The tribulations of the financial services sector are likely to keep the stock market from gaining momentum for the rest of the year and perhaps longer, according to Eileen Rominger, manager of the Goldman Sachs Large Cap Value Fund. While the overall market appears reasonably valued and even inexpensive by historic standards, she says, the fallout from the banking sector continues to weigh down many other industries.
"I don't see another large leg down, but it's likely that the market will be bumping along the bottom with lots of volatility," she says.
A reversal of fortunes in the financial sector, one of the keys to a sustainable market recovery, shows little sign of materializing, she says. While that could change if there is improved value and strength in critical balance sheet assets such as portfolios of credit cards and home equity loans, the opacity of the banks' portfolios makes any improvement very difficult to see. "Even some CEOs have been blindsided by write-downs," she says. "The value of assets on bank balance sheets is extremely hard to measure, and it shifts constantly because of market mood swings and liquidity issues."
During the first half of the year, four of the seven positions the fund eliminated were financial services companies, such as American Express, that were having a tough time battling economic headwinds. The financial companies that Rominger continues to own, including J.P. Morgan Chase, exercised restraint during the boom years and are in a better position to weather the slump. "The firm didn't grow its balance sheet aggressively in 2006 and 2007 when its competitors were taking huge risks. It's not without issues, but it has a better business model than other large banks and is more likely than other financials to get through tough times," she says. Although the stock fell about 15% during the first half of the year, the drop was less severe than those experienced by most banking stocks during the period.
Meanwhile, a big drag on the fund's performance has been Sprint Nextel, which lost nearly one-third of its value in the first half of 2008. Although Rominger declined to discuss the holding, the firm's most recent quarterly letter to shareholders took the view that "new management should steer [Sprint Nextel] in a positive direction with improved branding, execution and profitability initiatives."
Rominger says that the key to surviving through this stock market, one of the toughest in recent history, is owning stocks of companies with strong leadership, carrying a solid portfolio of assets and being able to control costs while raising prices.
She began her career as a junior analyst and newsletter writer at Oppenheimer after obtaining a bachelor's degree in English from Fairfield University. "I think a liberal arts degree is a great way to prepare for any career," she says. "It teaches you to learn to think, absorb a breadth of ideas and become a thoughtful reader."
The toolbox for her business career came from Wharton, where she earned her master's degree before rejoining Oppenheimer. Her stay at Oppenheimer lasted 19 years, and then she joined Goldman Sachs as a managing director in 1999. Her first job at Goldman was to shore up its value investing capabilities at a time when that branch of investing was considered archaic.
Today, she works with co-portfolio manager Andrew Braun as well as a team of ten analysts, and the group uses varying metrics to evaluate stocks in different industries. The banking industry, for instance, is well regulated and banks have a limited ability to raise prices, so their book value of assets is a key driver in the Goldman team's decision-making process. For other sectors, such as media, the focal point may be cash flow. Ideal candidates for purchase are often high-quality, overlooked companies with signs of positive internal change such as reductions in cost structures, divestitures of assets and improved free-cash-flow generation.
One reason that the large-cap value fund has held up relatively well is that it has bought companies with the fortitude to hold their own against the backdrop of the struggling economy and stock market. During the first half of the year, the fund fell by only 6.7%, while the S&P 500 index dropped 11.9% and the fund's average Lipper category peer dipped 13%.
At a time when volatility in the equity markets has sharply widened the gap between stocks of weak and strong performance, it may not be as profitable as it has been in recent years to follow indexes or quantitative investing techniques, Rominger says. "Between mid-2003 and mid-2007, when volatility was relatively low and the market was generally in an uptrend, quantitative investors who made a lot of small bets and got them right did well," she says. "In a tougher environment, it's more important to make decisive calls and evaluate each company on a stock-by-stock basis." The fund's recent performance history indicates it tends to outperform its benchmark, the Russell 1000 Value Index, in more difficult markets. It beat its bogey in two of the five calendar years between 2003 and 2007, and is ahead of it so far in 2008.
The fund's 22% stake in energy stocks has also played a role in its performance, according to Morningstar analyst Karin Anderson. "A focus on midsized firms with natural gas exposure and an avoidance of the major integrated firms has helped keep this fund ahead of most peers during the past year," she notes in a recent report. "Management homes in on companies that it believes can grow reserves faster than their peers and maintain a longer reserve life, which can help the firms allocate capital efficiently."
Rominger's key criteria for energy stocks are the assets a company has in the ground as much as the cash flow or earnings it has on paper, which are easier to dress up and can vary from year to year. "Earnings can fall off sharply if a company fails to replace reserves. Favorable geography and geology of reserves can really influence costs and, ultimately, the value and sustainability of the business," she says.
Rominger thinks that the geological, political and geographic trends threatening to limit supply point to higher energy prices ahead. The big reserve pools are no longer in the shallow waters off of the Gulf of Mexico, but in places like Nigeria and other parts of the world, where the unsettled political climate erects roadblocks to extraction. Supply has also been limited because the price of oil and gas was stagnant for so long that many producers underinvested in equipment and must now play catch-up. And it is highly unlikely that the spike in prices is merely a blip caused by speculators, given the dollar volume of financial vehicles they account for.
Despite the run-up in the sector, Rominger believes some oil and natural gas stocks have room to grow. Except for the last couple of years, she points out, energy stocks were out of favor for most of the last two decades. Certain companies have the ability to grow reserves at relatively low finding and developing costs. And while the stocks may be volatile, a number of positive developments have not yet been factored into their prices. Oil and natural gas producer Devon Energy, the fund's largest holding, has a North American base close to areas of high demand and a balanced 60/40 mix of natural gas and oil production. Its unconventional drilling techniques lower finding and development costs, and unlike many of its competitors, the company has a strong ability to replace and grow its natural gas reserves.
While Rominger acknowledges the contribution energy stocks such as Devon have made to performance since last year, she emphasizes that the fund is not a one-trick, sector-driven pony. In fact, her sector bets are limited to no more than a few percentage points more or less than the Russell 1000 Value Index. To add value in the well-mined large-cap value arena, she and her team pick stocks on a case-by-case, bottom-up basis and seek out high-quality, overlooked companies that are trading inexpensively relative to their industry peers.
Holdings in the technology group, which is underweight relative to the Russell 1000 Value benchmark, include companies that "are masters of their own destiny and won't become roadkill in a tough economic environment." She says that the CEO of fund holding Hewlett-Packard has cut costs and streamlined operations, which should help the company remain on a more even keel than many of its competitors. In the media area, management at Time Warner has done a good job of making the most of some of the company's undervalued assets, including its cable business, and may be able to extract more value from AOL.