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A Fund Manager Who Beats the Odds

If you went by the odds being offered last May, favorite Point Given had the best hope of winning horse racing's Triple Crown since Affirmed managed the hat trick in 1978. But avid handicapper and mutual-fund manager Larry G. Babin found better prospects among other contenders in the Kentucky Derby, the first of the three classic races. A chestnut called Monarchos, a 10-1 shot, piqued his interest -- and paid off, too. The horse won with the second-fastest time in the race's 127-year history. Point Given came in fifth.

Sure, a gambler with a taste for long shots might not be everybody's idea of the ideal money manager. But horse racing, says Babin, manager of the $1.3 billion Victory Diversified Stock Fund, isn't just about making big bets and taking on risk. As far as he is concerned, it's not even about making money. Rather, it's the intense scrutiny of numbers and probabilities that appeals to him. "It would be the same challenge if you didn't wager," he says. "It's about intelligent judgments. It's the mental challenge."

Translating that to the world of stocks, Babin has a penchant for scouring balance sheets and a keen taste for shirking the investing crowd. It has earned him an enviable record: In the 12 years since the fund was launched and Babin signed on to lead one of Victory's investment teams, it hasn't had a single calendar year of losses.

True, at times it has trailed the Standard & Poor's 500-stock index. But, over the long haul, the fund edges out its benchmark: a 15.3% annual return for the past decade, vs. the S&P's gain of 10.3%. "We are clearly the ones who do less well during the very strong and crazy momentum years when valuation is irrelevant," says the Cleveland-based 51-year-old managing director of Victory Capital Management.

Babin also makes big-picture calls for the fund, which invests in a blend of value and growth stocks. For instance, he loaded up on AOL Time Warner, Microsoft, and IBM last year, tilting the fund's tech stake to 19% -- almost double the S&P, according to Morningstar. It helped: The fund's slim 1% gain trounced the S&P's 13% loss. BusinessWeek's Mara Der Hovanesian recently checked in with Babin to hear about his methods and his forecast for the market -- as well as what he's buying these days. Following are are edited excerpts from their conversation:

Q: At this point, do you view stocks as cheap or pricey?

A: A lot of the historical valuation work shows that the market is somewhat expensive. But stocks are selling anywhere from 8 times earnings to 58 times, so certainly we are finding pockets of opportunity. We are fully invested, and we believe that we are going to make money [this year]. And we're clearly in a low-inflation, low-interest-rate environment, which has historically allowed for higher-than-average price-earnings ratios. There are a lot of moving parts to the valuation question, but compared to bond and money-market returns of 1.5% to 2.5%, stocks look cheap.

Q: Your strategy uses a combination of both growth and value styles. How does that work?

A: We don't think so much in broad themes like that. Value has clearly done better, but whether that's gone on long enough we wouldn't say. Some shops look at absolute value and kick the tires of companies. [Instead,] we look at value in a couple of ways. One is value by statistical cheapness, where we use traditional measures, such as price-to-book, price-to-cash flow, etc. We then rank all the stocks in our coverage universe by those statistics. We'll look at how they've done historically and then compare them to each other.

We also use a dividend-discount model, make certain assumptions about earnings growth and the discount rate, and then we judge and compare them to similar stocks within their category.

The third part of our process is a more qualitative tool that looks at growth catalysts -- say, management changes, industry consolidation, or earnings revisions. We try to be open-minded about what a potential catalyst might be.

Q: Tell us about some of the new purchases you've been making.

A: We began orientating the portfolio last year to companies and industries that would benefit from the inevitable recovery. After the 11 interest rate cuts by the Fed, we have, in our judgment, begun to pave the way. Before September 11, we felt that the economy was about to show improvement. Unfortunately, in terms of economic effect, [the attacks] delayed or postponed the recovery.... [We] are still suffering some of the pangs.

We began to build up our exposure to cyclical, basic, or capital goods, in particular. Our valuation work has portrayed stocks like Caterpillar (CAT), International Paper (IP), and Alcoa (AA) as undervalued. The media industry is also an important part of the consumer cyclical group, and we've been adding to that lately. Advertising spending has been really decimated, but we're seeing signals that that's beginning to show improvement.

We bought a fair amount of new Disney (DIS) stock under $20, which we've been accumulating for the past six months or so. We've added to AOL Time Warner (AOL) and Viacom (VIA). Also with the housing market and auto sales holding up well, it's our sense that a lot of apparel purchases may have been deferred. We recently bought Jones of New York...and are seeing signs that consumers are ready to replenish their wardrobes. Lehman Brothers just went back to suit attire [for their employees], and dot-com companies are trying to establish credibility. It's one of those trends in society at the margin: People's businesses have done badly, and they want to be taken seriously, so they're moving away from casual dress.

Q: What is it about managing money that gets you motivated?

A: If you want to be good at this job, you have to be a keen observer of the human condition and trends in society, whether it's demographic trends or trends in behavior. It all has implications for the companies we invest in. Every day there's some new information to process, and you try to understand the investment implications. It's also important to have succeeded in different markets. You shouldn't get too excited in the good times or too depressed in the bad times.

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