From the October 2004 issue of Investment Advisor • Subscribe!

October 1, 2004

Bedrock Value

Bart Geer's background in geology has helped him mine the value universe for the Putnam Equity Income Fund.

There have been a lot of rumblings in the last few months about the need to shift client portfolios from small- and mid-cap stocks to the equities of major corporations with multi-billion dollar capitalizations. Bart Geer, lead manager of the Putnam Equity Income Fund/A (PEYAX) since December 2000, heard those rumblings well over a year ago and began moving the fund's investments more into a large-cap direction.

Chief among the fund's stated goals is to provide investors with both income and growth of capital through building a diversified portfolio with a low tolerance for risk. Over the last 10 years the fund has managed to achieve just that, consistently paying dividends to shareholders and increasing the value of each investment while total assets in the fund continued to increase. This is among the reasons the fund was given four-star ratings by both S&P and Morningstar. From a historical perspective, the Putnam fund has slightly outperformed the S&P 500 Composite Index for the one-, three-, five, and 10-year periods, and its style peers for all but the most recent measurements.

According to Geer, any short-term performance lag is due to the fact that the fund may have moved a little too quickly back into a heavy emphasis on larger-cap stocks after having made some moves in the mid-cap direction in late 2000 and early 2001.

Geer has been managing money for 23 years, and while he has an MBA from the Amos Tuck School at Dartmouth, his undergraduate degree was in geology, not a bad academic background for a manager who constantly searches the investment ground for precious gems and metals in the form of value stocks. And while Geer characterizes himself as the one with his "finger on the trigger" and serves as the final decision-maker on picking stocks for the fund, he has two other key players on this team--Jeanne Mockard, who is also portfolio leader for the George Putnam Equity Fund of Boston, and quantitative analyst Mike Abata.

Since you have some assistance in managing this fund, could you explain how the responsibilities break down? I'm the lead manager, so I break ties. I'm responsible for stopping the buck.

Jeanne [Mockard] and I will typically work together on decision-making. It's more or less by consensus between the two of us. Mike [Abata] is there to give quantitative assistance on the portfolio, which means that he doesn't actually have a finger on the trigger, but when we're looking for guidance from Putnam's quantitative systems, Mike's the guy.

The way we work together is that we sit down together every two weeks. At that point we look at a custom optimization based on Putnam fundamentals and see what that model is recommending we do. But since we're not a quantitative product, Jeanne and I--as fundamentalists--take that [optimized model] and massage it to arrive at what we think is the appropriate fundamental response to the quantitative signals we've received.

Both S&P and Morningstar list this as a Large-Cap Value fund. Is that how you would define it? Yes, I would, because we use the Russell 1000 Value Index as a benchmark. We use that even though Russell 1000 Value is close to multi cap. It includes a fair amount of mid-cap stocks, but at least during my tenure, it's mostly in the large-cap space. That doesn't mean we're saying we wouldn't invest in mid-caps.

In fact, before I arrived at Putnam I used to manage mid-cap value money, and at the end of 2000 I was pretty confident that mid caps were more beneficially priced than large caps. So we made a pretty significant tilt in the portfolio to the lower-end capitalizations. Our capitalization was about $10 billion less than the average capitalization for the Russell 1000 Value. But by May 2003 we were getting signals from our models as well as from our analysts that indicated that was no longer the case. So as of last May we moved up our capitalization to approximately that of the Russell and we've subsequently moved past it. That turns out to have been premature, which is not unusual in signals of that sort. If you get it within a few quarters, that's okay.

Is this the only fund that you currently manage? It's the only style that I manage, but it's not the only fund. Basically, I'm the lead manager on all of the Russell 1000 Value products at Putnam.

How many funds would that be? It's not other funds so much as pieces of other funds. What I manage ends up approximately doubling the assets in the fund. The fund is about $2.8 billion in assets, but we're actually managing $6.1 billion in the style. A lot of the surveys only pick up the A shares, but there are a number of different classes, which is what brings up the total.

This fund is known for having tight risk controls. Can you talk a little bit about what that means? Every portfolio at Putnam gets a risk budget in terms of expected tracking error, which is a quantitative measure of expected risk. We have some very sophisticated systems and we can get a reasonably good approximation of the risks involved in any particular strategy. Like all forecasts, they're never 100% accurate, but we can get a reasonably good approximation of where our risk is and where we're spending it.

We typically like to spend our risk more on individual stock selection than we do on big group or sector calls. We don't want to say, "Oh, yeah, cyclicals are the place to be because of the China trade, so we're going to put 35% of the fund in cyclicals," even though cyclicals represent only 5.5% of our index. In all likelihood, unless everything in the market was very tightly correlated, we would very massively blow our risk index doing that.

At the same time, we're not afraid to buy the groups that we like in appropriate overweights and to sell the groups that we don't like in appropriate underweights. But we're not a "swing for the fences" fund on those types of issues. We've viewed our competitive advantage as being more on the stock level and then the industry level, and not that much of an advantage on the sector level, unless it rolls up from the bottom.

Tell me a bit about what goes into your stock-picking process, with a couple of examples. We look for stocks that are inexpensive. We're typically going to look for stocks that have good yield. Where do you get those stocks? To some extent our index describes where you get them. Our index is about a third financials, so financials is a large area for the fund. Not just because of our index, but because historically financials have had a very good risk/reward for the investor, particularly when they're inexpensively priced. In a market that's trading at 16.5 times next year's earnings, you've got companies that are trading at 11 times next year's figures. That makes them pretty inexpensive.

Our number one holding is Citigroup. It has an attractive dividend yield. It's a broadly diversified company. And it sells inexpensively, as I said about 11 times '05 [earnings]. That would be one example of a public stock that we own. And Citi's got a 20% ROE, which is above the market average. It's had reasonably good growth prospects, sells for a 40% discount to the market, and has a better-than-market yield.

The number two stock we own is Exxon/Mobil, which has the highest return on investment capital of the major oil stocks and has had a long-term record of doing so. It continues to have reasonably good single-digit unit production growth with excellent cost controls. It is a little bit richer than some of the other oils, so until recently we've been a little lesser weighted in Exxon/Mobil than we are right now. Oil in general has a reasonably attractive risk profile in our opinion. It's got underlying asset value. It throws off a lot of cash. Most of the oil stocks have dividend yields, as does Exxon. Again, it's not huge, but it's better than market level. So that would be our number two holding.

The number three holding is Bank of America, which brings us back to the banking side. Number four, still in banking, is US Bancorp, which is another great stock with a story that we like. It sells at less than 11 times earnings, even though return on tangible equity is around 30%. They've got a 35%-plus fee business in their revenue streams that makes the company a free-cash-flow machine. Management has told us that 80% of free cash flow is going to go into either dividends or share repurchases. So they're very shareholder friendly and the stock has a nice dividend yield.

Hewlett-Packard is number five.

Let's talk about that one because it's a different sector and also something of a surprise. We didn't even own Hewlett- Packard until they did the Compaq deal. As you know, the market got very negative about that strategy, about doing a technology merger. Walter Hewlett was against it and went around saying, "These have never worked. We shouldn't do it. It's a great company just the way it is."

Our view was that, in fact, the whole technology sector is maturing and becoming a little less "growthy" and a little more like value stocks. Hewlett-Packard, and the industry, needed to have capacity reduction rationalization. That was why we felt that the merger was the right move, although it represented a significant change from the last few decades when the technology sector was considered to be nothing but growth stocks with much higher valuations than they have today. We supported [the merger]. The stock got very weak on that and we bought in the teens.

Like most of our stocks, Hewlett-Packard happens to have a dividend yield. I think we would have bought it anyway, but that [dividend] has allowed us to increase our ownership and feel comfortable. The stock's got a 1.6% dividend yield. It was a little higher--as much as 2% dividend yield--when we were buying it. So it was even above market at that time.

Admittedly, the personal computer business, which was losing money at the time of the deal, is still just turning profitable. But server storage is an area where the company is sub-optimal, so they have opportunities to turn that around. And the printer business continues to be the cash cow that's driving the Hewlett-Packard story and its earnings. At the time we bought it, we felt we were buying H-P for very close to the value of the printing business. So we thought we were getting the turnaround story in the other areas essentially for free. We are now paying a modest premium for the turnaround in the other areas, but we are still comfortable that given the progress management's made it still is a reasonable strategy for us to take.

How about turnover within the portfolio? Would you describe your management style as active? I guess I'd say we're moderately active. I believe our turnover, at least the way we measure it, is between 35% and the high 40s. There's no correct turnover number in any given year because there can always be volatility and the real way to score turnover is to ask how well you did selling the things you should have sold and not selling the things you shouldn't have sold. That's the real scorecard.

If I have to put a number on it, I guess I would love it if it could be 35%. When it gets in the low 40s, I don't think it should get much higher than that.

But turnover is a natural consequence of our investment style. You have to look at value stocks, but the value universe is made up partly of growth-at-a-reasonable-price stocks, which are companies that are not "broken," and we hope we get a valuation opportunity that allows us to buy them attractively. Those stocks you can reasonably hold for fairly long time periods.

The other piece of the value universe is turnarounds and companies that may not be the best players in their sector, but whose stocks offer better-than-average opportunity. Those types of situations are typically best held until they get turned around and get recognized with good stock prices.

In an ideal growth portfolio you would buy wonderful growth companies and you would never sell them and you would have very low turnover. As a practical matter, the studies on growth companies indicate that over time a lot of growth companies fall off the cart and lose their growth characteristics. So the goal of a growth portfolio manager is to be pruning companies that blow up and aren't likely to come back to the growth universe. With value companies we have the opposite [scenario]. We're always trying to buy things cheaply. Sometimes we buy things that are maybe not the best franchise but do have the best stock price. When you do that, once the stock price recovers, you really should be looking for another opportunity. That sometimes drives turnover. There's a certain segment of the value universe that is bought to be sold, as opposed to bought to be owned forever.

Why should an advisor recommend this fund, as opposed to a similar product? I think if you look at the record, given what our objectives are--which is to offer yield, capital appreciation, tight risk control, and a smooth ride--we have achieved all those objectives. We compare quite favorably to a number of larger, better-known value funds that are getting a lot more money and have a lot more money than we do. I think if people did a truly competitive analysis, this fund is probably worth more than its market share would indicate.

Staff editor Robert F. Keane can be reached at bkeane@ia-mag.com.

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