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."

Muted Returns

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.

The fund is emphasizing a number of themes, including companies that serve the corporate sector, where healthy balance sheets and strong cash flows will support rising corporate spending. Companies with a strong presence in emerging markets and scalable business models that can leverage existing infrastructure also merit attention, as do those that stand to benefit from higher commodity prices.

Among the latter group, Babin believes that energy stocks, even after their recent surge, have the potential for further expansion. About a year ago, before the upturn in energy prices picked up steam, he began building the fund's position in that sector. He has ramped up the fund's exposure to nearly double the sector's weighting in the S&P 500 Index with stocks such as BP PLC, Schlumberger, Unocal and Anadarko Petroleum.

"People say there is a lot of oil in the ground, and we just need to find it," he says. "But we think global demand, driven by a growing middle class in India and China, will drive oil prices higher. The magnitude of the energy crisis has been vastly underestimated." Energy stocks, he believes, "have not yet begun to break into their all-time highs."

He is also slightly overweight in the technology sector relative to the index, where companies have been building cash and improving their balance sheets. He recently added to the fund's position in Texas Instruments. The stock had been under pressure because of its large exposure to Nokia, a customer that has been losing share in the handset market, and because of a decline in the semiconductor group as a whole. Babin believes that analysts, who are focusing on short-term problems with Nokia, are ignoring the company's improving profit margin and the potential for further improvement from manufacturing efficiency, cost cutting and pricing improvement. The company is also diversifying its customer base with other handset manufacturers, such as Samsung.

In the financial sector, he recently initiated a position in Genworth, an initial public offering of an insurance subsidiary of General Electric. The company, which offers life and health insurance as well as investments, was priced at a 7% discount to book value. Babin believes the company's management team should be able to increase return on equity as an independent company.

Although the fund is currently underweight in the financial services sector because of concerns over rising interest rates, several financial service stocks, such as PNC Financial Services Group and Citigroup, have high dividend yields of more than 3.5% weighing in their favor. "A dividend yield of 3% or more goes a long way toward meeting the returns offered by the stock market," says Babin. "This is not a yield-oriented portfolio. But if a company has the qualifications we are looking for, a good dividend is a plus."

Other new positions include Tiffany & Co. and Deere & Co. While stock of the well-known, high-end jewelry seller took a hit in the second quarter as investors mulled the impact of disappointing sales in Japan, Babin believes the powerful brand name overshadows what he considers a short-term problem. A recent drop in the stock of farm equipment maker Deere also presented a buying opportunity. With land values and commodity prices on the rise, he reasons, farmers are in a good position to make new equipment purchases.