How an Unorthodox Fund Beat the Odds in 2003

 Longleaf Partners International (LLINX) had every reason to fall short in 2003. Instead, it prospered--highlighting the talents of its managers and the soundness of their unusual approach.

This five-year-old offering, run by two of the three managers that direct venerable  Longleaf Partners Fund (LLPFX), is one of only a few international offerings with limited exposure to foreign-currency movements. (Using forward contracts, it hedges most, or sometimes all, of its currency exposure back into the U.S. dollar.) That put Longleaf Partners International at a disadvantage in 2003. As most foreign currencies soared in value against the greenback, it missed out on much of the remarkable currency gains that helped power the returns of most rivals.

To illustrate this point, consider that Japan's benchmark Nikkei 225 was up 17.6% for the year to date through Dec. 17, 2003, for investors who had no exposure to the yen's sharp rise--but the gain was 30.1% for those who did.

Another factor that could have derailed the fund was the caution of its value-oriented managers. Concerned that the strong rallies around the world were fueled by speculation rather than sound fundamental reasoning, and having trouble finding stocks that met their strict price standards, they let cash build up. The fund's cash stake, around 11% of assets at midyear, grew to more than 16% by the end of September.

Yet the fund thrived. Even with sluggishness over the past few months taken into account, it gained 41.5% in 2003, good enough to beat two thirds of its foreign large-value rivals and to surpass the MSCI EAFE Index, the most widely followed foreign-market benchmark, by a wide margin. (That figure far surpasses the averages for the foreign large-blend and large-growth categories, as well.)

Not Your Typical Foreign-Stock Offering
The fund overcame the odds by using the same unorthodox technique that has led its older sibling to outstanding long-term returns. Managers Staley Cates, Mason Hawkins, and Andrew McDermott (he's the one unique to this fund) look for companies that most investors are shunning. Indeed, they will own only businesses trading for far less than they think the companies are worth. When they find one they like, they are content to wait years, if necessary, for their conviction to pay off.

In 2003, contrarian plays on disliked companies such as Vivendi Universal (V) helped power returns. Vivendi fell deeply out of favor owing to the mismanagement of its former CEO and some moves by its new leaders that met with market disapproval. But it has bounced back strongly since the spring. Meanwhile, a less-well-known company, Fairfax Financial Holdings (FFH) of Canada, nearly tripled in value in the second quarter. And those are just two examples. The managers' willingness to own smaller fare didn't hurt, either--small stocks have climbed higher than bigger ones in most markets in 2003.

This fund will appeal to investors who want managers to make their own decisions rather than merely mimic an index or their peers. Take a look at the fund's country breakdown: At the end of September, it had 41% of assets in Japan (the EAFE has roughly 20%, and most foreign funds even less), and 19% in Canada (which isn't even represented in the EAFE and barely shows up in most peers' portfolios.) Conversely, the United Kingdom, the largest component of the index and of most rival portfolios at more than 20% of assets, currently gets just 7% here.

Why so much in Japan? The managers provide detailed explanations in their excellent quarterly reports. But their reasoning can be summed up by their recent comment that in early 2003, the Japanese market was selling at a level of "absurd cheapness."

That market took off over the summer. And the fund's recent sluggishness can be explained largely by the slowdown there; the Japan-stock category was by far the worst performer of all international categories over the fourth quarter of 2003. Top holding NipponKoa Insurance, which gets nearly 9% of assets and which soared earlier this year, actually lost ground in the last three months of the year. Thus, the fund lies at the category's bottom over that same time period.

The Issue of Concentration
Although the fund's recent performance shouldn't cause much chagrin because it covers such a brief stretch, neither should this reversal of fortune be ignored. Such a concentrated fund--the managers typically own fewer than 25 companies, and currently eight stocks get at least 5% of assets--is vulnerable if a few of those stocks don't keep up, or worse, get slammed. (It should be noted that the managers argue that concentration actually reduces the fund's risk level because they own only those names they know well and have the most confidence in.)

Therefore, this fund isn't appropriate for anyone who wants a broadly diversified fund--or one that's fully invested at all times. A more general criticism can be aimed at the fund's expense ratio, which, unlike that of its older sibling, is uncomfortably high.

There's no telling if Longleaf Partners International will continue to top most large-value rivals if foreign currencies keep rising. It didn't do so in 2002, when the same currency trend was in place. But its results in 2003 do show that a fund's currency strategy is just one of many factors that will affect its performance. More importantly, the 2003 success demonstrates how a sound, well-reasoned investment approach can help a fund even when it faces market conditions not entirely in its favor.

A version of this article appeared Dec. 30, 2003.