Managers find themselves vexed about the economy's direction.
A strong second half has the stock market on target
for possible double-digit returns in 2006, but as investors look toward
next year and beyond there seems to be a lot more hand-wringing than
high-fiving taking place on Wall Street.
Investors, it seems, have one eye on the Dow and the
other on the Fed. "The market doesn't know what to make of things,"
says Max Bublitz, chief strategist for Seneca Capital Management in San
Francisco. "This is a market that wants activity and guidance from the
Fed."
There are, of course, reasons for investors to be
encouraged going into 2007. The Dow Jones Industrial Average, up nearly
14% in early November, hit record highs in 2006, with the S&P 500
and Nasdaq lagging a bit behind at around 10%. Considering that
forecasters have been continually warning investors to brace for
single-digit returns, it was a positive year.
But it was also a year without any clear trends,
without any breakout sectors and with a lot of questions about what to
expect-or where to invest-in the months to come. Among the key
questions were those surrounding the collapse of housing prices and to
what extent, if any, this would ripple across the economy, possibly in
the form of reduced consumer spending.
As always, the course of the economy is another key
concern, as is the Federal Reserve's stance on interest rates and
inflation-particularly since the Fed's run of 17 interest rate
reductions over the past two-and-a-half years finally seemed to have
the desired effect of slowing down the national economy in 2006.
"The key theme was, the mid-cycle slowdown we were
looking for finally arrived," says Phil Orlando, senior portfolio
manager for Federated Investors Inc. "I think the Fed is correctly
waffling on this inflation issue. On the one hand, you have a
decelerating economy. On the other, core levels of inflation are
stubbornly higher than (the Fed) would like to see."
In 2006, value once again trumped growth-the sixth
time in seven years that has happened-with the Russell 2000 Value Index
up 13.26% as of the end of September compared to 4.21% for the Russell
2000 Growth Index. Taken with the strong possibility of a continued
economic slowdown in 2007, the extended value run has prompted many
managers to add weight to their large-cap growth allocations, although
exactly what differentiates growth and value is somewhat fuzzy these
days.
The precarious state of the domestic economy also
has many managers turning to the international market, with demand for
international holdings cropping up in a number of investments,
including stocks, REITs and the ETF markets. "It's because of need,"
says Michael Petronella, president of Dow Jones Indexes, which in
October launched with Wilshire Associates a family of indexes designed
to provide a broad measure of world equity indexes. "Managers are
looking to improve the importance of their funds and to seek out alpha
internationally."
Richard Driehaus, chairman of Driehaus Capital
Management in Chicago, says he's turning to overseas markets more
frequently in his search for aggressive growth opportunities. He sees
domestic economic growth headed for a slowdown in 2007, as the economy
bears the burden of absorbing an oversupply of housing.
"There's been a lot of speculation, and a lot of
people that own homes have withdrawn money from equities and now their
home values are flat or falling," he says. "That creates economic
consequences for financial institutions and those who bought the
mortgages. These things don't correct in three to six months."
The international market, however, is a story of
robust growth-creating far more favorable opportunities for investors,
he says. Driehaus says he favors Japan and the rest of Asia,
specifically the emerging markets of China and India, which together
hold 40% of the world's population. "Their growth rates are stronger
and starting at a lower base, and they're becoming more capitalistic,"
he says.
One example of an international investment theme is
the previously unfavored basic materials sector, where tight supplies
and high demand have created an ideal scenario for investors.
Specifically, Driehaus is making a play in the uranium sector, where
high demand for a scarce resource has uranium mining companies such as
Paladin Resources and SXR are poised for high growth.
Domestically, Driehaus says he's had to dig deeper to look for
individual growth opportunities, resulting in holdings such as San
Diego-based Illumina Inc., which generates large recurring revenues
through large-scale analysis of genetic variation and function. "It's
going to be sort of a tough market [domestically] because there really
are no major themes," Driehaus says.
The global economy has also entered into the thinking of some value
managers, despite the fact that value, on average, was able to achieve
solid returns in 2006 on the domestic front. James R. McGlynn,
portfolio manager of the large-cap value Summit Everest Fund, brought
investors a year-to-date return of 17% as of October 31.
McGlynn reaped rewards by making plays in the telecommunications and
utilities sectors this year, but his best performers were actually an
eclectic mix of names-including a number of 'tweeners that have been
simultaneously appearing among the holdings of growth and value funds.
In the case of Summit Everest, this would include companies such as
Cisco, AT&T and Exxon.
Looking ahead, however, McGlynn is trying to bulk up on industrial
companies that are underpriced and do a sizeable amount of business
overseas. Among the companies he's been buying towards this goal are
Tyco, 3M, Ingersoll Rand and Honeywell. "It partly has to do with the
traditional thinking that once the economy slows down, and profits fall
off a cliff, the business will still be there for these guys overseas,"
McGlynn says.
But he says each of the companies also has an appealing story. Tyco,
for example, is due to be broken up into parts in 2007, and McGlynn
reasons that investors can only gain from the breakup. Ingersoll-Rand's
share price has taken a beating due to the perception that it is
especially susceptible to fallout from the housing correction. But
McGlynn notes the company is buying back stocks and still reporting
good earnings throughout the rest of the world.
At the Wintergreen Fund-a multi-cap value fund started last
year-foreign investments have steadily risen from about 40% to 50% this
year. The fund's prospectus provides for up to 100% in foreign
holdings.
Portfolio Manager David Winters says he expects the emphasis on international investments to only increase in 2007. "We view the world as our oyster and there is a lot to do out there and so our focus is very much international or global investing next year," Winters says.
Like many of his colleagues, Winters has taken a step back from the domestic market-where he feels the Federal Reserve's 17 interest rate hikes and the falling housing market will add up to a slowed domestic economy-and looked toward Asia for value.
Among his holdings are The Hongkong and Shanghai Banking Corp. and the London-based Anglo American mining company, which have impressed Winters with their balance sheets and global reach. Speaking of Anglo American specifically, he says the company has heavy concentrations in diamonds and platinum, and a share price that has been beaten down by commodity investments going out of favor. "So much of the markets are moved by sentiment and the market is very negative on commodities right now," he says.
Winters says he becomes more "intrigued" with the energy sector as oil prices get lower. That, he says, could lead to the same type of reversal in investor sentiment that was seen in the commodities sector.
"Instead of having euphoria in the energy patch, you have a degree of
increasing fear that can often create disconnects between what things
are worth," he says. "If you're thinking rationally and long-term you
can oftentimes find securities that are quite good."
Quincy Krosby, chief investment strategist for The Hartford, says the
shift toward domestic large-cap value stocks this year represents a
win-win scenario in the eyes of investors, doubling as both a defensive
move against an economic slowdown and an indirect way of taking
advantage of overseas growth.
"It's a broad play," says Krosby, who is weighting portfolios toward
large-cap and international in 2007. "We would look at it as being
across a number of sectors and getting the companies that are best
poised to continue growing and conducting a global business."
She expects large caps to perform in the 7% to 9% range next year.
Krosby adds, however, that trying to distinguish between value and
growth in the large-cap space is becoming tricky, as the prolonged
outperformance run of value has created a lot of overlap in value and
growth multiples. "Managers in pure value have picked up so many
companies that have been called growth, I find it hard to look at portfolios at this stage and tell the difference," she says.
Multiples have narrowed so far, in fact, that the
anxiety continues to build on Wall Street over exactly when growth is
going to overtake value. As Krosby noted, it's in some cases a moot
question, as companies such as Microsoft, Dell and Oracle have been
appearing among the holdings of value as well as growth mutual funds.
The compression of the gap between value and growth
comes as the result of a six-year pullback from the unprecedented
premiums growth had over value at the height of the technology boom in
March 2000. In that time span, according to Morningstar, the
price-earnings ratio of the large-cap growth sector has shrunk from
40.13 to 21.05. For large-cap value, the change has been from 17.82 to
14.89. As of September, according to Morningstar, the price/book ratio
of growth vs. value was 3.70 to 2.37, respectively. In March 2000, the
difference was 8.13 to 2.86.
At the Sun America Value Fund, the narrow divide between
growth and value has led to the addition of "growthier" companies to
the fund's holdings, says portfolio manager Steven Neimeth. "For many
of these companies, they're trading at the lowest multiples they've
seen in the last ten years," he says.
Among the companies he recently has added, with an eye toward a rising
share price in 2007 or beyond, is Yahoo, which has a valuation in line
with the overall market but a growth rate that is two or three times
the market average, Neimeth says. The company's share price, meanwhile,
was down to a 52-week low in October. "Earnings growth is likely to
slow, but it's still far superior to the overall market," he says.
Other recent additions include Motorola, which
Neimeth bought at 15 times next year's earnings and with $5 per share
of cash on their balance sheet. "They've been weak due to concerns
about growth in the wireless industry," he says. "But it appears
Motorola has a technological advantage for the next couple of years due
to many years of high research and development spending."
Another one of Neimeth's value picks is Exxon, which
was trading at about 11.5 times forward earnings in October-only the
second time in 20 years that the stock's multiple has been that low.
The average multiple during that time was 16, he says. "Even if you
believe oil prices won't go higher, if it just gets halfway back to its
average multiple it will still be up significantly over the next year,"
he says.
Lincoln Anderson, chief investment officer of LPL
Financial Services in Boston, sees the growth versus value puzzle as
the biggest question entering 2007-something he recognized earlier this
year when he began digging into why so many recommended managers were
underperforming. "What we found was that a lot of them have been
shifting to the right, towards growth," Anderson says. "So the value
guys are getting more blendy and the growth guys are getting growthier."
At the same time, he notes, the passive indexes,
which are market-cap weighted, have been moving to the left in a
reflection of where money is pouring into in the overall market. It is,
Anderson says, a mirror image of the late 1990s, when growth completely
overshadowed value. With the indexes shifting left, and the managers
shifting right, he says, "I'm surprised we haven't had worse
performance."
A question investors should ask themselves in 2007
is not just whether or not they should be in growth, but what kind of
growth, says Rob Brown, chief investment officer with Genworth
Financial Asset management Inc. in Encino, Calif. "The most glamorous,
the most momentum-driven or story-driven growth is somewhat
susceptible," Brown says.
He is instead focusing on high-quality growth,
examples of which include Microsoft and Amgen. This group consists of
growth companies with proven business models, conservative financials
and "rock solid" profitability, rather than the wildly speculative
types of companies that were churned out of the technology sector in
the late 1990s.
"Quality large-cap growth is the single most undervalued chunk of the stock market," Brown says.