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Staying Afloat in Offshore Funds


Most investors were glad to see the back of 2002, which featured 12 months of slow economic growth, disappointing corporate profits, and gyrating equity markets, during which even the savviest fund managers struggled to make money. The MSCI World Index tumbled by 21% over the year, its worst performance in decades. And investors can't expect much of a recovery this year. "We are not forecasting a repeat of 2002's equity bloodbath," says Michael J. Hartnett, director of European equity strategy at Merrill Lynch & Co. in London. "But the equity markets will be flat at best in 2003."

Still, it wasn't all gloom and doom. Western markets briefly rebounded between the beginning of October and the end of December, giving beleaguered fund managers a helping hand. And even in the hardest of times, astute managers can make decent profits. Indeed, the results of BusinessWeek's quarterly survey of the 500 biggest offshore funds show that the 25 best-performing funds--most of which lost money over the year as a whole--all reported growth of 15% or more in the fourth quarter. By contrast, forces beyond the control of investors sank the 25 worst-performing funds, all but one of which invested in Japanese stocks.

Among the powerful trends that took hold in the fourth quarter: the surprising recovery of technology and Internet stocks. More surprising still was that Europe, in spite of its economic sluggishness, led the way. No fewer than 6 of the 10 best-performing funds focused on telecoms, technology, or the Internet. And 14 of the top 25 concentrate on Europe. Not bad, when you consider that the euro zone economy barely grew in the final three months of 2002 and could actually contract this quarter.

The surge came in part because many telecom, technology, and euro zone stocks were so undervalued by September of last year--trading well below 10 times earnings--that even cautious investors began to find them tempting. Continental stocks--especially in Germany, Italy, and France--had been particularly hard-hit by the euro zone's grim economic performance in 2001 and 2002, and were ripe for revaluation. And many euro zone telecoms and technology companies had slumped further than their U.S. and British counterparts because they had taken on massive amounts of debt to fund unsuccessful expansion strategies in the boom years of the late 1990s. "There was a counterreaction," says Carlo Seregni, who manages Bank Julius Baer's $190 million Special Europe Stock Fund. Seregni's fund chalked up a gain of 17.81% in the final quarter, making it the best performer of funds that focus on Europe.

The leader among all 500 offshore funds tracked by BusinessWeek was the $125 million Fortis L Eq Telecom World C Fund, which benefited from an unexpectedly strong revival in telecom stocks to rise 25.46% over the final three months. "The top line was quite weak for the telecom sector in general," says Sophie Debehogne, who manages the fund from Brussels (page 48). "But there were some very positive numbers on the free cash-flow side and a number of welcome managerial changes at the top of some companies."

Our data on the 500 biggest funds were gathered by Standard & Poor's, which, like BusinessWeek, is a division of The McGraw-Hill Companies. Offshore funds are domiciled outside the U.S., mainly in tax havens such as Luxembourg. Because the U.S. Securities & Exchange Commission does not regulate these funds, they are not allowed to be marketed to U.S. residents. Still, many American individuals and institutions do invest in them. And their performance is a good barometer of global economic trends.

Investors would do well to be wary of the rise in tech and telecom shares. The fourth quarter of 2001 saw a similar boom, which quickly turned to dust in the face of overcapacity and a drought of orders for capital equipment. The markets, however, were impressed this time around with a series of late-year developments at big tech and telecom companies in Europe and the U.S. Companies implemented serious corporate restructuring plans, sacked discredited managers who overexpanded in the boom years, and slashed debt levels. "We focused on the traditional stocks such as Verizon and SBC Communications, which, although they were operating in a difficult economic environment, did have strong and sound cash flows," says Paul Gorman, stock picker for the Pioneer Global Telecom fund, which was runner-up in our overall ranking, with a 24.88% return for the quarter. The most attractive buys were those "that had had financing difficulties but managed to convince the market that they weren't going to go bust," Gorman says.

Mid-cap and small-cap telecom and Internet companies were also back in vogue, especially in Europe. That's because some sections of the European market are growing fast. Seregni likes Norway's Telenor, for example, because of its strong presence in Russia and Eastern Europe. "If you're selective, you can make good returns on the telecom and Internet fronts," he says. "The best companies are leaders in niche markets." Seregni devotes 20% of his portfolio to telecom- and Internet-related small-cap stocks. Among his picks: T-Online International, the German Internet provider; ebookers, a British Internet travel company; and Switzerland's Micronas Semiconductors.

Given the dismal performance of the broad indexes, the fourth-quarter winners were all funds that stressed individual stock-picking skills. "We put less emphasis on top-down macro themes," says David Gasparro, head of retail investments at Schroders PLC in London. Two European-oriented Schroders funds--the Schroders ISF Italian Equity A Fund and the Schroders ISF Euro Equity A Fund--were among the top 25. The Euro Equity fund made money with French bank Credit Lyonnais, which rocketed in value after BNP Paribas made a merger move--only to be outmaneuvered by Credit Agricole. Schroders also benefited from the strong fourth-quarter recovery in European insurance stocks. Meanwhile, managers of the Italian fund struck oil with utility Italgas, which benefited from parent company ENI's decision to buy out minority shareholders.

Schroders' Latin American fund was also a star, despite the economic turmoil that plagued the region. Luckily, Schroders was light on Argentina stocks for the entire year and overweight on Mexico, which outperformed most of its neighbors. It also cut back on Brazilian stocks in the final quarter.

Although picking the right stock is key, some sectors as a whole outperformed in the final quarter and will likely continue doing so. Take banking and insurance. Credit Lyonnais' forthcoming merger has increased speculation among investors that there could soon be a new wave of financial sector mergers in Europe. That's sparked large-scale buying of shares in banks that are perceived as vulnerable to acquisition--such as Germany's Commerzbank and France's Societe Generale. Funds that invested heavily in takeover candidates, such as the Parvest European Financials C Fund, which grew 16.89% in the fourth quarter, were the beneficiaries.

Then there's property. Given the Continent's economic weakness, it may be surprising that European property continued to be a sizzling investment in the last quarter. Yet the Morgan Stanley Europe ex UK Property Fund leaped almost 20%. What's more, it was a star performer over the year as a whole, chalking up a gain of almost 34%. According to the Morgan Stanley fund's managers, Michiel C. te Paske and Sven van Kemenade, the secret is to spot undervalued real estate in the cheapest markets and then buy the stock of companies investing in it. Doing that generally generates income of 6% to 8%, and a 10% to 12% overall return. "Even in times of volatility, the income flow is still very stable," says te Paske. "So we have seen a lot of investor interest." Van Kemenade notes that property has "massively" outperformed other asset classes over the past three years.

With the expansion of the European Union now just a year away, investors are making the most of so-called conversion plays--companies in the 10 candidate countries that will benefit from accession. Funds such as the Griffin Eastern European Fund, the DWS Europe Convergence Fund, and Pictet's East European P. Fund were top performers. Among their favored stocks: Hungary's OTP Bank, which is seeing surging demand for financial services and is performing well despite strong foreign competition; and Polish timber and paper company Frantschach Swiecie, which is making big inroads into the EU market.

Japan is a world away from all this good news. All but one of the 25 worst-performing funds focused on Japan. The magnitude of the Japan investing disaster is easily seen: Of the 500 funds ranked, 442 made money in the fourth quarter; most that lost money were Japanese. Japan's Topix stock index fell 18%, with banking shares doing particularly badly. There could be more pain to come. The strengthening yen, continuing deflation, and the fallout from the banking crisis could push Japan into another recession this year. To make matters worse, the banks are dumping their big cross-shareholdings in major companies to raise capital and meet new regulations limiting the amount of stock that can be used as capital. "Most factors currently point to another year of poor returns," says Garry Evans, HSBC Securities Inc.'s Japanese equities analyst in Tokyo. The economy will contract by 0.7% in real terms, he predicts. The stock market could tumble an additional 10%.

That's why most stock pickers trolling the Nikkei follow a very defensive strategy. Cash-rich companies, those with unique technology, multinationals with a proven record abroad, and enterprises that have embarked on major restructuring are the best bets for a tough year, they say. Among the most attractive: Matsushita Electric Industrial Co., which, says HSBC equity strategist Hideki Watanabe, "is implementing more aggressive restructurings and is moving toward the development of strategic businesses and withdrawal from less profitable ones." Nissan Motor Co., whose new Quest minivan has had good reviews, is another HSBC buy.

European investors who profited in the fourth quarter would do well to pay attention to Japan. After all, Europe's biggest economy, Germany, has some decidedly Japanese traits: low growth, rising unemployment, and severe budget problems. As if that's not enough, Merrill Lynch's Hartnett points out that "the euro is appreciating, oil prices are rising, and U.S. and U.K. consumer spending are showing signs of easing." Add a war in Iraq to the mix, and portfolio managers, cheered as they might be by their fourth-quarter returns, should be anything but complacent. By David Fairlamb in Frankfurt, with Brian Hindo in New York and Brian Bremner in Tokyo


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