Online Extra: A Steady Hand Beats the Bears

Lou Holland's fund has outperformed its battered large-cap peers by sticking to a growth-at-a-reasonable-price strategy

Following one of the worst bear markets for blue-chip stocks in history, the tiny Lou Holland Growth Fund (LHGFX ) delivered a five-year, risk-adjusted return of 0.4%, compared with a 6% average annualized loss for all large-cap growth funds. Chief Investment Officer Lou Holland attributes that performance -- and the $60 million fund's A rating on BusinessWeek's Mutual Fund Scoreboard in its category -- to his growth-at-a-reasonable-price investment style.

At 63, Holland has been running money for 35 years, and he counts bond legend Bill Gross and TV investment-show host Louis Rukeyser among his good friends. He recently spoke to BusinessWeek personal finance writer Lewis Braham by phone from his office at Holland Capital Management in Chicago. Edited excerpts of their conversation follow:

Q: Where are the best investment opportunities?


I am most bullish on energy and health care over the next five years. Energy stocks are likely to outperform because of strong demand from China and India in the developing world. They're also an inflation hedge at a time when I believe the risk of inflation is high.

I expect health-care stocks to outperform because the demand for health care will increase dramatically as the population ages in the U.S., Europe, and Japan. The health-care sector has lagged the overall market by nearly 37% -- not including dividends -- since the start of the recent cyclical bull market on Oct. 9, 2002.

Valid concerns regarding future drug pricing, the effects of a Medicare prescription-drug benefit, and patent expirations on key blockbuster products pushed the pharmaceutical sector into a relative bear market just as practically all other asset classes rose over the past 26 months. Plus, troubles with existing drugs at Merck (MRK ) and Pfizer (PFE ) haven't helped. So valuations for many health-care companies are now attractive relative to the market. Yet stock selectivity is paramount as many companies still face difficult years ahead of them.

Q: What are your favorite drug and energy stocks?


We think Schering-Plough (SGP ) and Watson Pharmaceuticals (WPI ) have great potential going forward. We believe Schering-Plough is poised to be the fastest-growing large-cap U.S. pharmaceutical company over the next five years. Vytorin and Zetia, their new cholesterol drugs, could capture as much as 30% of the cholesterol market as doctors reconsider the new guidelines for healthy cholesterol levels.

Generic-drug maker Watson Pharmaceuticals has a reinvigorated drug pipeline, thanks in part to their collaboration with Cipla, an Indian drug company. Further, the generic-drug industry is about to enter a very fruitful period as many blockbuster drugs lose their patents between 2006 and 2008.

In energy, Total (TOT ) is my favorite integrated oil company out of the supermajors. The company should grow production at 4% through 2008, second only to British Petroleum (BP ). Total has also been consistently improving its return on invested capital and has gone from being one of the worst in this area to second best to Exxon Mobil (XOM ).

This trend should continue as the company continues to lower its exposure to its less-profitable chemicals business. Despite these very positive fundamentals, Total still trades at a slight discount to its peer group and a significant discount to British Petroleum. It also has a healthy 3% dividend yield.

Another favorite is XTO Energy (XTO ). It's the premier "acquire and exploit" company, meaning they buy and exploit previously developed, long-lived oil fields. XTO operates such fields better than anyone else, and this has resulted in their superior production growth and return on invested capital. On average, XTO doubles the oil reserves at fields it acquires. It currently has a deep inventory of drilling projects which should provide it with double-digit production growth for at least the next few years.

Q: After coming through three rough years and two good ones, what is your outlook for the economy and the market?


Long-term, I have two main concerns: demographics and debt. The major factor affecting economic growth is the aging of the U.S. population. Consumption accounts for approximately 70% of economic activity, and consumption slows down rapidly after the age of 55. This, coupled with outsourcing jobs to other parts of the world, leads me to believe the U.S. economy will grow at a 3% to 5% rate over the next five years compared with twice that for China and India.

The other factor affecting the economy is the level of debt in the system. The federal [budget] deficit is over $400 billion, household debt is at 113.8% of disposable income, and total credit market debt is $32.2 trillion, or 302% of gross domestic product. All of that said, I still think stocks can deliver 7% and bonds 3.5% annual returns over the long haul. If you pick the right ones, you can do considerably better than that.

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