Where Investment Pros See Opportunities Now

EDITOR’S NOTE: Want to know where the investment pros are putting their money these days? For insight into that question, SmartMoney is reporting this week from the annual conference for professional managers and advisors held by Morningstar. We’ll continue to update this conference blog with the latest news.

May 29, 2009, 2:10 EST -- In the closing session to the Morningstar conference, small-cap veterans John Rogers Jr. of Ariel Investments, Chuck Royce of The Royce Funds and Jeff Cardon of Wasatch struck a familiar note: Despite the severity of the crisis and the hit their funds took last year, there weren't many changes to their approach.

Throughout the conference, participants and moderators quizzed the panelists on what they were doing differently and routinely the answer was: not much. The buzzword for this trio: Holding high-quality companies (strong brands and positioning and solid balance sheets) for the long haul. The three investors are all known for holding stocks for years – even for a decade or longer — and as a result, most of them have been adding to their existing positions. Rogers, for one, said part of his outperformance year-to-date was because he added to some of the fund’s battered holdings including those in media.

Despite sticking with their basic strategies, the group admitted to tweaking them a bit. After such a disastrous 2008, Rogers, for example, said he was stress-testing companies balance sheets not just for a recession, but a much harsher economic climate. While always leery of firms growing quickly through acquisitions, he had stepped up pressure on companies in the funds to make sure they didn’t take on debt to make foolish acquisitions in this market. And the investors have also been doing some “spring cleaning,” selling weaker names and adding to the stronger ones. (Rogers volunteered that he sold Banco Popular (BPOP) in the past year and has added to holdings like Citi National (CYN) and Northern Trust (NTRS).) Royce, who typically avoids talking specific names says he has been doing the same with some of the fund’s infrastructure names.

Some of their favorite picks lately:

Wasatch’s Cardon: Liked technology firms and was still a fan of long-term holdings O’Reilly Automotive (ORLY) and Knight Transportation (KNX), which stand to benefit as smaller mom-and-pop firms go out of business and the fragmented industry consolidates.

Ariel’s Rogers: Scooped up shares of companies like CBS (CBS) and Gannett (GCI) when the shares were pummeled. He said both firms have diversified holdings. He has also been adding to asset manager Janus (JNS), tech names Dell (DELL) and Accenture (ACN) and real estate service firms like CB Richard Ellis (CBG).

Royce: Finding opportunities in technology in names like research firm Gardner Group (IT) as well as financial service firms like T. Rowe Price (TROW), Invesco (IVZ) and Cohen & Steers (CNS) as a back door play into real estate recovery.

May 29, 2009, 1:20 p.m. EST -- Trading ain’t cheap. So says Roger Edelen, a professor of finance at University of California, Davis, who tallied the costs funds pay – read: the returns they give up – every time a manager gets in or out of a position. Between commissions, the bid-ask spread and the impact the trade itself has on the price of the stock, the cost of a single trade can eat almost one percentage point of return, he explained at the Morningstar conference this morning. And given that most funds make a lot more than one trade a year, the total costs can add up to more than 2.3% per year.

Those costs aren’t tallied anywhere. And the fund’s returns are reported net of trading costs (and expenses). So when the investor sees that a fund returned, say, 5% one year, that’s 5% after trading costs and expenses have been paid. The problem, says Edelen, is that without understanding how the manager got that return, investors don’t know what to expect in the future. “So people chase performance – that bottom-line number,” he said. Understand that the trading costs, on the other hand, are a hurdle the manager has to clear, and “you can start to build your expectations for future performance.”

So what’s a savvy investor to do? Turnover alone isn’t a good enough proxy, Edelen said, because the size of a trade is as important as frequency. Funds that are large compared to their peers may not be as nimble; Similarly, highly concentrated funds are likely to make bigger (and more expensive) trades. For investors without the inclination to repeat Edelen’s years of Ph.D.-level research and analysis, here’s the rough approximator: look for low-turnover funds that are smaller, relative to peers, and that aren’t highly concentrated, and you’re likely to have a fund with a lower trading-cost hurdle to clear. -- Janet Paskin

May 29, 2009, 12:30 p.m. EST -- Reshma Kapadia talks with John Montgomery of Bridgeway Small Company Market Fund.

May 29, 2009, 11:15 a.m. EST -- Bob Rodriguez is upset. The ever-bombastic chief executive of First Pacific Advisers virtually shouted his speech to the crowd that gathered to hear him speak early Friday morning, the third day of the Morningstar conference.

Calling Alan Greenspan’s policies “insane,” dismissing the financial instruments created by “propellerheads,” and accusing stock analysts and fund managers of sloppy due diligence (“How could they have missed a breakdown of this proportion?", "What were they researching?"), Rodriguez began his keynote speech true to form — with an indictment of just about everyone.

His ire was focused, however, on the federal government. Both the policies that got us here — Alan Greenspan and Ben Bernake claiming that bubbles could not be discerned until after they had burst, Sen. Chris Dodd declaring that Fannie Mae and Freddie Mac were adequately capitalized — and the “unsound” ones being implemented today, “the true cost of which won’t be counted for many years.” It’s not just the money being spent by the federal government that angers Rodriguez. It’s the unintended consequences sure to result. One example: Federal support of GMAC, which took on too much risk in their lending practices, undermines the competitive capability of a more sound lending institution, Rodriguez says.

His self-described tirade built to a litany of dire predictions as to what we’re facing in the next 10 years. Expect the personal savings rate to jump from 2% from the beginning of 2009 to 8% by the end of the year. It will likely take 10 years for Americans to return to their pre-crisis net worth. Government efforts to stimulate the consumer are misguided, Rodriguez said. Instead of giving $8,000 to new homeowners, the government should put that money toward retraining the legions of unemployed or soon-to-be unemployed and getting them to work in industries that will contribute to America’s capacity to export. Otherwise, given the increased percentage of GDP government spending is taking up, we’re in for a long period of substandard economic growth. “The housing and auto industries will not be the beneficiaries of these new economic trends,” he explained. “Let’s not invest in buggy whips.”

Deficits are another concern, Rodriguez says. If foreign investors maintain their current level of U.S. debt ownership and increase it proportionately this year relative to the new debt being issued, they will have to spend another $800 billion this year, above and beyond the $724 billion foreign investors spent on U.S. debt last year. That level of foreign ownership is unlikely, Rodriguez said, which means the federal government will have to print $800 billion to $1.5 trillion in new money to make up the difference — sending us even deeper down the well.

Yep, the world is going to hell in a handbasket over the next 10 years. The audience response to this news? A standing ovation. -- Beverly Goodman

May 28, 2009, 7 p.m. EST -- Few veteran investors engender the affection that John Bogle, creator of the index fund, founder of Vanguard Investments 34 years ago and permanent industry watchdog, inspires. The first question (before a roomful of hundreds of financial advisers closing the second day of the Morningstar conference) was about his health—he had four stints in the hospital in the past year due to complications of his heart transplant. He’s doing fine, Bogle, who just turned 80, assured the crowd, and is “still filled with a great taste for the battle.” Besides, he added, “when one is granted 13 extra years of life, one is not inclined to bitch about a few days in the hospital."

Bogle also hit on his usual topics, taking on the notion that buy-and-hold is dead. “Buy-and-hold is never dead,” he boomed. Buy-and-hold investors hold 50% of the S&P 500, he posited. The other half is held by active traders—trading with one another, and paying transaction fees every step of the way. “Guess what—at the end of the day, at the end of the week, at the end of the month, year or decade” Bogle said, the buy-and-hold investors capture 100% of the return of the S&P, while the other half captures maybe 15% of the return because of costs. “The mathematics are easy,” he said. “Avoid all that trading like the plague.”

His take on some of the more recent innovations in the fund industry met with equal derision. Target date funds? “I’m increasingly nervous about them,” Bogle said, pointing to the fact that two people retiring in, say, 2015, might need very different investment strategies depending on their eligibility for Social Security, pension availability and many other factors. Plus, he said, he doesn’t trust the allocations. “If your fund has a 60% equity allocation and it’s not selling as well as your competitor’s with a 70% allocation, there’s tremendous pressure to increase your stock allocation to 70%. His final point: Most target date funds are simply too expensive.

As for absolute return funds or 130/30 funds? “Under no circumstances,” Bogle said. “We innovate for the sake of our marketers, our competitors have something so we need it too.” Stick with the tried-and-true strategies: Among them, of course, is indexing.

Finally, Bogle weighed in on exchange-traded funds, which he’s been critical of in the past. “I’m afraid my skepticism is increasing,” he said. He acknowledged that if an investor buys an ETF that holds a broad array of stocks (like Vanguard’s Total Stock Market ETF), they could save a little money over an index mutual fund in the long run. “That’s not an unreasonable thing to do.” But ultimately, he added, ETFs are mutual funds you can trade all day long in real time. “What kind of lunatic would try to do that?” He pointed to the Spider, which has 700 million shares—and yet 80 billion shares were traded last year. Even allowing for institutional trading, he says, ETFs simply encourage investors to time the market in a way that ends up being costly in the short term, due to trading costs, and detrimental in the long term, since market timing never works. --Beverly Goodman

May 28, 2009, 7 p.m. EST -- On Thursday Bill Gross, the legendary fixed income manager and co-founder of PIMCO, continued to sound bearish sentiments that have moved the stock market the last week. In the wake of one of the worst economic downturns since the Great Depression, Gross sees a new, grim world where “investors won’t be the winner.” Here are key points from his lunchtime speech and a subsequent sit down interview with SmartMoney.

U.S. Credit Rating at Risk: Gross noted the U.S. debt now equals 60% of GDP. “It will only take four years to get to 100%,” he predicts. “The ratings agencies say that will make us susceptible to a lower rating.”

More Job Losses: Get used to 7% to 8% unemployment in the years to come instead of the more typical 4% to 5%. “It will take time for all the real estate agents and the Wall Street derivative experts to figure out how to work in productive ways.”

Bear Market Traps: Beware of the “green shoots,” or unsustainable rallies triggered by isolated recent signs of growth.

Realistic Expectations: “Give up the notion that the Dow is going to 14,000 or the economy is going to accelerate to new peaks in a few years,” says Gross, “Or even that the house is going to catch up in value to what it was that you paid for it.”

Credit at a Cost: With the Treasury issuing epic amounts of debt, it will make credit more expensive for just about everyone else—from states and municipalities to corporations and individuals who need to borrow.

California on the Brink: Gross predicts that California will fall into the category of too big to fail. “If it failed, it would send a terrible signal around the world,” he says. Gross sees California moving to a BAA rating from an A- rating. Gross predicts the government will be forced to step in to guarantee loans. As it is, “PIMCO and no one else would buy California bonds,” he says. He also expects more state and local government downgrades. In order to regain credibility for missing so much, “Moody’s and Fitch will have to get tough,” he says.

Return of the Working Man: We have had a “mal-distribution of wealth,” with Americans making up 25% of world GDP. “The investor class was making a lot of money,” says Gross. “The working class was just doing decently.” In the new world, there will be some rebalancing in favor of the fire fighter. “Corporate America is not the fair-haired child anymore--it’s labor, it’s the wage earner,” says Gross. --Dyan Machan

May 28, 2009, 6 p.m. EST -- At a panel discussion of exchange-traded funds, Morningstar experts weighed in on ETF pitfalls, along with their least and most favorite ETFs.

One growing concern: the credit risk of exchange-traded notes or ETNs. ETNs are promissory notes issued by banks, usually used for exposure to currencies, commodities or foreign markets that aren’t very liquid. Their debt structure might seem like a technicality, but when Lehman went bankrupt, four of its ETNs went bust with it. Most investors got their money out before the collapse, noted Scott Burns, director of ETF analysis at Morningstar. Still, “one of the biggest issues now is ETN credit risk,” he said. His advice: check the credit ratings of the issuing bank, which is usually different from the ETN sponsor. And stick with banks that appear well capitalized and seem to have low risk of defaulting on their debt.

The pros also cautioned investors to steer clear of leveraged ETFs, which use options and other financial instruments to provide returns that are several times more than the market’s moves, up or down. Really, what they are is "exchange-traded derivatives," said Burns, which are inherently risky and inefficient for taxes. Plus, they get hammered when volatility spikes. “It’s not a happy place to be,” said Burns. Leveraged ETFs should only be held for a day, not as long-term holdings, he advised.

As for their picks, for commodity exposure, the panel recommended the Elements S&P Commodity Trends Indicator ETN (LSC). The fund uses a momentum strategy to load up on commodities with positive price momentum and short those that have been heading lower. According to academic research, going back 25 years this stategy has outperformed long-only commodity exposure by 5 percentage points a year, on average, said analyst Bradley Kay. “It’s the commodity fund with brains,” said Burns. “It has a great academic pedigree and has stood the test of time as an investable idea.”

Another fund they like: the Powershares Financial Preferred ETF (PGF). Preferred shares combine elements of stocks and bonds and these days the fund is traded at around half its “par value.” That gives investors the potential for doubling their original investment, and the ETF yields around 10%, noted analyst Paul Justice. Plus, the dividends are taxed at the favorable dividends tax rate, rather than as ordinary income. Of course, financials could still tank, which would take down this ETF, too. But investors can hedge their exposure, said Justice, by buying a "put" option on a financials ETF; that way if the whole sector crashes they'll still make money on the put. “Preferreds are a great place to be if you want to play financials in the recovery,” said Justice.

On the conservative side, the pros suggested Vanguard Dividend Appreciation (VIG). The ETF’s portfolio is made up of the highest-quality domestic stocks on the market, measured by things like their balance sheet and economic moat--how susceptible the business is to competition (the wider the moat the better). They also recommended iShares Barclay TIPS Bond (TIP) ETF, which provides a hedge against inflation. It isn’t yielding much now, but as inflation picks up, the ETF will pay off. “Inflation is a retirement killer,” said Burns. “It’s a thief that steals from the savers and gives to the spenders." If you think inflation will be more than 1% over next 10 years, he added, this is good fund to own for about 10% of your portfolio. -- Daren Fonda

May 28, 2009, 5:03 p.m. EST -- Jensen's Bob Miller reveals two technology stocks high on his buy list.

May 28, 2009, 2:51 p.m. -- Staff writer Reshma Kapadia asks FPA Crescent's Steve Romick where he is finding value.

May 28, 2009, 12:30 p.m. EST -- At panel with value investors Third Avenue Funds’ Marty Whitman, Oakmark’s Bill Nygren and Invesco AIM’s Meggan Walsh had the requisite number of mea culpas, given the battering many of these funds took last year. But as they move forward, the managers were split in their approach.

Distressed debt is a popular hunting ground for some intrepid value managers, but Walsh and Nygren don’t seem sold on the opportunity. Despite all the hoopla about the possible outperformance in distressed debt versus equities, especially in the banking sector, Walsh says she hasn’t really seen that over the past six months. And Nygren says he would rather own cash-rich, debt-free technology stocks like Microsoft (MSFT) and eBay (EBAY) at this point.

But Whitman, no stranger to distressed debt investing, says he sees a huge opportunity – so much so that Third Avenue is looking into launching a distressed debt fund. He divided up the opportunity among reorganizations, capital infusions into companies and investing in performing loans that were 85% to 90% likely to remain performing loans –perhaps the biggest area of opportunity. Whitman admits he’s a bit “spooked” by the stock market after last year and these loans allow him to get yields to maturity of as much as 30% without having to pay attention to the stock market. Some recent investments include the unsecured debt of GMAC, CIT (CIT) and Standard Pacific (SPF).

That’s not to say he isn’t investing in stocks. A Whitman favorite: Toyota Industries (TYIDY), the largest shareholder in Toyota Motors (TM). Buying the conglomerate allows him into Toyota at a 40% to 50% discount, and the auto maker is likely to gain significant market share as General Motors (GM) and Chrysler possibly bite the dust. Walsh also likes an auto-related play: Johnson Controls (JCI), which makes auto interiors and instrumentation as well as efficiency technology for heating, ventilation and A/C systems. The company’s stock has taken a beating amid the woes of the car makers, but it sports a solid balance sheet and some of its businesses, like power solutions (read: batteries), should benefit from the push for lower emissions.

As for Nygren, he has some unlikely picks for a value manager like Apple (AAPL) – in part because of the market’s tumble in the past year. He also likes drug retailer Walgreens (WAG). -- Reshma Kapadia

May 28, 2009, 12:10 p.m. EST -- Jeremy Grantham, co-founder of GMO, a Boston-based institutional asset manager, had been bearish on stocks for years. But in early March, just as the S&P 500 was crashing to new lows, he wrote that the market was 30% undervalued, with a “fair market” value of 900. That proved to be a prescient call, with the markets now trading around those levels. So where are we headed now?

Grantham spoke for almost an hour, giving an academic history lesson on everything from GDP to consumption and residential investment, sprinkled with graphs and charts on the markets and how different asset classes have performed. “I have every reason to expect a big flaky rally,” he said, based on historic post-bear market moves, adding “it’s quite likely” that the S&P will go over 1000 or 1100. Still, “the problems we face won’t go away in a hurry."

His advice to folks who have been on the sidelines in cash, wondering when to get back into stocks: “If you missed the rally, recognize you’ve lost round one and do damage control.” That means getting back in gradually but holding some firepower for the next big market dip.

More than U.S. stocks, though, Grantham said the best returns may be in emerging markets. While the developed world is “running out of poeple,” and "growth rates are falling in all developed countries,” the emerging markets have the population winds at their back, along with economies that will grow considerably faster than those in Europe, Japan and the U.S. “Big asset classes drive success,” he said, “and they’re very inefficiently priced.” In other words: don’t fret about which small-cap fund manager might outerperform the market by a point or two; the big money is in getting the broad asset class right -- and emerging markets may be the one to bet on for the next few years.

Commodities could be another good bet, he said. While we may solve our energy problems and find good subsitutes for oil, we are simply running out of iron ores, minerals and other natural resources. Even coal, he said, will be gone in 70 years at current rates of consumption. “Then we’ll be on our own and will have to get used to being frugal.”

Grantham closed his talk by advising investors not to be afraid of bubbles. “Bubbles drive the marketplace and you have to play them. They shouldn’t be feared because that’s how money is made.” Still, he warned, even some of the smartest minds in history--like Sir Isaac Newton--have been burned by bubbles. Heavenly bodies, said Newton, were far easier to predict than human behavior.

-- Daren Fonda

May 28, 2009, 11 a.m. EST -- There’s a nascent debate brewing here on investing in health-care companies. For a long time, most investors have been dazzled by the money to be made by an aging population’s increased demand for drugs, tests and procedures, coupled with health-care costs that are rising much faster than the overall cost of inflation. And with health-care stocks currently cheap, it’s an investing Valhalla for managers like Dodge and Cox’s Diana Strandberg and Fairholme’s (FAIRX) Bruce Berkowitz.

But other managers aren’t so sure. Echoing a theme sounded by Wintergreen’s (WGRNX) David Winters Wednesday, Marsico Capital’s Tom Marsico expressed his concerns about health care’s growth prospects Thursday morning. “Per capita, we’re spending a lot more money on health care than other countries,” he said. “We can’t afford it.” And as government gets more involved, our system may be forced to get a lot more cost-effective – and a lot less generous. For growth, he and Winters both said they’re looking elsewhere.  

-- Janet Paskin

May 28, 2009, 11 a.m. EST -- Another insight from the Thursday morning session: While Tom Marsico was reflecting on the crash, he let slip a telling glimpse into who’s really pulling the strings at his funds. Marsico and his investment team saw the tsunami coming, they said, and wanted to build their cash position. But the firm's institutional clients – 401(k) plans, pension funds and endowments – demanded that they stay fully invested. So they did – and lost 43% last year. Maybe Marsico's just scapegoating. But if he's not, his admission should be a wake-up call for retail investors (and the financial advisors in attendance at this conference) who think they're getting a professional manager’s unfettered best judgment when they invest in an actively managed fund.

-- Janet Paskin

May 27, 2009, 9:30 p.m. EST -- To most investors, it would seem the world’s markets have changed substantially during the last year. But the three managers on Morningstar’s Wednesday afternoon panel on global investing sounded the same notes they (and other value investors) have been singing for years. Oppeheimer’s Rajeev Bhaman, Dodge and Cox’s Diana Strandberg and Wintergreen’s David Winters reiterated their continued belief that growth is still global, and driven by an emerging middle class. To Bhaman, that means companies like Colgate-Palmolive (CL), which he likes because it’s the preferred brand in India, where only a third of the population currently uses toothpaste, he says. To Strandberg, it’s cellphone producer Nokia (NOK), and for Winters, it’s luxury jeweler Compagnie Financiere Richemont. Sure, all three pride themselves on their ultra-long-term focus, and it takes discipline to stick with a process when the world’s gone topsy-turvy, but considering their funds were down as much as 46%, it was disorienting to hear just how little has changed.

 -- Janet Paskin

May 28, 2009, 9:00 a.m. EST -- Janet Paskin talks to David Winters of Wintergreen Funds at the 2009 Morningstar Conference.

May 27, 2009, 6:30 p.m. EST -- Chris Davis, manager of the Selected American Shares (SLASX) and Clipper (CFIMX) funds, has a great long-term track record that has hit some rough patches the last few years. So, advisors were curious to hear about the five areas he said were ripe with opportunity.

Davis, who opened the conference with his keynote speech, is a longtime value manager in the tradition of Warren Buffett. He began in his typical aw-shucks style by warning his audience that when you manage a mutual fund, “the decisions you make have life-changing consequences.” To wit: His hairdresser recently asked him how many haircuts he thought it took her to be able to save $2,000. “I’m not sure, why?” he responded. “Because that’s how much I lost in your fund.”

Davis’s mantra — to both his hairdresser and his audience — is about staying in it for the long haul. An array of line graphs illustrated his point that no one (not even he) can predict the direction of the markets. What’s more, “underperformance is inevitable,” he says, and he urged the audience of financial planners and money managers to encourage their clients to stick with index funds if they weren’t able to ride out three years of underperformance in an actively managed fund.

Davis was typically cagey as to what stocks he’s buying, but pointed to five areas he likes these days:

Globally dominant businesses: “I call these companies camels, because they can go a long time without needing capital,” Davis said. These are industry leaders with strong pricing power in businesses with high barriers to entry — and are trading at near-historic lows. One example: Johnson & Johnson (JNJ). “It’s trading at 12 times earnings and has a 3% dividend,” Davis crowed. “You can just buy it and put it away.”

Beneficiaries of crisis: These firms have business models and management mindsets that allow them to take advantage of chaos, Davis said. They’re often able to make investments, acquisitions or buy back stock. Davis mentioned Berkshire Hathaway (BRK.A) and Lowe's (LOW) as two that fit in this category.

Select financial companies: “During times of chaos, lots of companies go out of business,” Davis said, “but the market share is still there, which means lots of business and less competition for the survivors.” And despite the dramatic changes and uncertainties roiling the financial-services industry, it’s a “nonobsoletable” industry. Some names mentioned: Wells Fargo (WFC) and JPMorgan (JPM).

Energy, commodities and agriculture: “This is basically a reminder that we’re 5% of the world’s population,” Davis said, and the “enormous megatrend” of the rapidly global middle class. Companies in all countries could benefit, but Davis has his eye on those that can profit from the growth in China and Brazil in particular.

Special situations: Davis said he was looking for “highly opportunistic, long-term investment opportunities” that may be a bit out of his usual domain. One recent example: Davis recently bought Harley Davidson (HOG) bonds after owning the stock for a long time.

-- Beverly Goodman