Bill Fries with Thornburg International Mutual Funds

Bill Fries is the lead portfolio manager manager for Thornburg's international mutual funds. He recently participated in the International Herald's global investing roundtable.
Many of my client's hold institutional shares of the Thornburg funds that Bill Fries co-manages.

Friday, December 7, 2007
The International Herald Tribune's 11th annual round table on global investing convened at The New York Times on Nov. 29. Participants in the discussion moderated by Judith Rehak were:
George Evans, portfolio manager of the Oppenheimer International Growth Fund; William Fries, portfolio co-manager of the Thornburg International Value Fund, and David Winters, portfolio manager of the Wintergreen Fund.

We are meeting amid fears that more subprime losses and a credit crunch could turn a U.S. economic slowdown into a recession, affecting Europe and Asia and even the robust emerging markets. Add worries about high-priced oil, the battered U.S. housing sector, and inflation in Europe, and it has been a year of turbulent markets. Against this background, what do you see for 2008?

Fries: After a year like we've been through, I think you have to be more cautious, because one of the things we've learned is that we don't know everything we thought we knew in terms of problems that companies might have. As far as the U.S. influence on the global economy, our monetary authorities are walking on a tightrope, because if they are too aggressive in trying to support the U.S. housing market by dropping interest rates, they likely will end up trashing the dollar even more than it has been trashed. It might be good for some U.S. exporters, but generally speaking I think it's maybe a factor of disequilibrium and would possibly lead to more inflationary pressures from industrial and energy commodities.
I think you need to be careful about company business models and the independence of companies' prospects from direct economic consideration. You want to have companies that have pricing power and the opportunity for volume gains because of innovation.

Asia has been one of the strongest markets in the past year. David, what is your view on that part of the world now?
Winters: I believe that in the history of human beings, there has never been so much material
progress by so many in such a short period of time. And it's our impression that it's not only the people who have progressed so far, but waves of other people coming behind them. So we're very enthusiastic about Asia in the long run. It doesn't mean that there are not going to be bumps along the way, but you've got enormous wealth being created, enormous demand for resources, and a wonderful work ethic. So long term, if you're any kind of investor, you've got to pay attention to what's going on in the Asia sphere.
In Europe and the U.S., I think there's lots to worry about and we think there is also quite a bit of inflation. So I think Bill is right on about pricing power and being cautious. That said, there are some gems in the U.S. and Europe, so we're optimistic long term.

Evans: The biggest story for the rest of my life is what's going on in China and India. But there's a lot that makes me more cautious now than I have been in three or four years. My caution is related to the effect that this subprime issue and related issues are going to have on the availability and price of credit, which inevitably has to have some effect on the real economy over the next few quarters. It depends also on what the monetary authorities do, but one of the marvels of the last two years is just how fantastic business has been for just about everyone. There's a lot of pricing power on everything from a diesel engine to a second-hand hull for a tanker.

Given these uncertain times, where are you finding the most interesting opportunities?
Fries: If the standard of living in emerging markets continues to move toward what Western Europe and the U.S. have had, we will probably have considerable progress in a lot of places, including infrastructure and retailing. The economic boom in China has been going on now for more than a decade at a 10 percent rate essentially, and probably has a long way to go, although it may change character. Some of the things we held when we met last year still look interesting. China Mobile, the cellular phone company, and China Merchants Bank are two that have performed very well. I like to look at history and if you accept the idea that China is in a development stage that might have been like the U.S. in the '50s, we have a long way to go in some of these institutions. Growth rates will be above average and I'm content to stay with those.

What about the more developed markets?
Fries: Europe is showing the way to develop an energy policy, and I think the price of a kilowatt of electricity at the margin from gas-fired sources is creating an umbrella that will ultimately bring green utility generating companies to the forefront. A couple of the stocks we like are E.ON, the German utility, and Fortum, a Finnish utility that is 60 percent hydro, with a big piece of nuclear and a very small part of gas.

Winters: In the U.S, the problems are well flagged, but there are opportunities as well. We do have stakes in a number of companies, and a big stake in Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire has come back into fashion because having $40 billion in cash is a good thing in this environment.
In Western Europe, we own shares in Swatch, the Swiss company that makes watches from the basic plastic watch to the middle-range Longines to Breguet. As you have increasing wealth around the world, not everybody can have a big car or a big house, but they all can have a watch. Swatch is very conservative; they have had a stock buyback program and we like that. We also own shares in Schindler, a Swiss elevator and escalator company that is debt-free, and with the urbanization and improvements around the world, they're a beneficiary. And they also have the elevator-escalator service business. We're trying to find niches that should do well, almost no matter what happens.

Evans: We're looking for themes defined by an industry or a group of industries that will grow
sustainably faster than global average growth over the long term, and then look for the winning
companies. Obviously, in emerging markets, a theme is mass affluence. Wealth creation is creating a slew of opportunities, and we have long-standing positions in luxury goods companies like LVMH Moët Hennessy Louis Vuitton. We own Swatch as well and also Richemont, which is the parent company of Cartier and Van Cleef & Arpels. Luxury brands are selling hand over fist in emerging markets. These are not lands of modesty and when you make it, you flaunt it. Also, the vast majority of luxury goods opportunities are European companies with bullet-proof barriers to entry, high margins, and high growth. They're fantastic long-term investments.
We have quite a few investments that are benefiting indirectly from the emerging markets boom, such as ABB, a Swiss-Swedish firm in the electricity transmission business, and Alstom, the French train and subway car manufacturer, and Siemens.
Restructuring is another theme, particularly in the context of Eastern Europe. We own Continental, which is half tire business and half automotive electronics. Their tire manufacturing in Western Europe was very expensive, about €30 per tire and labor. They moved it to Romania where labor costs went down to about €3 and revolutionized the profitability of the business. Another theme we have been investing in for a long time is aging. We own the top three hearing aid makers in the world: William Demant of Denmark, Sonova in Switzerland and Siemens.

What else interests you?
Evans: I am looking at a lot of self-financed growth. When the banks are worried about lending to each other or anyone, it's a healthy thing when a company has the wherewithal to generate enough cash on a sustainable basis to finance their own opportunities. Luxury goods companies are cash generative; so are clothing retailers like Inditex, which has the Zara shops, and Hennes & Mauritz.

Winters: We have certain ways of investing in emerging markets that are different from others. Our biggest position is Japan Tobacco. They have extensive emerging markets positions and they recently acquired Gallaher, the U.K. tobacco group. By putting the two companies together they have a wonderful franchise, a play on emerging markets and developed markets as well, in Japan and Western Europe.
We also like hard assets - for example, real estate. We own a Hong Kong company called Shun Tak with significant historical real estate holdings in Macao, which is on its way to becoming the favorite entertainment destination in Asia. Real estate prices have gone up a lot and we think Shun Tak's management is very good.

I note that you own a number of gambling-related stocks. Is this also related to Macao?
Winters: We like the term "repeat human behavior," and people enjoy gaming and entertainment, so we are involved in the sector. We have a stake in Wynn Resorts, a U.S.-listed company, which is extremely well run and very shareholder oriented. It has assets not only in Las Vegas but Macao and we think they have the premiere properties in both.

And what's your take on energy and materials stocks, which have had a terrific run?
Winters: We own shares in Anglo American, the mining company. They have a big position in
platinum, which is used in catalytic converters, and as the world goes green, Anglo American is a
beneficiary. You also have base metals in there, too, and Anglo owns 45 percent of DeBeers, the
diamond company. We think Anglo is kind of a unique asset play.
And there are niches in this commodity boom. Another company we own in the U.S. is Chesapeake Energy, a natural gas enterprise. Natural gas prices haven't gone up a lot, but it has significant assets, it's well run and natural gas burns cleanly. They have a very significant land base which they are continuing to exploit in terms of looking for more assets.

Fries: One of our holdings is Gazprom, the Russian natural gas producer. To me, natural gas is the next commodity that's going to go global. It has been a local commodity and because of that you have pockets of excess supply. But as oil prices move higher I believe that ultimately, natural gas will follow. One of the principal uses of natural gas in a world that is conscious of global warming will be as the marginal source, because you can't put nuclear power plants in place fast enough. Natural gas will provide the power that will be required in Western Europe and emerging markets so that's a good place to be.

Evans: I own a bit of CVRD (Companhia Vale do Rio Doce), the Brazilian iron ore miner, and I own Impala Platinum for the same reasons as David. We're not overweight, though. The thing that has really powered the materials stocks over the past few years has been a stronger commodities market than has existed on a sustainable basis since the 1970s. Prices won't go up as aggressively in the future but arguably they are sustainable, given emerging-market demand.

Fries: We own Freeport McMoRan, but that's about the only mineral exposure in out international portfolio now. We have owned Rio Tinto and BHP Billiton in past years.

What about the beleaguered banking industry? You both own UBS.
Fries: UBS certainly got caught up in the subprime trading, and a lot of that business is just flat out going to go away. I don't think the institutional end markets that you must have in order to have viable trading are going to be buying some sliced and diced mortgages from the U.S. anymore. In the long run that's a good thing if they pay attention to where they are really strong. I think the [UBS] franchise is too powerful to be ignored and you can buy that at less than 10 times earnings.

Evans: I own UBS and some Credit Suisse, both primarily because of the wealth management
business. Credit Suisse has been a little accident-prone over the last 10 years, but I believe that
management is a lot more aware of the risk they're taking. We're typically very underweight in banks and insurance companies. I like being able to analyze things I understand and if managements at some of these institutions can't tell you what is on their balance sheets there is very little probability that I can. But, the world is getting significantly wealthier, and people want professionals to manage that money. Wealth management is a great business with a great long term trend of more and more assets being accumulated. And it's a very resilient business, too.

Another thing we've been hearing about lately is health, or health care stocks as a defensive measure.
Fries: We own Roche, which has a 54 percent interest in Genentech, the U.S. biotech leader in
terms of creating products, especially in oncology. They have over 20 products in their potential pipeline, and they have the first right of refusal for products that Genentech develops outside the U.S. The other franchise we own is Novo Nordisk, which makes diabetes products. They continue to gain share in the U.S. where there is an aging population impact of diabetes and it has a limited number of competitors. These stocks are inexpensive now because people believe that whoever wins the U.S. presidential election is likely to make it more difficult to sustain high profit margins. That's a way off, and there will be an overhang on these stocks, but we think there is good value in these businesses.

Evans: Most of our health care is franchises in medical devices like Smith & Nephew in the U.K.,which does trauma products, and Synthes in Switzerland, which does the same thing, putting bones back together with bolts and plates and helping repair hips. There are patents, and it's a competitive business but the margins do remain pretty robust and there are new products coming out. So clearly, despite uncertain times, you all are still finding opportunities around the globe, and especially directly or indirectly in emerging markets.

Winters: As an investor, it's just a wonderful time. Things have changed so much, and you've also seen now the principles of Anglo-American finance filter all over the world.

Fries: On that point, it's interesting that we haven't been able to necessarily get people converted to the idea of democratic institutions, but we've had no trouble having them embrace the capitalistic market economy.

Understanding the Emotional Side of Investing

“There is a steady flow of wealth from the hopeful gambler to the men who know what the odds really are. Most people ignore probabilities and exaggerate risk.”
Tversky and Kohneman

Behavioral finance has become a very popular subject. Quantifying how people emotionally deal with their money (what mistakes they make over and over again and why) has produced many interesting findings. The late Amos Tversky, a Stanford professor, and Daniel Kohneman, a Princeton professor, did much of this pioneering work. One of their major discoveries is that a dollar of gain is not equal to a dollar lost in most people’s minds, certainly not when the dollar stakes were high. Who would bet his car against a neighbor’s similar car at even odds? Very few people would take this bet, because having no car is more of a bad than having two cars is a good. So, the value function is non-linear, which means most people have more displeasure in losing a large sum than the pleasure associated with winning the same amount. Most individuals want a two-thirds chance of winning to venture a big bet. Interestingly enough, most individuals don’t invest this way.
In addition, Tversky and Kohneman studied how investors used context in their decision-making process. In other words, people made up their minds differently depending on how the problem was presented to them. Perversely, when the potential gain in a transaction is stressed, people get nervous and wary; and when potential losses are played up, they are willing to assume what are in reality greater risks in order to avoid the losses.

For example, suppose a person has spent the day at the race track, and lost $140, and is considering a $10 bet on a fifteen-to-one long shot in the last race. This decision can be framed in two ways, which corresponds to two natural reference points. If the bettor focuses on the cash flow on hand, the outcomes are framed as a gain of $140 or a loss of $10. On the other hand, if the bettor frames his decision in the frame work of the whole days losses, then it’s a chance to get back to even (from a $140 loss) or to increase his loss a mere $10. Individuals do not adjust their reference points as they lose and can be expected to make bets they normally would find outrageous, even on dubious nags at fifteen to one. This is exactly how many investors have handled their investments. In reaction to huge losses in technology stocks, they have continued to not build a conservative balanced portfolio but have instead tried to chase gains. These investors are speculators still hoping that some day they may break even again.
It is always better to take your lumps and reset your reference points. Interestingly enough, the same reset is necessary with investment wins as losses. If your portfolio does exceptionally well, don’t start believing you are the new Superman of the investment world. Remember every time you flip a coin, it could come up heads or tails. The next flip of the coin isn’t influenced by results of the last toss.

If you want to minimize your investment risk, then don’t bet all your money on one filly or one spin of the roulette wheel. Instead invest in a balanced diversified portfolio; hold for the long term; and keep systematically investing each month through your 401(k) plan 403(b), IRAs and taxable account. Also, don’t forget to forgive yourself for all the wacky investment decisions you’ve made in the past. Remember to reset your reference points.

What can patience and diversification and rebalancing regularly get you? Well rewarded. The chart below is worth studying. Owning high-quality bonds in a down market can save you from serious losses. The value of being diversified is apparent when you consider the entire period returns (third column). Small cap, mid-cap and bonds all generated positive returns for the entire period while international stocks, Nasdaq composite and large cap stocks were all negative. If you had put everything you owned in the Nasdaq Composite in March 2000 at its peak and then held (not resetting your reference point) hoping to get back to breakeven, you just proved Tversky and Kohneman’s behavioral finance theories. I could update the chart above to include the last few years but it just further proves the point. Stay diversified and rebalance at least once a year.

Happy Holidays!

Emerging Markets Appear Vulnerable

Emerging markets appear vulnerable compared to the developed international markets. For instance, China is currently facing an inflation spike (+6.5%). Inflation is rising at the fastest pace in China in more than 10 years. The culprit is almost entirely food costs, caused by supply constraints. The Chinese government is trying to contain the inflation with price controls.

Chinese consumer spending (retail sales +17.1% year over year) remains too hot and is not sustainable. Unless China can begin to rein in its growth and control inflation we could be looking at a major correction. Investing in only one country or region is risky. The investment inflows into Asian and Chinese oriented investment vehicles have been of tsunami proportions.

Is the Chinese market ready for a correction? Given the alarming growth of the iShares FTSE/Xinhua China 25 Index over the last three years, I wouldn't be surprised. It looks surprisingly like many historic investment bubbles such as the Nasdaq high tech/internet bubble and the more recent housing bubble. Will the Chinese stock market suffer the same fate as the NASDAQ or the housing market anytime soon? That is unclear, but a pullback sooner or later is inevitable.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.

My goal is to structure each portfolio so that the overall equity allocation is equally-weighted between U.S. and international stocks. As we become a global economy this equally-weighted allocation just makes intuitive sense, but in the investment world this is a radical strategy. Most investment strategy is fashioned by looking at history (backwards) and frequently misses indicators that signal major shifts in the economic paradigm. The world is no longer U.S.-centric and this shift in growth is recognized in your portfolio allocation. If you decide to increase your international allocation, just make sure you do not overweight the risky emerging markets sector.