When he talks about the current state of the stock market, William Fries sounds like a teacher discussing a child's bad behavior with a concerned parent. "I wouldn't call this a 'bad market,' but I would say it's disappointing," says the long-time manager of the $2.2 billion Thornburg Value Fund, who was named Morningstar's international equity fund manager of the year in 2003. "When a company's fundamentals are solid, it's reasonable to expect that its stock will do well. But that hasn't been the case."
The performance of fund holdings in the financial services sector, which account for roughly one-quarter of assets, illustrates his point. Bank of New York has about $7 trillion in assets under administration worldwide, with $2 billion of that outside the United States. Securities servicing, private client services and financial markets services make up about three-fourths of the company's earnings, with more traditional corporate and retail banking activities accounting for the rest. Despite a business focus that is not heavily influenced by the direction of interest rates, the bank's stock dropped from about $35 in January to around $28 in August, largely because of investor concerns about rising interest rates.
Fund holding Lowe's Companies also has suffered this year because investors think rising interest rates could negatively impact the construction industry, as well as the bottom line of the country's second-largest retail home improvement store. Fries believes those concerns are overblown. "The housing market will be surprisingly resilient, and the Fed is going to keep interest rates under control," he says. "A ten-year bond with a 4.5% yield is not enough to curtail housing spending, and short-term rates are still low." He believes the company's modest valuation and its successful expansion from rural areas to more profitable suburban locations add to the company's appeal.
Still other companies in the portfolio have languished simply because investors have been slow to recognize their value, says Fries. Target Corp., the second-largest general merchandise retailer in the country, has succeeded in differentiating itself from its biggest competitor, Wal-Mart, by being a more upscale discounter and carrying higher-quality brands such as Mossimo and Isaac Mizrahi. It also has shed problem subsidiary Dayton-Hudson. Yet the stock sells at a steep discount to Wal-Mart. Health care and pharmaceutical stocks, which recently accounted for a total of 14% of assets, also have disappointed this year because of investor concerns about pricing controls.
To Fries, such disappointments have a silver lining. Based on forward earnings estimates, he pegs valuations of equities in the portfolio at "average or below average." Based on estimated 2004 earnings, the weighted average price earnings ratio of the portfolio is about 17. Other measures, such as price-to-book value, price to sales, and price-to-cash flow also stand below the market average, while projected earnings growth is slightly higher.
And while some stocks have fallen victim to market malaise, others have helped the fund minimize its losses so far this year. Stock of Alltel Corp., the seventh-largest wireless service provider in the United States, is up over 14% so far this year. Greeting card maker American Greetings has seen its stock rise from $17 a share to $24 a share over the last year. Other recent successes include Exxon Mobil, insurance holding company Aon and Lincoln Financial.
Despite some recent setbacks, Thornburg Value's winners have far outpaced its losers since its inception in 1995, when Fries left his job as a vice president at USAA Investment Management Co. to become a portfolio manager out of Thornburg's Santa Fe, N.M., headquarters.
Fries also manages the $1.25 billion Thornburg International Value Fund, which was launched three years later after he became cramped by the geographic restrictions of the domestic offering. That fund has landed in its Morningstar category's top decile in every year since it was launched in 1998. In 2003, its exceptional performance helped Fries earn Morningstar's Fund Manager of the Year in the international category, and added his name to a short list of investment managers whose investment process has proven effective both in this country and abroad.
Thornburg Value also has maintained its pace under a variety of market conditions. "Performance has thus far been exceptional," notes Morningstar Langdon Healy in a recent analyst's report on the domestic fund. "Since its late-1995 inception, the fund has crushed the S&P 500 Index as well as its average large blend rival. Meanwhile, the fund has been no more volatile than the bogey."
On the downside, Healy notes that an expense ratio of 1.43% is "a high hurdle for a large-cap fund to overcome relative to cheaper index offerings." And a smattering of foreign and small stocks may make it questionable for investors seeking a pure large-cap domestic offering.
Indeed, Thornburg Value's portfolio construction is unique. The portfolio holds only about 45 stocks. And while many are blue-chip household names others, such as Internet ad agency DoubleClick and FTI Consulting, are a rare sight in a value fund.
The eclectic mix comes from Fries' broad definition of value. He divides the portfolio into three categories. The first, Basic Value, conforms to the traditional value mold with characteristics such as low price-to-book and price-earnings ratios. They tend to be sensitive to economic cycles, and Fries tries to buy them when they are out of favor. Stocks in this group include Bank of New York, Smurfit Stone Container and Deere & Co.
A recent addition to the Basic Value category is Exxon Mobil. "A little over a year ago, oil was selling at around $23 a barrel and most analysts thought that the company's earnings would be lower in 2004. Obviously that hasn't happened, and the stock's price still does not reflect future prospects for growth." Fries says Exxon Mobil also has the highest return on capital invested, the highest profit margins and the lowest finding and development costs among integrated oil companies.
The Consistent Earners category contains many dominant blue-chip names whose revenue streams are not subject to the same ups and downs as those in the cyclical group. "Earnings may not grow as much as the basic value group on a cyclical upturn, but a nominal growth rate of 10% to 12% over the long term is a reasonable expectation," says Fries. Names here include Pfizer, Citigroup, Colgate Palmolive and Federal National Mortgage Association.
The category also includes stocks not normally associated with earnings stalwarts, such as media holdings Comcast and DIRECTV Group. Comcast, the largest cable television system operator and the largest high-speed Internet provider in the United States, enjoys the benefit of recurrent revenue from cable system subscriptions, as well as growth from consumer migration toward high-speed Internet systems. DIRECTV, a Direct Broadcast Satellite (DBS) service provider that has more than 11 million subscribers, should benefit from a 30% ownership stake by Rupert Murdoch's News Corp. Fries says the revenue streams of the two companies have not been affected by increased competition, despite investor concerns.
Fries recently added Microsoft to the Consistent Earner group. "Microsoft is well-positioned for continued capital appreciation," he says. "It has strong leadership, it continues to gain market share and it has executed its business plans better than its competitors. And it has a great business model and a unique position of power with its Windows operating system."
The final group, Emerging Franchises, truly distinguishes this fund from most of its peers. It contains higher risk names such as E*Trade Financial, Fox Entertainment Group and Nextel, which have the potential to grow faster than the other two categories of stocks. "Some people think it's unusual to have these kinds of stocks in a value portfolio," says Fries. "But they can be considered value stocks because I buy them when they are out of favor. It's a unique opportunity when smaller companies in the portfolio can have larger-than-average gains over time."
The largest holding in this category, Nextel, is a leading provider of wireless services in the United States whose networks cover 197 of the top 200 markets domestically. It historically has had the lowest termination rate and the highest average monthly bills of the major wireless service providers.
Fries says that Thornburg Value maintains a ballpark 40/40/20 asset split between Basic Value, Consistent Earners and Emerging Franchises. But in the more recent choppy market environment, he has decreased the Emerging Franchise niche to 12% of fund assets and fattened up the Consistent Earner category.
Fries uses a similar strategy in the international fund, which has a concentrated portfolio of about 50 stocks. As of August, the fund maintained a 42/38/13 equity asset split between Basic Value, Consistent Earners and Emerging Franchises. The basic value category consists of stocks such as Samsung Electronics and Toyota Motor Corp. Tesco, a leading supermarket chain in the United Kingdom and the fund's largest holding, is a Consistent Earner.
Emerging markets such as Mexico, South Korea and India account for 24% of fund assets, a stake that makes its exposure to those markets among the highest in its Morningstar foreign-large-blend category peer group. That allocation, as well as its lower-than-average median market capitalization of $7.6 billion, also makes its portfolio more venturesome than most. Still, Fries has kept the fund beta over the last three years just slightly below that of the MSCI EAFE. Among established markets, the United Kingdom, Japan and Germany account for 19.72%, 16.65% and 11.05% of assets, respectively.
Regardless of the language a company's CEO speaks, Fries thinks investors will need to shed some of their uncertainty before many of the stocks in both funds can realize the potential he sees for them. "The stocks held in both portfolios enjoy sound business models and attractive valuations," he notes in his latest letter to shareholders. "Uncertainties of the moment with regard to economic growth, inflation, politics and terrorist violence have corralled investor enthusiasm. Over time, the value of our portfolio holdings will reflect earnings development, particularly when market psychology changes for the better."