Overseas Stocks Are A Stock-Picker's Game

In the early 1990s money manager Ray Mills successfully presented his thesis on robust aerospace controls–computer-guided systems that keep rockets from tumbling aimlessly through space–to Stanford's aeronautics and astronautics doctoral committee. With such systems, he says, there's always a tradeoff between performance and control.

"Basically the more performance you want to get out of it, the closer it is to the edge of instability." The challenge is to design a system that "gives you near-optimal performance but has a much wider range of allowance for things not being what you thought they were," he says.

Like many other mathematicians, physicists and engineers, Mills long ago abandoned his childhood dream of rocket science for a more lucrative living on Wall Street. He joined T. Rowe Price in 1997, five years after receiving his Ph.D.

However, optimizing performance in an environment of instability is a way of life these days for the 52-year-old manager of T. Rowe Price's $6.6 billion Overseas Stock Fund.

Through careful bottom-up stock picking in precarious foreign markets his fund has posted a five-year annual return of 15.3%, net of fees, compared with 13.6% for the Vanguard All-World ex-U.S. Index Fund. Year-to-date his fund has logged a respectable 19% total return.

No, even the rocket scientist couldn't engineer his way around the financial crisis. Like nearly every other comparable fund T. Rowe's Overseas Stock Fund lost more than half its value in 2008 and early 2009 when markets froze globally. But today assets have more than made up for the ground they lost.

As a stock picker, Mills methodically searches for the right balance between performance and stability. For example, he can invest up to 15% of assets in emerging markets but has less than 7% in them now. One big reason: a 2010 London Business School study that showed little to no relationship between national economic growth rates and stock returns. "It seems like a no-brainer–you want to invest where the economic growth is best," he says. "But there's no pattern, absolutely no correlation."

So rather than bet directly on emerging countries' markets, Mills steers investors' money into carefully chosen multinationals with big stakes in growth markets.

He has, for example, been increasing his holdings in Unilever. The Anglo-Dutch consumer products giant gets half its revenue from emerging markets, and Chief Executive Paul Polman is shifting away from food brands like Knorr sauces and Hellmann's mayonnaise toward higher-margin home and personal-care items like Axe deodorant and Dove soap. At 19 times earnings Unilever isn't cheap (the S&P Consumer Staples Staples Index is trading at about 18 times earnings), but Mills isn't put off. "Could you get a better entry point?" he asks. "Maybe, but you could also wait and ten years from now look back and say, 'Wow, this thing has compounded like mad.' "

Nor is Mills scared off by slow-growth economies–if the business is right. One of his favorites these days is U.K. home builder Persimmon, which, he says, is sitting on enough cheaply acquired land and zoning permits to build housing in England's tight market for four years. "If you have the land, if you have the permissions–which these guys do–that's the sweet spot," he says. "This company is going to return its entire market value in the form of buybacks, dividends and special dividends over the next ten years."

Admittedly, Europe is a challenging place to invest these days. Euro zone unemployment is hanging above 12%, banks are sitting on mountains of dicey sovereign debt, and it seems like the entire continent is waiting anxiously for a German bailout that may never come.

But as Mills sees it, European companies tend to have stronger management and corporate governance than those in the developing world, and the European legal system is more predictable than, say, China's. Moreover, fierce international competition has forced once flabby conglomerates to trim bureaucracy and underperforming divisions.

Even France, with its high taxes and rigid labor rules, offers opportunities; Mills owns global insurer AXA and electrical-equipment maker Legrand, among others. "The companies are great," he says, although "every other management team we meet with in France is threatening to move to Hong Kong."

For all his bias toward big, solid companies, Mills thinks he can still get higher returns out of Europe, although he concedes "the easy money has been made."

Mills also has 19% of the fund's money in Japan, where he's bought stocks that he thinks will benefit from Prime Minister Shinzo Abe's unprecedented stimulus efforts. Central Japan Rail, for example, operates the bullet train from Tokyo to Osaka and owns a lot of retail real estate along the route. Earnings are rising as traffic increases and travelers spring for highly profitable first-class seats to avoid the crowding in steerage.