Fund manager Jeff Auxier thinks stock
values abound for contrarians waiting to pounce.
Jeff Auxier's avocation as a gentleman farmer has taught him a lot about agriculture, and maybe a little about investing. As the owner of a hazelnut and timber farm outside of Portland, Ore., the 47-year-old manager of the Auxier Focus Fund has observed that excessive production of those commodities in one year almost always leads to price drops the next.
As manager of the $110 million fund and another $300 million in separately managed accounts, Auxier uses the inevitable downturns brought on by speculation-driven market excesses to buy companies that he's been eyeing from the sidelines, sometimes for several years. "Successful investing often requires a contrarian approach and detachment from the crowd," he says. "This means avoiding high-flying stocks and buying shares that are out of favor with most investors. I look for situations where the easy money has been made and the stock is overpriced, and then wait for the drop."
True to form, he combed through the rubble during the 1990s thrift crisis, when he loaded up on banks that were selling at 40% of book value. Two years ago, he honed in on insurance stocks that got shelled by Hurricane Katrina losses and Spitzer investigations. Many of those insurance holdings, including St. Paul Travelers and Marsh & McLennan, remain in the portfolio.
On the bond side, he has purchased senior debt of troubled companies at significant discounts, and scooped up some utility bonds that got hit in the fallout from the Enron crisis. At times when the market is unappealing, he employs what he calls "market-agnostic" techniques, such as merger arbitrage, to help keep returns on an even keel.
Today, a market whipsawed by speculation promises to create more fallouts and more opportunities for bargain hunters, says Auxier. "There's been way too much speculation by hedge funds and others. Private equity investors are over-leveraging balance sheets instead of guiding companies to make better products. And stock investors are keeping an eye on the Chinese market, which is vastly overpriced. The market needs a good, clean purge, and I think a 20% or so correction would wring out the excesses nicely."
In his opinion, a few areas appear most vulnerable to a correction. "Real estate investment trusts are overpriced and investors are taking a huge amount of risk by investing in them as the commercial real estate cycle is peaking. We're in the midst of the most overpriced junk bond market in history. Investors aren't being compensated for the risks they're taking, there are too many issuers flocking to the market and a slowing economy remains a threat."
Although the fund has a presence in small-cap stocks, Auxier believes that corner of the market is also overpriced. "With some exceptions, small caps have done well since 1999, and whatever outperforms for several years usually gets trounced." As a general rule, he avoids technology stocks because the rapidly changing nature of those companies makes it difficult to analyze their prospects and invest in them over the long term. Instead, he prefers to use their volatility "to rent them with an exit strategy in mind." Usually, though, he is willing to wait patiently for turnarounds to play out, a strategy underscored by the fund's modest 28% turnover ratio.
Despite his view that the stock market is generally overvalued, he expects the economy to remain fairly resilient for the rest of 2007. A moderation in energy and commodity prices should generally fatten profit margins, although corporate profit growth will slow from previous years. Healthy balance sheets continue to sustain positive capital spending trends and stock buybacks. A lower dollar should generate higher sales for multinationals with a strong overseas presence. And U.S. legislative efforts aimed at weaning people away from housing and into more financial assets will encourage saving and investing.
Roaming For Value
The fund's go-anywhere mandate places no restrictions on company size or asset class. Currently, stocks account for about three-quarters of its portfolio. About 40% of the equity pie is invested in companies with market capitalizations of $10 billion or more. The rest is a 27%-23%-9% split between large companies with $5 billion to $10 billion in market capitalization, mid-caps and small caps. Cash stands at about 9% of assets, with bonds accounting for the rest.
As a rule, the fund allocates about 25% to 30% of its assets to non-equity investments. Having some of its money in cash and bonds hurt the fund in 2006, when it gained 11.75% versus the 15.79% return for the S&P 500. Taken alone, stock holdings appreciated more than 15%. Over the longer periods, however, the mix has generally worked and has beaten the market averages. From its inception in July 1999 to the end of last year, the fund's cumulative return of 84.5% trounced the S&P 500's 13.9% return by more than 70 percentage points. Much of the outperformance against the index has occurred during bear market years when the ballast of having some fixed-income assets kicked in. When the index fell 11.88% in 2001, the fund rose nearly 13%. In 2002, the fund's 6.8% loss stung less than the index's 22% drop.
With $2 million of his own money invested in the fund and a restriction against selling any of it as long as he remains its investment manager, Auxier has ample motivation to look for ways to limit downside risk. "Most investment managers aren't compensated in a way that aligns their interests with those of shareholders," says the manager. "I share the pain on the downside as well as the benefits of the upside."
A long stint as a separate account manager for high-net-worth clients at Smith Barney may have contributed to his sensitivity about the downside of sticking to one corner of the market. "I wanted one fund where someone could put all their money," he says of his fund's wide investment latitude. "I didn't want to be cornered into a small-cap style box that could fall 40 % in a single year."
Despite such conservative leanings, Auxier isn't afraid to zoom in on ideas he likes. The fund is concentrated in some 25 to 50 major stock positions, less than half the industry average, with another 50 to 100 small tracking positions in companies that he likes but considers too expensive to include as a major fund holding. "I may follow those stocks for three or four years before I add to the position," he says. "When they get hit by a bad market and the price is right, I'm ready to step in. But I want tennis balls that will bounce back, not chicken eggs."
In Auxier's view, today's tennis balls are large U.S. companies with broad international exposure that have not received the attention he thinks they deserve. "Companies like AIG, Wal-Mart and Wells Fargo present great investment opportunities because of their international distribution capabilities. They're a lower-risk way to invest in emerging markets such as Korea and Brazil than buying foreign stocks. And a lower dollar should spur higher sales for multinationals with broad distribution networks." Although a steady global distribution has been an undervalued asset for the last couple of years, he thinks that attribute will continue to gain favor as overall earnings growth estimates decelerate.
At the same time, the market's blind eye to the virtues of these stocks has made them compelling values, he believes. "The indexes have gone nowhere for several years. First there was distain, then boredom. Now, there is value. These are the lowest premiums I've seen on quality stocks in a number of years."
The fund also has sizable positions in several tobacco stocks, including Altria and Alliance One. Auxier likes them because of their high returns and predictable cash flows. While he acknowledges their litigation risk, he observes that "with $28 billion in tax revenue coming from these companies, the government has a lot at stake here."
Recently, he has swooped in on shares in for-profit education companies such as Apollo, ITT Education, Career Education, Lincoln Educational and Universal Technical Institute. The sector is suffering a serious downturn because in a strong economy students have more incentive to work than to attend classes. As the economy weakens and jobs dry up, he reasons, people will focus more on education. The companies also have experienced double-digit returns on invested capital, high free cash flow yields in excess of prevailing bond rates and miniscule mandatory capital requirements. "I'm just nibbling at education stocks at this point," he says. "They're not quite as compelling as some insurance stocks were two years ago."