Despite a recent slowdown, David Williams thinks energy and other cyclicals may grow.

David Williams believes that all the media banter about how large-cap growth stocks are the place to be is disturbing. "That kind of thinking is just following the crowd," says the 64-year-old manager of Excelsior Value and Restructuring Fund. "I try to be more open minded, and sometimes that means taking a contrarian view."
    Right now, contrarian money is on stocks that tend to move up and down with economic cycles, including energy, banks, financial services companies and construction. Those sectors have benefited from a strong economic recovery for most of the last few years, and Williams' fund was well positioned to take advantage of the upswing. Over the last five years, its performance has ranked among the top 4% in Lipper's Multi-Cap Core category, and among the top 3% over the last three years.
    More recently, however, falling energy prices and a faltering economy have raised concerns among investors about the future of cyclical stocks. At the same time, stocks of large growth companies in more defensive sectors, such as health care and telecommunications, have staged a comeback after years of lagging behind. The shift in market leadership was particularly dramatic in the third quarter of 2006, when the fund trailed the S&P 500 by more than five percentage points. In May and June, the fund fell sharply when fears of inflation and the economy reached a peak. Cyclical shares continued to lag over the summer, but began recovering toward the end of the year. As of mid-November, the fund's year-to-date performance trailed the S&P 500 Index by about one percentage point.
    Williams believes calling energy stocks yesterday's news is a mistake, even though few industries have outperformed as long as the sector without having profit takers come in and reverse the trend. Strong demand continues from growing markets in China and India. Alternative energy sources such as ethanol and liquefied natural gas have been slow to develop. And OPEC's existing fields are old, fragile and capacity constrained.
"I think it's reasonable to expect a $50 to $70 a barrel trading range, and at those prices energy companies in the portfolio can do very well over the long term," says Williams. "And a lot of bad news has already been factored into stock prices." He believes the group is inexpensive relative to earnings, cash flow and the value of their reserves. The energy companies in the portfolio sell at less than nine times forward earnings and have a return on equity averaging more than 20%.

"This is a magic combination," he says. "When you get opportunities like these, you hold on to them." Independent oil and gas producer and fund holding Devon Energy, for example, sells for around nine times estimated 2007 earnings, yet the value of its stock is 30% less than its net asset value. With 90% of its reserves in North America, the company has less exposure to international risks than many of its competitors. And after several years of acquisitions, it has a number of new projects coming online over the next few years. Another fund holding, Murphy Oil Corp., was hit by Katrina-related snarls but has a big production push from reserves in Thailand coming next year that should help improve earnings.
    The difference between stock price and the value of their assets makes Devon, Murphy Oil and other energy holdings in the fund solid candidates for purchase by larger oil companies, possibly at substantial premiums to their current prices. "Oil is getting more and more expensive to find so a company has to be big to be successful," says Williams. "It's anyone's guess whether energy prices and earnings will remain high and we don't see any major disruption yet. But continued active consolidation within the group should prevent energy stock prices from collapsing."
In addition to consolidation plays, Williams looks for turnaround situations among companies that are trying to get back on track with a major overhaul in the form of new management, cost cutting, mergers or right-sizing. In other cases, he looks for stocks where investors have overreacted to bad company publicity that forces share prices down, but that stand to benefit once investor perception improves.

Not so long ago, a fund with Excelsior Value and Restructuring's mission would not have been possible. Before around 1980, says Williams, companies had little incentive to cut costs and streamline operations because an inflationary environment allowed them to raise prices. But by the time he took over management of the fund in 1992, consolidation and restructuring in corporate America was in full swing, with banks leading the trend.
"Back when I began managing the fund there were about 5,000 banks in this country," says Williams. "Today, there are around 2,000." Media and telecommunications companies have also seen merger activity.

Over the last few years, greater oversight by regulators and the investing public has created more investment opportunities by motivating companies to take steps to forge a turnaround. "At one time a company could languish for awhile without taking action to change things," says Williams. "But boards are more proactive these days in demanding change."
    About 30% of the fund is in consolidation plays, with another 60% of assets in restructurings or turnarounds and 10% in stocks that don't fit neatly into either category. "If I've done well as an investor it hasn't been by identifying industries that are ripe for consolidation, but by buying stocks when they are unloved and unwanted," he says.

Reflecting his "buy on the cheap" philosophy, the median company in the portfolio sells at a little more than 12 times expected 2007 earnings, a 20% discount to the S&P 500 multiple and about as cheap as the fund has traded at since its inception. At the same time, Williams expects their earnings growth next year to be almost double that of the S&P 500 Index.
    As the portfolio's 14% turnover indicates, once Williams buys a stock it typically remains in the portfolio for several years. "Sometimes I get clobbered because I hold on too long and a company gets in worse and worse shape. But generally the philosophy works," he says.

Whether that allegiance pays off in the case of longtime fund holding Centex remains to be seen. Although the home builder's stock has been one of the fund's worst performers lately, the holding has been profitable longer-term. Still, Williams admits that "in hindsight, I probably should have sold the stock sooner. Traditional wisdom says to buy home building stocks at about book value and sell them when they're at one and one-half to two times book. I didn't do that, and the stock is now back to book value. It's premature to say that the worst is over, although it's a positive sign that interest rates are still low and employment is strong. The problem is that the housing market has gotten ahead of itself."
    A concentration in stocks like Centex and others that are sensitive to economic swings leaves the portfolio vulnerable in the event of a deep economic slowdown, according to Morningstar analyst Arijit Dutta. Despite that reservation, he adds, "Williams has shown an ability to get in at attractive prices, which has led to spectacular upside in the long run. For investors who share Williams' patience, this is a bold but rewarding choice."

In addition to its cyclical holdings, the fund also has a presence in some "growthier" names such as America Movil, a leading provider of wireless communications services in Mexico and Latin America. Williams bought the stock about four years ago, and the company has been acquiring smaller wireless competitors at a rapid pace since then and consolidating them into its own operation. It is now the largest wireless operator in Latin America, accounting for more than 70% of the Mexican market. Even after a run-up of more than 50% during the first ten months of 2006, it still sells at a reasonable 15 times estimated 2007 earnings.

Recent buys include Capitol One Financial, a company known mainly for its credit card operations that has made some bank acquisitions to diversify its asset base, including the recent purchase of North Fork Bancorp. Investor concerns about earnings dilution from those acquisitions brought the stock down to levels Williams considered attractive when he established the position in the third quarter.
    "Banks typically sell at 12 times earnings, and credit card companies tend to be cheaper," he says. "Right now, Capitol One is selling at less than ten times earnings, so there is potential for multiple expansion as it diversifies into banking."

Rockwell Automation, another recent purchase, is in the process of restructuring and selling its more cyclical businesses, which should result in high margins, higher cash flow and better valuations. The supplier of factory automation products recently announced the sale of its Dodge and Reliance motor systems business for $1.8 billion and is expected to use some of the proceeds to buy back its stock.

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