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Investment outlook: Three winning stock fund managers in 2010 make predictions

By Erin Schulte
Special to The Washington Post
Saturday, January 8, 2011; 11:08 PM

Investing in stocks in 2010 was a white-knuckle ride. Spring kicked off with the largest oil spill in history, and energy stocks were punished. The Dow Jones industrial average dropped a thousand points in a single day in May. Americans continued to question the strength of the U.S. economic recovery, and incessant talk of a double-dip recession dogged investors all summer. Unemployment numbers remained grim. And if you bought a house at the market peak, well, forget about getting out from under that mortgage. But as always, despite the bleak chorus of talking heads, there was money to be made in stocks.

More important, there were many ways to make money in stocks, as we discovered by talking to managers of three of the best-performing stock funds from 2010. One saw an opportunity in energy companies that sold off steeply after the oil spill in the Gulf of Mexico. Another profited from the telecom sector, on the hunch that cellphone service providers, in response to complaints about dropped calls and dead zones, would spend big to patch up notoriously spotty networks. And the third looked to emerging markets to outperform U.S. companies - though this year he's turning his focus back home.

We asked the managers about the most compelling investment ideas for the coming year, what will drive growth in 2011 and how they're re-configuring their portfolios for another successful run across a changing investment landscape.

Brian Barish, Cambiar Aggressive Value fund

The Cambiar Aggressive Value fund excelled in 2010 in part by making the best of a very bad situation: the Gulf of Mexico oil spill. Fund manager Brian Barish says the fund took a "brick to the forehead" from its large stake in BP at the time of the Deepwater Horizon explosion. Barish unloaded all of its quickly plummeting BP position by May and compensated by taking advantage of ripe opportunities elsewhere in the energy sector. The fund ended the year up 39 percent, outpacing the Standard & Poor's 500-stock index by 24 percent and other large-value funds by 25 percent, according to Morningstar. The key to success, Barish says, is finding stocks that are unfairly inexpensive and concentrating money there.

Washington Post: Can you tell us a bit about your strategy of investing in stocks that are inexpensive because of temporary negative issues?

After the gulf oil spill, the whole sector sold off ¿ integrated oil companies, exploration and production companies, offshore drillers ¿ which also created situations that worked for us.

Why is oil [around $90] a barrel today? There is an inexorable demand coming mostly from Asia. We're not finding giant oil fields to drill, and they're complicated to get to. Have any of these facts changed because BP had a terrible accident? Not in the slightest. In fact, the fact that we're being more restrictive about drilling will tighten up global oil supply. We put on several energy positions that sold off rather badly in the summer, and those have been very profitable: Apache, Repsol, Devon Energy and Halliburton. They're clearly undervalued in terms of reserves they have versus long-term price expectations for oil and gas.

WP: What market and economic trends do you think will shape the investment story in the year to come? What are people not talking about yet but will be in December 2011?

For most of the last 18 months, financial media have been dominated by negative chatter about why this economic recovery is going to be below par. There are a lot of structural issues in the U.S., but they mostly pertain to credit and the stuff credit attaches itself to, like housing and commercial real estate. We had a bubble, we massively overbuilt, and that excess inventory will take years to clear off.

But there are a lot of positive stories that were not part of this credit bubble. Oil and gas, technology and industrial America are doing really well and are positive sector stories going into 2011.

The consensus going into 2011 is underestimating the strength of the recovery.

I'm not an economist, but I think you could have GDP growth of 3.5 to 4.2 percent, driven by business investment. One of the items that got thrown into the Bush tax-cut extension was accelerated depreciation for businesses, where they can expense 100 percent of capital expenditures in 2011 and 50 percent in 2012. Let's say you're a company that wants to do a full information technology upgrade. You'd have to have your head examined not to do it in 2011. You're going to see very aggressive business capital spending.

WP: Given those trends, how will your sector allocations shift from 2010 to 2011?

We were fairly heavily weighted in tech and consumer discretionary stocks going into 2010. We are now paring back on those. It will be challenging to get return out of old-line, blue-chip tech companies like Microsoft, Intel and Dell because you have a paradigm shift. PCs are in the eighth or ninth inning of their life span, so that's not a fertile place to be investing when devices like tablets are just emerging.

Consumer discretionary was the best-performing sector in 2010, so we've moved on from a lot of names there. With rising gas and cotton prices, it's hard not to see things being more difficult in 2011.

WP: If tech and consumer discretionary are out, what stocks are compelling going forward?

We've been buying Archer Daniels Midland, an agricultural processing and transportation powerhouse. It's done nothing in 2010 and is very cheap by any conventional metric. Their biggest driver of growth is agricultural services, the transport and handling of commodities. Around the world you're having all kinds of supply dislocations. We have a tight supply outlook for cotton. Wheat hit a multiyear high because you've had terrible harvests in the former Soviet Union and Australia. ADM takes grain sourced in the U.S. and moves it to East Asia or the Black Sea. A farmer can't do that.

Also, multiples [for energy stocks] are still very low based on a $90 price per barrel for oil in 2011. I continue to think the global energy situation will show tightness in 2011. The price of oil is telling you that already.

WP: Any other favored sectors?

In tech, while I'm not optimistic about the longer-term outlook for PCs, I am optimistic about smartphones and tablets. We're going to have device proliferation in terms of tablets, smartphones, and TVs with integrated computer-like capabilities. We spent 2010 worrying about a double-dip recession, and you don't want to own these companies in a recession, so these stocks haven't done much. We like Corning, which makes the flat glass used in TVs and iPads and its clones. Another name we have a big position in is Flextronics, a contract manufacturer that makes BlackBerrys and Xboxes and services and telecom switches.

We seek to take advantage of material mispricings, and we tend to do a lot better when there has been some kind of market stress which leads to financial dislocation. The financial dislocation of 2008 and 2009 was so thorough and catastrophic that there continues to be a great many stocks materially mispriced some 21 months after the market low. I mentioned a few names already that remain well below pre-Lehman prices and look poised to return to pre-Lehman valuations, if not higher, [and] there are many more where that came from.

WP: What could be some negatives for the market in 2011?

Interest rate spikes and oil-price spikes would be the main risks. I don't think a 3.5 to 4 percent GDP number is baked into the consensus, and it's not baked into Treasury prices, either. With that kind of a growth rate in 2011, current Treasury yields are deficient. You might get yield pressure that could hold things down. Similarly with oil I'd be surprised if we didn't have a spike over $100 a barrel. You don't know how far that could go. Oil prices got out of hand in 2008 and were a contributing factor in making the recession that was already underway worse.

Finally, while the mood on Wall Street was really bearish in the summer of 2010, it got quite optimistic during the fourth quarter, particularly after the election. We're coming into the market in 2011 a little overbought, and that could resolve itself through a correction or the market going sideways for a while.

Doug Rao, Marsico Flexible Capital fund

Doug Rao, manager of the Marsico Flexible Capital fund, calls it a "go anywhere" fund. The fund invests in companies across the globe, across all market capitalizations and in a variety of capital structures. Rao says he simply invests "where we think the greatest opportunities for capital appreciation are." And in 2010, that was emerging markets. The fund ¿ which had about 30 percent of its holdings in emerging-market stocks in early 2010 ¿ surged 36 percent in 2010, beating the S&P 500 by 21 percent and other large-cap growth funds by 20 percent, according to Morningstar. Where will he head in 2011? Rao says the fund is moving its investments away from emerging markets and back into U.S. companies.

WP: What market and economic themes did you base your investments on in 2010, and how do you see those playing out in 2011?

The theme in 2010 was that the financial crisis in the Western world was a Western-world crisis. The emerging markets, while obviously impacted, simply slowed down. We positioned the fund for a pretty robust recovery in the emerging word. We thought the U.S. would do okay and recover, but we thought the recovery would be slow and muted in nature because of the de-leveraging of the consumer.

However, we were not in the double-dip crowd. If you look at the significant economic contraction that took place post-Lehman, it was a massive fearful response by U.S. consumers, who slashed spending in the area that was easiest to slash spending: durable goods, or big-ticket items. You need some level of confidence to want to acquire them. If you look at housing and automakers, half the jobs we lost were in those two industries. To replicate that contraction in the economy would be nearly impossible.

That gets us into 2011. We're feeling much more constructive on the U.S. recovery in 2011 because we are seeing confidence come back. We think the 90 percent of Americans who are and have been employed are going to open their wallets this year, and that will drive GDP in 2011. We're seeing a fairly significant uptick in cars purchased, although housing is still in the doldrums.

WP: What else makes you upbeat about domestic versus emerging-market stocks?

I try to go to China at least two times a year, and I was there six weeks ago. They have been consistently concerned about the U.S. not doing enough to stimulate the recovery and the possibility of a "lost decade" similar to what happened in Japan.

I think we already had the lost decade in the U.S. The market today is in the same place it was in 1999. We think the S&P can earn close to $100 this year, which means earnings have doubled but the market's flat.

Meanwhile, we are becoming more concerned about inflation in the emerging world. In part because of quantitative easing, there's an increase of prices of commodities that puts inflationary pressure on emerging markets, which is compounded by their own loose monetary policy. We think India, China and Brazil will spend the year fighting inflation, which is not the best backdrop for equity investing. I should add that, secularly, we are bullish on emerging markets. We think it's a wonderful environment for U.S. multinationals, and the number of households who are engaged in capitalism continues to rise every day.

Our portfolio has moved away from emerging markets and more toward economically sensitive stocks in the U.S. Emerging-market stocks have gone from 30 percent of our portfolio in late 2009 to 15 percent now. U.S. stocks have gone from 40 percent in early 2010 to 65 percent today, and cash and fixed income have come down.

I think the U.S. has been doing a good job at restructuring. You have to appreciate the irony ¿ TARP is going to turn out to be a significant positive for the U.S., but neither the Republicans nor the Democrats want any credit for it. The difficult choice turned out to be a right one: They're going to make money on most, if not all, the investments.

WP: So what sectors in the U.S. are appealing to you? Your largest holding as of Nov. 30 was U.S. Bancorp.

It appears the recovery in the U.S. is broadening in nature. We've been investing over the last six months more aggressively into the U.S. banking system. Everybody has been terrified of financial and Wall Street reform legislation. We look at companies in that space and the consolidation that's taken place, and we think U.S. financials are underowned and underloved.

We are also attracted to companies that can create efficiencies for corporate America, and industrials and technology are two sectors that dovetail nicely into that theme.

I'd say we're avoiding consumer staples without very strong brand profiles. We're also avoiding health care. We believe Washington will do something about the entitlement deficits, which will require cuts to Medicare and Medicaid.

WP: You mentioned you have less fixed income in your portfolio now. Is that momentum of investment in fixed income shifting?

The balance sheets of businesses in the U.S. are extraordinary ¿ they have more than $2 trillion in cash on their balance sheets. I'll highlight Oracle, one of the stocks we own in another fund, to show you the value of being an owner [of the stock] versus buying the debt. Oracle bought Sun Microsystems, and they paid $5.5 billion for it. They think they can generate $2 billion in operating profit from it. That's a 30 percent return even without revenue synergies. They issued debt at 3.85 percent to finance that. Who would you rather be ¿ an owner of the equity or a lender of that debt?

People are very fearful of the U.S. market. Everyone is running away from TARP. People are skeptical of the recovery. Outflows from the equity market have been significant, and inflows to fixed income have been strong. We're hard-pressed to see how you could get a real return on your investment in being too skewed to fixed income.

WP: How do you decide when to sell an investment?

All of our funds here are driven by forced displacement. If there's a better idea and we've run out of upside on an investment, if it's hit a price target or the thesis isn't working out, that's when an idea gets sold.

WP: What do you see as the primary risks to the market/economy in 2011?

If both Republicans and Democrats are going to try to find wins rather than compromise, particularly as it relates to the deficit, that would be a significant negative. It's a real overhang for the consumer. They have no sense as to what their ultimate tax burden might look like. Some level of certainty is better than what we have today.

Jerome Dodson, Parnassus Small Cap fund

"Can you hear me now?" might be one of Jerome Dodson's favorite questions. His fund, the Parnassus Small Cap fund, grew 37 percent in 2010, according to Morningstar, thanks in a big way to telecom stocks. Dodson bet that cellphone service providers would be eager to beef up networks to prevent dropped calls, dead zones and slow data ¿ and he was right. The fund outpaced the S&P 500 by 22 percent and its Morningstar category of small-blend funds by 11 percent, benefiting from both its telecom wins and investments in what Dodson calls "misunderstood, undervalued companies."

WP: Can you talk about your sector allocations going into 2010, and how those will shift in 2011?

One of the areas that did the best for us in 2010 was telecom. Do you have a cellphone?

WP: Yes.

Do you have problems with dropped calls and connection problems?

WP: Nearly every call I make from my iPhone in New York City is dropped.

You are not alone! My thinking was that telecom stocks were pretty depressed. And yet, the networks will have to make investments to get rid of those dead zones, and they're going to have to do something fairly soon. We're anticipating that's going to happen sometime in 2011, although as a cellphone user it probably won't benefit you until 2012. Telecom companies Finisar, Ciena and Ceragon were the three that did the best for us last year.

WP: Do you plan to stay invested in telecoms in 2011, given their price appreciation last year?

Even though telecom ran up a lot in 2010, I'm holding on to those three stocks. I think they have more room to run and that people will be surprised by how much service providers have to invest to get their networks going.

WP: I noticed that home builder Toll Brothers was among your 10 largest holdings in the fund as of Nov. 30. New-home sales are still tepid, and housing inventories are still high. Do you plan to continue investing in home builders in 2011?

Housing stocks haven't done that well in 2010, but I think that by the end of the year, housing will be much improved. I'm sticking with it, and it's one of the sectors I'm emphasizing for 2011.

I'm expecting employment to pick up. The economy is growing again. What happens is businesses try to work current employees very hard and wait until the very last minute to hire new people. At some point, though, they have to hire more people, and I see that happening in 2011. When people start working, they can buy houses.

Housing inventory is why the stocks [of home builders] are so low. Investors think people will not be building new homes, but I think that some new homes will be constructed. Some of those foreclosed homes are in bad condition. A lot of people would rather buy a new home than worry about fixing up damaged goods. I think inventory will be greatly reduced by the end of 2011, employment will pick up and housing will pick up late in the year. But the market is a discounting mechanism, so we're investing now.

If I do well next year, I think home builders will contribute to it.

WP: What's your investment strategy for the fund? How do you pick stocks?

There are three essential elements. We look for undervalued companies. If current price is below 65 percent of its intrinsic value, it's a candidate. Number two, we look for companies that have unique characteristics. Every company has competition ¿ you can't pick many monopolies. But there are companies that have a moat, or what we call "unique characteristics," something that gives them a competitive edge. The third thing we do is look at companies we think are good corporate citizens. We look at workplaces, charitable contributions, whether the product has a positive impact.

WP: There was a significant amount of monetary stimulus in 2010. Do you expect that to continue, and how does it affect your outlook?

I think the Federal Reserve will keep stimulus going until the rate of increase in employment picks up substantially. Right now, we're creating maybe 100,000 jobs a month ¿ that's still not very much. I think you really need 250,000 or 300,000 ¿ or preferably 400,000 ¿ new jobs a month before you bring down the unemployment rate. As long as job growth is low, they'll keep quantitative easing going. But if they see a few months of 300,000 new jobs created each month, they would ease up [on stimulus] for fear of inflation.

WP: Do you think the consensus about the economy for 2011 is too pessimistic or too optimistic, and how does this impact your strategy?

If you asked me six months ago, I would have said it was too pessimistic. Now everybody's become more bullish, but I'm still in the bullish category. The American economy is strong. We have entrepreneurs, an open society, a rule of law. It's a great place to do business.

But while I'm still very optimistic about the economy, I'm not finding the undervalued stocks I did six months ago.

WP: How do you deal with that?

I don't move to cash. I've had huge inflows into the fund, but I'm nervous about letting the cash build up, because if the stock market runs and I'm sitting in cash, I underperform. That happened five years ago. I'm trying to keep fully invested. One thing I do is add to current positions. The other thing I do is I have to relax somewhat the undervalued standards. I have 88 to 89 percent of the fund invested. [The rest is in cash.] I would like to be up into the mid-90s, but it's hard to do when you have so much coming in.

WP: How much money came into the fund in 2010?

We started 2010 with $115 million. Now the fund is almost $450 million. Part of that is appreciation of stocks in the fund, and some is the $200 million-plus of fund inflows we had in 2010.

WP: What do you see as the primary risks to the market and economy in 2011?

Oh boy. Here's what I worry about the most. Number one is employment. If employment grows slowly, which to me means less than 100,000 new jobs a month, that hurts my home-builder thesis. Even if interest rates and home prices are low, if you don't have people working, they're not going to buy homes. I don't look at unemployment rates so much as I do the number of jobs created. Every month when those new-jobs figures come out, those are the most important numbers.

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