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Europe: In defense of contrarian trades
Portfolio management team
Joe Joseph leads a team of veteran investors responsible for day-to-day management of the fund.
Key takeaways •European stocks demonstrated strength despite deep economic concerns and continued financial turmoil in the region. •U.S. small- and mid-cap stocks appear to be generally overvalued relative to their European counterparts. •The possibilities of a worsening situation with China’s slowdown have grown, suggesting near-term caution with respect to companies with high levels of exposure to China. How would you characterize sector strengths and weaknesses over the past three months? Heading into the summer, many investors anticipated market weakness, not unlike the summer of 2011. There was much to be concerned about with respect to Europe’s debt and the United States’ looming fiscal challenges — and these concerns are still on the table — yet European and U.S. markets performed well despite the prevailing negative sentiment. A number of cyclical sectors posted strong results, including consumer discretionary stocks, metals and mining stocks, and energy stocks. This third-quarter rally reminded investors that unanticipated strength in European stocks could still make itself felt despite substantial macroeconomic concerns. The general outlook was indeed negative close to the start of the quarter, but when we stepped back and looked at the markets, we saw what we considered excellent bargains. The market eventually adopted this perspective once more positive economic news emerged, including the announcement of the ECB’s latest pledge to lend support to struggling sovereigns, and so European markets rallied. In the meantime, China began to slow even more than expected, which poses a risk for Europe and the global economy. While there could be a recovery in China, the country has some significant structural issues that imply at least short-term bumps in the road, which makes us cautious in the near term about investing in certain international stocks that are particularly leveraged to the country’s growth.
Joseph P. Joseph (industry since 1987)
Randy J. Farina, CFA (industry since 1995)
John McLanahan, CFA (industry since 1996)
PUTNAM INVESTM ENTS | putnam.com
Q3 2012 | Europe: In defense of contrarian trades
Where are you finding the most attractive valuation trends? Today, non-U.S. small- and mid-cap stocks are available at compelling valuations, especially when we compare them with their U.S. counterparts. In the United States, where interest rates are extremely low, investors are searching for yield. This has caused dividend-paying stocks to trade at relatively high valuations. U.S. companies are generally in good health, but the economic outlook is not sufficiently robust, in our opinion, to support the valuation differential relative to non-U.S. small- and mid-cap equities. In the face of the more obvious, if overplayed, problems in Europe, and perhaps more warranted concerns relative to Japan, non-U.S. stocks are trading at about 10x forward earnings, which is close to their all-time valuation lows. We maintain our underweight to the two most defensive sectors in the benchmark — consumer staples and utilities — which we consider to be too expensive relative to more cyclical stocks. Consequently, we maintain benchmark-relative overweight positions in more offensive, cyclical sectors, including technology and consumer discretionary stocks. We remain mindful of several key risks, as well, including the potential for continued economic deterioration in China and further deterioration in the financial health of European governments. As investors focused on company valuations, how do you react to periods of high volatility? We tend to think about volatility in terms of fear and greed, and we believe that extremely volatile periods like we saw last year and in the second quarter of this year tend to be of relatively short duration. When fear overwhelms investors, we may seek to take contrarian positions — as we did with our European exposures heading into the third quarter — particularly if we are convinced such positions are supported by company valuations.
If we assume the U.S. recovery continues on an upward trajectory, how would that impact international small and midsize companies? It would carry important benefits for international small and mid caps. In Europe, for example, many companies capture about a third of their revenue from other countries, including the United States. The impact of a clear U.S. recovery would be even broader, of course, due to globalization factors, and would thus likely have profound effects on Japan, China, and a wide range of emerging-market countries. Why active management for international small-/mid-cap investing? If a sector in an international small-/mid-cap index performs particularly well, it may come, in fairly short order, to represent a very large portion of the index on a capitalization-weighted basis. But from a valuation standpoint, that sector may not represent the best value opportunity if you posit a one-, three-, or five-year investment horizon. In other words, there are times when momentum can push a sector above a reasonable valuation; an active manager might choose to underweight the sector, in that case, whereas a passive manager would be required to mirror the sector’s proportional index weight. This can be generalized to U.S. stocks as well. In the United States, real estate investment trusts (REITs) form a large part of some small-/mid-cap indexes, but we believe REITs are highly overvalued in the wake of investors’ recent flight to dividend-paying stocks. A dividend doesn’t guarantee safety. And if the U.S. economy were to improve in the next six to nine months or if interest rates were to rise, we would expect dividend payers like REITs to be at risk of experiencing a correction. As active managers, we would de-emphasize or avoid REITs in our portfolio today for precisely this reason.
Q3 2012 | Europe: In defense of contrarian trades
Putnam International Capital Opportunities Fund (PNVAX)
Annualized total return performance as of September 30, 2012 Class A shares (inception 12/28/95)
Last quarter 1 year 3 years 5 years 10 years Life of fund Total expense ratio: 1.47%
Before sales charge
9.34% 17.65 3.15 -3.93 11.22 10.28
After sales charge
3.05% 10.88 1.14 -5.07 10.56 9.89
S&P Developed Ex-U.S. SmallCap Index
8.33% 14.06 5.67 -3.17 12.04 6.39
Quarterly returns are cumulative. Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or a loss when you sell your shares. Performance of class A shares before sales charge assumes reinvestment of distributions and does not account for taxes. After-salescharge returns reflect a maximum 5.75% load. A short-term trading fee of 1% may apply to redemptions or exchanges from certain funds within the time period specified in the fund’s prospectus. The fund’s expense ratio is taken from the most recent prospectus and is subject to change. To obtain the most recent month-end performance, visit putnam.com. The S&P Developed Ex-U.S. SmallCap Index is an unmanaged index of small-cap stocks from developed countries, excluding the United States. You cannot invest directly in an index.
The views and opinions expressed are those of the portfolio managers as of September 30, 2012. They are subject to change with market conditions and are not meant as investment advice. Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. Investments in small and/or midsize companies increase the risk of greater price fluctuations. The use of derivatives involves additional risks, such as the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. The prices of stocks in the fund’s portfolio may fall or fail to rise over extended periods of time for a variety of reasons, including both general financial market conditions and factors related to a specific issuer or industry. Request a prospectus or summary prospectus from your financial representative or by calling 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
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