Beating the Street (12 page)

Many closed-end funds are more popularly known as country funds. These enable us to invest in our favorite countries, a more romantic prospect than investing in companies. After a nice bottle of wine in the piazza near the Trevi Fountain, who but the most coldhearted lout wouldn't want to invest in the Italy Fund? Here's a tip for the marketing department: attach 800 numbers for country funds to the telephones in the major foreign hotels.

There are at least 75 country funds and/or region funds in existence today. With the breakup of the communist bloc, this number is sure to grow. Two Cuba funds are being launched in Miami, in anticipation of the restoration of capitalism to Havana, and Castro hasn't even packed his bags.

The best argument for country funds as long-term investments is that foreign economies are growing faster than the U.S. version, which causes their stock markets to advance at a faster pace than ours. In the last decade, this certainly has been the case. Even in Magellan, my ratio of winners to losers was higher in foreign stocks than in the made-in-the-U.S.A. stocks.

But to succeed in a country fund you have to have patience and a contrarian's bent. Country funds arouse a desire for instant gratification. They can be traps for weekend thinkers. A good example is the Germany Fund, and its offshoot the New Germany Fund, both of which were conceived as the Berlin Wall was coming down, and Germans from both sides were hugging each other in the streets, with the rest of the world cheering them on. The great German renaissance was about to begin.

Behind the Wall, as an emotional backdrop, you had the magical reunification of Europe. By the appointed witching hour in 1992, centuries of animosity were supposed to disappear overnight: the French would kiss and make up with the Germans and the English would kiss and make up with the Germans and the French, the Italians would give up their lire and the Dutch their guilders for a common currency, and unity, peace, and prosperity would prevail. Personally, I found it much easier to believe in the turnaround in Pier 1 Imports.

As triumphant Berliners danced on the rubble of the Wall, the price of the two Germany funds was bid up to 25 percent above the value of the underlying stocks. These funds were going up 2 points a day on nothing but a wing and a prayer for an economic boom. The same overblown expectations now exist for the merger of North and South Korea, which I predict will come to a similar short-term end.

Six months later, when investors finally noticed the problems in this great German renaissance, euphoria turned to despair and the Germany funds quickly sold off at a 20–25 percent discount to the value of the underlying stocks. They've been selling at a discount ever since.

Meanwhile, in 1991, when people were still euphoric about German prospects, the stock market there did poorly, whereas in the first half of 1992, when the news from Germany was all gloomy, the stock market did well. It's hard enough to fathom these developments at home, much less from abroad.

Clearly, the best time to buy a country fund is when it is unpopular and you can get it for a 20–25 percent discount. Sooner or later, Germany will have its renaissance, and patient investors who bought the Germany funds on the dips will be glad they did.

There are many drawbacks to the country funds. Fees and expenses are generally quite high. It's not enough that the companies in which the fund has invested have done well. The currency of the country in question has to remain strong relative to the dollar, otherwise your gains will all be lost in translation. The government can't ruin the party with extra taxes or regulations that hurt business. The manager of the country fund has to do his or her homework.

Just who is that manager? Is it someone who once visited this country and has a travel poster to prove it, or someone who has lived and worked there, has contacts in the major companies, and can follow their stories?

I'd like to add my two cents to the U.S.-versus-the-world debate. These days, it's fashionable to believe that foreign-made anything is superior to the domestic version: the Germans are more efficient and make the best cars, the Japanese work harder and make the best TVs, the French are more fun-loving and make the best bread, the Singaporeans are better educated and make the best disk drives, etc. From all my trips abroad, I've concluded that the U.S. still has the best companies and the best system for investing in them.

Europe is filled with big conglomerates that are the equivalent to our blue chips, but Europe lacks the number of growth companies that we have. Those that do exist tend to be overpriced. There was L'Oréal, a French cosmetics company that Carolyn discovered in her fundamental analysis at the perfume counter. I liked the stock, but not at 50 times earnings.

I'm certain that hundreds of U.S. companies have increased their earnings 20 years in a row. In Europe, I'd be hard-pressed to find even 10. Even the European blue chips have no record of the sustained earnings that are commonplace here.

Information about foreign companies is sketchy and often misleading. Only in Britain is there a semblance of the careful coverage
that companies get on Wall Street. On the Continent, securities analyst is an obscure profession. In Sweden there is scarcely an analyst in sight. The only one that I could find had never visited Volvo, a company with the clout of a General Motors or an IBM.

Earnings estimates can be quite imaginative. We chide U.S. analysts for being wrong much of the time, but compared to European analysts, they are nearly infallible. In France, I read an upbeat analyst's report on a conglomerate called Matra. Filled with joyous expectations, I visited the company. A spokesman there reviewed the prospects for each division. The news was mostly bad: ruinous competition in one division, an unexpected write-off in another, a labor strike in a third, etc. “This doesn't sound like the same company I've been reading about, that's going to double its earnings this year,” I remarked. He sort of stared at me.

If you do your own research in Europe, you can turn the poor coverage to your advantage, for instance by discovering that Volvo was selling for the same price as the cash in its vault. That's why I was able to do so well with foreign stocks in Magellan. In the U.S., what makes stockpicking difficult is that 1,000 people smarter than you are studying the same stocks you are. It's not that way in France, or Switzerland, or Sweden. There all the smart people are studying Virgil and Nietzsche, instead of Volvo and Nestlé.

What about the Japanese, those champions of capitalism and overtime at the office, owners of Rockefeller Center and Columbia Pictures, and soon to be owners of the Seattle Mariners and maybe the Washington Monument after that? If you had come along on one of my research trips to Japan, you would have realized that this whole business of Japanese superiority was malarkey from the start.

Japan is the richest country in the universe where the people have trouble making ends meet. The Japanese admire us Americans for our closet space, our low prices, and our weekend homes. An apple costs them $5, and dinner costs them $100, and it's not even much of a dinner. They cram themselves into subway cars, and after an hour and a half they still haven't left greater Tokyo, which is bigger than Rhode Island. Along the way, they dream about moving to Hawaii, where they might get something for their money, but they have to stay in Japan and dedicate themselves to paying the mortgage on their $1 million, 1,000-square-foot hutch; if they sold the hutch, they'd have to move into another $1 million hutch, or else rent a $15,000-a-month apartment.

The Japanese predicament reminds me of the story about the man who brags about having once owned a $1 million dog, and you ask him how he knew it was $1 million dog and he says because he traded it for two $500,000 cats. Maybe the Japanese do have some $500,000 cats to go along with their $500,000 golf club memberships, and until recently they could have traded these for a few $100,000 stocks.

The advertising slogan “When E. F. Hutton Talks, People Listen” would have been an understatement in Japan. There, the slogan would have been “When Nomura Securities Commands, People Obey.” Brokers were entirely trusted, and their advice was taken as gospel. The Japanese bought $500,000 cats on cue.

The result was a wondrous market of stocks with p/e ratios of 50, 100, 200, which were so out of line with rational levels that bystanders began to theorize that the high Japanese p/e was a cultural trait. Actually, U.S. investors exhibited that same trait in the late 1960s, when our market was so overvalued that it took 22 years, until 1991, for the Dow Jones average, adjusted for inflation, to reach the all-time high it set in 1967.

The Japanese market has been subject to behind-the-scenes finagling to a degree unknown on Wall Street since the 1920s. Large investors in Japan had a money-back guarantee from the brokerage firms—when they lost money, the brokers paid them back. If only Merrill Lynch and Smith Barney would be so accommodating, it would put some confidence back into
our
stocks.

I got a hint that Japan was a finagled market on my first visit, in 1986. The trip was arranged through the Fidelity office in Tokyo, which employed 80 people. In his book
The Money Game
, Adam Smith wrote a chapter on Fidelity's founder, the industrious Mr. Johnson. Ever since it was published in Japanese, Fidelity has been famous in Japan.

Nevertheless, it took many letters and phone calls before a series of meetings could be arranged between me and some Japanese companies. I got the annual reports in advance and had them translated into English, and wrote out my questions. I used the same technique I follow at home, warming up with polite banter, peppering my questions with facts to show that I cared enough to do the homework.

Japanese firms are very formal and the meetings were ceremonial in nature, with a lot of bowing and coffee tippling. At one company, I asked a question about capital spending, which took about 15 seconds in English, but the translator took five minutes to relay it
to the Japanese expert, who then took another seven minutes to answer in Japanese, and what finally came back to me in English was “One hundred and five million yen.” This is a very flowery language.

At a later interview with one of the best-known brokers in the country, I got a hint of the extent to which Japanese stock prices are controlled. He was describing his favorite stock—I don't remember what the name was—and he kept referring to a number—something like 100,000 yen. I wasn't sure if he was talking about sales, earnings, or what, so I asked for clarification. It turned out he was picking the stock price 12 months hence. A year later, I checked, and he was exactly right.

Japan was a nightmare for a fundamental analyst. I saw example after example of companies with bad balance sheets and spotty earnings, and overpriced stocks with wacky p/e ratios, including the company that launched the biggest public offering in financial history: Nippon Telephone.

When a telephone company is privatized, I normally can't wait to buy it (see
Chapter 17
), but Sushi Bell was the exception. This was not a fast grower in an underdeveloped country with a hunger for a handset. This was a regulated Japanese utility in its mature phase, something like the old Ma Bell before it was split up, which could be expected to grow at 6 or 7 percent a year, but not double digits.

The initial offering was sold out in 1987 at a price of 1.1 million yen per share. I thought this was a crazy price then, and in the aftermarket the price nearly tripled. At this point, Nippon Telephone was selling for something like 3,000 times earnings. It had a market value of $350 billion, more than the entire German stock market and more than the top 100 companies in our
Fortune
500.

On this deal, not only did the emperor have no clothes, but the people lost their shirts. After the Great Correction, the Japanese government was able to foist more overpriced Nippon on the Japanese public via two additional offerings: one for 2.55 million yen a share and the next for 1.9 million yen a share. It's been all downhill since. As of this writing, a share of Nippon sells for 575,000 yen, an 85 percent discount from the 1987 discounted price. For investors on Wall Street to lose a similar amount, the entire
Fortune
100 list of companies would have to be wiped out.

Even at 575,000 yen per share, Nippon's market value exceeds that of Philip Morris, the largest company in the U.S. with 30 straight
years of increased earnings. After all its losses, Nippon is still overpriced at 50 times earnings.

Japanese investors, we hear, paid little heed to earnings and focused their attention on cash flow—perhaps due to a shortage of the former. Companies that spend money like drunken sailors, especially on acquisitions and real estate, are left with a huge depreciation allowance and a lot of debts to pay off, which gives them a high cash flow/low earnings profile.

Students of the Japanese market will tell you that the Japanese fondness for cash flow is another cultural trait, but there's nothing cultural about red ink. Red ink is the problem facing Japanese banks that lent money to all the purchasers of the $1 million dogs and the $500,000 cats.

Speculation plays a much larger role in the Japanese economy than in the U.S. economy. Merrill Lynch in its best years never appeared among the top 100 U.S. companies in the
Fortune
500, but at one point, 5 of the top 25 companies in Japan were brokerage houses, and another 5 to 10 were banks.

U.S. banks are criticized for making stupid loans to the Reichmanns and the Trumps, but even the dumbest of these real-estate loans were backed by some sort of collateral. Japanese banks were making 100 percent loans on zero collateral for office buildings where in the most optimistic scenario the rents would barely cover the expenses.

Until the recent sell-off, the only bargains in Japanese stocks were small companies that in my opinion are the key to Japan's future growth and prosperity, just as they are in the U.S. Small Japanese companies were ignored in the early stages of the great stock mania, and I concentrated my purchases there. When these small stocks reached the same crazy prices as the rest, I got out. All things considered, I'd rather be invested in a solid emerging-growth stock mutual fund in the good old U.S.A.