Top-down equity managers bet that old-line industries will outperform the market when the recovery kicks in later this year.
By Laurie Kaplan Singh
February 2002
Institutional Investor Magazine
They like the sheen of steel and aluminum. Paper looks good to them, too.
A contingent of top-down equity managers - they try to anticipate macro trends and then trade accordingly - are betting that the recovery will begin within the next nine months and that before it does, cyclical industries will outperform the market.
“The recovery will impact industries that have been in a recession for a very long time,” says Mark Bavoso, manager of the $1.8 billion Morgan Stanley Strategist Fund. “We’re talking about basic materials like chemicals, steel, copper and paper, which have seen capacity diminish over the last three years. This is where opportunity lies.”
Robert Doll, chief investment officer of Merrill Lynch Investment Managers equity funds, also predicts a recovery before the year is out. But he feels strongly that it will be distinctly different from past upturns in which basic industry stocks lead the market. “We believe there’s still a lot of excess capacity in many parts of our economy,” says Doll.
To better understand the conflicting forces influencing the U.S. economy, Institutional Investor spoke with three money managers who call big macro turns and whose stock selection is largely top-down: Morgan Stanley’s Bavoso, Merrill’s Doll and Robert Unger, manager of the $101 million Columbia Strategic Value Fund.
Unger’s Columbia fund was up a sizzling 29.8 percent last year. Bavoso’s fund fell 10.2 percent, versus an 11.9 percent decline for the Standard & Poor’s 500 index. Doll’s Merrill Lynch Large Cap Series Core ($496 million in assets), Value ($367 million) and Growth funds ($167 million) were down 5.2 percent, 0.4 percent and 10.4 percent, respectively, in 2001.
Doll agrees that a recovery will begin by the second quarter of this year, but he is investing in an anticipated upswing in consumer spending. “If the economy improves, discretionary consumer spending will pick up,” he says. The U.S. consumer still accounts for two thirds of GDP.
“We are approaching the one-year anniversary of the beginning of the Fed’s series of interest rate cuts; this is about the time we would expect the cuts to impact the economy,” says Bavoso. “The combination of stimulative monetary policy and low inflation is conducive to an economic recovery.”
“Generally, in the beginning of an economic cycle, the economy picks up about nine months after the market bottoms out,” says Unger, who also thinks growth should start again in the second quarter. “The money supply has increased at very high rates; this should soon produce positive results.”
Unger believes that the coming economic upturn will mirror the recoveries of the 1960s and 1970s, which were led by strong demand for aluminum, steel and paper. At best, he says, “these industries have had modest increases in capacity in the last ten years. Many companies have not built new facilities in over a decade, and some have reduced capacity during that time.” Unger thinks it’s only a matter of time before demand exceeds supply and puts upward pressure on prices.
As he sees it, increasing demand for basic materials will be fueled by guns and butter: U.S. government spending on defense and an upsurge in infrastructure projects around the globe. “These will be basic brick-and-mortar projects - highways, pipelines and green field plants,” Unger says.
Morgan Stanley’s Bavoso agrees that a recovery will begin sometime in 2002 and that it will give a big boost to cyclical industries like chemicals, papers, steel and copper. Although economic statistics indicate low capacity utilization rates around the world, Bavoso says, “it isn’t the traditional capacity that can be switched back on in a turnkey fashion to meet demand. A lot of capacity was built in the mid-1990s, but much of it has been eliminated and will never come back online.” With inventory levels at the lowest point in years, even small increases in demand will require manufacturers to go back into production. But as inventory restocking rather than actual demand will fuel the initial stage of the recovery, Bavoso thinks the expansion will be modest and possibly short-lived, with year-over-year growth of about 3 percent by the fourth quarter. “Real demand will take some time to build,” he says. Still, he adds, “this is a tradable event.”
Although successive cuts in the federal funds rate - from 6 percent on January 3, 2001 to 1.75 percent on December 11 - will result in a recovery, says Merrill’s Doll, the stock market’s response will be tepid. Doll reasons that “the rally will start from a valuation level that is not particularly cheap.” Moreover, “low inflation will keep nominal growth in the U.S. and the rest of the developed world very low. Earnings expectations for 2002 are probably still too high.”
Doll explains that while Federal Reserve Board actions often indicate the direction of a future market move, valuation levels are more indicative of the magnitude of such a move.
Like Unger and Bavoso, Doll thinks that many economically sensitive sectors, such as semiconductors and software, will outperform during 2002, but he cautions that buying these names now could prove to be a short-term mistake. “This segment of the market has rallied strongly as the market began to anticipate a recovery and rebounded from its September 21 low,” he says, noting the potential for a profit-taking correction in the first quarter. Between September 21 and January 11, for example, the semiconductor stocks Doll tracks appreciated approximately 85 percent, while software stocks climbed about 72 percent. Doll had begun increasing his fund’s exposure to stocks that are especially vulnerable to economic changes even before September 11, but recently he has been trimming positions, anticipating that he will be able to buy them back at lower prices.
“The profit-taking will be in those names that have recently performed best - the economically sensitive stocks,” he asserts.
Still, “slowly but surely, all of our portfolios are becoming more economically sensitive and cyclical,” says Doll. “We believe that September 21 was the bear market’s low, but that doesn’t mean we go straight up from here,” he says. “It’s usually two steps forward and one step back.” Unlike Bavoso and Unger, however, Doll isn’t stressing basic industry sectors. He thinks enthusiasts overstate their capacity constraints. “Many of these companies are getting more output from their existing capacity,” he says.
Doll predicts that consumer stocks will outperform when growth resumes. He thinks beneficiaries will include retailers like TJX Cos., auto-rental companies and real estate conglomerates such as Century 21 Real Estate Corp. and Coldwell Banker Real Estate Corp. Doll is also overweighting health care stocks, as he has for the past two years, because he feels confident that the sector will continue to benefit from good demographics (aging baby boomers) and new-product development. But he’s steering clear of tech stocks. “The fundamentals [for most technology companies] still leave something to be desired, and the valuations are reasonably high,” he says. One technology company Doll likes: Electronic Data Systems Corp.
Bavoso’s Strategist Fund, which for the past year has emphasized defensive sectors such as food, beverage and tobacco stocks, has increasingly shifted to basic material and industrial names, including Emerson Electric Co., General Electric Co. and SPX Corp. “It’s a diversification of the deepest cyclical plays,” he says. Bavoso also continues to overweight food stocks. “Technology companies will benefit from the recovery,” he says. “But the stocks’ prices already reflect this.”
Launched in November 2000, Columbia Strategic Value initially emphasized traditional value stocks like Champion Enterprises, Foster Wheeler Corp., J.C. Penney Co. and Service Corp. International. “At the time, this was the most attractive sector of the market,” Unger says. “Institutional ownership of these companies was historically low, and the stocks were selling at very low prices relative to their underlying assets and potential earnings.” Unger’s bet paid off handsomely when value stocks staged a strong comeback in the first half of 2001.
Taking profits, Unger began to reduce the fund’s value stakes last June, replacing many of the holdings with moderately undervalued growth companies, such as FEI Co., a manufacturer of electron microscopes and other products used in the semiconductor and data storage industries, along with basic material stocks like Alcan, Monsanto Co. and Westvaco Corp., which Unger thinks will benefit from even a modest recovery.
Unger also accumulated a sizable stake in certain technology and electronics manufacturing stocks like Adobe Systems, Micron Technology, Samsung Corp. and Sanmina-SCI Corp., which he believed were historically cheap and likely to benefit from an upsurge in inventory rebuilding as the economy heats up. As the market came to share this view, the fund’s technology holdings became the biggest source of capital appreciation in the past three months.
Indeed, technology stocks still account for about 22 percent of Unger’s fund’s investments. The second-biggest sector exposure: industrial stocks, at 19 percent of total assets. Last year those choices certainly served him well. But until he’s sure the recovery has arrived, Unger is sitting tight.
