Smarter International Investing

The following is a replay from the 2013 Morningstar Individual Investor Conference.

Jason Stipp: Hello and welcome back to Morningstar's Individual Investor Conference. We’ll be talking about international topics in this panel. This is our panel: Smarter International Investing. We’ll be covering things on diversification, potential areas of opportunity around the globe, and, of course, the hot topics of China and Europe, we'll get some great insights on where there might be opportunities in some of these areas.

A quick reminder along the way, we will be monitoring your questions. We'll try to take as many of those questions as we can. There is, to the right of your viewer, a place where you can submit questions for our panelists, so please do take advantage of that, and we'll keep an eye out for all of your queries.

I'm pleased today to be joined by three expert panelists. To my immediate left is Andreas Waldburg-Wolfegg; he is a portfolio manager at Columbia Wanger Asset Management, where he manages the Columbia Acorn European fund. Thanks for joining us, Andreas. Patty Oey, a senior fund analyst in Morningstar's passive funds research group. Patty covers primarily international equity exchange-traded funds. She joined Morningstar in 2007. Patty, thanks for being here. Dan Rohr, CFA, is a sector strategist for Morningstar, where his research responsibilities include industrial commodities in the Chinese economy. He also covers mining and timberland companies, and joined Morningstar also in 2007. Dan, thanks for being here.

Dan Rohr: Thanks

All right, so let's start off with a few general questions. I think broadly when investors are looking to go overseas--and we've seen them increasingly doing that, we've seen a lot of folks leaving U.S. equities, moving into fixed income, but also going overseas--they are looking for some kind of diversification. They feel like exposure to international economies will give them something extra for their portfolio. So, Patty, I'd like to start with you.

During the market crisis, correlations all seemed to rise, right? So, everything was moving in lockstep. With the market and equities seeming to move in the same direction on every bit of news, what correlation trends have we seen recently? Are you really getting differently correlated assets when you go overseas?

Patricia Oey: Well, I mean, since 2008, actually more recently like last year, we’re starting to see the different international markets kind of decouple a little bit. Emerging markets didn’t do as well last year and into this year they’re still not doing well. The U.S. is rallying. Leading into the financial crisis, one of the things that drove the diversification effects of like a broad foreign large-blend fund was actually the fact that Japan was doing poorly. So Japan was doing poorly for about two decades, and actually that was kind of the driver for diversification, for a U.S- equity-dominated portfolio. And because different countries, there are different things going on--right now Japan is doing better; emerging markets are still doing poorly. When there is a huge global risk on kind of a global crisis, yeah, we will see everything kind of correlate. But as we’re kind of coming out of this, we’re seeing correlations go down.

Stipp: Andreas, you invest in an area of the world where there has been a lot of attention, obviously, in the eurozone. Just in the [recent weeks], of course, Cyprus has been in the headlines, and we’re seeing markets globally respond to the small island nation. But you’re a fundamental investor; you’re bottom-up investor. So when you're looking at the companies in your portfolio, are you seeing them move in lockstep on these macro issues, or is the market starting to discriminate based on the fundamentals that you look for when you're investing?

Andreas Waldburg-Wolfegg: Just subjectively speaking, I think that they do react, of course, to these macro worries. The world continues to be worried about the stability of the eurozone, and whatever flares up in that story will always affect all stocks more or less at the same time.

Stipp: Are you noticing that you have to be more patient with your portfolio holdings? So you have a value that you expect these holdings are worth.

Waldburg-Wolfegg: Yes.

Stipp: The market’s moving up and down on some macro headlines. Do you have to really ride through a lot of that volatility, tune it out?

Waldburg-Wolfegg: Yes. Of course, like on a stock-picking level, that’s exactly what you need to do. You need to look at the company per se. You need to get really comfortable with what drives the company's earnings. Once you have that, then I think what is happening in the market overall is easier to tune out. 

Stipp: Dan, you cover basic materials stocks and commodities stocks. Are you seeing the market discriminating based on the value of those companies, like you expect they would? Or are you seeing that, just in that sector, a lot of stocks moving in lockstep?

Dan Rohr: Yeah, in basic materials you don't have the option of being macro-agnostic. Covering mining companies, I could get everything right with respect to these companies on the production side, with respect to their unit costs. But if I’m, say, directionally wrong on China, it’s not going to matter a darn bit. By virtue of that fact, I spend a fair amount of time looking at China.

As far as how these companies respond, when markets are improving, when markets are deteriorating, you are going to see some discrimination, principally centered around what their unit costs are looking like. So for some folks, a 30% fall in the price of iron ore constitutes an existential threat, whereas for others it simply means lower profits.

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Stipp: Patty, we’ve traditionally seen people looking overseas for that diversification again, but some indexes don't necessarily give them the diversification that they might expect that they're giving them. So you are in the ETF area. People are investing in ETFs for diversification. They're looking at international ETFs. What should they keep in mind to make sure they're truly getting the exposure that they think that they are getting?

Oey: Traditionally ETFs have been around for about 20 years. The earlier ETFs and a lot of the single-country ETFs are cap-weighted. So what you need to ask yourself actually is which companies actually have access to the capital markets, especially in the developing markets. Sometimes it’s the government that says that, "Oh, you need to raise money; you can go to the capital markets." It's not open like it is here in the U.S. Or maybe a company has good political connections, so they are able to go to the market.

So what you have in some of these countries is that the cap-weighted index is not really diversified at all. You have these mega caps, so somewhere like Mexico or South Korea. Mexico has Carlos Slim’s America Movil; sometimes that accounts for about 25% of a cap-weighted index. And in South Korea Samsung also about 25%. So performances of those companies can really dominate the performance of the index. And then in countries like Russia, China, and Brazil, a lot of the mega caps are actually government-owned. Then you never know. I mean, the government uses these companies sometimes as policy tools.

Waldburg-Wolfegg: The interesting thing is I find in these environments is that they actually don't really depend on the local economy. So when you buy these, you actually buy more of a bet on a certain technological trend in the case of Samsung in Korea.

Oey: Right. Like with [a country that has] a commodity cycle going. So, yeah.

Waldburg-Wolfegg: Definitely.

Stipp: So if I'm not potentially getting the kind of exposure I think I’m getting, or I’m getting a different exposure, how can I be better at getting that kind of a diversification? If I'm going to want exposure to one of these countries, maybe I don't want exposures to the global commodity market, I want exposure to Brazil. So what should I do?

Oey: Well, it's really tough, and actually there has been strong inflows into emerging markets. And a lot of our top actively managed picks have been closing or going to close soon. Virtus, that was the fund manager of the year, Virtus Emerging Markets Opportunities. Aberdeen Emerging Markets closed early this year. Another top pick, Oppenheimer Developing Markets, is going to close in April. Again, we don’t like the cap-weighted funds, like Vanguard Emerging Markets, VWO, or iShares Emerging Markets, EEM.

Stipp: You don't like them because they are not really truly giving you some of that exposure?

Oey: Right.

Stipp: OK.

Oey: So actually what's been interesting is that a lot of ETF providers have been trying to create rules-based indexes that can kind of tease out, maybe trying to grab companies that are more exposed to domestic growth trends. But it's kind of difficult. There are two funds that we do like for emerging markets. They are both minimum-volatility funds; one is iShares Emerging Markets Minimum Volatility, the ticker is EEMV. There is a PowerShares one; it is PowerShares Emerging Markets Low Volatility, EELV. These funds, they call from their broad parent index of like 800 emerging-markets securities. They try to create very low-volatility portfolios, and the benefit of that is that emerging markets are very volatile. In 2008, you could see the market go down more than 50%. It's hard to recover. These funds' index, the fall in 2008 was much less. So you have a steadier ride when you go through these vehicles, and we would recommend those over the cap-weighted funds.

Stipp: Andreas, you are running a European fund. Does that mean that all the companies are domiciled in Europe? Does that mean their sales are in Europe? How should investors wrap their minds around that, because the differences can be great? You can have a European-domiciled company that has most of its exposure to emerging markets or other markets.

Waldburg-Wolfegg: Yes.

Stipp: How do you think about it in running a European fund?

Waldburg-Wolfegg: So, we look at it in terms of what does the European pot have to offer, right? That is, in Columbia Acorn European, our European fund, 85% of our exposure is to companies that are domiciled in Europe and that achieved a large proportion, and when I say a large proportion it’s somewhere between 30% and 50%, of their sales all over Europe. That doesn’t mean that for a small part of our portfolio we don’t go and find things that we think are interesting, and they happen to be quoted elsewhere.

So a company we own in the portfolio is called FX Energy, and it’s quoted on the New York Stock Exchange, but it has most of its assets in Poland. It’s actually a shale gas developer in Poland. So, we want to have exposure to that because we do know that Poland is very keen on developing its shale gas reserves and is probably one of the only European countries that is really keen to do that. So we wanted to have exposure to that, so we found it through this U.S.-based company.

On the other side, on the other extreme, we also have, of course, companies that happen to be quoted, let’s say, on the London Stock Exchange, but that have all of their assets outside Europe. One of those examples would be Archipelago Resources that is quoted on the London Stock Exchange, but it has most of its assets in Indonesia.

Stipp: I’m going to ask you step outside of your role as a European fund manager right now, to some extent, and think of an investor trying to diversify a portfolio broadly. Is there a reason why I want exposure to Europe right now? It seems like with all of the issues going on there, I would want to stay away. But what about valuations or areas that look attractive? Make the case for being in Europe.

Waldburg-Wolfegg: I mean, the overarching case is valuations. Valuations are attractive in Europe. That’s the first and most important one I would raise. But then I think whenever there is blood on the streets, as they say, and everybody is worried about something big happening, that's really when we as stock-pickers become excited, because then often times everything gets washed out and valuations become very, very attractive for things that are good companies with good capital dynamics, good returns, that we also have known for a long time. And then that's the time to step in.

Oey: Can I offer some tactical ideas?

Stipp: Absolutely.

Oey: So on the previous session, my colleague, Sam Lee, he runs Morningstar ETFInvestor newsletter. He runs six model portfolios in there. There’s like a sector rotation strategy. He also has a country value strategy, and what it does is that it takes the reasonably liquid single-country ETFs, ranks them all based on price/book value ratio, and then looks for ones that are showing momentum as measured by its price relative to its 12-month simple moving average. The countries that popped up on that screen were actually, Italy, Spain, Poland, and then Thailand. So, Italy and Spain definitely have lots of value. Then with Thailand and Poland, I think Thailand kind of supplies into the Asian supply chain and technology and auto, and then Poland kind of feeds into Germany's export machine. So with the U.S. economy improving, that's why you're seeing those countries kind of pop-up on these screens.

Stipp: Dan, you mentioned something to me when we were preparing for this meeting. People investors can sometimes be drawn to the economic prospects of a country, and that's a very different thing than potentially the stock market prospects of a country.

Rohr: Yeah, certainly the academic literature on this on this topic would suggest, quite surprisingly to me, that there is not a terribly strong correlation between GDP performance and stock market performance, and interestingly that holds over very long time horizons, as well. So the starting P/E ought not to be a major factor in the respective performances that you are comparing. I suspect, in some cases, it's a function of the distinction between revenues and return on capital, where revenues are an analog to GDP and return on capital is basically what we’re looking for as stock investors.

Just to use one extreme example of that distinction, look at the Chinese steel industry, where revenues are perhaps twice what they were back in 2007, by virtue of the massive increases in demand we’ve seen and the increases in prices, as well. But by virtue of the overinvestment that the steel industry has undertaken, returns on capital have been awful. So you take a look at the largest company in that sector, Baosteel, the share price is down 75%, while revenue is up considerably.

Stipp: I have a question from a reader that I’d be interested to get your take on. It says, "Do the panelists believe U.S. companies with significant interest in foreign markets--Johnson & Johnson, PepsiCo, Yum Brands--serve as reasonable foreign market exposure?" So I think something like 40% or 45% of the S&P 500s sales are coming from overseas. So really if you're invested in the S&P, it's not like you're just invested in the U.S. market. Patty, what do you think about that? Figuring out where your exposure is coming from, you do get some foreign exposure there.

Oey: Right. I mean, definitely the higher growth in foreign markets is definitely driving earnings, and again it kind of lends to this argument that where companies are domiciled is not correlated to GDP. So that is true, but I think actually very generally speaking, companies tend to be more correlated to their home-country index. But one of our top picks for emerging markets, the American New World Fund, they pursue a strategy where they hold emerging-markets stocks, but I think about half the portfolio is in like McDonald's or Yum Brands, because they have very good exposure to emerging markets.

Stipp: Andreas, in the portfolio, have you found opportunities to get some international exposure outside of Europe at a good price because a European stock was maybe taken down, baby out with the bathwater, in some of the European issues that you’ve seen. Have you found that a good way to get international exposure to maybe attractive markets at a reasonable valuation?

Waldburg-Wolfegg: Yeah, I mean, fundamentally the way we look at stocks is we are interested in capital dynamics and returns on capital and sustainability thereof. So fundamentally what we're looking at is: How does this company achieve its returns, how sustainable is that motion, and how sustainable is it in the future? That will, of course, take into account what markets it sells into, right, and where it is based globally. So you look at a accompany, the tire company Pirelli, which we own in Acorn Europe, which has a very large exposure both to Brazil and to Russia, and that happens to be based in Italy, but whose sales to Italy are roundabout 10% of total. So yes, it's very important to understand where do the dynamics come from that maintain the return on capital, because in the end that's really what gets us excited is finding a business that has a very good, or an extraordinary even, return on capital and that can maintain that.

Stipp: We have a couple of reader questions about currencies, and I want to talk a bit about currencies, as well. So folks are wondering how you think about currencies when you're investing because this is potentially a wild card or something that you don't know exactly what the effects might be. Patty, when you’re thinking about international investing, what role do currencies play there and how should investors adjust or not adjust for that?

Oey: Well, generally speaking, currencies can kind of move away from their fair value in the short term, but in the long term, currencies are driven by interest rates, relative interest rates. So, I mean, definitely for the funds that I cover, a lot of them don't hedge their foreign currency exposure. So the foreign currency can be a large component of the return. And like something like Japan, the Japan market is returning like 20%, 25% year to date. But an ETF like, say, [iShares Japan Index] EWJ is actually being dragged down because the yen is falling, which is actually what is actually driving the market in Japan to go higher.

Maybe in emerging markets what we have is the governments kind of control the currencies to some degree. So in the long term, I mean, there are sort of positive fundamental drivers: economic growth, maybe the governments will let their currencies kind of like adjust to the more accurate fair value. So, long term we could see that kind of being like a positive tailwind for emerging-markets stocks.

Stipp: How do you think about the return component in your funds that might come from currency fluctuations? Do you make any adjustments for that, or do you see it as a risk, for example, in any stocks that you invest in?

Waldburg-Wolfegg: The only thing that worries us and that we look at is the transactional exposure, i.e., if a company makes one thing in one currency and tries to sell it in another, then we get worried about how the company manages that exposure. But what we have, of course, seen in the last 20 years is that companies all over the world have really increased their global footprint and have tried to match costs to sales, and that's not much different in companies that we look at.

Stipp: I'd like to move along and speak a little bit, Dan, about China. I know this has been an area where you've been focused because of your role as an equity analyst in the basic materials sector. This is, obviously, an area that gets a lot of attention, maybe on par with Europe recently, not necessarily in a great way. Recently there have been some concerns, though I still think a lot of hopes for investors in China. So you've written and researched a lot about the infrastructure boom of China, and you've had some concerns about sustainability there. Before we talk about valuations or anything like that, the fundamentals of China as an economy, should people think twice about whether it's going to keep it up from the levels that it's been able attain?

Rohr: Our thesis on China for the past several years has been one of, basically, an overinvestment story, overinvestment in everything from real estate to infrastructure, to manufacturing capacity. By virtue of that overinvestment, China is left with two potential paths that the economy can travel. One, investment growth slows from the roughly 14%, 15% it's grown at over the past decade, in which case the economy as a whole slows considerably, since investment is now 50% of the economy. Path number two, investment continues to grow at a heady rate. Overcapacity across the economy builds, and builds, and builds, until ultimately it will end in how these things tend to end, in a painful debt crisis.

It had appeared beginning in, say, the fall of 2011, the government was comfortable traveling down path number one. We saw official figures regarding fixed asset investment suggest strong slowing, and some of the harder-to-fudge figures that we watch pertain to say steel production or cement production and suggest an even sharper slowdown. It would appear, in the fall in 2012, the government lost its appetite, or rather lost its stomach for that slowing and went back to the same old infrastructure playbook that it had used for the past decade.

Oey: Which may be related to the changeover in the political spectrum.

Rohr: Yes, exactly. Fundamentally, we view that, to use an analogy, as hair of the dog. The recovery we’ve seen over the past couple of quarters has been narrow-based, focused on heavy industry at the expense of light industry, focused on real estate, focused on infrastructure. We haven’t seen real estate sales growth recover to levels that China had been seeing before. My worry is that if we keep traveling down this path, that debt crisis is going to be more likely, and the smooth handoff to a consumption-led economy is going to get harder and harder to achieve.

Stipp: So, I want to talk about the consumption-led economy in a moment, but the other issue that I see is China’s export economy. When we have different regions of the world, like the U.S., which is maybe doing a little bit better, but still in slow growth mode, and certainly there are still issues in Europe as a consumer potentially of Chinese products--Is the export economy of China, although we say China is this growth engine, if the people that it’s selling to aren’t buying as much or aren’t growing as fast, could that potentially have a negative effect on what we see for the economic growth in China?

Rohr: Thinking back to early 2008, maybe late 2007. I guess we were all under this dilution that perhaps there was some decoupling that had happened. We were all disabused of that notion in late 2008, and saw the Chinese economy suffer greatly when the OECD economies headed south. So, yes, weakness in the OECD does matter for the Chinese economy, but I think it's of secondary importance relative to the sustainability of the investment boom for the past decade and increasingly so over the past several years this has been an investment-led story, not an export-led story.

Stipp: As you had been alluding to before, there is a conventional wisdom that the dynamics of China will shift to be this consumer-led economy, where there's a rising middle class and that consumption internally will be the driver going forward. Has that started to play out or has that also been a bit oversold?

Rohr: I don't disagree that there will be a shift in the growth engine, but I think investors are likely to be, shall we say, disappointed with the horsepower that consumption out of China delivers, and there are a few reasons for that.

One, if we take a look back at the past examples of investment booms, this smooth handoff to consumption has proved rather difficult to achieve. Look at Japan, Korea, Taiwan, very notable examples. In each case, in the decade after the investment boom, consumption growth actually decelerated sharply.

The second reason I would say don't get too optimistic about a smooth handoff is Beijing has been trying to conduct this handoff since at least 2007, and things have just gone in the opposite direction that senior leadership has intended. The economy has gotten more and more out of balance.

Third, and finally, even if the senior leadership really truly wants to achieve a rebalancing toward consumption-led growth, they are going to have to overhaul major facets of the political economy that currently constrict consumption. So things like the Hukou household registration system, the interest-rate environment, and overhauling and liberalizing those aspects of political economy would be very unpopular at the provincial level, the municipal level, amongst the state-owned enterprises. We need to remember this is no longer the party of Mao or Deng, where one man's will can be exercised across the economy. It’s a consensus building exercise, policymaking is. So I’m not too optimistic about major policy overhauls in the areas that we need to see overhauls if consumption is really going to accelerate.

Stipp: Patty, for investors who are interested in China, do you have any sense, first, on valuation levels? So even if there are some concerns about China's growth, perhaps they're priced in or they’re more than priced in? Secondly, it's not so easy necessarily to get exposure to China. So what should investors keep in mind about their options to invest in this country if they happen to think that they want that exposure?

Oey: Right. So, as I mentioned before, you can kind of argue that China is kind of a state capitalism kind of society. If you try to go the passive route, a lot of these funds are cap-weighted, like a cap-weighted fund will have 50% exposure to banks and maybe the bulk of that exposure is actually the big four banks in China. They're all state-owned, and these were tools of the government. They are the ones who supported this infrastructure and capital investment boom. I mean, they are the ones lending to the state-owned enterprises, so they can build more capacity, build more roads and things like that. So like a simple index strategy is probably not ideal for China.

There is one fund we like. It’s Matthews Fund, Mathews China. It’s an actively managed fund, so we do recommend going the active route. And generally, for investors interested in Asia, we do generally like the Matthews Asia family. They are very well-run funds and have low expense ratios.

Stipp: What about the share availability? So, I know that there's a certain share class that you might not have access to as an investor. What does that mean? What I do have access to, what are the implications of that?

Oey: Right. Well, I guess it's very complicated. We have Chinese companies listed in the U.S. as ADRs. We have some tech companies, like Baidu, which is the Google of China, that’s just listed in the U.S. A lot of Chinese companies are only listed in Hong Kong, and then there are companies listed on Shenzhen and Shanghai Stock Exchanges, and actually most foreign investors are not able to invest in there because China still controls its capital inflows and outflows.

But actually when you invest in China, us investors here in the U.S., you end up investing in companies listed in Hong Kong and in the U.S. But again, a lot of them tend to be the big telecoms, the big energy companies, and the big banks. And then a lot of them are government owned. So not exactly the best ways to access the attractive long-term consumer growth story.

Rohr: Functionally, the mining companies I cover or Archipelago that Andreas owns are investing in China, whether we like it or not.

Stipp: Andreas, I’d like to talk a bit about Europe, so that I can bring you back into the conversation. We spoke a bit about this before and people maybe wanting to avoid exposure to Europe. Other investors may see that there could be some opportunity there because of valuations. I'd like to talk a little bit about how you think investors can be smart about making bottom-up bets in a region of the world that does potentially face some real risks and a slow-growth economy after the recession that it's currently in. When you're going in company by company, how do you account for that to make sure that you're making smart decisions here?

Waldburg-Wolfegg: Yes, I think it's really interesting, because if you think of Europe with the 27 members of the European Union, it's actually a country that has probably two thirds of the land mass of the United States, and it has almost 1.3 times the population, right. So if you think of the EU as one of world’s largest economic blocks and the largest consumer industry, or at least the largest block of consumers in the world, a large proportion of whom also share the same currency, you all of a sudden see also what the incredible potential is in terms of selling your product, rolling out initiatives, tapping into what is, to all extent and purposes, in all the countries, a very, very sophisticated and highly educated workforce.

That is true of all the countries that get into the headlines these days. I mean, it is certainly true of Spain, it is certainly true of Italy, it is certainly true of France. For people who are looking to produce or to invent sophisticated systems or sophisticated products, Europe certainly has the labor force to do that with. So we tend to get interested in things that are highly innovative, or that are consolidating in an existing industry, or that are fundamentally rethinking a way that things have been done in the past.

So an example I can mention is Eurofins Scientific. Eurofins is a company that was formed about 20 years ago. It has EUR 1 billion in sales today and it comes from less than EUR 100 million 20 years ago. And it came there both by a combination of growing organically and by acquisition. They operate in the sector of food and pharma and soil testing, and these were activities that until recently they were done by small laboratories across Europe, right. Gilles Martin, the CEO of Eurofins, had this idea that this was a cottage industry and it could actually be a lot more efficient if you really industrialized it. His idea was, "Well, I can buy companies across Europe, and I can concentrate them on two or three specific tests. And they will only do that, and therefore I can really improve the margin of these individual operations. And with it I can improve the Group's margins." He did this very, very successfully in Europe, and he has also done it in the United States. Over the last 20 years he has built now EUR 1.2 billion company that employs people all over the world and has, thankfully for us, provided excellent returns to shareholders, too.

Stipp: When you entered that stock, were there concerns about it that made the valuation attractive for some reason?

Waldburg-Wolfegg: Yes, I just met with Gilles Martin last week. We had lunch together, and we remembered how I met him the first time. He IPO’d the company at the end of the 1990s, beginning of the 2000s, and of course, six months, eight months out of the box, you had this first profit warning because it didn’t quite turn out the way that he had hoped it would, and of course, it was terrible. And he needed to work through that and manage his company and find good mangers to do it with them, and he did. So, these are the things that--I have a little screen that I like to run that are called busted IPOs, because I always think that the interesting thing about IPOs is that, as an investor, you get told there is an IPO, you get 400 pages of a legal document in front of you, and you get four days, if not less, to decide whether you should own it or not.

So, I always go like, this is a bad way of investing. I want to make sure that I’ve had the time to study the company, that I understand industry, et cetera, et cetera. So, I love my busted IPOs screen, because those are the things that people who rushed into it then dump out very, very quickly, and that’s where you can actually sometimes pickup really interesting companies.

Stipp: What about areas that you maybe are avoiding in your portfolio or are underweight? Is there anything where you are just not going to go there, and any systemic risk or issues going on in Europe that at least contribute to that decision?

Waldburg-Wolfegg: Well, it’s a four letter word and it’s called bank, right.

Stipp: A new four letter word.

Waldburg-Wolfegg: I mean, eventually, and that’s, of course, the big challenge for us is that eventually, and we don’t actually know when that eventually is, the balance sheets will have been sorted out. If you look at a country like Italy, I would think they’re still quite some ways away. But eventually you will have to look at these things, and you’ll have to take a view on credit quality, et cetera, et cetera. I personally believe that it’s too early, but I also really don’t have the luxury to totally ignore that sector. Even though if you look at our exposure to European financials, it has been almost, almost entirely void of banks. If we go into the finance sector, it’s always specialist finance companies, brokers, specialist insurance companies, things like that. But I would want to say that since the mid-2000s in Western Europe we haven’t really owned a bank, I don’t think.

Stipp: One last question for you on Europe. Your portfolio, according to Morningstar data, had a pretty sizable overweight in consumer cyclical names, which might seem curious to people if you’re investing in consumer cyclical in an area of the world that’s in recession. Is there any appeal you can talk about on the sector level, or is it just a byproduct of your stock-picking process?

Waldburg-Wolfegg: It is certainly that. Consumer cyclicals, of course, are a big, big bucket. There’s a lot of stuff in there. But valuation is always the thing that can drive these decisions. Last year, and we still own the stock in the portfolio, we bought Ocado in the U.K., an Internet retailer, that was washed out and that people had a hard time believing in. I think that this is the kind of thing where you need to take a structural view.

Ocado is an Internet grocer. Now, ever since the times that somebody really famous joined a very, very small Internet grocer in California, Internet grocery has a really bad name. It's been kind of proven that it doesn't work kind of, but yet it’s very, very appealing as a concept to have your groceries delivered to your home rather than having to go for your daily shop or your weekly shop. It’s actually the weekly shop that is more attractive than the daily shop.

So we did spend a lot of time on analyzing this, on trying to figure out whether what the management was saying about its cost structure, about its efficiency lines, whether we could at least, like, follow their reasoning, and we spent a lot of time talking to grocers on both sides of the Atlantic. We ended up taking a position in the stock. It seems to be working. They seem to be getting out of the woods in terms of achieving profitability, in terms of staying within their capital budgets when it comes to extending their capacities, et cetera, et cetera.

Stipp: So certainly finding some at least individual opportunities in consumer cyclicals.

Waldburg-Wolfegg: Yeah.

Stipp: Patty, I need to talk to you about a hot topic among Morningstar readers, and that is income. We had a few questions now about how investors may be able to pick up some yield in international investments. I anticipated that we would be coming to this. So I asked you ahead of time to think about some of the dividend or yield opportunities. What did you find? Where can investors go international and get a little bit of yield?

Oey: I’ll give some fund ideas, and then I’ll talk about some of the caveats. So in the international equity dividend space, our favorite is PowerShares International Dividend Achievers. The ticker is PID. This fund is similar to the popular and widely held Vanguard Dividend Appreciation, VIG, and the reason why they use the word Achievers is because they are screening for companies that have increased their dividends over a certain period of time. So this fund, actually is slightly less volatile than like a broad foreign-blend fund, and we generally like to see less volatility in foreign markets. So we like that fund.

But I just want to mention a few caveats about the whole dividend strategy internationally. Dividend funds in the U.S., they can be about as volatile, or maybe less volatile than the S&P 500. But in international dividend funds, actually that’s the opposite. They're as volatile or maybe more volatile. The reason why is because foreign companies, they pay dividends, it's more related to how the company is doing. So if earnings are not very good, they might cut dividends, and in the U.S. the companies tend to try to avoid cutting dividends. So you see that going on.

You also have currency effects. I mean, in the U.S. we just only have one country, whereas when you invest in an international dividend, you have all these different countries and currencies that are moving in many directions. So if you’re looking internationally for a steady stream of income, that’s probably not the best idea. So you see these dividends funds, you see their dividends kind of move around, not necessarily always up, but they go down, too. So investors need to keep that in mind.

There is also some tax issues. Investors should remember dividend funds tend to pay out qualified dividend incomes in the U.S., and these international equity funds, the dividends may not necessarily be qualified. And so you might want to put them in a tax-deferred account. But, on the flip side, some countries will withhold some taxes for dividends paid to foreign investors. If that's the case, the fund company will give you the information how to claim that as a credit, but you can only do that if you hold the fund in a taxable account. So there are two things going on.

This withheld tax can account for like 30 basis points to over 100 basis points of the yield. But I just want to point out on Morningstar.com and on the funds' factsheets the yield is always net the foreign dividend tax withholdings. You’re not going to get a lower-than-expected yield. So those are some issues that investors should think about.

Stipp: What about international REITs?

Oey: Yeah. So REITs, our favorite fund is the Vanguard International Real Estate fund, the ticker is VNQI. That fund is yielding about in the 5% range. What investors should keep in mind is that it's not only a REIT fund; it also has real estate development companies. It holds developed and emerging-markets real estate companies, and it holds a lot of Hong Kong and Singapore real estate development companies. And those own assets in their neighboring emerging markets. So in the near term for REITs, this easy monetary policy is a positive tailwind, and then on a very long-term view, there are positive trends in emerging markets that everyone is aware of that rising middle class, general urbanization. So that's a fund we like.

Stipp: Dan, I also ask you for what your best idea is in your space or where you're seeing opportunity. You told me at one point there aren’t a lot of opportunities right now. Do you have a specific name that investors might want a take a closer look at?

Rohr: Well, sticking to the long side of things--the short side has been rather interesting of late--but on the long side, on an absolute basis, nothing. On a relative basis, I'd say we tend to like producers that meet two criteria. And that's, one, low-cost enough that you can withstand a sustained slump in prices. Then, two, if you can find, one, a company producing a commodity that's not directly leveraged to Chinese fixed asset investment. So, one company that I cover that happens to meet both those criteria would be Cameco, which is a Canadian company, has a U.S. listing, CCJ. They are the world's largest uranium miner, and they are also very, very low-cost.

While this is ultimately a China play, it's starkly different from, say, an iron ore miner or a copper miner, such that China doesn't need to keep building 15% more luxury apartment buildings or shopping malls year-in, year-out. What you're betting on here is the government's commitment to build out its reactor fleet. China is a relative minnow right now when it comes to uranium consumption. But if the government does achieve its objectives with respect to future reactor build, it's going to be the 800-pound gorilla in the room. I think, given what we've seen recently with cities like Beijing suffering under clouds of poisonous smog, I think that only serves to strengthen the government's resolve to meet this objective.

Stipp: In the time we have left, I want to take a few more reader questions. Patty, this might be a good one for you. We've got a couple of questions on frontier markets, so people want exposure to some of the smaller and even more emerging emerging markets. Are ETFs a good way for them to think about maybe coming in and getting exposure to a smaller emerging country?

Oey: There might be a handful of single-country ETFs, and I guess we generally don’t recommend those. Those are extremely volatile. I think Guggenheim has an ETF that kind of has a bunch of what they consider frontier-markets countries, their companies in the fund. I would say they are probably OK for very risk-tolerant investors. We actually don’t cover those funds, so I can’t speak to them that much.

Stipp: But probably for a small slice of investors’ portfolios.

Oey: Very, very small slice, yes.

Stipp: Do you have any thoughts on some of the fundamentals of any of those smaller markets? Is there any work that you’ve done on the ETF team about something that might look attractive or not attractive or a place where there is too much risk?

Oey: One thing, I think, is attractive now is maybe Mexico. So, as I mentioned before, Mexico, there is one big stock there, and that’s America Movil. That stock actually has been under a lot of pressure over the last few months. What’s happened is that, there has been a new president that came in earlier this year. He is trying to move forward with some of these big-bang reforms that the Mexican government has not been able to push through, and he actually is kind of moving along. He was able to kind of pass some education reforms; next up is telecom and television reform in Mexico. We’ve got America Movil, and then in media we’ve got Televisa and, I’m sorry, forgot the other one.

But anyway those companies are huge monopolies in Mexico. They charge above-market rates, and they’ve been doing really well. But the government wants to break them up. It will be beneficial for the consumer, and maybe we’ll see more competition. We’ll see lower prices. So America Movil, as I said, last year it was about 25% of the iShares Mexico fund, which is I think the ticker is EWW. So that was a huge overhang on that stock as we had these negative issues. And also in some of their other markets, like Brazil, they’re also seeing some less favorable regulatory environments. So the stock has been heading down now; it's only 15% 16% of the fund. I think all the bad news is kind of reflected in current valuations. For Mexico, if the reforms pass it will be positive for the country in the medium term, so it could be positive for the ETF.

Stipp: Last question, because we're almost out of time. The idea of indexing versus active management, maybe I could get a brief answer from a few of the members of the panel. So in emerging markets, have you done any research to show--and we talked about some of the problems with some of the indexes, but they can be low-cost, as well--about whether active management really gets you a lot more than taking a really low-cost emerging-markets fund? What would you say about the trade-offs there?

Oey: With the highly rated open-end actively managed funds, some of them have done very, very well in the last 10 years. I mean maybe even like hundreds of basis points higher than the cap-weighted index. I mean, emerging markets are less efficient, so there is an opportunity for active managers to get more off them.

Stipp: Andreas, when you are looking at your portfolio versus some of the benchmarks, how different does your fund look? Are you hewing it all to the benchmark? Or are you really looking to just find the opportunities where you find them?

Waldburg-Wolfegg: Well, there is about 1,800 names in the benchmark, and the portfolio is somewhere between 50 and 80 names. So that in itself already tells a big story. Like, as I was talking about the banks, it's really important to be aware of what's in the benchmark, and to know what bets you are taking and why you are taking them. I think that’s very, very important. We continue doing that, and that's really one of the key skills that we try to develop and to hone. And that's really the main thing where we try to do differentiate ourselves.

Stipp: All right. Well, panel, I think we’re just about out of time. I want to thank Andreas from Columbia Acorn Funds, Patty and Dan from Morningstar, for your insights today on the international scene. There's a lot to talk about; investors are certainly very interested. So thank you for bringing these ideas to the table today.

Oey: Thank you.

Rohr: Thanks a lot.

Waldburg-Wolfegg: Thank you.