A Star in Putnam's Darkened Sky
By Eric Wahlgren
Turns out some of those companies that seemed like bad apples in the last few years may end up being juicy stock picks. While outfits like Tyco (TYC ) and Rite Aid (RAD ) were tainted by accounting scandals, at the core they still operate solid businesses that can generate shareholder value. That's part of the investment philosophy behind Putnam's New Value Fund (PANVX ), which seeks, among other things, shares of promising companies that are trading below value because of past corporate misdeeds or allegations.
Fund manager David L. King bills the fund as good for aggressive investors who want to diversify by style -- adding value to growth investing, for instance. Over the past five years, the New Value Fund has outperformed the benchmark Standard & Poor's 500-stock index by nearly 8 percentage points on average.
MORE TROUBLE AHEAD?
Putnam, the nation's sixth-largest mutual-fund company, is recovering from its own scandal. Federal regulators accused the Boston-based firm of letting managers and customers buy and sell shares rapidly in certain funds in a practice known as market timing -- at the expense of other shareholders. Although such trading for quick gains is not illegal, Putnam had supposedly banned it. In November, it settled Securities & Exchange Commission charges without admitting or denying any wrongdoing. And Chief Executive Larry Lasser and managers connected to funds in which market timing allegedly occurred have left Putnam.
The matter isn't resolved. Massachusetts securities regulators have warned of additional potential charges. And Putnam's fund investors continue to withdraw money, although the outflow seems to be shrinking. King, who has been running New Value since he created it in 1995, says he sees no irony in investing in scandal-ridden outfits while working for an employer that has had its own troubles. The "focus is on serving existing customers over growth," he says.
At the end of 2003 and after the SEC settlement had been announced, New Value's assets stood at $1.27 billion, 12% greater than a year earlier. Chicago-based Morningstar calls New Value "one of Putnam's most compelling funds," although the mutual-fund researcher has also recommended that investors hold off on sending new money to Putnam for now.
Recently, BusinessWeek Online writer Eric Wahlgren chatted with King about his views on investing, stock picks, and whether Putnam's problems have affected his fund. Edited excerpts of their conversation follow:
Q: People might be leery of investing in a fund at a company where market timing allegedly occurred. Did market timing occur in the New Value fund? A:
Q: People might be leery of investing in a fund at a company where market timing allegedly occurred. Did market timing occur in the New Value fund?
A:It was not a vehicle to my knowledge. The fund is not particularly highly correlated to the Nasdaq or to Asian markets, which is the basic premise behind this time-zone arbitrage play. And Putnam has instituted a 2% redemption fee that's levied on any investor who wants to sell within five days of buying shares in a fund.
Q: What's your strategy? How do you pick stocks? A:
Q: What's your strategy? How do you pick stocks?
A:An important element is that it's a large-company fund as opposed to a large-capitalization fund. Market capitalization is a mixture of the true strength of a company and people's opinion of a company. But I focus on companies with at least $1 billion in revenue -- and companies that have continuity. Companies we invest in have been around for at least 10 years -- and often much more than that.
When such big companies get in trouble, you can normally expect them to come back at some point. It's that coming back that often offers the highest returns. In addition to the focus on the company's size, I believe quantitative and fundamental research techniques are complimentary and powerful when used together.
Q: Some of your biggest holdings have been touched by financial scandal. Take conglomerate Tyco (nearly 4% of net assets) or home-mortgage lender Fannie Mae (FNM ) (nearly 3.5%). These outfits might scare off investors, but your fund sees promise, right? A: Q: Tyco has suffered severe negative publicity while some of its managers stand trial for financial mismanagement. What's your rationale for owning it? A:
Q: Some of your biggest holdings have been touched by financial scandal. Take conglomerate Tyco (nearly 4% of net assets) or home-mortgage lender Fannie Mae (FNM ) (nearly 3.5%). These outfits might scare off investors, but your fund sees promise, right?
A:Including companies that may have negative publicity is not just to be contrarian. The point is that we look for value, and it's sometimes accompanied by negative short-term news flow. So while we would happily invest in a high-quality company that appears cheap, if another company offers more upside simply because of considerations that are short term in nature and that we expect to go away, we're willing to buy that company. By Eric Wahlgren
Q: Tyco has suffered severe negative publicity while some of its managers stand trial for financial mismanagement. What's your rationale for owning it?
A:Tyco continues to be in a corporate turnaround that's going to have a long duration. The company was assembled largely by acquisition of other companies. The stock continued to score well quantitatively and appeared inexpensive by traditional valuation measures. We know that was a direct result of the scandal around management. We thought there was a significant margin of safety vs. the worst possible outcome.
When the stock declined from the $40s, which is where we started buying it, down into the high single digits, we continued to buy it. While the stock is still not up to the level where we first started buying it, we have made a considerable profit in the fund based on our willingness to buy it at lower and lower prices. There has been a big recovery move from the low -- and I believe there's a substantial second leg ahead of us over the next several years as Tyco cleans up inefficiencies throughout its business portfolio.
Q: Drugstore chain Rite Aid also was accused of misrepresenting financial results. Why is it a good bet? A:
Q: Drugstore chain Rite Aid also was accused of misrepresenting financial results. Why is it a good bet?
A:We've had success in owning Rite Aid largely by avoiding buying it at too-high prices on the way down. The holding was quite profitable a few years ago as it traded from the low single digits to about $10. We sold most of our position and then bought aggressively as it retraced back to $2 a share again. The company has just begun to report profitability.
And even as it was losing money, cash flow was turning strongly positive. Through refinancings, Rite Aid has addressed the riskiest aspects of its balance sheet. The stock remains very cheap based on its potential. If Rite Aid is able to return to profitability levels that it experienced in the past or to what industry leaders like Walgreen's (WAG ) show, there would be quite a bit of upside to earnings and the stock.
Q: What other stocks do you like right now? A:
Q: What other stocks do you like right now?
A:An interesting theme is developing in the portfolio. As performance in the market over the last several years has centered on small- and mid-cap stocks, some well-known large companies have lagged and become good relative values. Companies like Disney (DIS ), McDonald's (MCD ), and [home-improvement retailer] Home Depot (HD ) were never owned in this portfolio prior to the last 18 months.
Despite being household names, stock performance of these three issues had lagged badly through the beginning of 2002. In each case, new management or new strategies have emerged just at a time when the market had given up on them to some extent. So even though we're willing to buy companies that are lower in quality or off the beaten track for high returns, it strikes me that the best opportunities right now may be in these household-name companies that have been overlooked in favor of smaller companies.
Q: The fund in the past five years has on average outperformed the S&P 500 by nearly 8 percentage points. So far this year, the fund was higher but slightly underperforming the S&P 500. Why? A:
Q: The fund in the past five years has on average outperformed the S&P 500 by nearly 8 percentage points. So far this year, the fund was higher but slightly underperforming the S&P 500. Why?
A:It's too short a time period for me to have any reflection on it at all. We really make a point of a long term in the fund. The market, so far in 2004, has continued to have a small-cap bias. The movement we've been making into larger stocks has maybe held us back slightly in the short term. Our performance is right around the median.
One of the primary benefits of investing in this fund is to allow aggressive investors to diversify by style. As we saw when the bubble burst in the early part of this decade, even if you can afford to invest aggressively, you can get stuck in one style, and it can really destroy your portfolio. The New Value Fund has enjoyed substantial absolute appreciation since the day the Nasdaq peaked, despite being a relatively aggressive equity fund.
Walhgren covers the markets for BusinessWeek Online in New York
Edited by Beth Belton