From the July 2008 issue of Wealth Manager Web • Subscribe!

July 1, 2008

RiverSource catches the tailwinds of undervalued industrial and energy stocks-and then holds on tig

When credit markets came unglued last summer, financial stocks collapsed. That was bad news for large value funds, which traditionally hold big stakes in banks and brokers. During the six months ending in March, the average large-value fund lost 14.0 percent, lagging large-blend funds by nearly two percentage points, according to Morningstar.

With financial companies still reporting red ink, it is hard to know when stocks will hit bottom. But value funds could be positioned to rebound sharply when the markets revive. Large-value portfolios now have a price-earnings ratio of 14.1, a bit below the market's historical average. Despite their modest prices, many value stocks are reporting healthy earnings growth, including companies in energy and commodities. Strong export sales could help many of the industrial stocks that are popular with large-value funds.

Which fund is the best choice? To make a selection, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alphas and Sharpe ratios must also surpass the medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens narrowed the field from 1,276 contenders down to 60 finalists. Top performers included American Beacon Large Cap Value, Eaton Vance Tax-Managed Value, and Phoenix Insight Value Equity. But we awarded the title to RiverSource Diversified Equity Income, which had the highest five-year returns.

RiverSource won by following an unusual strategy that combines bottom-up stock picking with an effort to emphasize the most promising industries. "We focus on those parts of the economy that are enjoying tailwinds," says portfolio manager Warren Spitz.

Beginning in 2001, Spitz began overweighting industrial and commodity companies. At the same time, he shifted away from financial stocks. Spitz made his move because of changes in economic indicators. During the 1980s and 1990s, interest rates and inflation trended down, he says. That made it easier for consumers to borrow and boosted profits of banks. After the stock market downturn started in 2000, the economic winds shifted. Inflation and interest rates began rising, making loans more expensive. While inflation hurts banks, it can enable manufacturers to raise their prices and boost profits.

The move away from financials proved profitable, as industrial and commodity stocks outperformed the markets. Because he thinks inflation will continue rising for years, Spitz expects to continue overweighting industrials and avoiding financials. "Even after the credit crunch passes, there will still be excess capacity in the whole banking and financial services area," he says. "The margins are going to be lower going forward."

After targeting an industry, Spitz sifts through individual companies, looking for undervalued stocks that appear poised to begin reporting improving earnings. He often starts buying unloved shares when they seem stuck in the cellar. If the stock starts to recover, he buys more shares. Recently, Spitz began acquiring GM and Ford. Although the auto makers are losing money, he sees better days ahead. Spitz says that the companies have cut their health and labor costs. In addition, Detroit is improving the quality of its vehicles. "When the economy gets better, there will be a substantial improvement in the earnings of the auto makers," Spitz says.

Another holding is Caterpillar, the big producer of heavy equipment used in construction and mining. While demand in the U.S. is slowing, the company is recording growing sales abroad. The stock is cheap because investors figure that the company will be hurt by the economic slowdown, says Spitz. But he figures that earnings will begin turning around in 2009.

Spitz also owns Deere, the agriculture equipment giant. The company is increasing its market share and recording strong sales abroad. With consumers around the world demanding more food, farmers are enjoying high prices. That is helping to boost Deere's sales. "Farmers are replacing used equipment faster than they did in the past," says Spitz.

RiverSource has been overweight energy for several years. The fund owns some integrated companies, such as Chevron, but Spitz is emphasizing oil services and drilling companies such as Baker Hughes and Halliburton. As demand for energy grows, oil service companies will be able to increase their prices, says Spitz.

RiverSource typically buys stocks that sell for below-average price-earnings multiples. But Spitz does not take stocks simply because they are cheap. Instead, he looks for companies with strong cash flows. Buying steady companies is particularly important in today's shaky markets, says Spitz. "If you just screen for the cheapest stocks, you will come up with a lot of financials and stocks that will not necessarily do well in a slow economy," he adds.

The fund typically keeps 65 percent of its assets in dividend-paying stocks that yield more than the market average. Such high-yield stocks tend to be relatively cheap. In addition, the dividends help to cushion the portfolio, providing income during down markets.

After buying a stock, Spitz waits patiently for results to improve, typically holding for three years or longer. By trading deliberately, he has produced winning results through a variety of bull and bear markets.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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