Reform Debate Makes Health Stocks Cheap

FORT WORTH, Texas ( TheStreet) -- Adriana Posada, manager of the American Beacon Small Cap Value Fund ( AVPAX), says uncertainty surrounding health care reform has made stocks in the industry cheap.

The $2.4 billion fund, which has earned four stars from Morningstar ( MORN), has doubled during the past year, better than 72% of peers. The fund has gained 12% annually, on average, during the past decade, beating 85% 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 bear?

Posada: The most recent recession was a "balance sheet" recession. Despite low interest rates, debt levels are too high and credit activity is too low. Mortgage debt, financial and corporate sector, and commercial real estate debt all continue to be in restructuring mode, so balance sheet health still remains a goal for many entities.

The government debt situation is even worse. There is no doubt that the market of 2009 was a bull market. Much of the data today show signs of strength, but we are comparing to an economy that literally fell off a cliff in late 2008 and early 2009. We do not think we can predict with any precision what will happen in 2010. The important question to ask as investors is what the risks are in our portfolios that could lead to losing capital, and are we being compensated for those risks.

What is your favorite sector?

Posada: The portfolio's largest relative overweightings as of December were in the health care and information technology sectors. Concerns over the health care reform debate in Washington, and the uncertainty surrounding the details of any final health care reform legislation, caused valuations in this sector to reach levels that we found attractive under any likely compromise legislation.

The information technology sector is a quality sector with companies that have solid balance sheets, stable margins and rising estimate trends. These attributes offer a solid combination of growth potential and modest defensive characteristics, which are attractive as the economy regains its footing.

What is your least favorite sector?

Posada: While the financial sector is our largest absolute allocation, it is one of our largest relative underweightings. However, we have seen a number of small-cap banks that have the opportunity in this environment to grow market share, even through accretive acquisitions from the Federal Deposit Insurance Corp. We favor those with strong deposit franchises and regional strength or distinctive niche businesses.

The materials sector also is a large relative underweight as we have found most companies in the sector to be expensive as commodity prices began to pick up steam with the quick rebound of emerging market economies.

Are stocks cheap or expensive?

Posada: Currently, broad valuation measures imply substantial and sustainable growth in corporate earnings. The multiple on estimated 2010 earnings using a weighted harmonic average of all companies comprising the Russell 2000 Value Index is around 15.5 times. This is not extremely expensive, but is not cheap either. This calculation excludes around 30% of all companies, a majority of which are expected to post negative earnings in 2010.

In conclusion, broad valuations are not overly attractive and incorporate much risk, including the risk of current bullish expectations for earnings growth. Despite the continued short-term focus on Wall Street and the majority of market participants, history suggests that attractive long-term fundamentals, solid business models, profitable redeployment of excess capital and a low purchase prices have the greatest impact on return. The fund's subadvisers focus their efforts on assessing these qualities in the companies they own.

What could throw your predictions off course? Or what is the biggest threat to your forecast?

Posada: The American Beacon Small Cap Value Fund is a very diversified portfolio that is well positioned with a mix of growing companies that have good valuation support and good defensive characteristics. There are a number of unknowns that remain important factors that could derail the fragile recovery in the economy and the markets. Among these are the ultimate outcome of health care reform legislation, the velocity of new jobs creation, trouble for sovereign buyers, extension of government programs such as removing the assistance caps for Freddie Mac ( FRE) and Fannie Mae ( FNM), the level of interest rates, and the Federal Reserve's ability to remain accommodative while containing inflation.

-- Reported by Gregg Greenberg in New York.
Before joining, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.

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