Laming has been lead manager of the Buffalo Equity and the Buffalo USA Global funds since their inception in 1995 and lead manager of the AFBA Five Star Equity and the AFBA Five Star usa Global Funds since 1997. He is also comanager of the Buffalo Small Cap Fund and manager of the Great Plains Trust Company Science and Technology Fund. On February 14, 2001, Working Money's David Penn tapped Laming's fund management experience to identify the risks and benefits of global investing.
We realized that for a firm like Buffalo Funds, which is more focused on domestic companies, a better way to invest in some of these countries would be to focus on US-based companies that receive most of their business outside the US. After all, in China, Coca Cola, Inc. (KO), is the soft-drink industry leader and Motorola, Inc. (MOT), is a wireless leader. -- Tom Laming
I understand that some of the strongest overseas growth you've seen hasn't come from companies in other countries, but from US companies operating overseas. Could you comment about that aspect of Buffalo USA Global? It goes back to the inception of the fund. We actually thought about starting an international fund and chose not to, partly because we knew that we weren't international fund managers. You need a different set of tools and we didn't think we had that infrastructure in place. Yet, we wanted to provide the fund for some of our 401(k) and pension clients. As we were looking around the world trying to identify which companies were doing well and which ones weren't, what kind of products were being bought, and so forth, we realized something interesting.
Which was? We looked at the Petronas Towers in Kuala Lumpur, the tallest buildings in the world. A US firm makes the elevators in those buildings. The architect is a US firm and I can almost guarantee that every PC in those buildings has an Intel or Advanced Micro Devices (Amd) microprocessor. And we looked at China, where, according to brand awareness poll data, the most-recognized beverage is Coke.
We realized that for a firm like Buffalo Funds, which is more focused on domestic companies, a better way to invest in some of these countries would be to focus on US-based companies that receive most of their business outside the US. After all, in China, Coca Cola, Inc. (KO), is the soft-drink industry leader and Motorola, Inc. (MOT), is a wireless leader, although some European companies are not far behind. Intel Corp. (INTC) and Micron Technology, Inc. (MU), are leaders in the semiconductor industry in Asia and Latin America. With the exception of a handful of companies such as Ericsson (ERICY) and Nokia (NOK), all these technology leaders are US-based companies.
After you realized that, what did you do? We saw this phenomenon consistently across the board, so we thought we'd start a fund that, by definition, has international exposure, yet owns only US-based companies. To be considered for our fund, companies must get at least 40% of their revenue or income from international sources. This prevents us from just saying, "Wal-Mart's growing internationally, so let's add it to the fund."
It's not growing internationally? It is, but about 90% of its operations are in the US. We want to focus on companies that have large exposure to the growth of international economies.
Why 40%? There isn't anything magical about the number. We did some screening and tried to make sure our universe was large enough. We didn't want to limit it to, say, 80% and have only 12 companies to own. We recognized that 40% of revenues from international sources was far larger than average -- probably at least double that of the average company in the Standard & Poor's 500. It is sometimes reported that 25% of the revenue of the S&P 500 comes from international sources, but most of that is coming from the top 50 companies.
Can you tell me more about that? With our fund, you're getting both large- and small-capitalization multinational companies. Usually, "multinational" denotes a really large company, but our smallest market cap holding is something like $60 million. There are some companies in areas such as technology, consumer products, and health care where the US is such a leader that the only competition is from other US companies, and size is not what prevents these companies from going overseas.
Give me an example. Intel Corp. The company doesn't compete with foreign companies for the sale of microprocessors. They compete primarily with AMD.
As the rest of the world grows, these companies are going to benefit and maybe even have reduced competition elsewhere in the world versus what they see in the US. Coca Cola doesn't have an obvious Chinese soft-drink competitor. But there are potential negatives. We do have to be concerned with the strength of the dollar, as well as other risks associated with investing in a multinational company. The 40% minimum requirement for sales or income assures that all of our holdings will truly participate in global growth. That's the reason for the 40% rule.
Thinking back to the inception of the fund in 1994-95, were there global events you wanted to take advantage of over the coming years? We were aware of positive events taking place globally and thought it was important that we offered our clients who had a 401(k) or pension a chance to participate in those events. Advisors would come up to us and say, "Gee, we wish we had the ability to allocate, say, 10% to an international fund that you would run."
But you didn't have one. Not at the time. So the decision to offer such a product was based on several factors. It seemed like a better way to do it, rather than charge a client 2% in annual expenses, which is typical of traditional global funds.
What do you charge? According to Morningstar, the average world fund, which can own US companies as well as companies in other countries, charges 1.81% -- nearly 2% in annual management fees. We charge only 1%. The other funds charge more because there are additional expenses associated with managing a portfolio of foreign securities.
Do you think investing in US companies with significant overseas operations provides a safer type of exposure than trying to invest directly in a foreign company? We don't have the volatility problems that foreign funds do, which we clearly saw during the Asian crisis. Just from a commonsense standpoint, we don't suffer a lot of the risk of investing directly in foreign securities.
What's an example? In the 1980s, the French government nationalized industries. That's not all that long ago. This sort of thing happens every decade. Even the governments of some of the more developed countries have done things that have been pretty devastating to investors.
Think back to the days before Castro came to power in Cuba. Many of the apartment buildings the Cubans use as living quarters used to be hotels belonging to foreign investors. When you invest directly in a foreign company and the government decides that things won't operate the way they used to because they're going to take over the company, you're left holding nothing. And you have virtually no legal recourse. You might get a legal judgment in a US court, which you have absolutely no ability to collect. We mitigate those kinds of risks.
How does that work? There is generally less enforcement of security laws and supervision of stock exchanges in developing countries. Attempting to deal with a legal issue related to a foreign investment might require you to sue a company in a country where you have far fewer rights than what you may have in the United States. And collecting a judgment from a US court against a foreign company may also be impossible.
What risks do you have to deal with? I would say the two biggest types of risks, beyond the expected economic risk, would be political and currency. Politically, you still have the possibility of a government giving some kind of adverse ruling on a product or forcing the company to pull the product off the shelves. You would have that with any foreign investment. There's no difference there relative to our fund.
Then there's currency risk. Our fund would like to see a weak dollar. Interestingly, the fund has outperformed the Standard & Poor's 500 since inception, even though the dollar has moved against us almost the entire time. If I had seen a chart of what the dollar was going to do prior to starting the fund, I would probably have said, "Gee, maybe this isn't the right time to do this because we're going to be fighting a headwind."
|And that's a headwind we've seen everywhere. It has made the biggest difference in our slower-growth companies, such as McDonald's and Coke. When you're looking at a single-digit growth rate or a low double-digit growth rate, the company could easily lose half of that growth in a quarter due to currency fluctuations. But the impact won't be as significant for a company growing at a faster rate. |
For most of the stocks we own, we rely to a large extent on the companies' treasurer to hedge their receivables. Intel may sell $10 million worth of Pentiums to Toshiba, which may not be delivered for another two and a half months. Now, at that point they take on some currency risk. If the dollar moves against them, what they thought was going to be $10 million ends up being $9.5 million after translation. Who knows better about hedging its receivables than the company itself? That's another thing that has helped our fund to do well, even though the dollar has steadily moved against us.
That's interesting, both with regard to the dollar's trend and your reliance on the company treasurers to take care of the currency hedging. So you don't do much currency-specific hedging in the fund itself? We do absolutely nothing relative to currency. The only time we involve ourselves with currency is when we forecast earnings. Then we make assumptions and change our earnings forecast based on the strength of the dollar, but to be honest, our strategy focus is so long-term that we really don't concern ourselves with currency. Over the long run, we tend to believe currency is going to be neutral. Over the short run, it's clearly not. We're focused more on the three- to five-year investing horizon and we welcome a weak dollar for this time horizon, although as we've seen, the dollar can go against you for a considerable time.
Did the 1995-2000 US bull market especially benefit US companies with significant overseas revenues? The fund was started in May 1995 and a few years after that the Asian financial crisis occurred. We really felt that. It wasn't the sort of crisis we'd expect every five years. It was basically depression and anarchy in certain parts of Asia. Many of our companies, particularly in the technology area, had an awful lot of exposure in Asia. A lot of companies, especially in Korea, became hungry for cash and started dropping prices just to be able to sell product more easily and raise cash. That hurt a lot of our semiconductor holdings from a competitive standpoint. And then, of course, Asia is where most PCs get manufactured. A lot of the end-demand is there also, so a lot of product is sold into Asia. That demand just dried up.
You used the word "depression." Was it that marked? Over that five-year period, not only did the dollar move against us, but we also had a good year and a half of economies that were beyond recession. "Depression" is an awfully strong word, but circumstances were much closer to a depression than a typical recession. Even though that five-year period has been a bull market here in the US, it hasn't been a steady bull market elsewhere.
One of the benefits of the fund was having the corporate management here in the US. There were days when you couldn't sell foreign securities in the Asian exchanges. They were closed. We were never barred from buying and selling in our fund. The New York Stock Exchange is more established and better regulated than exchanges in Asia, so that helped us. The last five years have been a bull market, and since the rising tide lifts all ships, as the old saying goes, we might have benefited from that, but overall, it was really a difficult period. I wouldn't expect the next five years to include another depression in Asia, nor would I expect the dollar to strengthen again steadily for the next five years. I may be wrong, but I hope not.
Was Russia's debt default in 1998 nearly as damaging as the situation in Asia? No. I'd say Eastern Europe has probably had as small an impact on this fund or the companies it holds as any region. The fund is much more affected by Asia, Europe, and to a lesser degree, Latin America and South America. And just as important, there's no expectation built into the price of these stocks based on how Russia performs. There is for China and the rest of Asia, but nobody seems to be buying any of these stocks, which would inflate the price/earnings ratio (P/E), based on their expectations for Russia. It hasn't been a factor.
Of the companies, particularly in Asia, that have done well in spite of those problems, which ones are most likely to continue doing well? Technology, the largest sector holding in our fund, has been most affected by Asia. Looking forward, we clearly have excess inventory in everything from PCs to cell phones. That's going to fix itself this year sometime.
How and when? I'm not sure when, but inventory problems have an automatic means of correcting themselves with order cancellations. Subsequently, either the inventory works its way down or it becomes obsolete. Sometimes that's the case with technology. Steel doesn't become obsolete; it stays around. But semiconductors lose value every day they're sitting on the shelf. Those problems tend to last anywhere from three to nine months. Nine months is a long time in the technology sector.
What do you expect to happen? We expect the technology market, at least in the area of semiconductors, wireless phones, and infrastructure, to improve by the latter half of 2001. The conditions are going to improve dramatically. Most of those areas now carry valuations that we're very comfortable with, although there are still certain areas in wireless that we think have ridiculous valuations. That's the case with some of the newer companies that still have Internet-like valuations.
Does that go for everything? We're comfortable with the valuation of companies such as Motorola. You can afford to take the bad news in terms of inventories or order levels once the valuation reaches an acceptable level. We think we're almost there, at least in our technology holdings.
What about some of the more high-flying technology and Internet stocks? It concerns us and could affect the fund and the entire market for much of this year. Companies that are more Internet-related or that carry Internet-type valuations still have a long way to go before their stock prices are rational. We've gone through the burst of a bubble. Looking back to 1987, which was the last time a true, good-sized bubble burst occurred, we see that it can take a long time for prices to get back to the old highs. I think a lot of people are thinking, "When will Yahoo! go back to its old high or when will Amazon go back to its old high?" I'm not sure Amazon will ever get back to its old high. I actually think Amazon is likely to go to zero. After 1987, it took IBM 10 years to get back to its old high. It took Microsoft until October 1989, Intel until March 1990, and Texas Instruments until August 1993 to get back to 1987 highs.
Are we in a similar situation now? We probably are for internet stocks such as Yahoo!, Amazon, and even Aol. Even though we were heavily weighted in technology during 2000, we sold several stocks -- some partially, such as Motorola, and some completely, such as Applied Microcircuits -- back in the first quarter of 2000. We did that because we are very sensitive to valuation and we stick to it. We don't just keep changing the price target and seeing if prices will keep going up. This is real money, as opposed to just a recommendation on a report.
We trimmed quite a few things. Tech is still our largest sector holding, but we were still up last year, partly because we got rid of the fluff in valuations. But now we see valuations that we think make an awful lot of sense. We bought stocks of companies we haven't owned before, such as Solectron Corp. (SLR), Adaptec, Inc. (ADPT), and Agilent Technologies, Inc. (A), at the end of last year. (See Figures 1 and 2.) We think the outlook is positive for most of the technology stocks, but a lot of the high-profile names, the ones that have made the most headlines over the last year or two, won't be good places to be.
What kind of parameters do you use? In terms of parameters, we usually look at price-to-earnings and price-to-sales ratios. Price-to-sales helps us for companies that, for whatever reason, have depressed earnings. They may be going through an inventory crisis and aren't shipping much product right now, and they may not be making any money. With no earnings, we have to assess whether we think the margin structure of the business is going to change over time.
What's an example? A good example would be a company such as National Semiconductor, Inc. Given what's happening right now in terms of order levels and inventories in semiconductors, we try to determine whether estimates are too high for almost every semiconductor company. I wouldn't be surprised if almost every single semiconductor company ends up reporting a disappointing March quarter. What we really rely on is the company's price-to-sales ratio because at this point, they might be showing earnings that really aren't normal due to fluctuating inventories. We take a longer-term view by trying to determine what a company like National Semiconductor could make three to five years from now.
But we could end up misjudging the market growth for that segment. And even if we got that right, the margins could get squeezed. Products that used to sell for 40% gross margins could sell for 20% gross margins. If we get the margin structure reasonably correct, though, then price-to-sales analysis will work well.
The three- to five-year focus probably helps in that regard. We aren't trying to outguess the market on a short-term basis. We're not trying to figure out whether National Semiconductor is going to have a positive or negative surprise in the next quarter, because we don't think we'll win at that game. This almost sounds upside down, but we view the next three to five years with more visibility than we do the next three to five months. I have much more confidence about where National Semiconductors' sales are going to be three to five years from now than I do over the short-term. With the inventory situation as bad as it is now, their revenues could easily be down. But are their revenues going to be down three to five years from now? Of course not. Then we have to ask ourselves, "Is this a good value for the stock?" We assess the end market by using a strategy we call our road map of long-term trends.
What does that entail? We have the industry expertise. We have people with the background to assess businesses and try to make three- to five-year projections on everything from demographics to the shift from analog to digital photography.
That shift from analog to digital is everywhere. I have no doubt about what's going to happen in the photography industry in terms of analog versus digital. Digital photography is going to get bigger every year. It will not go down one year over the next five years. The same is true in the shift from analog to digital cable.
What all that means is that there are some things we know with very high levels of certainty, and those are the things we're trying to get at. The next step is to identify stocks that will benefit from the changing environment and buy them at reasonable prices. We probably spend more of our time working on what we think is going to take place over the next three to five years than we do on any other single factor that guides us to the stocks that we own.
Because you look at longer-term trends, is it fair to consider your approach a top-down approach to investing or is it as much bottom-up as it is top-down? That's a good question. The first step is top-down. When people think of top-down, they start with the economic environment -- where interest rates are headed and so on. We consider top-down as a road map of trends.
What's an example? Let's take the deregulation of the electric utility industry. We try to determine how likely the long-term trend of deregulation is and whether we should own companies like Enron. We also look at issues like demographics, or the increasing dollar content of semiconductors in consumer electronics. We will literally tear apart a Sony Walkman and a MP3 player to determine the trend in semiconductors. The cassette Walkman doesn't have much semiconductor content. The CD Walkman has more, and a MP3 player has nothing but semiconductors. As long as this trend continues to hold, we'll get more and more semiconductor content in consumer electronics. That's the nature of our top-down approach.
Once you do that, then what? Once we identify these trends, then we do a bottom-up analysis to determine which companies will benefit from this increase in dollar content of semiconductors, for example. Other good examples are Coca Cola and McDonald's. We graphed the penetration of both these companies into different countries versus the countries' per capita gross domestic product (GDP). We emphasize market penetration, which we measure by analyzing product consumption. Then we try to determine, based on penetration levels, whether the companies have further upside potential. So we start off with a top-down process, and once we identify the top-down trend, we switch to a bottom-up analysis and identify the individual companies that will benefit from the trends we see.
How much emphasis goes into the timing of your buys? Sometimes we come across a trend that we feel strongly about, but there's nothing worth buying right now. An example is Internet commerce. I am confident that more goods and services will be bought over the Internet next year than this year, but that doesn't mean we will automatically buy Amazon, Inc. (AMZN). What we always do is we step back and try to determine how much money these guys are going to make. We can assess this for companies such as McDonald's and Coke, but when we try to assess the long-run profit margin for Internet commerce companies, it becomes difficult. Everyone can sell over the Internet, so the margin structure will be low. Consequently, when we analyzed the valuation of Internet companies, we only found one company that met our criteria.
Can you give me a couple of holdings in the USA Global Fund that have continued to perform or exceed expectations? Recently, almost all technology stocks have come down, but most of our technology stocks held up well throughout 2000. This is probably because we're sensitive to valuation. Some of the newer stocks we bought, such as Agilent and Solectron, have continued to show good results. They haven't been as affected by the inventory concerns and that sort of thing.
|One of the groups that performed consistently over the past couple years after going through a rough time is the pharmaceutical sector. We own stocks in that sector mainly because of our demographic analysis. As the aging population grows both in the US and internationally, there will be a growing demand for pharmaceutical products. One company we have benefited from is Aflac Group (AFL), a company that is based in Columbia, GA, but gets more than 80% of its revenue from Japan. (See Figure 3.) It has benefited from Japan's aging population, and the end market continues to look positive. It's not an expensive stock, and we still expect a lot out of it. |
Do you do much sector rotation in the Buffalo USA Global fund? We don't do anything based on rotations, but I do recognize periods where people start getting concerned about a specific sector. I see investors making rotation-type moves among sectors by balancing one sector that's volatile with another that shows consistent earnings.
Remember, we have the 40% rule on sales or income from outside the US. If we step up above that 40% rule and look at the overall trend analysis, we see a representation of many different sectors. That leads to a widely diversified fund, with some notable exceptions. We don't own any electric utility companies in the global fund and we don't have much financial exposure, either. We only own two finance companies. Not many banks qualify for our fund; they have too much exposure here in the US. Aflac and American International Group (AIG) are big holdings. Certain areas just don't have global reach; we don't have any retailers, for example, because very few retailers have major exposure overseas.
For those categories that qualify, we have large exposure. These include the pharmaceutical (Figure 4) and technology sectors. We have a nice blend, which I think is what helped us last year. When our tech stocks were going down, our drug stocks were going up, and we were still up last year in a negative market. I could see a reversal this year with drugs not being as good of an investment, especially during the second half, which is when I think technology will start coming back strongly.
But I always had an interest in how companies work, how products are developed, and why one company buys another, and I decided that maybe I could leverage my background in technology into the finance arena. I wasn't sure whether that would lead to the finance area of a technology company or becoming a technology analyst for a mutual fund company. It ended up being the latter. I was a tech analyst at Waddell & Reed before I joined Kornitzer Capital, which is a smaller firm, but obviously much more fast-paced in terms of growth.
Had you bought much stock or owned mutual funds before you started having second thoughts about engineering? Yes. I had always saved consistently and participated in whatever the company offered in terms of a 401(k) plan, and I managed my own IRA. I certainly know how naive I was about thinking that I was adding much value at the time, but that's certainly where I developed an interest in it. It was a long process, because I really didn't know anybody in this business. At one point, I decided that if I was ever going to make the transition, I probably needed to get a master's degree in business administration (MBA). So I quit work and headed off to business school. I didn't have a well-defined map charting out where I was going to be in three years. It just played out this way.
The job of a portfolio manager has to be one of the most stressful jobs a person could have. What do you enjoy about your work as a portfolio manager and what are some of the things you still find rewarding and compelling about the work? I find the analysis of companies and products, especially on the technology side, very challenging. Predicting whether one standard is going to win out over another and how consumers will adopt one technology versus another or one company's product versus another is difficult. The challenge is what makes the job exciting. The fact that there are no laws dictating that if you do this, then the following will happen makes the job simultaneously challenging and frustrating. Sometimes you can be completely correct about the technology -- why one product might be better than another -- and that doesn't mean the market will react in the way you expected, because other factors such as marketing also play a role in its success. It's fun to try to figure that out and then implement a strategy and try to take advantage of it.
Because we are a relatively small firm, we meet with a lot of our shareholders. A day doesn't go by that I don't talk to a client. We try to help other people, and that is rewarding. Besides my client's money, I invest my own money in these funds. I care about these investments as much as all my clients. That adds a personal touch.
Are there common mistakes that mutual fund investors make? Problems that just keep coming up? I think the biggest mistake I've seen is investors chasing returns. If they own a fund that didn't make it into some top-10 ranking for a specific group for one year, they will sell it and buy one that did make it. By doing this, they end up getting nowhere. Instead, they generate a lot of taxes. We're very tax-sensitive. Although I thought our 35% turnover last year was high by our standards, it is very low compared to most mutual funds. A lot of firms are constantly turning their portfolios over (rapidly buying and selling), and their after-tax return is not even remotely close to their pre-tax return. After paying taxes, you may not have done as well as you think. Investors who keep chasing whatever they think is going to be the hot fund are not gaining any benefit.
What should investors do? An investor should have a plan that covers asset allocation and risk tolerance. They should stick with the plan and adjust it at most once a year. Unfortunately, that adjustment probably occurs more often than it needs to. The only way to be consistently wrong in this business is to keep jumping from one horse to another as each pulls up lame. If you find an investment strategy, whether it's a mutual fund or even your own strategy, stick with it. You're going to be much better off. That doesn't mean that all mutual funds are going to do well in the long run. You still have to do your homework. The biggest mistake I've seen is investors trying to second-guess and switch funds too frequently.
Look for a fund that is consistent. It doesn't necessarily have to show up as the best fund in a given year, but look at its five-year performance as well as its risk level. Morningstar's website is a good source for information on fund performance.
Thanks for your time, Tom.
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