You can't rely on indexes to pick international stocks, this 5-star fund manager says. Here are 3 of his top selections.

By Philip van Doorn

Krishna Mohanraj of Diamond Hill Capital Management says investors should focus on quality, rather than regional or sector approaches take by stock indexes

You have probably seen coverage of a renewed interest in Japanese stocks among well-known investors, including Berkshire Hathaway (BRKA) CEO Warren Buffett. But Krishna Mohanraj, who runs a highly rated international fund for Diamond Hill Capital Management, prefers a company-specific approach over a geographic focus.

He is the portfolio manager of the Diamond Hill International Fund , which was established at the end of 2016 as a limited partnership, before being converted to a mutual fund with shares available to the public in June 2019. It has a five-star rating (the highest) within Morningstar's "Foreign Large Blend" category.

Mohanraj discussed his approach to stock selection and how investors can be underserved when riding along with the allocation of international indexes. Three of his top picks are below.

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Here's a three-year chart showing how the fund has performed relative to its benchmark, the MSCI ACWI ex USA Index, in U.S. dollars:

The total returns include reinvested dividends. The Diamond Hill International Fund's return is net of expenses, which are 0.74% of assets under management annually for its institutional share class.

Diamond Hill Capital Management is based in Columbus, Ohio. Mohanranj works out of Dallas and is the sole manager of the Diamond Hill International Fund, working with a team of four analysts.

It is the nature of the mutual fund business in the U.S. to divide the world into U.S. and non-U.S. stocks, and funds need to have benchmark indexes for performance measurement. But Mohanraj doesn't like the typical broad international index approach. During an interview, he paraphrased Warren Buffett: "There are so many bad businesses out there." A broad international index, such as his fund's benchmark, includes regional and sector allocation targets that have to be maintained.

He also objects to the typical approach in stock indexes tracking emerging markets, because companies "get lumped into a bucket." Economies such as South Korea, Taiwan, Peru and Columbia aren't comparable, he said.

"For us, international investing has to be selective," which means a focus on individual companies rather than industries or countries, he said. Then again, regional considerations play a role: "There are spaces where we know where we would never invest -- Chinese banks and real-estate companies and some Japanese banks."

The Diamond Hill International Fund has a high active share relative to the index -- 91% as of March 30. Active share is a measurement of how differentiated a fund's portfolio is from that of an index. Index funds that passively track benchmarks can have low expenses. But if you are paying more for active management, you should expect fund managers to provide investment exposure to companies they favor, free of index allocation considerations.

Moharanj also said that the Diamond Hill International Fund's annual turnover is about 20%, which is a low figure. He said the high active share reflected his investing preference to target good businesses trading at "cheap" valuations.

Three examples

The Diamond Hill International Fund typically holds between 45 and 55 stocks. Mohanraj named two companies in Japan, and one in India, as examples:

Nintendo

Executives at Nintendo Co. Ltd. may be surprised at the success of "The Super Mario Bros. Movie," with global sales topping $1 billion in April. Scoring such a hit underlines the strength of the videogame maker's brands that were developed in-house, and the movie's "value for the franchise translate across ages," according to Mohanraj.

But what he really likes about Nintendo is that net of cash, the company's shares trade in the "low single digits" relative to expected profits over the next 12 months.

The Nintendo Switch console gaming system hit the market in 2017, so gamers are looking ahead to the next generation of equipment. About 25% of Nintendo's balance sheet is cash, Mohanraj said, because the company is gearing up "to invest at the bottom of the cycle."

Over the years, when Nintendo has introduced new gaming platforms, there has always been risk that the next console won't be a hit with gamers. "There is operating leverage when it works, because sales go through the roof. First-party game sales have a high margin," he said.

Nintendo owns 32% of the Pokémon Co., which makes one of the most popular game series played on its systems. Nintendo's first-party properties include Mario, Donkey Kong, Metroid, Zelda and many others. Competing game-console makers don't have first-party titles with anywhere near the level of recognition or loyalty Nintendo has for these series.

Another thing for long-term investors to consider, according to Mohanraj, is the combination of value for Nintendo's customers and opportunities for growth. Videogaming is the "cheapest for consumers with the highest return on capital" for producers, he said.

Astellas Pharma

Astellas Pharma Inc. is based in Tokyo and has grown from a small manufacturer of generic medications into a well-known innovator with a pipeline that has included Xtandi prostate cancer medication, which comes off-patent in 2026 and 2027, Mohanraj said.

Fear of patent expirations can pressure pharmaceutical stocks, but Mohanraj is comfortable with what he calls a diversified R&D pipeline. Astellas's Padcev bladder cancer medication was approved for sale in the U.S. in 2021 and Europe in 2022. The company is also working on medication and therapy to treat blindness and "a drug for vasomotor disorders in women," he said.

He added that executives of Japanese companies "do not sell actively," and that investors "discount innovation."

"That is where we can find value. This would be much more expensive if it was a U.S. company," he said.

HDFC Bank

Mohanraj said that in India, 70% of banking activity is handled by public banks "that are not well managed." This presents an opportunity to private banks to expand their market share in rapidly growing market. The World Bank expects India's GDP to expand by 6.3% this year.

Mohanraj said that India's rapid growth reflects a dramatic improvement to its infrastructure and the "financialization" of its populace, with a new identification system similar to U.S. Social Security numbers, making it easier for everyone in the country to have access to financial services. This, "along with everyone having a mobile phone, with the lowest service in the world, combines tor economic growth," he said.

He added that as a private bank, HDFC looks "most attractive" because the public banks cannot compete by paying competitive salaries to employees. Meanwhile, "banking penetration, from mortgage loans, car, motorcycle and small business loans, is so low that banking growth you would expect in a market like that is two times or three times GDP growth," he said.

Top holdings

Here are the largest 10 holdings of the Diamond Hill International Fund as of March 31:

Company                                              Ticker     Country         Industry                         % of portfolio 
Fairfax Financial Holdings Ltd.                      CA:FFH     Canada          Property and Casualty Insurance            3.7% 
Unilever PLC                                         UK:ULVR    U.K.            Household/ Personal Care                   3.3% 
Spotify Technology SA                                 SPOT      Luxembourg      Internet Software/ Services                3.3% 
Samsung Electronics Co. Ltd.                        KR:005930   South Korea     Telecommunications Equipment               3.3% 
Novartis AG ADR                                        NVS      Switzerland     Pharmaceuticals                            3.2% 
Fomento Economico Mexicano SAB de CV               MX:FEMSAUBD  Mexico          Beverages: Nonalcoholic                    3.1% 
HDFC Bank Ltd. ADR                                     HDB      India           Regional Banks                             2.9% 
Check Point Software Technologies Ltd.                CHKP      Israel          Internet Software/ Services                2.9% 
Tencent Holdings Ltd.                                HK:700     China           Internet Software/ Services                2.7% 
Tesco PLC                                            UK:TSCO    United Kingdom  Food Retail                                2.7% 
                                                                              Sources: Diamond Hill Capital Management, FactSet 

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-Philip van Doorn

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05-27-23 0857ET

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