Oppenheimer Value Fund integrates "earnings power" into a value strategy.
After a multiyear stretch of market-beating performance, value stocks will need the backwind of an earnings catalyst to keep moving forward, Chris Leavy, manager of the Oppenheimer Value Fund, believes. "The major differentiator that causes value stocks to perform differently from each other is long-term earnings," he says. "Studies show that 89% of the performance differential between value stocks can be explained by three-year earnings power."
Leavy calls the three-year benchmark an "analytical
sweet spot because it is an under-researched area and Wall Street does
not generally project out that far." His definition of strong earnings
also defies traditional guidelines.
"The concept of 'earnings growth' has some connotations that get a bit confusing in the value space, where we often see earnings recovery situations," he says. "If a company earned $1 two years ago and we think it can earn $5 in a few years, saying that it has a growth rate of 500% is somewhat misleading." Instead, Leavy looks at how key drivers will affect earnings over the next few years, the right multiple based on earnings projections, and the upside of a particular idea compared to other value stocks in the same sector.
The fund's style-straddling strategy, which Leavy has used since he became its manager in 2000, merits attention in an environment where it may not be a bad idea for value investors to keep a foot in the growth door. According to a recent report by Oppenheimer senior investment officer Jerry Webman, "Growth stocks have provided middling returns as investors refuse to pay historical premiums for rapid earnings growth. As the economy begins to decelerate from unsustainably high levels of growth, investors will begin to pay premiums for true growth companies at a time when growth is scarce."
While Leavy's criteria often uncover stocks that
appear "growthier" than those held by most value funds, they often bear
little resemblance to traditional growth stocks. When he bought shares
of Aetna a few years ago, investors were staying away because the
insurer was losing market share in the managed care business. "Our view
was that Aetna's policy design made the company a magnate for sick
people and that a redesign would lead to better patient selection. So
even if the customer base became smaller, the company would become much
more profitable. And that would create a compelling earnings number
relative to the price of the stock."
A company need not be having problems to appear on Leavy's radar screen. "We're agnostic about why an opportunity presents itself," he says. "If it got there because of investor complacency rather than a specific problem, we're indifferent."
Fund holding United Technologies, which has businesses in elevators, air conditioning, aerospace, and other areas, is an often overlooked stock that compares well to other industrials, he says. While the company has a meaningful competitive advantage in a number of the markets it competes in, it also has room for margin improvement in some of its businesses. He cites United Technology's Otis Elevator division as one that has been gaining market share with innovative products, including an elevator that frees up space for leasing. Its servicing business should benefit from robust elevator equipment sales, he adds.
Leavy selects stocks within each sector of the benchmark Russell 1000 Value Index that are inexpensive and have superior long-term earnings and cash flow potential. He doesn't make big macroeconomic bets through wide sector deviations. Typically, the fund's portfolio stays within 10% of its benchmark weighting. So, for example, if the index has a 12% sector weighting, it will have from 2% to 22% of its assets in that sector.
The biggest shot at outperformance comes from selecting what he considers the best stocks in each sector. The fund focuses its bets on a narrow band of 40 to 50 holdings, less than half the number for the average stock fund, with the top ten slots often accounting for about 45% of fund assets.
"Stocks within the same sector can perform very differently from each other," he says. "Most stocks in a sector will move in one direction, but there will be one or two that move a lot more." In the consumer staples area, for example, fund holding Altria has forged ahead in recent years while other stocks in the sector have turned in a tepid performance.
While the fund's portfolio valuations are about in line with it category peers the growth rates of its stocks, as well as its volatility, are generally higher. "However, that moderate volatility seems to us a small price to pay for the fund's excellent performance under the current manager," notes Morningstar analyst David Kathman. "The past five years have seen whiplash-inducing ups and downs in the market, so this fund's consistently good results are all the more impressive." However, warns Kathman, "the fund's recent hop into large-cap-blend territory is a warning that it may not always be the defensive play that investors expect from a value fund."
Earnings Hot Spots
In pinpointing the earnings hot spots for 2006 and beyond, Leavy says a combination of attractive valuations and potential for strong earnings growth make a number of technology stocks strong candidates for superior performance over the next several years.
"The individual product cycles of the companies we own are set up to take revenue and earnings higher," he says. "And when you look at the corporate customer base of the technology sector, you see healthy balance sheets among companies that have underinvested in technology over the last two or three years."
The purchase last year of fund holding Synopsys, which designs software for the semiconductor industry, was driven by an earnings glitch following a transition in accounting practices. For many years the company had recognized revenue from product subscriptions up front, rather than gradually over a period of years as it came in. When it switched to the subscription model of revenue recognition, investors became jittery after accounting revenues took a hit, even though the cash flow at the company remained the same.
"We think design automation software industry growth will be attractive over next few years," Leavy says. "As chips become more complex, design component becomes more important. Synopsis has competitive products that are well positioned to take share." A new CFO with restructuring experience should help improve expense ratios relative to sales.
Revenues at Microsoft, another technology sector holding, will be driven by two product cycles as the company rolls out the new operating systems for the desktop and server markets. "As these rollouts unfold over the next two to three years we should see faster upgrade activity," says Leavy, who believes earnings per share could move into the $2 range over the next three years.
On the other hand, the fund is significantly underweight relative to its benchmark in traditional consumer cyclicals such as retailers, automobile manufacturers and apparel companies. Oppenheimer predicts that a weakening housing market, coupled with higher energy costs, will precipitate a noticeable consumer slowdown that would "constrain economic growth to levels more sustainable than what we saw in 2005."
Leavy says allocation decisions do not necessarily
point to a strong conviction about the direction of the economy.
"Consumer cyclical and technology companies are both considered
economically sensitive," he says. "So if you overweight one and
underweight the other, you're really not making a big bet about what
you think the economy as a whole is going to do."
However, sector decisions do reflect the relative merit of each sector. "The consumer's balance sheet is stretched," he says. "They've typically been overspending. So your starting point is very different than what you face in the business-to-business technology sector." Many technology companies are poised to grow revenues faster than expenses, which will create higher margins down the road, he says. On the other hand, many consumer cyclical companies are close to maxing out on their operating leverage and have less opportunity for margin expansion.
A flat yield curve is the major reason the fund is underweight in financial services companies, particularly those in the banking business. Still, Leavy sees some opportunities in the sector among institutions whose businesses do not rely heavily on lending activity. Brokerage firm UBS AG, which trades as an American Depository Receipt, has a larger private wealth management and asset management arm than most brokerage firms.
"The effort to build up that part of the business has really paid off over the last few years," he says. "The wealth management business is less capital-intensive than other areas of banking, so UBS can grow its business and still have enough cash left to buy back its stock. And even if you allow for some deceleration in business growth you still see significant earnings if you look out a few years."