Given the market's recent gyrations, you don't have to be a widow or an orphan to be a bit, shall we say, price-conscious.
That mindset is nothing new for
, skipper of the large-cap $10.5 billion
Merrill Lynch Basic Value fund and our guest for the inaugural
-- a weekly money manager interview. We picked Kevin because he won't buy a stock unless it combines a catalyst for growth with a cheap stock price relative to its cash flow, book value, earnings or dividend yield. Not bad criteria to stick by if you're a buyer in today's market.
1. With the Nasdaq flexing its muscles again this month, what does that mean for value investors? Where is this market heading?
At the end of the day, it's going to all come back to valuations.
Managing Fund Since
YTD Return/Percentile Rank in Category
1-Year Return/Percentile Rank in Category
Source: Morningstar. Returns as of June 7 in the large-cap value category. Holdings as of March 31.
I know the Nasdaq rallied 20% the first week in June, and it was due for a bounce just technically. But I don't think we're going to go back to where we were because I think a lot of people woke up to the fact that they want to own companies that at some point are going to make money.
A lot of people probably looked at their portfolios and realized some things about what they own; they don't know what they did. They don't have any revenues and they're relying on the secondary market for the next round of financing to re-invest in that business. That window's shut now, and
they're thinking my God, what do I own here?
I would have bought everything in technology in the last two months if I thought the stocks were cheap, and they weren't. So
, wonderful companies -- I have nothing bad to say about the companies -- but 120 times earnings for Oracle? And 100 times earnings for Cisco? Where is Cisco going to go? To 200 times earnings? It may take years until they grow into the multiple, and the stock may stay flat for a number of years.
2. Has the universe of stocks that meet one of your four criteria expanded significantly since the March pullback?
Funny thing is, it was as big as it's ever been in March. It was a polar market. It was 20 stocks on the Nasdaq and anything dot-com working, and the rest of the universe underperforming. A lot of basic industry and capital goods stocks were making new lows every day in March. Same with the financials, same with the drug stocks, same with everything but technology. So actually, our universe was greater in March than it is today.
The technology stocks were hideously expensive in March, and they may be just
expensive now. They haven't hit our screens since this tech wreck started. Conversely, some of those stocks that were being picked out of a lot of people's portfolios in March,
at 25; that's near 40 now. Or
Bank of America
at 40; that's at 60 now. So you've seen the rest of the market actually catch up to the Nasdaq.
3. What stocks and sectors are you most excited about?
I think you've got to be careful about high-multiple technology stocks -- high-multiple any stocks. I'm avoiding getting caught up in the frenzy of Nasdaq's record week.
I'll give you our sector bets. We have about a 14% weighting in energy, and I don't know if you've noticed, but oil's at $30 a barrel and natural gas is at $4.50 and it's June. A lot of the companies are using $22 per barrel and maybe $3 on natural gas, in terms of modeling for the current year, and we're a heck of a lot higher than that on both oil and gas. So I think the earnings momentum is in energy, and we feel very good about owning
, and in the oil-service area,
. We're probably in the early stages of a rig-count recovery around the world.
Defense is an area we're pretty intrigued by. We own
and we own
. We also own
, which is sort of a quasi-defense company. For the first time since Ronald Reagan, defense budgets are going up, not down. That bodes well for companies like Northrop Grumman and Lockheed Martin because of the consolidation that we've seen in the industry in the last 10 years.
4. You're heavily weighted in financials, too. Where do you see these stocks heading?
It's a very simple analysis. You don't own financial stocks when interest rates go up and you own 'em when interest rates go down. It ain't more complicated than that.
Banks really got smothered in the last year. We were actually underweight all of last year in financials because you don't fight the
. And then once valuations got absurd in March, we started really taking a serious commitment to the group, and had been buying these stocks hand over fist in the first quarter of this year.
I think we've been rewarded for that stance in the last couple months here, and I think we're almost near the end of whatever
feels like he has to do to choke off the economy. Last time I looked, about 19% of the portfolio was actually in financials. And I guess that has grown due to the stocks' appreciation in the last two months, but also because we were very aggressive in the beginning of the year in adding new names to the portfolio.
We have a particular interest on the insurance side, believe it or not.
, I mean, these stocks were trading at book value in March, and the property and casualty cycle actually was already showing signs of recovering. People weren't paying attention because they were watching the technology stocks go up every day. And so, if you broke down our financials, we have probably one-third of our weighting in insurance.
the biggest holding in the fund -- it's almost 5% of the fund -- and
is next, and then we have a smattering of other names, like Bank of America,
, which are really more restructuring stories than a play on interest rates.
5. Value managers like to talk about value traps: where a stock will look cheap, but it might just continue to get cheaper. Where do you see value traps today?
I think you see value traps today in a lot of the commodity-based chemical companies, paper companies and REITs
real estate investment trusts. This whole discussion of Old Economy/New Economy -- I understand the discussion. I want to own new Old Economy companies. What I mean by that is I want to own companies that are not a slave to the economic cycle, as it means to grow their earnings. I want to own companies that actually can use the Internet to their advantage, that actually have manufacturing, but actually understand what B2B business is and are using the Internet to their advantage in order to grow their earnings over the next few years.
I was talking to somebody today, and I was showing them the difference between
, and how I look at the world. WorldCom probably trades at 16 times earnings. Its stock is down 30% because of the problems that they're having with the
takeover, but they probably are growing their earnings on a three- to five-year period anywhere between 15% and 25%, and they're an Internet backbone company and they have the wind at their back, and the stock is cheap.
Now, I weigh that on the same page as US Steel, which is trading at five and six times earnings. But to me, the Internet does nothing for these guys. It doesn't affect their business one way or the other, and all they are is a slave to the economic cycle. Sure, US Steel's a hell of a lot cheaper than WorldCom, but US Steel's also a slave to the economic cycle, and we're nine years into an economic recovery. I don't see the economy accelerating from here, so it doesn't get any better than it does for US Steel right now, vs. WorldCom, where the world is their oyster over the next five years.
6. In recent weeks, a lot of people have pointed to dot-com stocks trading at, near or even below the amount of cash that they have on hand. What's your take on dot-coms with fat cash positions and really low stock prices?
In my smaller fund
a Basic Value clone available only to variable-annuity investors, we own a company called
, which trades at $5 and change and has $4 a share in cash. But Inprise has revenues, and there wasn't a cash burn on the company. So my question would be, what's cash value going to be for this company a year from now? How much is the burn factor? Because if the burn factor is 100% a year from now, it's not the same story, it's a totally different discussion.
You know, you've got to have the ability to generate cash, you just can't have cash on the balance sheet which is given to you from an IPO. You've got to be able to put that cash to work, generate revenues, generate cash flow and generate future earnings so that your cash actually can increase, or at least you can start showing earnings.
We also own a stock in our fund called
. It's a small e-commerce company. The stock trades at $3, and there's probably a dollar and change of cash on the balance sheet. The company probably does somewhere in the neighborhood of $60 million in revenues, which is basically $4 a share in sales. The cash came down a little bit in March, probably comes down a little bit in June, but I think most of the drain is probably behind these guys and so that's probably a stock that fits. There's probably a whole host of others that I don't own, that I don't know about.
7. If you had to pick three stocks that you'd hold for five years, what would they be?
WorldCom is one. It's a new position for us. I'm not relying on next quarter's earnings to make money on WorldCom. I'm just relying on them getting the Sprint deal behind them.
is actually another one that we bought in the last six months. These guys have new management and they've invested in the businesses they think are higher-growth businesses, like storage and software. They're not investing in the businesses where they were losing money for all those years. They've pared down on their distribution. In other words, they're not going to sell the whole world, they're trying to focus in on the sellers they use, and they're trying to get themselves on the PC side looking more like
, in terms of a direct model.
Lockheed Martin is also a new name. They're going through a myriad of problems now and mostly to do with their satellite division, but five years from now, with defense budgets rising the way I think they're going to be rising, I feel pretty good about just buying it and putting it away for a while and seeing what transpires.
We've done a wonderful job of losing money in Philip Morris. When I took this fund over
in July 1998, I actually sold out the position.
Philip Morris is always going to be a cheap stock. It's always going to have a fat dividend yield. It's always going to look attractive on a price-to-earnings ratio and a price-to-cash flow ratio. But you really don't want to get involved in a company that's facing a myriad of legal lawsuits because you can't analyze those. I have a team of five to six people who work with me on these funds, and we'd need 50 trial lawyers around the country stocked in every courthouse, waiting to see what the next lawsuit's going to bring down. I don't have the time and energy to do that, and I just can't analyze the company.
9. What's the last stock you bought for the fund?
The last stock I bought for my fund is
We spent a lot of our time in the last two months trying to figure out what we can buy in technology, and we really couldn't find all that much. But we bought National Semiconductor, probably less than a month ago. It traded down from 85 to 44, and so, with an earnings estimate next year somewhere in the neighborhood of 17 times when we bought it, and estimates still going up, not down, we thought the selloff was probably overdone.
10. What's the last stock you bought for your personal portfolio?
. These guys are a Las Vegas-based casino company. They don't have the property that
has. They have the Sands downtown, they have properties there; they also have properties around the country. The stock's at book value, they're building a new casino in Atlantic City that they're going to start breaking ground on in the next six to nine months with
. For a company that has done nothing but hit estimates or beat estimates, for the stock to trade at $5, which is at book value, a third of sales and seven times earnings and probably three times cash flow, is a gift. An absolute gift.