Putting the Bull Back in Merrill's Funds

Equities guru Bob Doll talks about his investing philosophy, his recent portfolio picks, and future Fed moves

By Robert Barker

Just a couple of years back, the bulls at Merrill Lynch were running some of the doggiest mutual funds around. Then in June, 1999, after an illustrious career at OppenheimerFunds, Bob Doll joined Merrill as chief investment officer for equities in its fund-management group. A full turnaround isn't assured, but Merrill's funds are definitely on the upswing, with 38% of them now in the top-performance quartile for the past five years. At the end of 1999, just 8% of them could make that claim.

Doll, who has been promoted to global chief investment officer of Merrill Lynch Investment Managers, is also directly responsible for three big-stock portfolios, including Merrill Lynch Large-Cap Value (MALVX ). Last year it returned 11.9%. Through Apr. 18 this year, it's down 1.4%, vs. 6.2% for the Standard & Poor's 500-stock index. To see what stocks Doll likes now -- and what he makes of the Federal Reserve's decision this week to ease credit -- I spoke with him by phone. Here are edited excerpts of our discussion:

Q: Does the Fed's latest cut in short-term interest rates change your investment outlook?


It doesn't. While I can't say we thought they would cut rates on Apr. 18 in the morning, I think what was clear in our minds was that the Fed was and is still in an easing mode, and we were going to get more rate cuts somewhere along the line. Today's better than tomorrow, and tomorrow would've been better than the next day. I think it's inevitable that rates will go lower. There's weakness in the economy, and the Fed needs to address it. [Inflation-adjusted] short-term interest rates are still pretty high.

Q: Implied in the move is a lack of fear of resurgent inflation. Do you share that?


Sure do. There are precious few companies that are able to raise prices, and lots of sectors and industries are under pricing pressure. If there's a risk in general, it's more a deflationary than an inflationary risk. The one exception to that, of course, over the last couple of years has been the energy complex. And while that's come down some of late, I don't know that we're out of the woods in terms of energy price increases.

Q: Speaking of energy, just running over some of the stock in your portfolio, I see you do have a number of big energy names, Chevron (CHV ) and ExxonMobil (XOM ) among them. Tell me, which companies do you think will be able to take advantage of the current situation best?


The portfolio is overweighted in energy, that's accurate. Within energy, we're underweighted in the big, integrated companies, relative to benchmarks. We favor energy in two areas: One, the refiners, where we think the refinery spreads are interesting enough that those companies will continue to coin money for a while longer; also, the independent [exploration and production] companies that can benefit not only if we get some more pricing but also from some unit gains.

Q: Let's take the refiners first. Which names do you favor there?


Valero (VLO ) is an interesting name. Ultramar Diamond Shamrock (UDS ) [is another of our] favorites. But I think it's really a sector play. I wouldn't quibble if somebody wanted a different refiner. I just think having some exposure there makes sense.

Q: You're just looking at refinery profit margins? No special situations?


Correct. They all have their restructuring issues since much of the capacity in refineries is pretty old. We haven't built many new refineries, which is part of the reason we get spreads like this from time to time.

Q: Now, among the independent exploration and production companies, which stocks do you like?


Devon Energy (DVN ) is the favorite there. Others that are related to the sector are Calpine (CPN ) and El Paso (EPG ). Some people define those as energy companies; some put them in the utility category, [but] they're clearly gas-related.

Q: What's so special about Devon Energy?


The unit-growth profile. Anytime I can buy [good] unit growth in a slow economy, I get interested. And then on top of that, if you have a wild card of potentially higher prices, that just could be icing on the cake, if you will.

Q: Most of the last decade was really a great time for large-cap stock-pickers. Do you expect that to continue, or will the past year's comeback in small-caps continue?


In December, we issued 12 predictions on the markets for this year, and one of them had in it something exactly to this point. We basically said we expect small, mid- and large[-cap] companies to outperform megacap companies. And I would stick with that.

Q: So does that mean you're underweighted General Electric (GE ), for instance?


Yes, that's exactly right.

Q: Why is that? What's the fundamental reasoning that you think the megacap names that had done so well for so long will subside?


I think that it was the easy place to go, and momentum usually begets momentum. I have a chart that shows the Russell 1000 [an index of the 1,000 largest companies in the U.S.]. If you take the expected 2001 and the long-term earnings-growth rates, the highest and lowest decile in terms of [market] capitalization were virtually identical. And yet the price-earnings ratio for the small 100 was half that of the big 100. So, similar fundamentals at half the price. It's a very simple concept to say that I think you get more for your money leaning down in capitalization.

Q: If my mother-in-law came to you and said: "I have a bunch of money to invest, Mr. Doll, and I want to know how to invest it," what would you tell her?


I would first ask her what's her time horizon and presume it's long enough to consider equities.

Q: O.K.


Presuming she has a five-year time horizon, you want to dollar-cost average into the market, for starters. None of us can pick highs and lows, so take your $100,000 and divide it by 10 and put $10,000 in a month for the next 10 months. With that kind of money, you're best off -- this is a little biased, I recognize -- but you're best off in packaged products, so I would pick some mutual funds. I would have 80% of it weighted in the U.S., 20% out. I would have 70% to 80% in larger-cap securities and 20% to 30% in small and midsized companies.

Q: And how do you define small and midsized?


Call the cut-off $10 billion dollars [in market value]. So I'd have 20% to 30% of the money in companies below $10 billion in size.

Q: What's your favorite -- your best investment idea today?


Oooh. I guess my favorite idea should in some sense be my biggest overweight, and right now, my biggest overweight is in Philip Morris (MO ). It has been a wonderful stock, and I think that continues. Their earnings growth has been better than expected. Valuation -- while not as cheap as it was 12 months ago -- is, I think, still pretty reasonable.

Q: And tell me, how do you see the spin-off of Philip Morris' Kraft Foods unit working out?


Many of us have been hoping for this for years. I think it will do nothing but accentuate the value of both pieces on their own: The tobacco operation for its cash flow, and the Kraft operation for its No. 1, No. 2 positions in lots of lines. Also, it generates pretty good earnings, pretty good margins, and wonderful cash flow.

Q: Do you have a sense of what the market cap of Kraft will be?


That's a great question. Obviously all the analysts are speculating on that. I guess the approach that we take and the analysis that we've done is that the sum of the parts will be greater than the whole, and therefore there's more value to be unlocked in this company.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online.

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Edited by Patricia O'Connell