Offerings from Oberweis, Rainier, and Seafarer are proving even small funds can be competitive when it comes to picking stocks across the globe.
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By Rob Wherry | 01-05-14 | 06:00 AM | Email Article

This article originally appeared in the December/January 2014 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

Rob Wherry is associate editor of Morningstar Advisor Magazine

Andrew Foster is used to spending hours on a plane as he searches the globe for stocks he believes are undervalued. A recent 10-day trip spanned more than 15,000 miles as he visited with more than a dozen management teams in Mumbai and Hong Kong. Only a typhoon kept him from traveling to mainland China. Such due-diligence trips are routine for Foster, who launched emerging-markets fund Seafarer Overseas Growth & Income in 2012 after almost a decade of successfully guiding offerings at Matthews International Capital, the parent firm for the Matthews Asia funds.

"You want to make sure reality matches your analysis," Foster says. "It's worth the trip if you come back with one good idea."

Foster and peers such as Ralf Scherschmidt of Oberweis International Opportunities and Henrik Strabo of Rainier International Discovery are part of a cadre of managers running small funds that are trying to keep pace with their bigger brethren in Morningstar's international fund categories. Their funds may not have the long performance records of, say, Gold-rated  Oakmark International . But the managers have proven themselves at their current funds and previous charges. Indeed, the Seafarer and Rainier funds were in the top quintile of their respective peer groups in 2013, while Oberweis International Opportunities' 55% gain last year was tops in the foreign small/mid-growth category.

These managers, though, have their work cut out for them. The old adage is that investors should pay up for international managers because they can exploit local market inefficiencies. A good manager with analysts on the ground can find attractive stocks long before others do. To that end, J.P. Morgan has an annual research budget that surpasses $100 million. T. Rowe Price has 12 experienced analysts that just focus on the Middle East and Africa. By comparison, Scherschmidt has four analysts--for the entire globe.

Another obstacle to contend with is a series of index mutual funds and exchange-traded funds that allow advisors to get more focused coverage to a certain region or country and different-sized companies within those areas. For example,  Vanguard FTSE Emerging Markets and  iShares MSCI Emerging Markets , two of the five largest ETFs, hold a combined $97 billion of total assets. Investors can also purchase international ETFs that focus on emerging-markets small caps, dividend payers, and bonds. Emerging-markets factor-based ETFs are also emerging. Active managers must duel with these funds for assets.

"There is a value-add for sure for [an active manager], especially in a market that is hard to focus in on," says Dave Stock, chief investment officer of Rainsberger Wealth Advisors in Colorado Springs, Colo. Stock uses a mix of active funds, index funds, and ETFs in his practice. "At some point we are vehicle-agnostic," he says. "But it's a good overlay to have some active management."

Foster, Scherschmidt, and Strabo must also navigate a shifting international investing landscape. Emerging markets were key performance drivers the past decade as demand for commodities and infrastructure projects led to robust economic growth.

Now, though, bellwethers such as China and Brazil are expected to grow 7.7% and 2.4%, respectively in 2013, below the levels that made them darlings in the 2000s. Concerns about the Federal Reserve ending its tapering policy have also weighed on these markets. The average diversified emerging-markets fund was flat in 2013, and India equity funds were down a staggering 11%. Meanwhile, Japan has jumped as economic reforms have taken hold. The average Japan stock fund was up 26% last year.

Here's a look at how each of these managers tackle the challenges of investing internationally--with resources reflective of their small asset bases.

Oberweis International Opportunities: Exploiting Earnings Surprises
Scherschmidt welcomes competition. That's because he thinks they often get things wrong. So much so that he incorporates into his stock-picking strategy what is called "post-earnings-announcement drift." Research has shown that share prices are slow to react when companies announce surprise earnings. One explanation is that instead of analysts updating their valuation models based on the new information, they cling to their original theses, not wanting to be the first one to say a company is in turnaround mode. As a result, the stock price eventually "drifts" toward a higher price over weeks or months.

"The analysts don't understand the company," he says. "That's when we go in."

The phenomenon doesn't get arbitraged away, he says, because there will always be people who are more concerned with keeping their jobs than sticking their necks out.

"A lot of firms are unwilling to jump into a stock they think may be overvalued," says Stock, who has put some of his clients in the Oberweis fund. "They have a hard time buying it even when it breaks out to a new high."

An earnings surprise isn't the only detail Scherschmidt and team analyze. They also evaluate companies on data points that fall into three buckets: business fundamentals, valuation, and catalysts. In short, Scherschmidt wants to own companies with growing profit margins and market shares and an attractive valuation relative to his perception of their intrinsic value. The portfolio will typically consistent of 50 to 90 companies in developed international countries that have market capitalizations between $100 million and $5 billion. Last summer, that process led him to Alcatel Lucent , the French telecom equipment maker. Scherschmidt says the firm lost market share over the past few years as competitors marketed better products. But, he adds, a new CEO appointed earlier this year is shuttering or selling off non-core businesses, paying down debt and refinancing other liabilities, leading to cost savings that could easily top $1 billion. (Earnings have already started to improve.) He's also been adding to Japanese auto-parts makers.

"People stopped buying new cars [in the downturn], but at some point those cars get old," Scherschmidt says. "They have to be replaced or repaired."

Scherschmidt helped launch the Oberweis fund in early 2007, just as the financial crisis was taking hold. The fund's five-year performance attribution shows Scherschmidt has been able to add value compared with his foreign small/mid-growth category counterparts in most sectors, especially energy and industrials. The fund's top performers during that time were GungHo Online Entertainment, a Japanese video game company, and Ashtead, a U.K.-based heavy equipment rental firm.

However, Scherschmidt does have one glaring blemish on his record. The fund dropped a staggering 60.5% in 2008, which put it near the bottom of the foreign small/mid-growth category rankings. Scherschmidt got caught holding a large chunk of industrials that underperformed that year. While the loss didn't shake Scherschmidt's conviction in his stock-picking process, he did take steps to better manage risk in the portfolio. For example, he now uses a tool provided by Empirical Research Partners that measures the fund's risk across sectors, countries, valuations, and individual stocks. While the fund has beaten the peer group average every year since then, its overall Morningstar Risk rating remains high.

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Rob Wherry does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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