SAN FRANCISCO ( TheStreet) -- Paul Alan Davis, manager of the Schwab Dividend Equity Select Fund ( SWDSX), expects a big year from IBM ( IBM) as the company generates more cash and rewards shareholders through dividends.The $1.4 billion fund, rated four stars by Morningstar ( MORN), has risen 21% during the past year, trailing the S&P 500 Index. However, the fund's three- and five-year performances beat more than 75% of competing funds. Welcome to TheStreet's Fund Manager Five Spot, where America's top mutual fund managers give their best stock picks in five fast and furious questions. Are you a bull or a bear? Davis: We don't use cash to reflect our bullish or bearish stance as other managers do. At the same time, our stocks indicate that we are very constructive with the market going forward. The Dividend Equity fund is a more conservative fund by nature, investing in approximately 130 dividend-paying stocks. Schwab Equity Ratings doesn't specifically have a bullish or bearish stance as it attempts to pick out the best relative performers in the future. We can interpret though, by looking at the highest-rated stocks, that it favors small-cap and mid-cap stocks, as it has from the early part of 2009. From 2007 to 2008 the Schwab Equity Ratings favored large-cap stocks in more defensive industries such as pharmaceuticals, large diversified financials, defense and staples. This went a long way to explain why our fund turned in such solid performance in 2007 and 2008. This year however, we have underperformed because we didn't own enough "junk" that ran fastest from the bottom.
Presently, we are less defensive than we have been in the past relative to the fund's history. At the same time, we are not less defensive than other managers due to our emphasis towards yielding stocks. The top three sectors in the fund are technology, finance and health care. And we have a larger energy stake than we have had in several years, another bullish sign. What is your favorite stock? Davis:IBM is a stock that best describes our investment process. It has been a top holding for most of the fund's existence and the performance pattern is similar to many of the stocks we own in the Dividend Equity fund. IBM is a stable cash flow-generating firm. The cash generated by its core businesses gives management the flexibility to use the cash in shareholder friendly ways, such as repurchasing shares, making acquisitions and paying dividends. What is your favorite under-the-radar stock? Davis: Harsco ( HSC) is an under-the-radar stock we find attractive in the small- to mid-cap range. It is an industrial services and engineered-products company that should benefit from a rebound in the infrastructure and manufactured metals areas. The firm specializes in providing industrial services in the international petrochemical, utility and multi-dwelling residential construction projects. Fundamentals and relative valuation metrics look strong relative to other industrials. What is your favorite sector for 2010? Davis: The fund is overweight in staples, financials and energy. We have favored higher-quality financial names such as Goldman Sachs ( GS) and JPMorgan Chase ( JPM), and while the yields haven't been as high as lower-quality banks, the total return has been favorable. Within the financial sector, we continue to be underweight real estate investment trusts and banks, and overweight diversified financials and insurance.
What sector would you avoid in the coming year? Davis: We are underweight the consumer discretionary sector, although much less than we used to be. We are also underweight in industrials and telecommunications. Some of our sector decisions are dictated by our search for yield. Retailers, for example, generally have lower yields, as do technology and transportation names. We try to find the high yielders relative to each category so as to not miss out on the performance when specific industry groups run. As a result, we maintain exposure to nearly all industry groups regardless of the low yields present in that industry. If you look at the S&P 500 last year through Nov. 30, the return on stocks that paid a dividend was 19%, while the return on non-yielders was 51%. -- Reported by Gregg Greenberg in New York.