Value funds have been among the top-performing fund categories over the past year, and few have been better than
Merrill Lynch's Mid-Cap Value fund, which is up 30.8% over the past year and 14.9% year-to-date, according to
Recent Daily Interviews
Moody's Investor Service's
To get some insight into how and where to find values in today's volatile market, today's Daily Interview sought out Elise Baum, portfolio manager of the Mid-Cap Value fund. Baum says the carnage in the technology sector has opened up many tech stocks to her that had previously been out of her reach, and that she also sees value opportunities in health care, biotech and financial stocks.
TSC: What is your definition of value? And what is your assessment of the market, year-to-date?
One of the things that characterize the markets on a year-to-date basis as opposed to last year is this: Early last year, investors were willing to pay any price for growth. We now have seen a real return to fundamentals and valuation. And with this, we have seen an increased breadth to the market. To us as a mid-cap value fund, fundamentals have always been important as well as an understanding of companies' and industries' competitive landscape and market opportunities. And we have placed these factors within the context of valuation -- not only in the context of the company's own historical valuation range, but also how the group has been valued over time.
One of the things that gives us more flexibility in terms of our definition of value is that we look at each stock within its own historical range and also within its industry range. Certain industries tend to trade richer than others, particularly industries with longer-term growth opportunities. We are able to buy stocks when they hit the low end of their own range or the low end of their group range.
While many funds will not look at a stock when it has a P/E above the market P/E, we are willing to do that if that's a low valuation for a particular stock. So what this does is it opens up a broad range of industries to us. And right now we are finding a lot of opportunities in some areas previously shunned by investors. This year, we are focusing a bit more on technology stocks because there are so many that have traded sharply lower.
And certainly there are companies with problems out there, but many good companies are being taken down with the bad. And the same has been true for health care, medical device companies, biotech and financials. I'd say that with increased volatility in the marketplace, there's greater opportunity for a fund such as ours, which has a value-oriented investment process, because many areas that were untouchable last year are suddenly hitting our valuation screens.
I'd also point out an increased breadth in the market, where we've seen small- and mid-caps performing much better. Clearly that has favored our fund, because we focus on stocks with market capitalizations of less than $10 billion.
TSC: What do you make of the current earnings outlook, which seems very mixed and confusing? How do you pick through the rubble of bad companies to find the good ones?
What we have certainly noticed as have many other investors is that earnings misses have been most pronounced in the telecom, networking and components manufacturing sectors. From our perspective, there has been the greatest disparity from expectations on the manufacturing companies and technology hardware and networking stocks. We're finding that in a broad range of other areas, particularly the industries that may have entered the slowdown first, we're actually seeing some signs of stability. So our focus has been more on software as opposed to hardware.
With one or two exceptions, we have no exposure to telecom, semiconductors or components manufacturers. We have focused instead on the companies that started experiencing slowdown in many instances surrounding the year 2000. These are companies where the expectation level is low to begin with, where they have had several months "rightsizing" the company and getting a more focused approach. Demand is also starting to come back, because certain spending can only be deferred for so long. At this point, we're seeing some pent-up demand for a number of these companies.
So I'd say
we're looking at some software companies, some health care companies which are having very good results and selectively in other areas as well, such as some insurance stocks.
TSC: For the sectors and companies, what kind of recovery path do you see them charting in the next half of this year?
We'll be watching very closely the Fed meeting coming up on June 27. It appears now that the market is anticipating as much as a 50 basis point decrease in rates. This will be a key data point. If the Fed cuts the rates by 50 points, it will send a very strong message to the market that they are behind this stand, supporting the economic outlook. So this would be the first thing to watch out for. Assuming that they do cut aggressively going forward, our outlook for the consumer sector becomes even more favorable, and we have focused on the consumer services and consumer staples stocks.
TSC: What differentiates value stocks from value traps?
One of the most important things to look for is this: It is not enough to simply find stocks that are cheap on fundamentals. I think it's merely the first step. The second thing is to identify a near-term catalyst that could cause perception to change. In the stocks we invest, we would like to not just identify one catalyst but really multiple potential catalysts. With that sort of support, at least one or more than one catalyst would come to fruition, and you can get some very nice upside for the stocks.
When we buy a value stock, we'd like to see the turn at hand or feel that there is a data point which causes the market to turn more favorable. Another important factor is for the companies to have defensible niches -- whether there are barriers to entry. Because we're looking at mid-cap companies, it's very important for them to have a very defensible position. You don't want a market or an industry that is becoming commoditized. Especially for smaller companies, they have to be able to excel in at least one area with patents or with some legislation preventing new entrance or if innovative new products that give the company an edge.
TSC: How do you apply your ideas to picking stocks? Could you give us examples of the stocks you like on these bases? All of your top holdings -- including Charter One Financial (CF) - Get CF Industries Holdings, Inc. Report, Boston Scientific (BSX) - Get Boston Scientific Corporation Report, Cendant (CD) , Banknorth Group (BKNG) - Get Booking Holdings Inc. Report and Network Associates (NETA) -- have been doing very well.
A number of our holdings have done very well on a year-to-date basis. One particularly attractive stock that has not had as much a move up as others is medical device manufacturer Boston Scientific, known for making cardiac stents.
The stent market has been maturing of late. That's not the real reason we are attracted to the stock. It's because there is a new market opportunity with drug-coated stents, which we believe could be a catalyst for this stock. The drug-coated stents are still in a development stage and there are a number of players trying to break into the market.
Johnson & Johnson
is a perceived leader at this point in time. But it's still too early to call.
We see a number of reasons why Boston Scientific's drug-coated stents could be successful. We also see some catalysts that are at the moment perceived as negatives for the stock. Resolution of any one of these issues could be a catalyst: There have been some manufacturing problems with its Israeli partner. There have been some patent issues, and recent acquisitions are dilutive in the near term. The reason I mention these is because there's a strong chance that they will resolve their manufacturing problems, they could come to a settlement on the patent issues and the recent acquisitions provide new growth catalyst for the stock as well. Furthermore, study results on their drug-coated stent could also be a positive. Right there we have four or five catalysts.
On the basis of the company's current opportunity and earnings power, it's a very moderately priced stock.
TSC: Regarding your other holdings, what do you like about financial stocks?
As far as our financial stocks are concerned, we have a number of regional banks and thrifts, which we believe will benefit from the steeper yield curve, and they don't have a lot of credit risk exposure. We don't think they will be subject to some of the issues that plague the money center banks.
We also have stocks that participate in what we would call the e-processing revolution and e-trading. These stocks have been taken down sharply. We believe some of these stocks have very strong franchises, and although they are going through some changes right now, we think they will be survivors. We do own shares of
, and we do expect a poor quarter at
, but in the longer term at these levels, Knight is very attractive. But we are watching this quarter very closely.
TSC: What's your take on Cendant's acquisition of Galileo (GLC) ?
There have been a number of changes at Cendant as it's trying to boost its growth rate. The company has always had a very strong cash flow. Gallileo gives them a terrific growth opportunity to do that. It should be accretive in the near term and open up some broad markets for Cendant. The value of their assets has been overlooked previously and while there's been some nice upside move, it's not expensive given their earnings. And now kicking their growth rate into high gear, I think it's a compelling story.