David King
Putnam New Value Fund
by Marla Brill
MFI Publisher
With the once yawning valuation chasm
between value and growth stocks now narrowed to a mere fissure, the question for
investors is whether there is really such a thing as a true bargain in the stock
market any more. In March 2000, the growth component of the S&P 500 Index had a
price earnings ratio of 48, while the value segment was priced at just 22 times
earnings. Today, growth and value stocks in the index sport price-earnings
ratios of 21.5 and 15.4, respectively. Energy stocks that once peppered the
portfolios of value managers have become too expensive for some of them, while
health care stocks they once shunned now turn up regularly on their investment
radar screens.
The crossover comes after five years in
which the quest for value has spanned across companies both large and small. The
S&P 500 Barra/Growth Index plunged an average of 8.16 percent annually over the
five years ending March 31, compared with an increase of nearly 2 percent a year
for the S&P 500 Barra Value Index. The S&P MidCap 400/Barra Growth Index eked
out a .36 percent annualized gain, while the value component of the index had a
return of 14 percent a year over the same period. The S&P SmallCap 600/Barra
Growth Index rose 5 percent a year, compared to nearly 14 percent for the S&P
SmallCap 600/Barra Value Index.
David King, the 48-year-old manager of
Putnam New Value Fund says that despite their multi-year run there is still
plenty of value left in value stocks. But he's looking in different places for
it than he used to, and keeping upside expectations in line with the richer
valuations of traditional value stocks in today's market.
"We're no longer running into estimated
upside to fair value of 100 percent, which is that we saw with a number of
financial stocks in 2000. In some cases the stocks we're buying sell at 15 to 20
percent below our estimate fair value. In others, the discount might be as much
as 50 percent to 60 percent." The latter group, he says, consists mainly
of larger, financially strong insurance, health care, and airline companies that
have fallen out of favor.
The kind of stocks that show up on his
investment radar has also changed. "Three or four years ago, we looked at a lot
of mid-cap names," he says. "Now, we're finding better value in much larger
companies." To qualify for inclusion in the portfolio, a company must be in
business for at least ten years and have at least $1 billion in trailing
12-month revenue. It must also be cheap compared to other stocks based on
traditional measures such as price to book, price to sales, and price to
earnings ratios. The fund is concentrated in about 70 names, with the top 20
stocks often accounting for about half of assets.
At the beginning of last year, the
portfolio had a weighted average market capitalization below that of King's
investment universe, which resembles the Russell 3000 Value Index. With new
buying focused on larger companies the portfolio's weighted average market cap
now exceeds it.
King insists that the move toward
larger, better quality companies is a more a matter of adjusting to market
conditions than changing stripes. "One of the main tenets of value investing is
that you take what the market gives you. In another environment, we would not be
unhappy with owning smaller, lower quality companies. But that is not the
environment we are in now."
He points out that the line between
value and growth stocks is constantly shifting, and that the market's seeming
preference for one or the other rests on just a couple of sectors. "The strong
performance of energy stocks is a large part of the reason that value has beaten
growth recently. If technology does well, then growth will be seen as dominant."
As for the widely-held prediction that growth will outpace value in the years to
come, he notes that "There is some indication that on a valuation basis, we
could see a rotation to growth in the future. But I don't think style variation
will be as dramatic as it was in 1999. And I'd be surprised if the difference
between the two in terms of performance is extreme."
"Temporary Price Dislocations"
Recent purchases include a number of
larger companies with attractive earnings potential that have moved into value
space because of negative news and the "temporary price dislocations" it brings.
Names in this category include some former darlings of the growth camp such as
Pfizer, Home Depot, and Intel. Two of the fund's best performers last year were
Walt Disney and McDonald's, which King began buying about two years ago.
"There's a lot of skepticism and negative chatter around the stocks we buy,"
says King.
That was certainly the case with Tyco
International, one of the fund's top holdings and one of its better performers
in 2004. King began purchasing the stock in 2002 after the company's CEO was
indicted. He kept buying it on the way down after "dramatic market overreaction"
to the barrage of negative revelations about lavish corporate spending. The fund
paid an average of $17 a share for the stock, which now sells at around twice
that level.
In a similar show of resolve, King
held on to the fund's stake in Providian Financial in 2001, even after a
struggling economy decimated its sub-prime lending portfolio and the company's
stock became the second worst performer on the New York Stock Exchange that
year. Since then, the lender has shored up the quality of its customer base, and
the stock has recovered to about $17 a share.
More recently, a number of
well-publicized events helped cloud the outlook for some companies in the
financial sector and brought their stocks down to cheaper levels. Despite the
storm clouds swirling around them about their accounting practices, King has
been buying shares of Fannie Mae and Freddie Mac over the last year. He admits
he has lost some money doing so, but believes that the market has overreacted to
their problems. "Two or three years from now," he maintains, "those stocks will
be higher than they are today."
Late last year, New York Attorney
General Eliot Spitzer's investigations into several insurance and financial
services companies (including Putnam's parent company, Marsh & McLennan) raised
concerns about the entire sector. Amidst the controversy, King scooped up shares
of several property and casualty insurers such as Hartford Financial, Chubb
Corporation, Ace Limited, and XL Capital. He added the latter two companies late
last year when their incorporation in Bermuda raised concerns about a lack of
regulatory scrutiny and sent their stocks tumbling. Hartford and Chubb made
their initial appearance in the portfolio late last fall after the two stocks
had fallen victim to fallout from the Spitzer investigation. King calls the
downturns "an isolated incident that doesn't have permanent implications." The
industry continues to provide a fertile hunting ground for fallen growth stocks.
A common growth fund holding, insurance giant American International Group,
recently tumbled into King's universe of value stocks after revelations about
accounting irregularities at the company.
At its recent price of $27 a share
pharmaceutical giant Pfizer, another fallen growth stock buy, sells at a
discount to King's estimated fair value in the mid-to-high 30s. Aside from the
stock's attractive valuation, he's also drawn to its dividend yield of over 3
percent. It now accounts for about two percent of fund assets. Unlike many fund
managers, he points out, he does not own Merck. "There are a lot of patent
expiration issues with this company," he notes. "Not owning it last year was
probably one of the best moves we made."
He is also sidestepping regional banking
stocks, an area he once targeted aggressively, because he thinks they've become
overpriced. Despite an increase in the number of bank mergers, he says, "recent
acquisitions have not been completed at very large premiums. The market's
positive overreaction to mergers has been particularly evident among smaller
banks." He's finding better value among mega-banks like Citigroup, the fund's
largest holding.
King has fairly modest expectations for
the energy sector, the major driver behind the surge in value stocks last year.
"I don't think oil prices will go up dramatically at this point," he says.
"We've reached a new plateau. We could see some moderate upside for energy
stocks, but from here on it won't be earth shaking."
Putnam New Value Fund At-A-Glance
Manager: David King
Assets: $1.75 billion
Top five holdings: Citigroup, Exxon
Mobil, Tyco International, Boeing, Lockheed Martin.
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