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Managers Place Big Bets on Small-Cap Value

U.S. small-cap value stocks-consumer discretionary, industrials, financials and energy in particular-are poised to deliver solid returns as the economy and the stock market continue to improve, according to investment officers at recent outlook briefings.

"The U.S. economy is on a slow grind in terms of improvement," said Payson Swaffield, chief income investment officer at Eaton Vance.

Thus, in full anticipation of a slow-but-steady recovery, the Hennessy Focus 30 Fund, a quantitative mid-cap fund that screens for companies with price-to-sales ratios below 1.5 and annual earnings growth, has just boosted its equity sector weighting to 48.5% for consumer discretionary stocks and eliminated all consumer staples. A year ago, the fund had 33% of its portfolio in consumer discretionary stocks, and 10% in consumer staples.

That said, consumers have learned to be frugal, so the Hennessy Focus 30 Fund is splitting its consumer discretionary holdings between high-end specialty retailers, such as Williams Sonoma, and budget stores, such as Dollar Tree and Family Dollar, as well as do-it-yourself outfits, including Advance Auto Parts, Tractor Supply and Jo-Ann Stores.

As to why Eaton Vance is similarly bullish on small-cap stocks, Richard Bernstein, chief executive officer of Richard Bernstein Advisors, an Eaton Vance sub-advisor, said that he looks for unusual scarcities of capital. In 1998, the Russian and Asian financial crises preceded 10 years of strong returns for emerging markets. Currently, small companies in the U.S. are not able to raise money because banks are unwilling to lend to them, Bernstein said.

However, a lack of confidence in the economy and the specter of inflation are holding the markets back, speakers said. The U.S. national debt, is on track to hit $12.5 trillion, or 89% of annual GDP, this year, according to Eaton Vance.

In fact, the Federal Reserve is now purposely working to trigger inflation to create a larger negative real return on cash, in order to prompt banks to resume lending and institutions and retail investors to begin investing in equities again, said John Brynjolfsson, chief investment officer of Armored Wolf, another Eaton Vance sub-advisor. The Fed Funds rate is 25 basis points and inflation is 1%, making the real return negative 75 basis points, Brynjolfsson explained. But even that isn't stopping investors from continuing to pour money into fixed income instead of equities, he said. Thus, in addition to keeping the Fed Funds rate at 25 basis points, the government in November will begin spending up to $100 billion a month to repurchase Treasuries and other fixed income reserves, he said.

The Federal Reserve announced Wednesday it will buy $600 billion of U.S. Treasuries over the next eight months to spur the recovery.

"The Fed is trying to create a negative real yield on cash to get people to invest again," he said. "So we want to position investors against a declining dollar and rising inflation."

And this picture isn't likely to change anytime soon. "The scenario of the next three to five years is employment and housing will remain under pressure and global debt deleveraging will continue for seven years," Brynjolfsson added.

Thus, in the face of monetary policy uncertainties, besides small-cap value, Eaton Vance is also recommending inflation-protection vehicles, floating rate funds, commodity funds, high-yield bonds, Build America Bond funds and absolute-return strategies, Swaffield said.

Until Washington offers tax breaks to help businesses create jobs and puts economic growth back on track, investors will continue to be spooked and avoid equities, agreed Neil Hennessy, chief investment officer of the Hennessy Funds.

"We have a crisis of confidence that is turning quickly into a crisis of clarity. This is the lowest level of investor confidence I have seen in my 30-year history in the asset management business," Hennessy said. "U.S. investors want yield, safety and absolutely nothing to do with stocks."

And it's no wonder, considering home prices continue to fall, unemployment remains high, economic growth is anemic and the markets remain markedly volatile, as evidenced by the Flash Crash and the rise in high-frequency trading, Hennessy said.

"Retail investors don't understand how a market could fall 1,000 points in 20 minutes," Hennessy said, revealing that when some clients called him that day, May 6, to tell him they were getting out of the stock market for good, he told them, "I don't blame you."

So far, Washington has only offered short-term solutions through bailouts, TARP, housing credits and Cash for Clunkers, Hennessy said.

Michael Cirami, global bond portfolio manager at Eaton Vance, agreed that monetary policies in the U.S. "are causing distortions" while failing to take "meaningful deleveraging" into account. "The debt problems we had before the crisis are still there and will eventually have to be addressed either through defaults and restructuring, or through inflation," Cirami said.