By Robert Barker
BusinessWeek and Salomon Brothers Fund (SBF ) share an odd bit of common survivorship, if you will. Both the magazine and the $1.5 billion closed-end mutual fund started life in September, 1929 -- just before the following month's stock-market crash.
BW remains a part of its founder, the McGraw-Hill Companies, but Salomon Brothers Fund is now managed by a unit of financial giant Citigroup (C ). And today, Mike Kagan is the ancient fund's latest manager, having led it since September, 1998. Since then, the fund has returned 42%, vs. 32.5% for its benchmark, the Standard & Poor's 500-stock index, according to Morningstar. This year, the portfolio's value is off about 6%, according to Thomas J. Herzfeld Advisors, the Miami closed-end fund specialist firm.
To see where Kagan is now steering the fund, along with some $4 billion in other assets he runs in similar style, I met with him this week in Chicago at Morningstar's annual investment conference, where 1,000 investors and financial advisers had gathered. Edited excerpts of our discussion follow:
Q: What are you doing in Chicago?
A:I'm here for a couple of interviews and for numerous one-on-ones [meetings with company managements].
Q: What kinds of companies will you be checking out?
A:It's a very eclectic mix, everything from BEA Systems (BEAS ) and Walgreen (WAG ), to Household International (HI ) and Fiserv (FISV ).
Q: How do you go about picking which stocks to buy?
A:I run large-cap core money, and so it's a mixture of value and growth [stocks]. I have everything from deep value to aggressive growth. It's generally large-cap stocks, so at least 75% of the portfolio will be $10 billion [in market capitalization] or bigger. There's a smattering of smaller stuff. I consider that spicing for the pie. And the portfolio is going to be highly diversified....My goal is to beat the [S&P 500] and to do it every day, every week, every quarter, every year. So I'm smart if I do it, and I'm dumb if I don't.
Q: Example, please.
A:A good example of that would be, oh, let's take AT&T (T ) and WorldCom (WCOM ).
A:They're both big telecom companies, but AT&T has got a real mixture in there. It's got some pure telephone businesses, it's also got the cable [broadband] business. We think that the market values AT&T like [it's] a big telephone company with a little cable operation. We think actually it's a big cable operation with a telephone company attached to it. And our breakup valuation on it is about $35 a share. And where we differ from the Street is in the value of the cable operations, not in the telephone.
Q: And WorldCom?
A:It has got all of AT&T's issues that it faces in its telecom business and not the benefit of that cable operation, which is so nice and stable. Long-distance pricing is difficult. The Internet-backbone business is difficult. There are just a lot of issues that the telecom business faces right now. That's why the stocks have gotten killed.
Q: So you have separated out AT&T as a winner?
A:AT&T looks like it has very little risk to it. Now, I should also mention that AT&T is particularly interesting to us right now, because in our conversations with the company, it sounds to us like they may actually have a positive earnings surprise this quarter.
Q: Is that right? In the second quarter?
A:Yeah. The cable operations are doing better than expected. They are having better success in selling broadband services, so operating margins are going to be better than expected....The operating margin at AT&T's cable operations is far below the industry average. It's around 25%, vs. 40% for good peers.
Q: How come?
A:There are a couple of reasons. One was that they had underinvested. And one of the reasons why AT&T's cash flows have been bad the past couple of years is because they had to put a lot of money into broadband. But they've done it. And actually, the capital expenditures peaked in the first quarter of this year. In my experience, the single best time to buy a cable company is right after capital expenditures peak.
Q: Is AT&T Wireless (AWE ) now undervalued, or do you think that's getting a fair value in the market?
A:I think AWE is undervalued right now.
Q: What's a fair value for AT&T Wireless?
A:Probably $19 or $20.
Q: What's another example of how you operate?
A:Let's talk about the energy sector. I was very positive on the energy sector last year. I was quite aggressive in it and made a great deal of money in it. But I started getting concerned about six weeks ago, as I saw inventories of gas and oil and gasoline and refined products start to build. So I cut back on the aggressiveness of my oil position, so that right now, what I own is the most defensive type of oil positions you can have, which are the internationals.
Q: Such as? A: Exxon (XOM ), Royal Dutch (RD ), and Total (TOT ) would be the overwhelming bulk of my oil positions right now. And I don't have any of the positions that I had that were aggressive last year, like El Paso (EPG ), Enron (ENE ). Those names have been cut back or gone. And the reason is that when oil prices go up and down, [the internationals] don't vary all that much.
Q: What's a relatively new name that you've added to the portfolio?
A:I've been adding in the insurance area, especially in the property and casualty sector, and also in reinsurance. XL Capital (XL ) would be one that I've added. Another one that I've added is Marsh & McLennan (MMC ). You're in the early stages here of a pricing upswing, and I really like pricing upswings. They give you visibility for a few years of nice earnings growth.
Q: How about ACE (ACE )?
A:Yup. ACE is one [company's management] that I'm seeing [this week]. And if I were to rank them, I'd say that the worst business right now is reinsurance, so that's probably the one that has the most upside to it, and that's where XL comes in. We were just visiting with Hartford (HIG ), that's another stock that I own. And the pricing cycle is in full swing right now in their commercial markets.
Q: What should a prospective investor of your fund worry about? What would give them a bad surprise?
A:The big issue for a shareholder in my fund is going to be what the [overall] market does. My fund is going to mark very close to the market. That's the goal. When I talk about beating the market consistently, I really mean that. So what I'm trying to do is really to beat the market -- steadily, steadily, steadily. Never get killed. If I outperform by a lot, great. But I'm trying to hit singles and doubles. I'm not trying to hit home runs.
Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online
Edited by Patricia O'Connell