In the topsy-turvy market of the past five years, these managers led their funds to some of the best performances in their respective areas. Here’s what they’re bullish on now.
Guarding against inflation
In addition to owning stocks for growth and bonds for income and ballast, you need a “third pillar” in your portfolio at all times, argues money manager Rob Arnott, chairman of the investment consulting firm Research Affiliates. To fully diversify your portfolio and to fight against inflationary money printing, you also need exposure to alternative assets such as commodities and currencies, he says.
Trouble is, it’s often difficult to manage assets such as this on your own. Rather than bury a tin of Krugerrands in the backyard, you’re better off investing in alternatives via professionally managed funds, Arnott argues. That’s what his portfolio, Pimco All Asset All Authority, does — it buys other Pimco funds that specialize in specific alternatives. The funds he selects aren’t the cheapest around, yet Arnott has still managed to beat 98% of his peers over the past five years.
This year will be a challenge because “nothing is cheap” in alternatives. So patience is in order. Arnott, for instance, is looking for pockets of under-valued commodities. He is investing in emerging-market bonds, which are yielding more than the going rate of inflation, unlike U.S. Treasuries. And he’s parking cash globally so “we can pounce on opportunities when people are terrified” — and prices on alternatives fall to more attractive levels.
: Over the long term, money is likely to flow to fiscally healthy emerging markets, Arnott says. This fund is invested in the currencies of countries with low debt-to-GDP ratios, such as Brazil and Kazakhstan.
Like many commodity funds, this one uses options contracts to mimic a diversified basket of real assets. In doing so, though, Real Return underweights energy commodities, which Arnott thinks are fully valued.
: Despite the strong balance sheets of countries in Asia and Latin America, “emerging-market bonds are paying a 3.5-point spread over U.S. Treasuries,” Arnott says. Yet “their quality is better than a lot of developed-world sovereign debt. That is pretty cool.”
Bargain hunting, safely, in Europe
Katrina Dudley, who co-manages this fund with Philippe Brugere-Trelat, doesn’t just look for beaten-down stocks — which there are plenty of in Europe these days.
“We look for companies that have a catalyst on the horizon that will cause their shares to reach full potential,” she says. The managers also like to get paid dividend income while they wait. There’s more opportunity for that in Europe, where the average stock yields 3.8%, vs. 2.2% for the U.S.
This balanced approach doesn’t always lead to sizzling numbers. Over the past year, Mutual European out-paced the MSCI EAFE index of foreign stocks but fell just shy of cracking the top 50% of European equity funds. Still, the strategy did help the fund, owned by Franklin Templeton, limit losses in 2008 to 33%, while its peers plunged 50%.
Dudley says Europe is a better hunting ground for bargains than North America. One way to tell is looking at price-to-book value ratios, which measure stock prices against the value of the assets on a company’s balance sheet. The average P/B ratio in Europe stands at 1.5, vs. 2.2 for the U.S., highlighting a larger than average gap.
To find the best bargains, Dudley often focuses on stocks unfairly weighed down by scandals or the fact they just happen to be headquartered in an economically troubled country.
UBS UBS GROUP AG
: Dudley says the CEO of this Swiss bank is following through on promises to get out of the riskiest parts of investment banking, while building up the more stable and profitable private wealth management business. Yet UBS’s share price does not fully reflect this fact, she says.
BP BP PLC
: The British oil giant — whose shares trade at around a 40% discount to industry peers — appears to be working its way out of many of its problems, Dudley says. BP has already spent around two-thirds of its estimated $40 billion to $50 billion liability for the 2010 oil spill in the Gulf of Mexico.
: This U.K. firm flies under the radar because of its banal niche: It makes cans for beer and other beverages. Rexam dominates Europe, but also large parts of Latin America. Dudley is also fond of Rexam’s penchant for selling low-performing units and returning most of the proceeds to shareholders.
Targeted risks in global fixed income
There are times when Mary Ellen Stanek and her co-managers are willing to take on some risk for the chance of bigger gains. In 2009, for example, Core Plus’s six-member management team bought financial sector debt as the rest of the market was selling out of banks. Still, Stanek & Co. don’t go to extremes.
Rather than loading up on long-term bonds — which would be vulnerable if interest rates were to rise — the managers have kept the fund’s average maturity to 6.5 years, nearly a year less than their average peer.
And believing that some parts of the Treasury market are quite expensive, Stanek says they’ve reduced the fund’s exposure to Uncle Sam’s debt to just 11%, or about a third of the weighting of the Barclays Capital U.S. Universal Bond index, a broad benchmark of domestic bonds.
Look to corporate bonds, which account for 45% of Core Plus’s portfolio, vs. just 30% for its peers. Stanek can keep as much as 20% of the portfolio in high-yielding, low-quality debt, but today she has trimmed that exposure to just 8%. “There has been a pretty significant rally in high yield,” she says. “If you see that turn the other way, the selling pressure could be high.”
Instead, Stanek is buying investment-grade bonds. This is true not just in the U.S. but also overseas, where she says political uncertainties have pushed up the yields on the debt of firms that otherwise have strong fundamentals.
Financial sector debt: The spread in yields between Treasuries and high-quality bonds issued by companies in the financial services industry is still wide, Stanek says. “So we own bonds of Goldman Sachs that will mature in 5½ years,” she says.
Foreign multinationals: “You won’t find the sovereign debt of Spain in the portfolio, but we will own bonds of high-quality corporations that might be domiciled in Europe,” Stanek says. Example: Telecom Italia, which, despite its name, generates more than a third of its revenue in fast-growing Latin America. For added safety and stability, though, she sticks with foreign corporate debt issued in U.S. dollars rather than euros.
High-quality commercial mortgage securities. Because this debt is backed by mortgages on commercial real estate, it can be risky in a so-so economy. As a result, “we only invest in the most senior classes of the securities and look for loss protection of 30%,” Stanek says. In other words, “losses on the underlying loans could reach 30%, and we’d still get all of our money back,” she says.
Demand from emerging-market consumers
While the emerging markets are often associated with highfliers, Matthews Pacific Tiger’s managers prefer to invest in companies that take a measured approach. “Often we see managements that set their goals around 30%-plus growth, but that can lead to bad financial outcomes,” Shroff says.
This fund is different in other ways. China often gets the lion’s share of the attention in Asia, but Gao and Shroff don’t hesitate to look throughout the region, in places such as Indonesia and Malaysia. “We’ve found valuations that were a lot less expensive in these markets,” Shroff says. That value-minded approach helped the fund generate gains of nearly 4% annually over the past five years while its peers lost nearly 2% a year on average.
Both managers see a big shift taking place in China, the region’s largest economy. Rather than focus just on exports, businesses there are cultivating local consumer demand. “In that sense, we’re finding opportunities in service-oriented industries,” Gao says, such as health care, tourism, and insurance.
And though Gao and Shroff expect China to keep slowing, other countries could take off. “Indonesia and the Philippines are trying to stimulate investment in infrastructure,” Shroff says. As a result, “you can choose from a diversity of businesses that was perhaps not easy to find five years ago.”
Perusahaan Gas Negara (PGAS: Indonesia Stock Exchange): PGN operates the largest pipeline for natural gas in Indonesia. Demand for the fossil fuel has been growing. As a result the company, which collects a toll when the gas is distributed, has been reaping big profits.
Sinopharm Group (1099: Hong Kong Stock Exchange): Government spending on health care is rising 15% to 18% annually in China. That should benefit the country’s largest pharmaceutical distributor, which has expanded into more than half the major cities in China. “We expect sales to grow above the industry average for the foreseeable future,” Gao says.
SM Prime Holdings (SMPH: Philippine Stock Exchange): The Philippines’ largest shopping center developer and operator already runs 50% of the malls in the country, Shroff says. But there’s room for growth beyond Manila — and in China, where SM Prime has four malls with plans to grow to 10.
Seeking companies with steady growth
The managers of this Steady Eddie fund have a knack for finding fast-growing companies close to home.
Frels and Henneman start by looking for businesses poised to increase earnings at a rate faster than the average blue chip. They’re willing to think smaller than average — the market value of their typical holding is $14 billion, vs. $42 billion for the S&P 500. (This has worked to the fund’s advantage, as smaller shares have whipped larger ones over the past five years.)
But that profit growth has to be sustainable, and the stocks have to be priced right. “We want to see 9% to 10% earnings growth consistently,” Henneman says. By the way, they’re not kidding when they say they want to “see” that growth. “We usually maintain a position in a stock for a long time, so we like to stay in contact with management,” Frels said. No wonder two-thirds of the stocks in this $2.4 billion portfolio have operations in or near Minnesota’s Twin Cities area, where Mairs & Power is based.
This quirky approach has paid off. The fund has consistently lost less during market downturns — it beat 96% of its peers in 2008’s financial panic and actually made money during the 2000-02 bear market — while still getting a long-term boost from the smaller blue-chip companies that Frels and Henneman can identify. The result: Mairs & Power Growth has outperformed 93% of of its competitors over the past decade, according to the fund tracker Morningstar.
Frels and Henneman worry about the prospects for slowing growth in the U.S., especially if tax rates rise in 2013. As a result, the managers are focusing on American firms that generate a good chunk of business in the emerging markets. While growth has also been slowing in places like Latin America and China lately, those economies are still expected to expand at a far faster clip than the U.S.
The good news: You don’t have to pay up for that international exposure in this market, according to the managers. Says Henneman: “We’re not having any trouble finding names that we’d like to buy now.”
3M 3M COMPANY
: With a new CEO in tow, this Minnesota-based manufacturer plans to boost research and development. “That should set the company up nicely for long-term growth,” Henneman says. So should the firm’s global footprint: 3M generates about 70% of sales overseas.
Cray CRAY INC.
: Cray may be a small stock, but this Seattle company is a pioneer in the supercomputer industry. After signing a deal with Intel last year, it will have a leg up in building and programming supercomputers for universities and government agencies. Says Henneman: “We expect an earnings growth rate of 15% to 20%.”
Medtronic MEDTRONIC PLC
: This maker of stents, defibrillators, and other medical devices has a competitive edge thanks to recalls at a major rival. And Medtronic’s own outlook is also promising. The company, which generates nearly half of its sales abroad, “continues to expand into emerging markets, where health care spending is growing at a rapid rate,” Frels says. Plus the stock’s price/earnings ratio is a third of what it was a decade ago, after the tech wreck.