The importance of downside protection knows no borders.
A cautious tone bubbled to the surface at the 2007 Morningstar Investment Conference. Stretched multiples, unsustainable returns, and unreasonable expectations were among the phrases bandied about by some of the best investing minds in the industry.
This cautionary tenor got us thinking again about the importance of downside protection. Simply put, funds that lose a lot less than their rivals in down markets greatly improve their chances of outperforming over a full market cycle. Research using Morningstar's new Investor Return--an estimate of how the typical investor in a fund has fared over time--shows that investors have a much better chance of staying the course and succeeding in such funds.
Further to Fall?
As rosy as things have been in the United States, they've been even better overseas. Helped by improved corporate profitability, economic reforms, a booming global demand for natural resources, and an increase in the value of many foreign currencies versus the dollar, international funds have soared. The MSCI EAFE Index has returned an average of 22.8% annually over the past three years--nearly double the S&P 500 Index's return. Success has been widespread. All but two of Morningstar's international stock categories have returned more than 20% annually over the past three years.
It's tough to think about the downside in such a buoyant environment, but it's worthwhile. Fortunes can change quickly, and it's best to be prepared. The MSCI EAFE Index, for example, posted big gains for a nice stretch before tumbling in 2000. It then proceeded to shed more than half its value by late 2002.
But a number of international- and world-stock funds held up comparatively well in that same stretch, and a few even made money. Below we highlight international managers that provide the best of both worlds: downside protection and strong overall performance.
First Eagle Overseas
These funds wrote the book on marrying downside protection with strong performance. Hall-of-fame manager Jean-Marie Eveillard is back in the saddle after the unexpected departure of his protégé, Charles de Vaulx. Eveillard will gradually step away from day-to-day operations over the next few years, but this shop remains solid. Eveillard's Benjamin Graham-inspired strategy permeates the walls. Simply put, Eveillard is a cheapskate who only buys stocks trading at big discounts to the value of their underlying assets and operations.
When he can't find bargains, Eveillard lets cash pile up. At the height of the dot-com bubble in the late 1990s, shareholders were hauling assets out of this fund as it lagged its riskier rivals. But Eveillard stuck to his value guns, saying that he'd rather lose half his shareholders than half his shareholders' money. Those who left likely regretted it. These two funds are among a tiny group that actually made money in every calendar year from 2000 to 2003, while the MSCI EAFE and S&P 500 Indexes hemorrhaged red ink. Even with the disruption caused by de Vaulx's departure, we still think shareholders in this closed fund have a winner.
Like the team at First Eagle, the team at Mutual Series puts a premium on avoiding the permanent loss of capital. These funds have varying degrees of foreign exposure, but all use a contrarian strategy and focus on firms with strong free cash flows that trade at big discounts to management's estimates of intrinsic value. The managers are patient long-term investors who will add to existing positions on weakness, lowering the fund's average cost. Price sensitivity and strong stock-picking have enabled these funds to easily top the bulk of their peers and their benchmarks during market pullbacks and over the long haul.