Online Extra: Searching for "Emerging Quality"
Eileen Rominger likes to play it safe. The veteran manager of the $2.3 billion Goldman Sachs Mid-Cap Value Fund always keeps her portfolio well diversified and looks for companies where she sees positive catalysts for change.
Her caution has enabled her to deliver positive returns in both bull and bear markets, and she produced a sizable 17.5% annualized gain over the last five turbulent years. Those results earned her fund an A rating for the mid-cap value category on BusinessWeek's 2004 Mutual Fund Scoreboard. Personal finance writer Lewis Braham recently caught up with her at her New York office. Edited excerpts of their conversation follow:
Q: What are the unique advantages of your fund? A:
Q: What are the unique advantages of your fund?
A:As a value fund, price is a very important component of our investment strategy. However, the prospects for the business are equally important to us. We strongly emphasize looking forward, rather than back, to assess the likelihood that a company will generate strong or improving returns on capital -- our key definition of quality.
We particularly like the combination of a cheap stock price plus a good probability of seeing positive change occur, for example, a change in management or cost structure. We think these situations represent "emerging quality" plays. The mid-cap part of the investment universe is particularly rich in this sort of opportunity.
Q: How do you execute this strategy? A:
Q: How do you execute this strategy?
A:First, we have put considerable resources behind it. We have nine industry-specialist portfolio managers who work on it. They each have on average 16 years of investment experience. Second, we approach valuation very rigorously within an industry context. We don't try to force all companies into a single valuation template. Third, we have maintained a nimble and responsive decision-making structure. We are long-term investors, but are willing to act crisply based on either increasing or decreasing investment conviction levels.
Q: How do you control volatility and portfolio risk? A:
Q: How do you control volatility and portfolio risk?
A:Our first line of defense is getting our research and valuation work right, and acting on that in a timely manner in both buying and selling. However, we are also thoughtful about sizing our enthusiasms appropriately. There is no scarcity of interesting companies in the mid-cap value space.
We typically own 80 to 100 stocks in the fund. For diversification purposes, we want to provide investors with a very broad exposure to market sectors. Since we're actively seeking out good ideas across all industries, we generally don't significantly over- or underweight sectors vs. the benchmark.
Q: In which sectors are you currently finding the best opportunities? A:
Q: In which sectors are you currently finding the best opportunities?
A:We continue to be very positive on the fundamentals for North American natural gas. Demand should continue to be strong, driven by a reasonably robust economy and the desire for clean fuels. Supply is constrained by rapid declining reserves and limited ability to import. The value of reserves should therefore continue to appreciate as finding and development costs increase.
In this environment, it is extremely important to invest in gas companies which are disciplined in the way that they allocate the shareholders' capital. We look for companies like EOG Resources (EOG ), which is primarily a North American natural gas producer with operations in Texas, the Rockies, and Canada, as well as other locations. EOG's management has performed extremely well from both an operating and a financial standpoint.
On the operating side, it has maintained very low finding and development costs. It has also built a gas reserve base with a relatively long life of 13 years -- the industry average is about 10 years -- and did so in a highly cost-effective manner. Consequently, its return on capital is a healthy 16% on a strong balance sheet.
Another industry we favor is electric utilities. Following poorly conceived and poorly executed deregulation attempts in the 1990s, the industry has regrouped. Capital spending is generally down, exposure to low-return unregulated investments has been decreased or eliminated, and free cash flow is up. Further, company valuations seem reasonable.
PPL (PPL ) is one of our favorites in this industry. With facilities in Pennsylvania and the United Kingdom, PPL has divested some international assets and improved its balance sheet. It finished two rate cases in 2004, which should allow an improved return on equity. With a rising cash-flow profile, we believe there's significant potential for dividend growth.
Q: Can mid- and small-cap stocks continue outperforming large-cap? A
Q: Can mid- and small-cap stocks continue outperforming large-cap?
A: Mid- and small-cap value stocks experienced nothing short of a depression in 1999. The recovery of the past few years has been sharp, but it has brought the stocks back to a "normal" valuation level, rather than an extremely high one.
For example, the Russell 2000 Value Index reached a p-e discount to the Standard & Poor's 500-stock index of about 70% in 1999. Today, the discount is 39% -- only slightly above historic average valuation levels for small stocks. Based upon this, I think small- and mid-cap stocks are equally likely to outperform or underperform large-cap stocks in the next year or so.
Q: Value stocks have also beaten growth. Do you see that continuing as well? A:
Q: Value stocks have also beaten growth. Do you see that continuing as well?
A:While small-value stocks fared worse than large ones in 1999, they all severely underperformed their growth counterparts. The p-e of the Russell 1000 Value Index reached a discount of nearly 70% to the Russell 1000 growth index. Currently that discount is at a more normal level: 30% vs. a 24-year average of 33%. On this basis, it would seem that either could outperform with a more or less equal likelihood.
Another factor could be an environment of rising interest rates. Obviously, rising rates are negative for all financial assets, but they are more negative for long-duration assets. Growth stocks are longer-duration assets than value stocks because more of the cash flow is generated in distant future years.
Historically, following a rise in rates, value stocks have outperformed growth stocks. This was true in 1981, 1983, 1987, and 2000. It was not true in 1994-95, however, when value and growth performed about the same following a rise in rates. If interest rates rise in 2005, I think that value stocks could likely experience another year of outperformance relative to growth.