Larry Babin is looking to corporate America rather than the consumer to support a sustained economic recovery. Recently, the portfolio manager of the $2.1 billion Victory Diversified Stock Fund had 12.75% of its assets in consumer staples companies, compared to 21% weighting for the Standard & Poor's 500 Index. Since the fund's charter restricts him to having between 50% and 200% of the S&P 500's eight sector weightings, the current allocation toward consumer staples is close to his most bearish allowable posture.
That may seem surprising, considering that consumer staples companies are often seen as a haven during uncertain economic times. After all, classic reasoning goes, people have to eat, drink, and brush their teeth regardless of economic conditions. But even companies that make bread-and-butter products have found it difficult to pass along to consumers the rising cost of raw materials without hurting sales. Several of them, including Coca Cola, Tyson Foods and Colgate-Palmolive, have recently cut their earnings outlooks.
Babin says much of the problem lies in the harsh reality that people cannot spend what they do not have. "Consumers are already living beyond their means, so their spending power is limited," he says. "Meanwhile many companies, particularly in the technology sector, are building cash and have strong balance sheets. Over the last few years, company balance sheets have improved and consumer balance sheets have deteriorated."
The fund's contrarian stance for a sector that still commands hefty valuations is not unusual. Babin, along with co-managers Paul Danes and Carolyn Rains, often take a jaded view of what the market favors. Instead, they look for both value and growth stocks that are trading below their historical valuations and possess a catalyst for change that will cause that undervaluation to be recognized by the stock market. Often, they'll swoop in on bad news, such as a disappointing earnings announcement or an unfavorable analyst report, or when a stock is simply being ignored.
They sell once valuations become too rich, or there is a change in expectations for future business prospects. "We don't set price targets when we buy because there is no predicting how far momentum investors will drive stock prices up," he says. Much of the fund's 95% annual turnover rate, he adds, comes from "trading around" the fund's 50 or so existing positions, rather than new additions and deletions.
The risk of a contrarian strategy, of course, is that the crowd is occasionally right. Earlier this year, Babin added online bookseller Amazon to the portfolio after it had suffered a decline because of concerns the company was compromising margins to drive volume with lower prices and free shipping. A scalable business model and opportunities for international growth added to the appeal of the buying opportunity presented by what he thought was a temporary dip. But his opinion about the stock changed as he saw indications that margins would indeed continue to deteriorate. "We sold the stock after three months and we just about broke even," he says. "That's fairly unusual for us, because we usually have a time horizon of about three years."
Since the fund's inception in 1989, however, its contrarian ways have usually rewarded investors. In 2000, Victory Diversified Stock Fund's emphasis on mid-caps helped it gain 1% as both the S&P 500 and its large-cap peers saw negative returns. Since 1989, the fund has only lost money in 2002, when shares dropped 22.8%. The fund's performance ranks in the top decile of Morningstar's large-blend category over the last one-, three-, five-, and ten-year periods.
Although the fund uses the S&P 500 Index as its bogey, top sectors and stocks, as well as performance, can differ markedly from the index. "This fund isn't a typical large-blend fund," notes Morningstar analyst Todd Trubey. "Holdings range from turnaround stories to true growth stocks, making it more volatile than most peers. The management team isn't afraid to make this compact offering look quite different from its S&P 500 bogey, in fact that's how it aims to beat it over time."
The mission for the fund to outperform has become more challenging, as its manager faces what he calls "muted" returns from the stock market as well as mixed economic signals. Babin notes that increases in income and employment have been limited by productivity improvements, as well as by jobs that have been shipped overseas. "These are some serious structural issues that politicians will have to deal with," he says. At the same time, he adds, "the vast majority of people do have jobs, and they are enjoying appreciating home values and low interest rates."
Against this economic backdrop, Babin sees stock market returns in the 5% to 10% range both this year and next, which he says "is not bad, considering that equities are competing against ten-year Treasuries yielding a little over 4%. We're in a long-term deflationary world. So even if Treasury rates go up another 100 basis points, equities still look good by comparison." He predicts that while market rallies may be limited, downturns will be modest as well.