Fund manager Rich Cervone's stock-picking strategy, "cash flow and controversy," sounds like it could be a Jane Austen novel knockoff. But while the strategy isn't a romantic classic like
Pride and Prejudice
, shareholders are enchanted with the fund's returns.
Cervone and co-manager Jim Wiess have been dictating the direction of the
fund (PINVX) since the summer of 2002. Over the past three years, the large-cap blend fund has returned an average of 19.36% annually, more than 17 percentage points better than the
. Cervone attributes the success to buying stocks that are stumbling in the near term but have the potential to generate lots of cash down the road. The fund is up 3.5% year to date.
sat down with Cervone to learn what plot twists he has in mind for his shareholders.
The Street.com: You say you like to look for stocks with a mixture of "cash flow and controversy." That's pretty catchy. But what does it mean?
: When Jim Wiess, my colleague on the Investors fund, and I talk about cash flow and controversy, we are referring to a type of situation in the stock market where you have a company that is likely to generate significant future free cash flow that is temporarily in a controversial situation, which could cause the stock of that company to be undervalued.
Investing is really the act of laying out cash today to receive more cash in the future. When you purchase an equity security, you are buying a piece of a business -- and a business is worth the present value of the future cash that it will generate for its owners. Our strategy in running the Investors fund is to view equities as streams of cash flows. We are simply trying to purchase, for our clients, a lot of future cash flow for a low price. Controversy frequently creates low prices, so whenever we see it, we take a look, because there could be a great investment opportunity in the midst of that controversy.
What are some examples from your portfolio?
The stock of
( CFC), based on our research, is significantly undervalued. Currently, just about every business related to housing and mortgage finance is viewed very negatively in the stock market.
We've had a very strong housing market in recent years and the largest refinance boom ever. It is logical that both housing activity and mortgage originations will slow significantly. However, our analysis indicates that the stock prices of most businesses related to housing and mortgage finance discount scenarios that are far more negative than what we see unfolding over the next few years.
Countrywide's most valuable asset is its mortgage-servicing portfolio, which has been growing at 30% annually. The fees Countrywide earns from servicing mortgages will continue to grow, even as mortgage originations slow or even contract. The company has gained significant market share in both originations and servicing in recent years, and we expect those market-share gains to continue, regardless of the overall industry environment.
The Putnam Investors fund also owns homebuilders
and home improvement retailer
. As with Countrywide, our research indicates that all of these securities are significantly undervalued based on our analysis of their future free cash flow. It is the current controversy over the so-called "housing bubble" that is creating the mispricing of these securities, in our view.
Any controversial names outside of housing?
is another stock we believe is undervalued. The company's growth is slowing. However, even under modest assumptions, the stock is very attractively priced. The business requires effectively no equity capital to operate -- the cash and short-term investments on its balance sheet significantly exceed its shareholders' equity. This means that every dollar of net income can be paid out as cash to the owners of the business, and this is exactly what Dell has been doing via its share repurchase program.
Based on our estimates, the amount of cash that will be distributed this year to Dell shareholders via share repurchase, net of issuance, is about 4.5% of Dell's market capitalization -- this is the economic equivalent of a stock with a 4.5% yield. And we expect free cash flow at Dell to grow 8% to 10% over the next few years.
The company's decelerating growth causes certain types of investors to sell. For us, it's all about valuing the business based on realistic expectations. We think Dell is worth north of $40 a share.
When can this strategy go wrong? In other words, can you have too much controversy?
We don't think there can ever be too much controversy. Controversy, by itself, cannot cause an investment to turn out to be a mistake. The way we can be wrong is if our estimate of future free cash flow is incorrect, thereby causing our estimate of business value to be incorrect.
We attempt to deal with this problem by thinking in terms of a range of outcomes. In other words, we have a base-case forecast, and then we ask ourselves, "what would the forecast look like if everything went wrong? What would the company be worth under that scenario?"
We also develop a bull-case scenario forecast and fair value. So, we end up with a range of fair values, and we look for stocks that are trading at the low end of our fair-value range. These are very pessimistically priced stocks -- stocks where you have a margin of safety.
Speaking of controversy, your fund is very heavy now in financial services companies. With an inverted yield curve and a tightening Fed, isn't this a bit controversial in its own right?
The fund is significantly overweight the financial services sector. This is not because of any top-down view that we have, but is simply the result of where we are finding the most undervalued stocks. The Fed has been tightening for a while now and the yield curve is very flat. This has driven an extremely pessimistic attitude about the short-term earnings prospects and also the short-term stock price performance prospects of most financial services companies.
Our view is, first, this is old news. Everybody knows the yield curve is flat, and everybody knows it is a near-term drag on earnings, particularly for many of the large banks.
Second, while the Fed's tightening campaign and the yield curve are near-term headwinds, they are not long-term issues. They have little, if any, effect on the long-term cash flows and therefore on the intrinsic value of a financial institution. In the future, we will have some flat yield curves, some steep yield curves and some in-between yield curves.
It really all washes out in the long run, but right now, the negative headlines have created some tremendous values. Our top picks in the sector are
Bank of America
, Countrywide Financial, and
Capital One Financial
Your fund is described by Morningstar as large blend, which means it mixes growth and value stocks. Where do you find more "cash flow and controversy" stocks -- on the value side or growth side?
First, let me say that we don't differentiate between value and growth. We buy businesses for less than we think they are worth, so that's value investing. But we own some very rapidly growing companies, such as
The growth rate of a business, or lack thereof, has an impact on what the business is worth. There is really no line in the sand that separates value from growth -- a wide range of growth rates exist out in the world, from companies that are shrinking to companies that are growing very rapidly. We are finding ideas across the board, but probably slightly more among higher-quality companies that tend to have earnings growth rates above the S&P 500.