Mark Donovan learned about the profound impact that near-term changes in a company's fortune can have on a stock when he began his career in the early 1980s as an equity analyst at Value Line. "I got to see the effects that quarter-to-quarter results have on stock prices across a breadth of industries," he says. "The ranking system at Value Line was overwhelmingly momentum-driven, so I developed a healthy respect for the power of momentum factors."
Now, as overseer of the 13-year-old John Hancock Disciplined Value Fund, Donovan seeks out companies whose stocks are selling at a discount to his fair value estimate based on traditional metrics such as price-earnings ratios or cash flow. But what distinguishes this value strategy from the rest of the value pack is his eye for a near-term push from momentum components such as rising earnings, sales growth and accelerating free cash flow. "It's not just about having a long-term outlook. There has to be some visibility to an upturn in a company's numbers," says the 50-year-old manager.
Such visibility can sometimes come from unexpected places, such as fund holding Manpower. A leading staffing firm with more than 400,000 clients in the U.S. and overseas, Manpower has both benefited and suffered from a slowing economy. On the one hand, the recession has hurt all staffing firms, and employment is often the last economic indicator to turn positive coming out of a recession. But at the same time, Manpower has the financial strength and industry dominance to survive while many small and midsize competitors fall by the wayside.
"When the economy turns, this stock has huge recovery potential, and it is very cheap based on 2010 earnings potential," he says.
Donovan also considers balance sheet strength, solid management, and other quality yardsticks, and as the economic recovery struggles to gain traction he is focusing on companies with the wherewithal to straddle both sides of the economic fence. "I need to see evidence that a company can not only make the most of each incremental dollar of revenue if the economy recovers, but also endure if it doesn't," he says. While he thinks the U.S. economy seems to be on the way toward a recovery, he also believes the threat of inflation and removal of government stimulus money pose risks that merit consideration.
Stock market trends support the argument for moving up the quality scale. Over the last year, valuation spreads between lower-quality and higher-quality companies have narrowed, giving investors less incentive to assume greater risk. "Since valuations have reverted from distressed levels to more normal ranges, getting the analysis right on the fundamental merits of a business's valuation and earnings power will be the differentiating factor for performance going forward," Donovan observes.
Robeco Boston Partners, the Boston-based subadvisor to the fund, has reasonably optimistic expectations for the market as a whole. A recent report from the firm, titled "U.S. Equity Market Outlook: The Skeptics May Be Confounded," points to a number of positive trends, most notably upward earnings revisions. Since the market low in March 2009, consensus earnings estimates for the Standard & Poor's 500 Index in 2010 have risen from $55-$60 to $74-$76, and many companies have beaten Wall Street estimates.
Additionally, the equity risk premium-the rate of return that investors demand over and above riskless Treasurys-has narrowed significantly since March but still stands well below its historical average. If investors become more emboldened by improving stock prices and are willing to accept more risk, price-earnings multiples could expand. "In terms of the market, we think conditions potentially support total returns over the next few years that would be in line with longer-term averages, which for the S&P 500 Index is approximately 10%," notes the firm in its analysis.
In Donovan's view, consumer durable companies may lag other areas of the market, at least over the next several months. While stocks of companies involved in the appliance, housing and automotive industries rebounded sharply in 2009 when the recovery began, he believes their current prices far exceed their prospects for sustained growth and sees the potential for a sharp pullback on any short-term earnings disappointments.
On the other hand, fund holding Lincare's dominant market position could help the company beat upcoming challenges on the health care front. With a $2.4 billion public value, the provider of oxygen tanks and respiratory devices is one of the fund's smaller holdings. But in a fragmented industry that has long been dominated by mom-and-pop private companies, it is considered a leading player. Since most individuals in need of breathing assistance devices are over age 65, recent changes to Medicare reimbursement rates have cut profits among suppliers, and many have backed out of the market. Though Lincare has been hit by lower reimbursements as well, Donovan believes the company's ability to buy out smaller players unable to adjust to regulatory change is giving it a growing share of the market that will more than compensate for regulatory challenges.
Certain technology companies also appear attractive. Although the fund's sector and stock decisions are not constrained by a particular benchmark, Donovan takes notice of the Russell 1000 Value Index and typically won't go beyond double-weighting a particular sector. Reflecting his enthusiasm for tech stocks, the fund recently had 14% of its assets in the sector, a level that is almost triple the benchmark weighting and represents a fairly hefty stake for a value fund.