John C. Thompson of Thompson Plumb Growth Fund

THOMPSON: Over the last decade, Fannie Mae has had an average P/E of about 14 to 15. It currently trades at about a 9.5 P/E, which is close to its historic low. The company enjoys a return-on-equity of about 25%, and it has grown its earnings consistently for many years.

The stock has been hurt this year by two factors. Since corporate loan demand has been weak in the past few years, banks have used their lending capacity to purchase mortgages, thus competing with both Fannie Mae and Freddie Mac. However, we think this will be a short-term phenomena, since Fannie and Freddie have lower costs of capital than banks. Also, Fannie and Freddie have been hurt by political risk. The Bush Administration threatened to revoke their charters, but we feel this action is unlikely, though the stock has been hurt by this possibility.

S&P: Has Microsoft gotten too big to show significant upsides?

THOMPSON: Microsoft is basically a monopoly and can charge monopoly prices, which makes them extremely profitable. Though their growth has slowed a bit in recent years, they have grown much faster than tech rivals like Cisco Systems (CSCO) and Intel Corp. (INTC). Microsoft’s earnings grew in 2001 and 2002, during the bear market, while profits at other tech companies fell by 50% to 60%.

S&P: What are your top sectors?

THOMPSON: As of June 30: financials, 22.6%; health care, 21.9%; consumer discretionary, 19.0%; information technology, 16.7%; consumer staples, 9.2%; industrials, 6.9%; and energy, 3.8%.

S&P: You seem to be underweight in tech.

THOMPSON: In the mid-1990s, we were heavily invested in tech — double the weighting of the S&P 500 index, 30% to 15%. We became worried about the enormous rise of P/E’s, so we significantly scaled back our tech exposure in 1999. By February 2000, our tech allocation was only one-third of the index’s. We were also worried about the fundamental performance of these companies, but our decisions were primarily based on valuations. At that point, our portfolio took more of a value complexion.

We remain significantly underweight in tech today, though that depends on how you classify companies like First Data Corp. and Paychex Inc. (PAYX), two big holdings in our fund. We don’t consider them to be tech, but Standard & Poor’s does.

S&P: The fund has beaten the large-cap blend peer group for the one-, three-, and five-year periods through July. What do you attribute this to?

THOMPSON: We adhere to a strict valuation discipline, so we have significantly underweighted the technology, telecom, and Internet sectors, among others, which performed poorly during the bear market. We also benefited from positions in such rising stocks as AutoZone Inc. (AZO), Wells Fargo (WFC), and CIT Group (CIT).

S&P: What are your sell criteria?

THOMPSON: We typically sell when a stock’s trading multiple exceeds its long-term average. We also sell when we find a better investment, or if we detect a problem with a company’s earnings before the market does.

But we don’t sell and trade much, so the fund’s average annual turnover rate is under 50%.

S&P: Have the Fed’s recent rate hikes impacted your stock selection process? Will you reduce your financial exposure?

THOMPSON: Not at all. For example, we initially purchased Fannie Mae in 1994 when the Fed started an aggressive tightening campaign. The stock’s price increased four-fold in the next five years. We also bought a lot of financials in late 1999 and early 2000, when the Fed was again raising rates. These kinds of stocks become very attractive after they fall in price.

S&P: Crude oil prices are reaching historic highs. Does this affect your stock picking? Will you add to your energy holdings?

THOMPSON: We recently added to our energy holdings, particularly ChevronTexaco Corp. (CVX) and Exxon Mobil (XOM). We think higher energy prices present the biggest short-term risk to the American economy. However, while oil stocks have performed well recently, their gains have paled compared with the dramatic rise of oil prices. Thus, oil and energy stocks have considerable upside potential.

Contact Bob Keane with questions or comments at: [email protected].