From the September 2006 issue of Boomer Market Advisor • Subscribe!

September 1, 2006

Three top managers on what you need to know

It's no shock that a cloud of pessimism hangs over the mutual fund industry. But a strengthening economy at home and stellar returns in the international emerging market space have some investors wondering why. And they're looking for managers to get off their cash and find the alpha they're paid for.

With this in mind, Boomer Market Advisor brought three active managers together from high-profile fund families to let us in on exactly where they're finding good deals.

Jeff Everett, CFA, chief investment officer of the Templeton global equity team, weighs in on the large-cap international space. John O'Hare, manager of the Oppenheimer MidCap Fund, makes his case in a tough mid-cap environment. Lastly, Bob Fetch, a partner at Lord Abbett and manager of the firm's Small Cap Value Fund, joins us for the small-cap perspective.

Boomer Market Advisor: We've been to a number of fund industry conferences lately and still sense frustration on the part of managers about the lack of good deals they're finding. Is this accurate, and if so, what can be done about it?
Jeff Everett: We focus on the global markets. As far as this global malaise, whether it's our fund or somebody else's, I think advisors have seen the average P/E stock stay lower in the past 10 years. The market has come way down from that standpoint. They see this convergence and they say "everything is priced the same; there's no alpha left." I couldn't disagree more. I think just because everything's priced the same doesn't mean everything has the same opportunity going forward. I think stocks have tremendously diverse and diverging opportunities, and it's up to us to find them. I think one thing that is apparent, and I talk with an awful lot of people, is that financial advisors want to maximize their clients' wealth. And I think now is as good a time as ever, if you want to maximize your returns, to look beyond the [United States]. I think that's what people are starting to do. That obviously benefits us, but it opens up your opportunity enormously. I would say that for the lazy investor there might be a lot of malaise overseas. But I think for the active, aggressive investor that's searching out new ideas, there is plenty of opportunity. The key is finding the ideas first.

Bob Fetch: Doing what I've been doing since 1983, and being a student of the markets from that time, I've been through this many times before: the sudden dips as well as some of the frenetic, exuberant market runs. The important thing you learn over time is to not get caught up emotionally in the market environment. Having the discipline helps you make educated decisions because you've got the proper framework. The way we do it here is very much valuation first with strong fundamentals analysis complementing the process. From day one, we have looked for stocks that are selling historically cheap and inexpensive on an absolute basis in relation to their earnings prospects, profitability levels and fundamental outlook. Fundamentals drive your prices over time. In the short run the market is almost a voting machine driven by sentiment and psychology, but when those fundamentals play out in a positive fashion, you see compound results over meaningful periods of time that benefit you through appreciation.

BMA: There have been a lot of specific comments made about the poor performance of the mid-cap space. What will it take to turn that sector around?
John O'Hare: If you look at the historical studies, typically mid caps have outperformed large caps on a long-term basis over 50 and 70 years. They've just slightly under-performed small caps during this period, but they've done it with much less volatility. So, if you look for the sweet spot in the market, it's been mid caps for 50 to 70 years. Small caps are very young emerging companies and have inherently much more volatility and less seasoned management. When you move up to mid caps, you typically have more seasoned management, the balance sheet gets stronger and you still have room for growth.

BMA: So on a risk-adjusted basis they've really outperformed every class?
JO: Exactly. If you look at a risk-adjusted basis, mid caps have been the best place to be, because you've had 96 percent of the small-cap return with about one-third less volatility. And you get a higher return than large caps. When your biggest shares are in Wal-Mart, you don't have anywhere left to grow. Mid caps still have a lot of room.

BMA: John and Bob, as domestic managers, what, if anything, do you watch out for in the overseas markets that could impact your funds' performance?
JO: That's a good question. Most of the companies have their business models that are in predominantly U.S. markets that we can understand. You do have to look at international factors going on in places like in India, China and Europe. And quite frankly, we talk a lot about India and China, but you should watch Europe, too. A lot of U.S. companies sell to Europe, and a slowdown in Europe can be more important than a pickup in India. When you get into a lot of names that I own, they're purely domestic, so those things don't matter. But as you get to some of the technology companies, for example, they may do half their business in Europe. My short summary for it is that you do have to pay attention to it, but my mid-cap portfolio is primarily driven by what happens in the United States.

BF: In various portfolios I've managed, I've done some selective holding of some internationally based companies, but they've always been ones that were listed here, at a minimum -- either directly listed or as American Depository Receipts. There always have been thousands of small-cap alternatives domestically. I haven't had to concern myself so much about finding similar companies elsewhere to enhance my portfolio's return. At the same time, it's important to track those external events because the majority of small-cap companies we own do business overseas. They are largely international companies, they just happen to be domiciled domestically. Many of the greater growth opportunities are beyond our shores in terms of rates of growth. This is especially true if you've got a large market share here today in providing products domestically that are better than anyone else around the world.

BMA: It's hardly a secret that the U.S. market hasn't performed as well in the past few years as those overseas. What's caused the explosion of opportunity in the international space?
JE: I would cite three reasons why international opportunities have exploded, and it's not necessarily each one of these, it's the interaction between them. First, it's demographics. The 2 billion people from China, Russia and Eastern Europe are joining a little thing we call the global economy. Just 10 years ago in Poland there were 65 companies traded; now there are 367 companies traded. The second reason is women; take a look in just the United States. In 2000, we had 67 million women in the formal labor force. Fifty years ago, that figure was 19 million. A four-fold increase in their workplace numbers means a lot in terms of incremental pickup of growth and productivity. The third reason is the formalization of the international capital markets. Just five years ago, we didn't have a national credit bureau in India or South Korea. Now they have them and that's vitally important. So, when you add those three together, again, it's a multiplicative process, not an additive one.

BMA: But what happens when investors, especially baby boomers who are looking for investment protection, flip on the television and see the situation in Lebanon? Suddenly, the international opportunity might not seem so great.
JE: They do get skittish, but I'll tell you, that's an opportunity with us. And I don't say that out of spite. First of all, let's go back over time. For years, there's no question investors have not had to worry about policy errors, if you will. You know, in the 1970s we had fiscal expansion and deficits going crazy. But one of Sir John [Templeton]'s original investors is very successful in the oil business. So I asked him the same question you asked me, "Hey, what about the geopolitical situation? Is it any worse than it has been in the past?" He said, "The oil always makes it through. Go back to the Suez Canal Crisis. The oil always made it through because they want their money." And I would tell you, in terms of geopolitical issues, it seems to me that we may fight about Iraq, we may fight about the multinational force in Israel or Lebanon now, but you know what, I really think leaders are smart enough to keep their personal cat-and-dog fight from scratching the real world. I don't want to be accused of looking at the world through rose-colored glasses. There are risks. But even in the Middle East, over the initial days of the conflict in Lebanon the markets were positive. So, is there uncertainty? Yes. Does the market reflect it? Yes. Is it a one-way negative street? No, not at all. It gets back to the maturity of the capital markets and a sign that investors are learning. They're compartmentalizing the risks, as they should, and not taking it out of proportion. We know there are risks, we know what they are, but let's keep it proportional to the opportunities. And they're coming around to seeing that the world is probably not as dangerous a place as you might have thought.

BMA: So let's get specific. Where are you finding the good deals? What sectors are the three of you excited about?
JO: Well, that's difficult because if you watch the tape in the last few weeks, nothing's exciting. Everything's going down and we are having a significant correction in the market. If it continues, it could even be qualified as a bear market soon, the way it's going.

BMA: Really? Is it that bad?
JO: Well, in the mid-cap and small-cap areas, certainly. I think the small-cap industry is down 18 percent this year. It's a big drop. And 20 percent is a bear market. So, in the mid and smaller areas, you're looking at bear market type of numbers. I am seeing [value] in the consumer discretionary areas right now, if you have a long-term outlook. There are some very good retail companies and some restaurant companies that are starting to look very attractive. Some of the business service companies I own are at a good valuation. Even some of the health care companies I've owned for years have good value. What I'm saying is that because the whole market is going down, you're seeing opportunities in a lot of markets. But where I'm not seeing a lot of opportunity is the energy area, because that's the area that has outperformed. It hasn't gotten inexpensive enough to make it worthwhile for us.

BF: A great place to start is in the utility sector because our holdings are such an anomaly. This product that we've been managing here at Lord Abbett is similar to what I was managing at my previous employer, but they didn't have room for utilities because they tended not to have the same reward opportunity that the average stock did and, at times, were maybe more defensive in a lousy market environment. We feel the utilities we ended up buying actually had some very strong fundamentals working in their favor, but the stocks themselves had been ignored. When the valuation and rich reward of these stocks became apparent to us, they were one of the few places where you had more upside than downside. It was hard to say that was true in most other names where the market risk had increased meaningfully.

JE: I'll give you something that I think investors are missing big time. One of the biggest opportunities we see is the opportunity for financial service firms, such as Merrill Lynch or CitiGroup, to gain business from the overseas opportunities. One of the great missing ingredients in the emerging market space is in financial services. It's even missing in places like Japan. Who would think it, with the bank strength they've got over there? But there's very little choice for Japanese investors. They're starved for new products and innovation. The Japanese banks have been so worried about patching up their balance sheets, they haven't focused on the consumer. And right now, there's no local Merrill Lynch. Americans do financial services better than anybody in the world, period, hands down. The great thing about this industry is that you have all the opportunity of the world opening up, but yet you have no new competition, which is an amazing opportunity.

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