Investing in competitive advantage

Finding strong companies and suitable stocks in a time of market turmoil

June 2009

Edward A. "Ned" Gray, CFA
Senior Vice President
Senior Portfolio Manager
International value equity team

In the current environment, evidence of the economic weakness around us is difficult to avoid. As the number of transactions across the global economy shrinks corporate revenues, increasing costs put pressure on profit margins and net earnings.

The narrowing ratio of profits compared to interest on bonds and other debt, against a backdrop of tightening credit, constrains the options available to corporate management and further heightens the risks of investing in some company stocks. And though corporate difficulties are severe, we believe the market’s reaction might be called extreme.

The historic sell-off in global equity markets reflects not only an awareness of the severe current operating challenges the global slowdown has helped precipitate, but also a perception that these challenges will be harsh, enduring, and ubiquitous.

In our opinion, risk aversion is quite logical and appropriate under the current circumstances, but we believe investors would be prudent to ask whether the universal revulsion currently in evidence is both fully and uniformly justified. Is there opportunity in this adversity, and if so, opportunity for whom? As long-term investors seeking value in strong operating companies with stock prices that inadequately reflect their strengths, we feel one of the most appropriate places to seek this opportunity are at the level of the companies themselves.

What key objectives are these companies most keen to achieve? What traps are they most intent on avoiding? In other words, what key competitive advantages will strong companies pursue in an effort to ride out the cycle and work to enhance their strengths while planning to emerge stronger on the other side?

For what kind of company does an economic downturn present a catalyst for improvement? We believe that some key distinguishing characteristics involve both a building of strength and an avoidance of weakness. Further, these qualities should be in place long before the first cracks in the market appear.

Preparation — Companies that can capitalize on a downturn and act from a position of strength, based on a range of alternatives and flexibility, may be those that are well prepared. The qualities that create a competitive advantage include:

• Having sturdy barriers to entry (into the industry).
• Having a focused, long-term strategy — an internal compass.
• Being a low-cost producer.
• Having geographic spread — diversification of risk, and the ability to extend local advantages and minimize isolated exposures.
• Maintaining perspective downstream (that is, closer to the point of sale than to production or manufacturing of products) and thus knowing when and how customers are exposed.
• Maintaining perspective over time — having the courage to invest at the economic cycle bottom and show restraint at the top.

Execution — Good preparation tends to enable strong management to execute on opportunities that could present themselves, but what kinds of opportunities emerge in a downturn?

• Strengthening market share — taking advantage of the tightening constraints under which competitors must operate.
• Exercising flexibility in managing costs — controlling costs internally, negotiating advantageously with suppliers and customers.
• Consolidating a base of productive assets — paring noncompetitive segments and acquiring good assets at a discount to replacement cost.
• Maintaining strong generation of free cash flow.

Valuation — The preceding comments outline an analytically challenging but conceptually straightforward approach to assessing prospects for companies' success in a difficult economy. For investors, we believe that an important assessment is valuation, and that real opportunity for outperformance does not necessarily reside in “quality” companies per se, because quality has generally been recognized and incorporated into the stock price. In our opinion, opportunity resides in companies where quality goes unnoticed or where offsetting risks are exaggerated.

In heightening the market’s neglect of certain corporate characteristics and its exaggeration of certain risks, a downturn may enhance the competitive advantage for investors with the perception to distinguish them. The rationale for expecting this pattern to prevail rests on the very severity of the downturn itself. The unanimity of negative sentiment, the universal recognition of the depth of the downturn in historic context, and the ready thematic application of lowered economic expectations across entire sectors and industries have all contributed to the risk imputed in current stock prices.

Against this wave of bearishness, the subtleties of competitive advantage may put up relatively faint resistance, at least in the short term, and investments in good companies may be sold off along with those in bad companies. We believe that investing in companies at the depths of the cycle, though, can prove very successful over time because competitive advantage tends to be manifested in stronger, more resilient earnings and eventual re-rating by the market.

Important notes about risk

Investing involves risk, including the possible loss of principal.

International investments are subject to risks not ordinarily associated with U.S. investments including capital loss from unfavorable fluctuation in currency values, differences in generally accepted accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Diversification may not protect against market risk.

Have your clients carefully consider the Funds’ investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses, which may be obtained by clicking here or calling 800 523-1918. Investors should read the prospectus carefully before investing.

*Not FDIC insured     *No bank guarantee     *May lose value  

MF-05-04-09 COMPADV(4488)

The views expressed represent the investment Manager’s assessment of the market environment as of May 2009 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.