The Acid Test: Good Governance

Great Companies' James Huguet thinks there is nothing more important than transparency -- the reason he likes GE, Motorola, and Microsoft

To spot the best stocks for your long-term portfolio, check the quality of corporate governance. That's the strategy of James Huguet, co-CEO and chief investment officer of Great Companies, which manages the TA IDEX Great Companies-America fund (IGAAX ).

He recommends looking for a strong outside board of directors and how the company handles financial disclosure, among other factors. Another criterion, Huguet says, is to measure an outfit's intrinsic value against the market price of its shares, which preferably should be at a discount to value. This approach appears to have had a long-term payoff: Since the fund's inception in 1998, it has done 15% better than the S&P 500 index.

Huguet reports that his biggest holdings include General Electric (GE ), First Data (FDC ), and Medtronic (MDT ). He also looks for potential turnaround situations such as Hewlett-Packard (HPQ ), Motorola (MOT ), and Prudential (PRU ). A recent acquisition in the technology area was Logitech International (LOGI ).

These were a few highlights of an investing chat with Huguet presented July 14 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chat

Q: Jim, the stock market did a little better today -- what's your outlook?

A:

We're really positive on the market. As we look at it, we see a strong dollar and strong economic reports. Despite the fact the Fed is raising rates, we have a strong economy, and we're positive on the way things are looking right now.

Q: How do you see the earnings season shaping up? Looks like tech already has some good news from Apple (AAPL ) and Advanced Micro Devices (AMD ).

A:

Yeah, we think earnings are going to be strong.... Our biggest caution is the price of oil -- if oil can stay in check and end around the low $50s, we should do quite well. But even with the high oil prices, companies are hanging in there and doing just fine, so unless there are some huge surprises, we think earnings reports should be on target for the most part through the end of the year.

Q: What companies would you buy for the long term? Maybe you can give us some names that attract you because of quality of corporate governance.

A:

We tend to be long-term investors in general, so when we look at companies, we look for ones we'd own for five years. We like General Electric right now. We have recently added Hewlett-Packard to our list -- with their new management they'll get stronger. We like Fortune Brands (FO ) -- very well-positioned, well-managed company.

One of the recent additions we've made to our tech portfolio is Logitech International -- very well-positioned, and one of the better-managed tech companies out there. We also own Genentech (DNA ) -- we really like them. Electronic Arts (ERTS ) is an excellent company that we've owned for a long time.

So there are quite a few companies across a variety of sectors that we like. PepsiCo (PEP )is another, as is Colgate-Palmolive (CL ). Colgate has generally done well over a long period of time -- they hit a slow period but have come out of that and have done well for some time.

Q: How do you know when to buy and when to sell?

A:

Well, there are several things we consider. We look at the market price of the company relative to intrinsic values. Those at discounts to value are attractive. We also look at a company's return on invested capital -- somewhere in the 8% to 10% range is desirable. We also like companies that have returns on capital above their cost of capital. Essentially, we're looking for companies making money.

We also like those that are in turnaround situations -- say a new CEO has come into the company who can take the company to a new level. Look at Prudential (PRU ), where that has been the case. Look at HP, Motorola. We think Motorola's new CEO is going to do a tremendous job. So we like those situations where the basic fundamentals are in place, but the companies just needed a great leader....

When companies are closing in on their intrinsic value, we'll reduce our position in the company -- if not sell it outright, then take it down to market weight. We'll also sell if there are major changes in corporate governance. That's our main screen, really -- What's their corporate governance? Our sell discipline really looks at the company and says, "Has something materially changed?" -- corporate governance, value, these key factors. If the governance has changed for the worse, we won't hesitate to take them out of our portfolio.

Q: What do you think about the Procter & Gamble (PG ) and Gillette (G ) merger? Is PG worth buying?

A:

I think PG is the best-managed consumer-products company in the world. The addition of Gillette makes PG an even stronger company. With PG's marketing and sales power, they'll do even better with certain products, like Duracell, than Gillette did. Add the fact that you've got Warren Buffett saying he's going to put more money into PG, and you've got another sign that this is a terrific company to own right now.

Q: How do you feel financials will do over the next few months, JP Morgan Chase (JPM ) in particular?

A:

We like financials, and JPMorgan is an interesting company. The new CEO there has proven himself in those kinds of situations, and we have a lot of confidence in him as a manager. However, we don't think the credit-card business is as attractive as it has been. I wouldn't be surprised to see the folks at Morgan Stanley (MWD ) get rid of Discover Card.

Of all the sectors out there, though, the financials have expanded faster than any other sector in the S&P 500, from 6% in 1975 to over 20% right now. We like financials, but the challenge there is to really accurately calculate their intrinsic values.... We like Goldman Sachs (GS ) a lot right now. Morgan Stanley has an opportunity to turn around right now as well. But overall, we like the sector very much.

Q: Any comments on Bank of America (BAC )? Or on its MBNA (KRB ) deal?

A:

I think BAC has done a terrific job positioning itself through the various acquisitions it has made. I'm not as crazy about the MBNA deal as some others -- it's a decent move, but not a home run. I look at BAC as a company that has done a tremendous job building their franchise and has made some tremendous acquisitions. This isn't their best, but it won't damage the company either.

Q: Your thoughts on Citigroup (C )?

A:

Citigroup, if you look at it from a financial standpoint, the market price is around $46. The company's intrinsic value, according to our estimations, is $64. So that's a tremendous discount.

We also look at something we call "perpetuity value." It's like the ongoing value of a company, if it were not to increase its sales or do anything different. For Citigroup this is still $51, higher than the market price.

From a valuation standpoint this is a real opportunity to buy a well-performing company at a discount to just about any sort of value metric you could use. This is something you don't get to do very often. However, the company is still having some corporate governance issues -- they're doing the right things, but there are people who are concerned that the company is not doing enough. Q: How has your core portfolio -- IDEX Great Companies America (IGAAX ) -- performed so far this year and longer term?A: Longer-term, if you look at it since inception, we've outperformed the S&P 500 by about 15%. This is since 1998. So over the long run, we've done very well. In terms of this year, on a year-to-date basis (through June), the total return was down 0.11%, which is 0.7 percentage points better than the index and 0.49 percentage points better than the category. And our current numbers are not set for the next quarter, but we're still outperforming the index by 0.15 percentage points, and 0.11 percentage points better than the category. (The source here is Morningstar.)

Q: What's your top holding in the fund? You named a bunch of stocks earlier.

A:

In Great Companies-America, we have a strong ownership position in General Electric. First Data (FDC ) is another, and we have a strong weighting in Medtronic (MDT ), a medical technology company.

Q: Did your attention to corporate governance steer you away from companies that have gotten into trouble? No Enron or WorldCom skeletons in your closet?

A:

No, we never owned Enron, never owned WorldCom. It has, frankly, helped us stay away from some companies. We have owned some that did have problems -- American International Group (AIG ), for example. The problem with these issues is that they are hidden -- they don't go public until exposed by investigations.

We avoid those companies with shaky governance, but we can only do so much. Our large-cap core portfolio does have the highest corporate governance metrics, according to Lipper, the highest in the category.

Q: Jim, what are the factors you measure when you consider a company's corporate governance?

A:

We look at a number of different factors. The first thing is the structure of the board of directors. Do they have a strong outside board? When we see companies that have a strong presence, we'll typically go deeper into the company and look at how they're handling financial disclosures. We'll look at the firm's overall corporate behavior, it's not just any one thing.

When you look at corporate governance, it's integral to a corporation. You can't change it overnight -- companies develop their values over time, not overnight, and they'll take just as long to turn around. It takes time to change their core values -- to get them to become a part of the overall operation.

Q: For the next three years of President Bush's term, which sector do you like?

A:

Well, I do look at businesses that have proven to be good over long periods of time. I like health care, but that has nothing to do with President Bush. This has more to do with demographics. Back in 1975, [health care] was 6% of sector weights -- now it's 13%.

I think financials are going to do well in this environment, and I think technology is going to do well. I think we're through with the tech companies that have no profits -- we're far more realistic about them now.

I think energy will continue to be a fairly strong sector -- not as strong as it has been for the last 12 months to 18 months, but it'll still remain an important sector in the economy.

Q: Specifically among energy stocks, how do you like ConocoPhillips (COP )?

A:

I think they're a very well-managed company with excellent potential over the long term. They're the kind of energy company we like -- they're integrated well and have the whole gamut of services. They're well positioned in the industry, and with Exxon Mobil (XOM) are one of the truly premier energy companies out there. I view Exxon as the GE of the oil industry, if you will, and think COP is a tremendously well-managed company also.

Q: Do any pharmaceutical or biotech names meet your standards?

A:

We do like Johnson & Johnson (JNJ ), even though it's not a pure pharma. We like Wyeth (WYE ), which is trading around $45 with an intrinsic value of about $55. We like Amgen (AMGN ), a company that's trading right on its intrinsic value -- $67, trading at $69. These would probably be the major companies in that sector that we really like.

Q: What do you think of Google (GOOG )? Have you measured its intrinsic value?

A:

We have looked at Google -- we've looked at it relative to eBay (EBAY ) and Yahoo! (YHOO ), which we've owned in the past. The concern we have for Google is that it's hard to follow their financials -- they've been limited with their disclosure. So we're not comfortable estimating their intrinsic value. Frankly, they've been a surprise for me in that they've done a tremendous job and given some excellent returns for investors.

Managing a company that has expanded that quickly is very difficult -- so far they've handled it, but the stock has slowed down a little. I don't know how much upside potential is left in the stock in the short term -- I'd be a little bit concerned about it honestly. But up until now it has definitely been a strong performer.

Q: Do you keep tabs regularly on companies you like to make sure they aren't falling short of your criteria?

A:

Yeah, we do. We keep what we consider to be a bench of companies that have a lot of the traits we're looking for, and might be simply waiting on them due to valuation issues. We did that with Adobe (ADBE ), for example, which we've liked for a while but wasn't attractive as an investment until the price came down. We'd certainly look at companies like Adobe, where it really just is the valuation keeping us away. When the valuation does drop, we jump in and buy them.

Q: Is there a way the average investor can apply some of your standards in checking out stocks?

A:

Yeah, I think you certainly can. When you look at corporate governance, for example, you can get annual reports that show the makeup of the board; you can look up analyst reports, etc.

It's difficult to do valuations unless you have a solid accounting or mathematical background, but there's certainly enough information from analysts out there who have calculated their own.

If you take two or three opinions that seem to be close together from these guys, you can probably get pretty accurate numbers. Certainly chief executives are often well-publicized, and you can search through their resumes and track records. So as an individual investor, there's a lot you can do. You may not be able to get one-on-one meetings with corporate executives, but with some diligent research you can certainly find out a lot about these companies.

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