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The Eclectic Art of Valuation

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By Lawrence C. Strauss

CHUCK DE LARDEMELLE AND CHARLES DE VAULX of International Value Advisers search far and wide for good investments. Their go-anywhere, eclectic approach, which spans various market-capitalization sizes, geographic regions and asset classes, has led to good results. Since its inception in October of 2008, the $4.5 billion IVA Worldwide /zigman2/quotes/200320416/realtime IVWAX -1.45% Fund (ticker: IVWAX) has generated an annualized return of 18.25%, versus 4.37% for its Morningstar category. They co-manage the fund, as well as the IVA International /zigman2/quotes/204165163/realtime IVIOX +1.25% Fund (IVIOX), and oversee about $7.5 billion. The duo has a lot of experience, having spent many years working for famed value investor Jean-Marie Eveillard at First Eagle Funds.

Messrs. de Vaulx, 48, and de Lardemelle, 37, have about 20% of their assets in cash. They see better growth in overseas markets and, to hedge the risk of inflation, have about a 6.5% stake in gold. Barron's interviewed them last week at their office in midtown Manhattan.

Barron's : Let's start with the big picture. How does the economy look to you?

De Vaulx : Investing, at least the way we do it, requires exercising a judgment call both on the economic outlook and on valuation. Often investors don't do too well because they focus maybe too much on the outlook and not enough on valuation. Our view is that the economic growth will be somewhat muted for many years in countries where there were such excesses in terms of consumption and household indebtedness -- whether it is the U.S., the U.K., Ireland, Eastern Europe or Spain. At the margin, there is a better outlook in countries that misbehaved less, including various emerging markets.

What about the U.S., specifically?

De Vaulx : In the long run, we believe economic growth will be muted. We don't necessarily believe in a double dip. But the GDP [gross domestic product] growth rate will decelerate, maybe to 2% or 2.5%. We see no evidence of small businesses being formed or of jobs being created, and we see taxes going up rather than down.

But didn't the most recent numbers show some job creation?

De Vaulx : Sure, but those levels of job creation are tiny compared to what they are in a typical V-shaped recovery. We aren't sure when the growth rate may decelerate. The federal government will create several hundreds of thousands of temporary jobs for the census. And there have probably been instances of companies cutting their costs too deeply, and they may have to do some rehiring. But by and large, the American psyche has changed, in that the willingness to spend is less. There is an eagerness to save more than there was three or four years ago. And, in any case, even if Americans wanted to go shopping again, we doubt banks will be eager to lend to them.

What about other parts of the world?

De Vaulx : Unfortunately, in places such as Germany, France and Switzerland, where households didn't misbehave, the economic growth prospects may be even more muted than they are here, because of the impact of what's going on in Greece, Spain, and Portugal. As long as these countries, and Italy as well, insist on staying part of the euro zone, they will all experience deflation. It also hurts France and Germany, both of which used to export a lot to those countries. Muted economic growth prospects means it is harder for corporate profits around the world to go up as much as they would have in a traditional V-shaped recovery.

How do valuations look?

De Vaulx : The markets have bounced back quite a bit over the past year, but that's nothing new. In the past, violent bear markets have typically been associated with huge rallies. My only concern is that in the U.S. specifically, the market did go up 70% or so from its lows a year ago. And yet when the lows were made at 666 on the S&P, the market wasn't dirt cheap. The market was trading at about 13 times on somewhat, but not totally, depressed earnings. The dividend yield was no higher than 2.7% at the time, and the balance sheets for REITs [real-estate investment trusts], banks and various companies were quite sloppy.

So in the U.S., based on a muted economic outlook, valuations today are more comforting than they were three or four years ago. Yet valuations aren't as comforting as they were a year ago. Returns on equities will be modest. More than ever, this is a stockpicker's market. Those returns may come with some volatility, which may be upsetting to some individual investors. But it would be good for us, as it makes it easier to buy low and sell higher when things go up and down like a yo-yo.

What about the investment outlook overseas?

De Vaulx : The good news is that valuation is more compelling overseas than it is in the U.S. In '08, most foreign stock markets fell a lot more than they did in the U.S. But most foreign markets, especially in local currency terms, didn't bounce back nearly as much as they did in the U.S.

Valuation is very compelling in Japan, for example. And with an economic outlook that is better in many emerging countries than in the U.S. for the next five to seven years, coupled with better valuations in most markets, we expect better returns from some of the foreign stocks we own. In fact, in our global fund we are underweight U.S. stocks right now.

Your holdings include high-yield bonds. High yield has had a spectacular run. Why keep those holdings in the portfolio?

De Vaulx : We have been net sellers of high-yield bonds. A year ago we had as much as 30% to 35% in high yield, versus around 15% today. The market has done so well, and we have had to sell quite a bit. The bad news is that the average yield to maturity of the high-yield bonds we still have left is only around 6½% to 6¾%, which barely qualifies as an equity-type return. We think of an equity-type return as more like 8%, 9% or 10%.

The good news, though, is that our bonds are very short term, mostly three to seven years. So, if inflation were to come back in two or three years, that won't hurt us. And we hold extremely high-quality high-yield bonds.

Do you have anything to add, Chuck?

/zigman2/quotes/200320416/realtime
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/zigman2/quotes/204165163/realtime
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