September 24, 2002

Van Harissis and David Brownlee of Sentinel Balanc

S&P Rank: 3 StarsPlaying Defense

Quick Take: In a year when investors have been pulling money out of stock mutual funds at a record pace, assets in the Sentinel:Balanced Fund/A (SEBLX) have held steady, says Van Harissis, who oversees the fund's stock portfolio. The $230-million fund, which invests in stocks and bonds, has had neither excessive outflows nor inflows of cash, he says.

In picking stocks, Harissis hunts for undervalued shares of companies with strong free cash flow.

The fund lost 9.9% this year through August, but that put it well ahead of the Standard & Poor's 500 index, which was off 19.4%, and about even with the average large-cap fund balanced fund, which fell 9.8%. For the three-year period ended in August the fund has edged out its peers, slipping 1.5%, versus a loss of 2.2% for the average large-cap balanced fund.

The Full Interview:

Van Harissis would rather be investing aggressively, but disappointing corporate profits and the tepid economic recovery have forced him into a crouch lately.

The Sentinel Balanced fund currently has about 55% of its assets in stocks, compared to a more typical 60% to 65%, says Harissis. In the last few months the fund has been adding bonds, which now comprise some 40% of its holdings, he says. The remainder of the portfolio is in cash.

"Right now, I think the environment out there dictates some caution," says Harissis, adding he would "love" to see the fund's stock allocation at its mandated maximum of 75%. For that to happen, company earnings will have to pick up quickly, he says.

When he is buying stocks, Harissis looks for what he calls "the 10% solution," that is, a combination of factors, including dividends, that can provide at least that much in total return.

Harissis focuses on mid-sized and large companies with strong free cash flow, or money earned from operations, minus capital expenditures. He sees this as a more accurate gauge of a company's health than earnings, which he notes can be manipulated.

He prefers inexpensive shares. The price-to-earnings ratio of the portfolio is about 18.5, compared to 20.5% for the Standard & Poor's 500 index. The fund carries a price-to-cash flow multiple of 12.5, versus the index's 14.

After the fund manager identifies a cheap stock, he scans for a catalyst, like new management or a restructuring, that can give it a boost.

Low debt is high on Harissis' list of buy criteria, and he also wants companies that can grow their bottom lines. "It doesn't have to be frenzied growth," he says. Percentage gains in the mid-teens are fine.

Two of the most recent additions to the portfolio, which usually holds 65-100 stocks, are energy stocks: Kerr-McGee (KMG), and Tidewater Inc (TDW). Stocks in the sector, including those two, look cheap, Harissis says, because they don't reflect oil prices, which have risen of late because of the threat of U.S. military action against Iraq.

Kerr-McGee, which explores for oil and natural gas and also has a chemicals business, is attractive because it has been selling off poorly performing operations and is itself a potential takeover target, Harissis says.

Harissis says he likes Tidewater, which supplies ships and support services to energy companies, because it is debt-free and sports a dividend yield of more than 2%.

Neither stock has moved much in the time he's owned them, but he thinks they will eventually pay off, Harissis says. He bought both within the last month. His Kerr-McGee shares cost him $47 on average; they closed today at $45.55. Harissis paid about $28.50 per share on average for Tidewater; the stock closed at $29.03 today.

Another energy company, Exxon Mobil (XOM), has been in the fund for a long time and is one of its top holdings. Harissis says he has no strong feelings about the stock one way or the other currently, but he's content to hold it because he thinks it can generate returns over time.

Among other new investments, Harissis began buying food maker ConAgra Foods (CAG) in May. The company, the fund's tenth-largest holding, has been unloading non-core assets, while retaining higher margin products, and will use proceeds from the sales to reduce its debt, leaving it a "much stronger financial entity," says Harissis. His ConAgra shares cost about $24 on average; the stock closed at $25.50 today.

Railroads have been a favorite of Harissis's this year. These companies tend to have dominant market shares in the geographical areas they serve, which helps give them pricing power, even in weak economies, he says.

The fund added shares of CSX Corp (CSX), which operates rail lines primarily in the east, in July. Looking forward, the company stands to do well as it sheds badly performing units, Harissis says.

"We think their ability to generate returns is going to improve over the next few years," he says of the Richmond, Va.-based company. "So, with some patience here, we're actually going to be a buyer as time goes by."

The fund's CSX shares cost about $34 on average. They closed at $29.02 today. Harissis reasons that his average cost in the stock will decrease as he buys more of it. He also owns Union Pacific (UNP) and Canadian Natl Railway (CNI).

Harissis also likes stocks of defense contractors, which he expects to benefit from increased military spending in coming years.

Raytheon Co (RTN), which provides electronics and communications systems to the Pentagon, holds second place in the portfolio. Genl Dynamics (GD), a ship builder that also produces information and communications systems, ranks fourth. Both have P/Es in the mid-teens, which should expand as investors realize the companies' revenues are climbing, Harissis says.

The No. 1 stock in the fund is Berkshire Hathaway`A` (BRK.A), a holding company for insurance companies. Harissis has owned it since early 2000. He initially bought a stake when value-oriented stocks, like Berkshire, were out of favor with investors, who were chasing technology and telecommunications companies.

Harissis says he has always admired the way Warren Buffett, Berkshire's chairman and chief executive, has increased the stock's total return over the long haul. He also expects the company to prosper as insurance rates continue to rise.

Sentinel Balanced uses bonds to generate income, says David Brownlee, who manages the fund's fixed-income investments.

The fund currently has 75% of its debt holdings in mortgage-backed securities, including collateralized mortgage obligations, which Brownlee likes because of their relatively high yields. The remaining 25% is invested in corporate bonds. Brownlee's portion of the portfolio holds high quality bonds. The bond portfolio has an average duration (a measure of sensitivity to interest rate changes) of 3.5 years, he says.

Typically, the fund would own some Treasuries, Brownlee says, but he is concerned about these securities, which, he notes, would be hurt if interest rates increase.

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