July 16, 2004 — The Smith Barney Fundamental Value/A (SHFVX) began buying large pharmaceuticals companies late last year. At that time, their stocks were trading at historically low multiples based on any measure you’d care to look at says Peter Hable, who has managed the $4.9 billion fund with John Goode since its inception in late 1990.
Many companies in the sector had fallen out of favor because of concerns over a paucity of new drugs, patents expiring on older products, and competition in the U.S. from low-priced imports.
However, Hable and Goode expected the group to pick up when the Federal Reserve began raising interest rates, which they reasoned would make drug producers attractive to defensive investors. They saw the stocks improving in late 2004 or early 2005. While they waited for the turnaround, they could collect the fat dividends that the companies usually pay, Hable adds.
Earlier this month, drug manufacturers Merck & Co (MRK), Johnson & Johnson (JNJ) and Pfizer, Inc (PFE) were ranked seventh, eighth and ninth in the portfolio.
“It’s a group that we think will perhaps be a bit of a dormant asset for a while,” Hable says. “But as we move out into late this year we see this group reflecting its historic conservative nature and attracting funds.”
Waiting for investments to pay off hasn’t kept the fund from staying ahead of its rivals. Smith Barney Fundamental Value was up 4.2% through June this year, while the average large-cap value fund gained 3.5%. The Smith Barney fund returned 4.5% on average for the five years ended in June, versus 1.4% for its peers.
Cheap stocks and hefty dividends are two things the fund managers prize, as are solid balance sheets and leading market shares. And they prefer to see earnings in the “high single digits,” or better, Hable says.
Once they identify shares trading at a discount to the underlying assets of a company, they want to make sure that its earnings exceed its cost of capital, and that it generates cash. Strong free cash flow, Hable points out, enables a company to buy back stock, repay debt, invest in the business, or pay dividends.
Companies that have just completed a major round of capital spending also appeal to Hable and Goode. That can depress share prices, but it leaves them poised to rise as they benefit from the outlays. Generally, that’s “when they’re going to start to reap excess returns,” Hable says of companies that have reached the end of an expenditure cycle.
In picking stocks, the managers also scan for companies that appear to be in position to gain from economic or demographic trends.
For example, over the last few years the fund has had a large exposure to companies that produce basic materials, Hable says, because they should prosper if the U.S. economy rebounds. These stocks, which include aluminium producer Alcoa Inc (AA), account for about 7% of the fund’s assets.
The fund can buy companies of any size, but large stocks make up some 70% of the portfolio.
One of Hable’s favorite stocks is media giant Time Warner (TWX), whose advertising revenues, he believes, will get a boost from the strengthening economy, as well as the presidential election and the Olympic games.
In addition, Time Warner has “gone through a tremendous cash drain” in recent years because of acquisitions and debt payments, “so they are clearly moving into a time frame here where they’ll be a free cash flow generator,” Hable says.
Another stock Hable likes is Raytheon Co (RTN). The defense contractor, which held sixth place in the portfolio earlier this month, has been undergoing a restructuring, so it’s in a position to start generating cash, he says.
When it comes to selling, the portfolio managers will trim a holding or eliminate it from the portfolio if it becomes too pricey, or a company’s financial health takes a turn for the worse. Hable says he and Goode look to hold stocks for three years or more. “We’re trying to buy things on the cheap and let them come to their valuations,” he says.
As a result, the fund’s turnover tends to be lower than its peers. Smith Barney Fundamental Value’s turnover rate was 34% last year, compared to 64.1% for similar funds. However, the approach can lead to higher volatility since the managers can stock up on out-of-favor names. The fund has a higher three-year standard deviation, a measure of volatility, than its peers.
Looking at the overall stock market, Hable sees it ending the year in the black, thanks to the improving economy, but he doesn’t expect big gains. “If we, again, had to make a guess, we’d say certainly it will be a positive year,” he says. “But we’ll see much more muted returns than we saw lastyear.”
Contact Robert F. Keane with questions or comments at:[email protected].