investment. I also often go to conferences held in the U.S., where there can be 25 to 50 companies from a particular region. Those conferences allow me to meet with management teams and stay abreast of recent developments. I attended two such conferences in early January, one for German companies held in New York and the other for Latin American companies held in Florida, which allowed me to meet individually with more than 30 management teams in a highly efficient manner.
5) What has the Morning Meeting been like during the last couple of years, as the global economy has struggled through obstacles ranging from recession and sovereign debt to political upheaval and natural disasters?
Let me start by saying our ramped-up global resources have increased my effectiveness. Years ago, I might have had to do currency or government policy research on my own but now there are analysts and economists that focus almost entirely on those things. And not only have we improved our resources, but we include more people in the discussions now as well. Economic reports and forecasts, currency movements and fixed-income spread updates used to take up to two or three minutes of the Morning Meeting. But now, that is all so interconnected and so important that discussing it might take up a good half hour before we begin to dive into sectors and individual companies. Because these are the factors and issues driving market movements, we all must pay close attention. Having those resources so much more involved in the conversation has been invaluable.
6) What’s it been like managing an international growth fund during such a volatile and uncertain period?
Probably the most notable effect from the volatility during my three-year tenure on the Fund is that we have to pay so much more attention now to the macro environment. We have used the same fundamental, bottom-up process when looking for high-quality international firms but we’ve had to add an emphasis in our approach on the macro overlay. Putting a company’s balance sheet, growth potential and valuation into the appropriate government, currency and geographical context has been necessary – particularly over the last year when headline risk has been so prevalent. For example, the appreciation of the yen has been dramatic recently and that really hurts what are deemed to be the higher-quality Japanese companies – the exporters. It has created a major headwind for them while also providing Korean stocks with a pretty substantial tailwind. All of these things need to be taken into consideration when looking at each company’s business model and the risks to which it is exposed.
Another effect from these tumultuous years has been our use of some light currency hedging. During my time managing the Fund we’ve lowered the portfolio’s net exposure to the euro, yen and British pound at one point or another in order to protect on the downside. We don’t make these decisions lightly, as we prefer to carry the currency exposures of the underlying securities in the portfolio, but when we have high conviction in the asymmetry of potential currency moves, and believe that move is not in our favor, we try to shield our U.S. dollar-based investors from those risks. I’ve also learned to appreciate the massive changes in global monetary and fiscal policy and their impact on business, consumer and investor sentiment.
7) Have you made any material changes to the Fund since you took over as manager?
In 2009, my first year as manager, the Fund’s upside was limited versus the benchmark. It was conservatively positioned, a posture that I agreed with at the time. Unfortunately, as I was learning the international universe that first quarter of 2009, it was difficult to react as quickly as I would have liked when the market turned around. The high-quality companies that helped mitigate downside risk in 2008 and early 2009 didn’t do as well once the compression reverted, relative to mid- and lower-quality peers. However, since then, with my knowledge of the space and the additional global resources available to me, I’ve been able to be more nimble to protect on the downside and opportunistic (using those shorter- or medium-term holdings buckets) to capture the upside after any rollover.
8) Where are you finding opportunities now, and how is the Fund currently allocated?
As always, I am focused on picking good stocks first, and the country and sector weights are largely driven by that fundamental stock-selection process. At a sector level, we continue to underweight the materials and financial sectors along with consumer staples, and remain overweight in energy (primarily through services) and consumer discretionary. Technology remains the Fund’s largest overweight because so many of those companies really fit the fundamental characteristics we’re looking for in core holdings. Telecommunications is also overweight but that is partially due to the very low (less than 2 percent) weighting in the benchmark.
The Fund’s largest country weights remain in developed Europe (the U.K., Germany and France) and Japan. And while we did reduce emerging market exposure this year relative to 2010, specifically in China, we envision adding some exposure there this year as opportunities develop.
We are vigilant in assessing the right time to shift to a more aggressive and cyclical positioning, largely a confluence of valuation, expectations, and the ability of Western governments to drive economic growth, however short-lived.
Apple (4.1 percent of assets at 12/31/2011) is the Fund’s largest position; it might seem odd that an international fund’s largest holding is an American company, but this enterprise continues to build a robust business and gain market share around the globe. We feel the company’s leadership in product design and development combined with attractive valuation and potential dividend yield gave us no choice in embracing this rather consensus position. We continue to focus on a handful of European leaders who are well positioned to capture global growth outside of Europe. These include adidas, Diageo and Volkswagen (2.3, 2.5 and 1.8 percent of assets at 12/31/2011, respectively). We continue to focus on increasing Asian wealth and consumption, especially of luxury goods, with holdings in LVMH, which owns the prestigious Louis Vuitton brand), luxury Swiss watch maker Swatch and Pinault-Printemps-Redoute, which owns the Gucci and Bottega Veneta brands (1.5, 0.8 and 2.0 percent of assets at 12/31/2011, respectively).
9) What is your outlook for the months ahead?
To succeed in this environment, we must not only correctly anticipate the policy changes of western governments, but also the markets’ reaction to them. So far this year, it seems that investors are electing to sell last year’s favorites, staples, health care, telecoms, utilities and buy its laggards, especially materials and certain industrials. Financials are mixed thus far, with the most troubled banks continuing to struggle.
While this early trading will probably not be kind to the Fund’s relative performance, we currently lack conviction that it will continue through the year (though we are keeping an open mind).
The most obvious roadblock to deep cyclical leadership in the western world is the current self-reinforcing cycle of high government debt loads leading to a lack of confidence and therefore less investment and hiring, which then leads to lower gross domestic product (GDP) and tax revenues, and thus ever-higher debt/GDP ratios – not an attractive picture. We struggle to come up with a scenario in which global nominal GDP reaches a sufficient, sustainable level to achieve “escape velocity,” where this cycle is broken. Currently the entire investment world is pondering the effectiveness of recent European policies, especially with respect to bank funding and capital requirements, and the knock-on effects on medium-term economic growth.
China, of course, is an important factor in the performance of cyclical stocks generally and materials specifically. To the extent that China has embarked on an easing cycle, these sectors will undoubtedly receive a boost. However, we do not expect Chinese easing to resemble 2009, when massive government-induced loan growth flowed directly into large infrastructure projects of various types. Instead we expect continued focus on internal consumption, affordable real estate and on reviving the health of small and medium businesses that have been left behind by the banking system.
In addition, the cyclicals do not have the same depths (margin and earnings estimates, working capital draw downs) from which to rebound as they did in 2009. While many will point to the stretched valuation spreads (for instance, consumer staples appear expensive versus the market) of less-cyclical companies, we cannot think of a time or situation (highly questionable growth and very low interest rates) where this should be more true, or accepted. Therefore, we are careful not to overstay our welcome as certain stocks become overvalued in our eyes, yet we look to reinvest those proceeds not necessarily in “cheap” cyclicals, but in current or new investments that we think have attractive business models, management teams, pricing power and end markets combined with reasonable valuation.
10) Given that outlook, why do you think Advisors International Growth Fund should be in an investor’s portfolio?
As I would always argue, I think having international diversification in a portfolio is beneficial for almost all investors. Not having all of your “eggs in the U.S. basket” seems like a smart move from both a return potential, because so much growth is outside the U.S., and a currency diversification standpoint – many believe there is a significant threat that the U.S. government printing more money will inflate its currency. In addition, the universe of international companies is roughly double the number in the U.S., providing a plethora of opportunities to choose from across geographies and sectors.
Regarding the Advisors International Growth Fund specifically, our focus on risk mitigation and conviction level in Fund holdings helps us in our effort to participate in positive market environments, while striving to protect our gains in weaker markets. We seek to avoid large risks by not chasing returns or forcing ourselves into large bets while also being disciplined in our bottom-up investment process, making consistent decisions based on our fundamental research.
We think in a world in which economic growth is under pressure, firms with competitive advantages will prevail. And because finding firms with competitive advantages is the focus of our investment process, we believe the Fund will continue to do well going forward.
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Consider all factors. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
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