Putnam Investors takes full advantage of a change in strategy.
Pointing out hefty losses, even if they happened a
few years ago under different management, is a strange approach to
promoting a mutual fund. Yet that's what some folks are doing when they
recommend Putnam Investors Fund.
A major overhaul in 2002 produced a turnaround in performance, and Putnam officials note that "even though the fund is outperforming, its new and current investors still benefit from the fund's tax loss, meaning they don't have to pay any capital gains tax on the fund's distributions."
The unusual pitch suggests an increasing awareness, particularly among financial advisors, that capital gains distributions will likely have more of an impact on returns going forward than they have in recent years. The issue of "tax drag," or the toll that taxes take on performance in taxable accounts, has been dormant for a number of years. Investors didn't seem to care too much about it in the late 1990s, when stocks were generating bountiful returns that overshadowed tax drag. And over the last few years many equity mutual funds, which banked substantial capital losses after the 2000 bear market, have used them to offset taxable gains.
But as the funds deplete those tax losses,
shareholders could see higher tax bills. Ironically, funds that
realized the biggest losses years ago, including those that brought in
new managers to engineer an overhaul by weeding out underperformers,
may be among the most tax-friendly now because they still have a cache
of tax losses tucked away.
When Richard Cervone and Jim Weiss took over Putnam Investors in 2002, their mission was to transform the flagship fund from a struggling large-company growth offering to a more rounded portfolio that blends elements of both value and growth investing. Since then, it has transformed into a solid large-cap core holding, according to Morningstar analyst Laura Pavlenko Lutton, who notes that "Weiss and Cervone have turned in strong returns thanks to solid stock-picking across a variety of sectors and reasonable volatility. In our view this is one of Putnam's best offerings and a capable broker-sold core fund."
In 2003, the first full year under management by the
new team, the fund ranked in the 49th percentile of Morningstar's
large-blend category. In 2004 and 2005 it rose to the 18th percentile
and 17th percentile in the category, respectively.
With heavy weightings in the struggling consumer and financial sectors, this year has seen the fund underperform both the S&P 500 Index and its peer group. Rising interest rates, high oil prices and a weak housing market combined to make investors wary of companies whose fortunes hinge on consumer spending and strong economic growth.
But Cervone says that the bad economic news already has been factored into stock prices. With the Fed taking a breather on rate increases and commodity prices coming down, he believes the stage is set for recovery among some sectors of the economy that investors have shunned.
Cervone points to Home Depot as a stock that has been mispriced and misunderstood. At its peak in 1999, it traded at about $70 a share, or 63 times forward earnings. As of October it was trading at around $36 a share, approximately 12 times expected 2007 earnings, yet the company's profits and cash flow have almost tripled since the stock peaked.
A slowing housing market and poor stock performance
have contributed to investor pessimism and Cervone concedes the company
will see some meaningful softness over the next few quarters. But he
says that the slowdown, which is widely recognized by investors and
already factored into the stock price, is likely to be temporary and
that Home Depot will likely use its ample free cash flow to reward
shareholders through dividends and share repurchases.
Home Depot is not the only cash-rich fallen growth stock that wary investors have turned into a bargain. "I'm seeing some compelling values now," he observes. "Compared to the fair value of their businesses, the prices in select sectors and stocks are more attractive than they've been in ten years."
Cervone, a former architect who earned a master's degree in business from Columbia University in his early thirties, bases his estimate of private market value on the present value of future free cash flow. "In the short run stock prices can deviate from business values, but in the long run they move into sync," he says. "Companies where we find the greatest mispricing are the most interesting. It doesn't matter whether they are growth stocks, value stocks or stocks that pay dividends."
In addition to looking at valuation, he considers investment potential based on projected earnings growth, vulnerability to competition, capital requirements, balance sheet strength and management's use of cash. "Some companies generate a lot of cash but use it to inflate current earnings or invest in ways that destroy shareholder value," he says. "We look for those that use cash in a disciplined way, by reinvesting it in the business when that makes sense or distributing it to shareholders when that's the better choice."
The fund is peppered with a number of large, blue-chip growth companies that sell at valuations well below peak levels, such as Wal-Mart. In 1999, the stock was selling at 50 times earnings. Today, its stock price is about the same as it was back then, yet its earnings have grown at double-digit rates every year. According to Putnam estimates, the stock is priced at about 15 times projected 2007 earnings.
With over one-third of its assets in the financial sector, Putnam Investors has felt the brunt of the Fed's series of interest rate hikes this year. "Because of the tightening by the Fed, prices on many of these stocks are quite low compared to private values," he says. "But we believe those interest rate increases are largely behind us. As the economy decelerates over the coming quarters, as it has already started to do, the core inflation rate is very likely to come down into the Fed's 1% to 2% comfort zone." Historically, he says, financial stocks get cheap when the Fed raises rates and rebound once the tightening cycle is over.
Prices of some of the fund's financial sector holdings, such as Capitol One Financial, "more than discount any business weakness that could happen." The firm has a strong history of credit management, strong growth in its consumer finance businesses and a new path for growth with its entry into the regional banking business. Cervone expects Capital One to generate $4 to $5 per share of free cash flow in 2007, and to grow cash flow in the high single to low double digits over the next several years. "Given the numbers we see Capital One generating, the shares are worth significantly more than current prices," he says.
Strong performers this year include Apple Computer,
whose stock rose from $51 a share in July to $74 in early October.
Cervone believes Apple should continue to dominate the digital media
player market with its extremely popular iPod, as well as gain market
share in the personal computer area. Its ease of use and the current
lack of viruses make the Mac a compelling choice for consumers, he
says. And in just the six months from January to June 2006, Apple's
share of U.S. retail notebook computer sales doubled from 6% to 12% of
the market. Although he pared the position after the stock's run-up, he
believes Apple stock still has room for expansion and represents an
attractive long-term holding.
U.S. Steel and Caterpillar also turned in strong performances. The producer of steel products has benefited from consolidation in the global steel industry, which has improved profitability, while Caterpillar's stock got a boost from strong demand for construction and mining equipment.
Disappointments include computer maker Dell, whose stock declined as investors became concerned about its slowing growth rate. Cervone says the weakness was due in part to some strategic missteps, as well as tougher-than-expected competition, particularly from Hewlett-Packard. Although he has lowered his growth estimates, he believes Dell is "still a good business with tremendous cash flow," and that the stock is attractively priced.
Homebuilding company NVR also declined in response to investor concerns about the slowdown in the housing market, which was more severe than many anticipated. NVR's operational efficiency and competitive strength should enable it to offset the effects of a softening housing market, says Cervone. "We are about halfway through a difficult correction in the housing industry," he observes. "In a few months the news will start becoming less bad."