You can’t rely on indexes to pick international stocks, this 5-star fund manager

By Philip van Doorn

Krishna Mohanraj of Diamond Hill Capital Management says investors should focus on quality, rather than regional or sector approaches take by stock indexes

You have probably seen coverage of a renewed interest in Japanese stocks among well-known investors, including Berkshire Hathaway (BRKA) CEO Warren Buffett. But Krishna Mohanraj, who runs a highly rated international fund for Diamond Hill Capital Management, prefers a company-specific approach over a geographic focus.

He is the portfolio manager of the Diamond Hill International Fund , which was established at the end of 2016 as a limited partnership, before being converted to a mutual fund with shares available to the public in June 2019. It has a five-star rating (the highest) within Morningstar’s “Foreign Large Blend” category.

Mohanraj discussed his approach to stock selection and how investors can be underserved when riding along with the allocation of international indexes. Three of his top picks are below.

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Here’s a three-year chart showing how the fund has performed relative to its benchmark, the MSCI ACWI ex USA Index, in U.S. dollars:

The total returns include reinvested dividends. The Diamond Hill International Fund’s return is net of expenses, which are 0.74% of assets under management annually for its institutional share class.

Diamond Hill Capital Management is based in Columbus, Ohio. Mohanranj works out of Dallas and is the sole manager of the Diamond Hill International Fund, working with a team of four analysts.

It is the nature of the mutual fund business in the U.S. to divide the world into U.S. and non-U.S. stocks, and funds need to have benchmark indexes for performance measurement. But Mohanraj doesn’t like the typical broad international index approach. During an interview, he paraphrased Warren Buffett: “There are so many bad businesses out there.” A broad international index, such as his fund’s benchmark, includes regional and sector allocation targets that have to be maintained.

He also objects to the typical approach in stock indexes tracking emerging markets, because companies “get lumped into a bucket.” Economies such as South Korea, Taiwan, Peru and Columbia aren’t comparable, he said.

“For us, international investing has to be selective,” which means a focus on individual companies rather than industries or countries, he said. Then again, regional considerations play a role: “There are spaces where we know where we would never invest — Chinese banks and real-estate companies and some Japanese banks.”

The Diamond Hill International Fund has a high active share relative to the index — 91% as of March 30. Active share is a measurement of how differentiated a fund’s portfolio is from that of an index. Index funds that passively track benchmarks can have low expenses. But if you are paying more for active management, you should expect fund managers to provide investment exposure to companies they favor, free of index allocation considerations.

Moharanj also said that the Diamond Hill International Fund’s annual turnover is about 20%, which is a low figure. He said the high active share reflected his investing preference to target good businesses trading at “cheap” valuations.

Three examples

The Diamond Hill International Fund typically holds between 45 and 55 stocks. Mohanraj named two companies in Japan, and one in India, as examples:

Nintendo

Executives at Nintendo Co. Ltd. may be surprised at the success of “The Super Mario Bros. Movie,” with global sales topping $1 billion in April. Scoring such a hit underlines the strength of the videogame maker’s brands that were developed in-house, and the movie’s “value for the franchise translate across ages,” according to Mohanraj.

But what he really likes about Nintendo is that net of cash, the company’s shares trade in the “low single digits” relative to expected profits over the next 12 months.

The Nintendo Switch console gaming system hit the market in 2017, so gamers are looking ahead to the next generation of equipment. About 25% of Nintendo’s balance sheet is cash, Mohanraj said, because the company is gearing up “to invest at the bottom of the cycle.”

Over the years, when Nintendo has introduced new gaming platforms, there has always been risk that the next console won’t be a hit with gamers. “There is operating leverage when it works, because sales go through the roof. First-party game sales have a high margin,” he said.

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