Cash, Not Earnings, Makes the Grade for Some Managers
July 14, 2003
CHICAGO - Financial advisers flocked to the windy city last month for the 2003 Morningstar Investment Conference, where the mutual fund industry's top stockpickers discussed their investment strategies and what it takes to beat the market. Given the wave of corporate scandals that has swept the financial markets the past few years, several managers are reminding investors that cash is still king.
A panel featuring three top managers focused on looking beyond corporate earnings for companies that churn out a ton of cash, or "cash cows" as they were referred to at the conference. Managers on the star-studded panel outlined several criteria that govern their selection process. "We stay away from serial acquirers," said John Rogers, chairman and chief executive at Ariel Asset Management. "WorldCom and Enron made a slew of acquisitions that masked their true financial state."
Rogers, manager of the $1.6 billion Ariel Fund, said that his firm is taking accounting principles more seriously due to the headline risk that has pervaded Wall Street the past several years. Specifically, Chicago-based Ariel recently hired New York-based consulting firm Deloitte & Touche as an outside investigator to conduct background checks on companies it plans to add to its portfolio.
Rogers' value offering targets stocks that are selling at 40% of their intrinsic value. He also prefers companies that are in stable industries with high barriers to entry, which gives them an inherent competitive advantage, he said. Many of those stocks fall under the consumer goods and financial services categories. The portfolio tends to be light in technology and energy names. Although his fund has been beaten up a bit of late, his long-term track record is outstanding, having bested 80% of his peers over a 10-year period with a 9.9% return.
Some of the stocks he likes right now are companies that were trampled in recent years but still have a good brand. For example, he is currently buying shares of T Rowe Price and Waddell and Reed, two financial services firms that have good management teams and clean balance sheets, in his opinion.
Doug Eby, co-manager of the $1.5 billion Torray Fund, sniffs out companies that offer higher margins and better returns on invested capital than their costs. He focuses on companies that generate cash rather than simply pinning investors' hopes on earnings performance. "The ability of managers to manipulate [earnings] numbers is great," he said. "It's harder to manipulate cash flow." But he believes that stock valuations have come down so there is less of a chance that corporate executives will manipulate their numbers.
More than half of the fund's assets are committed to healthcare and financial stocks. The no-load offering has trounced its peers over the last decade, producing a 10-year annualized return of 13.7%, which ranks second among all large-value funds. Its top holdings include Amgen, Merck, Franklin Resources and Clear Channel Communications. Amgen, the world's largest biotechnology company, recently became its top holding following additional purchases and a powerful price move. Indeed, the stock is up a whopping 125% since last July. Eby believes that the stock's high price multiple is justified by a solid drug lineup that includes oncology treatments Aranesp and Neulasta. It also generates double-digit sales and earnings growth, he said. Another stock it has recently added to its portfolio is bond insurer Ambac Financial Group.
Another member of the panel, famed fund skipper Mario Gabelli, defended his ownership of media titan AOL Time Warner, which has been knocked around quite a bit since its ill-fated merger. He thinks Richard Parsons is doing a good job at the helm and that a good time to buy a company's shares is when there is "blood in the street." Gabelli, manager of the $1.7 billion Gabelli Asset Fund, looks for stocks that are trading at discounts to what he thinks is their private-market value, a long-term valuation measure.
In terms of individual sectors, he likes the dental and pharmaceutical groups because they cater to the growing elderly population. "Twelve-percent of the population is over 65," he said. "Ten years from now, that number will be 20%." One stock he particularly likes is Boston Scientific, which makes drug-coated stents for open-heart surgery patients.
Gabelli also addressed some of the issues facing the mutual fund industry including shareholder rights plans and corporate governance. "We need to bring checks and balances back to the boardroom," he said. Gabelli has been particularly outspoken about eliminating poison pills at public companies that are vulnerable to a hostile takeover. The anti-takeover device has been a hotly contested issue in recent years, as many have complained that it upsets the balance of power between shareholders and management.
Gabelli staunchly defended the quality of corporate management in the U.S., calling it "terrific." He stressed the important role acquisitions and dividends will play in the next few years. Overall, he said the keys to success in the post-Enron era are buying a business run by good people and thinking outside the box.
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