Putnam's David King shops for bargains among tarnished growth stocks.
With the once yawning valuation chasm between value
and growth stocks now narrowed to a mere fissure, the question for
investors is whether there is really such a thing as a true bargain in
the stock market any more. In March 2000, the growth component of the
S&P 500 Index had a price earnings ratio of 48, while the value
segment was priced at just 22 times earnings. Today, growth and value
stocks in the index sport price-earnings ratios of 21.5 and 15.4,
respectively. Energy stocks that once peppered the portfolios of value
managers have become too expensive for some of them, while health care
stocks they once shunned now turn up regularly on their investment
The crossover comes after five years in which the quest for value has spanned across companies both large and small. The S&P 500 Barra/Growth Index plunged an average of 8.16% annually over the five years ending March 31, compared with an increase of nearly 2% a year for the S&P 500 Barra Value Index. The S&P MidCap 400/Barra Growth Index eked out a .36% annualized gain, while the value component of the index had a return of 14% a year over the same period. The S&P SmallCap 600/Barra Growth Index rose 5% a year, compared to nearly 14% for the S&P SmallCap 600/Barra Value Index.
David King, the 48-year-old manager of Putnam New Value Fund, says that despite their multiyear run there is still plenty of value left in value stocks. But he's looking for it in different places than he used to, and keeping upside expectations in line with the richer valuations of traditional value stocks in today's market.
"We're no longer running into estimated upside to fair value of 100%, which is what we saw with a number of financial stocks in 2000. In some cases the stocks we're buying sell at 15% to 20% below our estimate fair value. In others, the discount might be as much as 50% to 60%." The latter group, he says, consists mainly of larger, financially strong insurance, health care and airline companies that have fallen out of favor.
The kind of stock that shows up on his investment radar also has changed. "Three or four years ago, we looked at a lot of mid-cap names," he says. "Now, we're finding better value in much larger companies."
To qualify for inclusion in the portfolio, a company must be in business for at least ten years and have at least $1 billion in trailing 12-month revenue. It also must be cheap compared with other stocks, based on traditional measures such as price to book, price to sales and price to earnings ratios. The fund is concentrated in about 70 names, with the top 20 stocks often accounting for about half of assets.
At the beginning of last year the portfolio had a weighted average market capitalization below that of King's investment universe, which resembles the Russell 3000 Value Index. With new buying focused on larger companies, the portfolio's weighted average market cap now exceeds it.
King insists that the move toward larger, better-quality companies is more a matter of adjusting to market conditions than changing stripes. "One of the main tenets of value investing is that you take what the market gives you. In another environment, we would not be unhappy with owning smaller, lower-quality companies. But that is not the environment we are in now."
He points out that the line between value and growth stocks is constantly shifting, and that the market's seeming preference for one or the other rests on just a couple of sectors. "The strong performance of energy stocks is a large part of the reason that value has beaten growth recently. If technology does well, then growth will be seen as dominant." As for the widely held prediction that growth will outpace value in the years to come, he says, "There is some indication that on a valuation basis, we could see a rotation to growth in the future. But I don't think style variation will be as dramatic as it was in 1999. And I'd be surprised if the difference between the two in terms of performance is extreme."
Temporary Price Dislocations
Recent purchases include a number of larger companies with attractive earnings potential, which have moved into value space because of negative news and the "temporary price dislocations" it brings. Names in this category include some former darlings of the growth camp such as Pfizer, Home Depot and Intel. Two of the fund's best performers last year were Walt Disney and McDonald's, which King began buying about two years ago. "There's a lot of skepticism and negative chatter around the stocks we buy," says King.
That was certainly the case with Tyco International, one of the fund's top holdings and one of its better performers in 2004. King began purchasing the stock in 2002 after the company's CEO was indicted. He kept buying it on the way down after "dramatic market overreaction" to the barrage of negative revelations about lavish corporate spending. The fund paid an average of $17 a share for the stock, which now sells at around twice that level.
In a similar show of resolve, King held on to the fund's stake in Providian Financial in 2001, even after a struggling economy decimated its subprime lending portfolio and the company's stock became the second-worst performer on the New York Stock Exchange that year. Since then the lender has shored up the quality of its customer base, and the stock has recovered to about $17 a share.
More recently, a number of well-publicized events helped cloud the outlook for some companies in the financial sector and brought their stocks down to cheaper levels. Despite the storm clouds swirling around them about their accounting practices, King has been buying shares of Fannie Mae and Freddie Mac over the last year. He admits he has lost some money doing so, but believes that the market has overreacted to their problems. "Two or three years from now," he maintains, "those stocks will be higher than they are today."
Late last year, New York Attorney General Eliot Spitzer's investigations into several insurance and financial services companies (including Putnam's parent company, Marsh & McLennan) raised concerns about the entire sector. Amid the controversy, King scooped up shares of several property and casualty insurers such as Hartford Financial, Chubb Corporation, Ace Limited and XL Capital. He added the latter two companies late last year when their incorporation in Bermuda raised concerns about a lack of regulatory scrutiny and sent their stocks tumbling. Hartford and Chubb made their initial appearance in the portfolio late last fall after the two stocks had fallen victim to fallout from the Spitzer investigation.
King calls the downturn "an isolated incident that doesn't have permanent implications." The industry continues to provide a fertile hunting ground for fallen growth stocks. A common growth fund holding, insurance giant American International Group, recently tumbled into King's universe of value stocks after revelations about accounting irregularities at the company.
At its recent price of $27 a share, pharmaceutical giant Pfizer, another fallen growth stock, sells at a discount to King's estimated fair value in the mid-to-high 30s. Aside from the stock's attractive valuation, he's also drawn to its dividend yield of more than 3%. It now accounts for about 2% of fund assets. Unlike many fund managers, he points out, he does not own Merck. "There are a lot of patent expiration issues with this company," he notes. "Not owning it last year was probably one of the best moves we made."
He is also sidestepping regional banking stocks, an area he once targeted aggressively, because he thinks they've become overpriced. Despite an increase in the number of bank mergers, he says, "recent acquisitions have not been completed at very large premiums. The market's positive overreaction to mergers has been particularly evident among smaller banks." He's finding better value among megabanks like Citigroup, the fund's largest holding.
King has fairly modest expectations for the energy sector, the major driver behind the surge in value stocks last year. "I don't think oil prices will go up dramatically at this point," he says. "We've reached a new plateau. We could see some moderate upside for energy stocks, but from here on it won't be earth shaking."