10 Questions With Ken Gregory

Ken Gregory might not be the Fund Junkie, but he is a fund junkie.

In the wake of last year's bloodbath, fund investors and plenty of battered stock investors are asking the same thing: How can I build a diversified portfolio of mutual funds that will grow my assets over time without white-knuckle volatility?

Enter Ken Gregory, chief investment officer at Orinda, Calif.-based Litman/Gregory & Co., which picks the sub-advisers for the Masters' Select funds, publishes the No-Load Fund Analyst, and manages money for private clients. Gregory tells us how he'd build a portfolio for a long-term investor, names his favorite managers, and gives shareholders of sagging Janus funds his 2 cents on that shop's prospects.

Ken Gregory, Chief Investment Officer Litman/Gregory & Co.

1. Let's say I'm a moderately aggressive investor with a 15-year time horizon. What should I own?

Gregory: For somebody with a time horizon of 15 years, I think it makes sense to use a neutral allocation that is 100% in equities. It's a long enough time-horizon to justify that. Our philosophy is that unless we see a fat pitch opportunity, we would stay within neutral allocation.

By that you mean staying the course with a portfolio that matches a broad index like the Wilshire 5000 Total Stock Market Index?

Putting It In Neutral Using the Wilshire 5000 Total Stock Market Index as a benchmark, a neutral or diversified U.S. stock portfolio would look something like this.
Sector Allocation
Sectors	% U.S. Stock Assets
Technology	22.3
Financial Svc.	17.8
Healthcare	13.9
Consumer Discrtionary/Svcs.	12.2
Utilities	8.8
Consumer Staples	6.1
Energy	5.9
Other	5.2
Producer Durables	3.3
Materials/Processing	2.6
Autos/Transportation	1.8
Capitalization Allocation
Large-Cap	75%
Mid-Cap	15
Small-Cap	10
Style Allocation
Growth	42%
Blend	17
Value	41
Source: Morningstar.com, Vanguard.com, and Wilshire.com

Gregory: Yes, and maybe have some international exposure and small-cap exposure. You can break it down in terms of growth and value and how much international do you want, how much small cap do you want, etc.

How much of that portfolio would you put in a foreign stock fund?

Gregory: A neutral foreign allocation in the type of portfolio that we were talking about is about 20% in an international fund. And that's about where we would be now, at 19% or 20%. We view international stocks as offering reasonably good long-term opportunity, but not -- definitely not -- what we would call fat pitch.

2. What would you overweight now, or what is a fat pitch today?

I would overweight the value side [as opposed to growth] and as we look at the market right now, we see the best values in the mid-cap and smaller-cap area. We are overweighting primarily in the mid-cap sector, because we're a little bit worried about being too aggressive in the small-cap sector this late in the economic cycle. If we do end up having a recession, small caps -- because they're less liquid -- tend to take a greater-than-average hit in a cyclical bear market.

Conversely, we would still underweight growth, especially larger-cap growth. It's been hammered hard in the last five months or so, but in our opinion it was so overvalued that it's still on the expensive side.

I'll make two points to justify that. First, five-year earnings forecasts for the Russell 1000 Growth Index have come down in recent months, but they're still extremely high -- up near 25%, which is, if you look at the history of those forecasts going back 20 years, they have not been this high other than the recent period that we've been in. That's simply not realistic, attainable earnings growth for a whole broad universe of stocks over that long a period of time. So I still think there's a lot of optimism built into earnings forecasts.

And then, if you look at the prices growth stocks are selling for in the Russell 1000 Growth Index, what it's selling for relative to its earnings forecast, well, it's come down a lot, but it's still quite a bit above its long-term average, even factoring in, those -- what I think are going to turn out to be overly optimistic -- earnings forecasts. So we still think that sector is overvalued, and we would underweight it.

The area that we think is the most attractive fat pitch right now is high-yield bonds. Typically, with a portfolio like the one you described, we wouldn't have any fixed income in the portfolio, but this is a time where we would put in a high-yield bond element.

High-yield bond funds are coming off a few tough years, but what are you seeing there?

Currently, high-yield bonds are yielding about 14% -- that's almost a 9% spread over 10-year Treasuries. That spread is at its all-time high. If you look at what level of defaults that spread is pricing in, it's pricing in a default rate of about 11%, which is around the all-time high (which was reached in 1991) in terms of defaults that we're actually going to actually incur in any given year.

So, basically, we view the high-yield bond market as pricing in a recession -- it's pricing in a hard landing already. And if we do, in fact, have a hard landing, I wouldn't be surprised in the near-term for high-yield bond prices to go down further. But if you look out 12 months, there isn't much downside risk from here. If you look at two or three years, my expectation is you're going to get a 13% or 14% return from the yield, plus you're going to get another 15%-30% in appreciation on top of that.

3. Underweighting growth stocks is underweighting tech stocks. After its stunning run in the late 1990s, some say the sector is oversold and some, like you, say it's still too expensive. What do you see down the road for tech stocks?

Gregory: The reality is that there's a fair price for every type of asset, regardless of how good its fundamentals are. Generally, when people become that optimistic, they tend to become overly optimistic, and they don't sharpen their pencil as much and do careful analysis. I think there's a lot of buying of tech in the last year that didn't have a careful analysis attached to it.

It really became a momentum game, and I think a lot of professional investors that didn't want to play felt they were forced into doing it. They'd underperformed because they'd underweighted tech, and they felt that they couldn't afford to underperform any more, so they increased their exposure. All of that continued to kind of feed into what was going on.

A lot of things change, but human behavior doesn't. We go through these cycles, and I'm sure it will happen again at some point, where people get caught up in a story and they stop doing careful analysis and they learn the lesson again.

I think over the next few years what we might see is that tech doesn't bounce back as quickly as people might have thought, since we've been taught to buy in dips. Obviously, this has been one heck of a dip, but if we're wrong and tech stocks remain overvalued there's justification for prices to keep falling further. What often happens when you have a big decline and you don't have the rebound right away is [that] people start to get discouraged. They start to lose confidence and kind of overreact the other way.

So there's a potential for the technology sector to actually go to an undervalued level. I don't know whether that's going to happen. I think what's different now is that the markets react a lot faster. It's harder to say how this will really play out. What I'm suggesting could happen would be maybe a period where tech gets undervalued and people just get so disgusted with it that they stay away from it for a while.

4. Last year set a record with more than $40 billion flowing into tech funds and beating 1999's record. Before 1999, the old record was $4.4 billion. Also, the average diversified growth fund has more than 40% of its money invested in tech. Have you seen such a vast, pronounced, and profound migration of money to one sector of the economy?

Gregory: This time tech got up to be 33%, 34%, 35% of the S&P? Energy stocks in the late 1970s and early 1980s I think got up to close to 30% of the S&P, so it was very similar.

That was a period of great inflation in general, but in oil prices in particular. There was a gas shortage and prices were skyrocketing, and I think that there was a feeling that we were going to run out of oil.

What can investors learn from these two situations?

Gregory: I think they're related just from the standpoint that investors oftentimes have short memories. They look at what's worked recently and they see a trend. It's very easy to kind of buy into underlying reasoning for why that trend seems to be there and extrapolate it forward many years.

We've seen plenty of trends over the years, whether it was international stocks in the late 1980s or it was small-cap stocks in the early 1980s or there was growth stocks recently. In each case, you had an asset class that had huge outperformance, and by the latter stages of that outperformance, the mutual fund industry was coming out and launching lots of funds focused on the area and people were piling in that area. Then that asset class became the worst performer for three or four years.

5. What's your advice for investors who are sitting with a battered, tech-heavy portfolio today?

Gregory: First of all, they have to take a close look and understand how much their overweighting is, and what is a reasonable weighting. The S&P 500 is now back to a tech weighting in the low 20s, and that might be a starting point. And if they're significantly over that, it should be because they're significantly more confident that tech will outperform given their time horizons.

Beyond that, I think people have to be honest with themselves about their ability to assess that. I think some people read an article in a magazine and make a big jump in their thinking to a level that gives them a lot of conviction in an area like tech.

I think it makes sense for investors to ask themselves whether they really have enough information, and if they've really analyzed it well enough to have a basis for maybe weighting tech 50% over the market weighting.

I think that a lot of people will realize, if they're honest with themselves, that they probably haven't done enough analysis, or maybe don't really know how to do it, or maybe they don't have enough information to be that confident. I think a way around that is to use funds that will invest in tech, but don't have a mandate to be there, and if they can identify funds run by managers in whom they have a lot of confidence and kind of defer the decision to them, that's one way around it.

6. You pick portfolio managers for a living, so if you had to pick one growth manager who would it be and what put he or she at the top of your list?

Gregory: Glenn Bickerstaff who runs a (TCGEX Quote)TCW Galileo Select Equity Fund. We spent a lot of time with him and his team over the last few years, and basically, he has got great clarity in terms of his investment approach, and he is extremely disciplined, maybe one of the most disciplined stock-pickers that I have ever met, in terms of executing it.

There are a lot of smart people picking stocks, [and] I think more often than not, it's not just the brain power, but it's their ability to really stick to their discipline and not make decision errors like extrapolating a trend too far into the future or focusing too much on what's happened recently or becoming overconfident because you've had a string of successes. Those are the types of decision errors that human beings make. Portfolio managers are human beings and they make those mistakes. But I think Glenn Bickerstaff is extremely disciplined and probably makes less of those mistakes than most people.

He also has a singular focus. He's one of the most focused stock-pickers that I've ever run into, just in terms of just focusing on the business of stock picking and eliminating other distractions, whether they be marketing or whatever.

7. I just pulled up the fund's record over the past year and it's held up pretty well. Does a tough year 2000 give us a good chance to see who was lucky and who was smart among growth managers?

Gregory: I think to a certain extent it's true. You see some funds have performed phenomenally well, way beyond benchmarks in the couple years prior to 2000, and through the first part of 2000. And then they totally collapsed. I think those are funds that were kind of riding the wave, more momentum-oriented, that I personally wouldn't have as much confidence in.

8. If you had to pick a value fund manager, whom would it be?

Gregory: It's hard to choose between Bill Nygren, who runs the (OAKLX Quote)Oakmark Select and Oakmark funds, and the team headed up by Mason Hawkins that runs the (LLPFX Quote)Longleaf Partners fund. I like them both for very similar reasons.

(Click here to read a recent 10 Questions column with Nygren in it, and another one focused solely on him.)

I think they both, again, are highly disciplined, with real intellectual honesty and clarity of thinking. They have a very well-defined process that they execute consistently. It's a lot of the same things we see in Glen Bickerstaff; they're obsessive in gaining an edge, in getting more and better information to be able to make decisions. They're very focused on what they do -- all of those things are important.

They also have great cultures in their firms where I think that they'll be able to keep people together. There's an enthusiasm and a positiveness in their organizations that gives us more confidence, because if we invest in a fund, we do so with the hope that we can own it for a long time.

9. Speaking of confidence, that may be an issue for a lot of folks who own shares in Janus funds that took a beating last year. In 1999 and into 2000, Janus' funds loaded up on tech/telecom stocks that put them in the sweet spot of the market and got a mountain of money. Since then they've lost Chief Investment Officer Jim Craig and have seen their style age pretty poorly. How do you think Janus' funds will do down the road? (Janus' Helen Young Hayes helps manage the (MSILX Quote)Masters' Select International fund.)

Gregory: The question that I'm wondering about, and I'll speculate on the answer, is how flexible they'll be to the changing environments? I think if you look historically at Janus, they have evolved over the years.

In the early 1990s, they were not as aggressive as they are now. Now, there are more people there in key positions and they have many more funds, so the profile of the firm has changed, but I think that they are pretty flexible thinkers, and I think that they've already kind of admitted that they were too confident in some of the stocks that they owned and particularly, I think, in the tech sector.

We actually just spent, a couple months ago, a couple days in their office, and I've got a lot of respect for the quality of the people they have there. What I would suspect is that they will adjust and they will find good opportunities in the stock market. If they're outside tech, then they'll have exposure outside tech. I think they will still have technology exposure, but I think they will look at everything to find where good opportunities lie.

I think the biggest question mark I have with them is just their asset base. I think that it will be harder for them to do as well in the future as they've done in the past because they're running so much money. I think they'll do OK and, as an investor, unless I felt that my whole reason for buying Janus in the first place was wrong, I wouldn't panic. I've got a lot of confidence in the people that are at the organization.

On the other hand, I wouldn't just automatically assume that they're going to hit the cover off the ball. They're going to be competitive and do well, but I think their asset base will make it a little bit harder for them to do as well as they had prior to this downturn.

10. More broadly, folks' expectations really have to come down, right?

Gregory: Absolutely. For almost 20 years now, we've had very high returns from stocks compared to long-term averages. And the returns have been, up until the last few years, almost entirely driven by following interest rates. But now we've gotten to a point where interest rates can't go down that much further any more -- they can certainly blip down a little bit, but they've gone from 15% to 5%, and there isn't that much room any more.

So we're not going to see that huge price-to-earnings multiple expansion that we saw since the early 1980s. I think there's a very good chance that over the next five, six years that returns will be in single digits for the stock market. So I think whatever equity funds you own, their performance is going to be a function of the market environment. You're not going to see 30% compounded returns as often in a single-digit return environment as you would in a 20% return environment.

Doesn't look like the recent concept of 20% gains as the cellar is not really going to age very well.