A Different View of Value

Putnam Tax-Smart Equity Fund's Richard Cervone discusses why his outfit doesn't always see stocks with high p-e's as unattractive

The managers of Putnam Tax-Smart Equity Fund (PATSX ) are careful not to pull the trigger on too many portfolio trades. Instead, they seek to avoid generating significant short-term capital gains, which could force shareholders to pay substantial taxes, creating a wide gap between the fund's pretax and aftertax returns.

The fund invests in undervalued large-cap stocks while monitoring and minimizing taxable distributions to shareholders. Less volatile than its peers, the fund -- not surprisingly -- boasts a lower portfolio turnover rate. Expenses also run lower than the peer-group average.

For the three years ended Jan. 31, the $293 million fund gained 5.1% annualized, vs. a drop of 0.4% for the average large-cap growth fund. The portfolio outperformed over the five-year period as well, edging down 0.2%, while its peers fell 7%. For the one-year period ended in January, the fund gained 7.9%, beating the peer group's gain of 2.2%. Based on risk-and-return characteristics over the last three years, Standard & Poor's gives the fund its highest rank of 5 STARS.

Jim Weiss is the fund's lead manager. Richard Cervone and James Yu joined the management team in March, 2004. Palash Ghosh of Standard & Poor's Fund Advisor spoke recently with Cervone about the fund's investing strategy and top holdings. Here are edited excerpts of their conversation:

Q: What are your buy criteria?


We use a strictly bottom-up process to construct a portfolio of large-cap securities we think are trading at prices below their intrinsic value. The most important determinant for "value" is discounted free cash flow. We're also cognizant of parameters like capital allocation, dividend growth, share buybacks, etc.

We aren't "value" investors in the low price-earnings (p-e) or low price-book sense. We invest in stocks with relatively high p-e's, like eBay (EBAY ) and Apple Computer (AAPL ), because we believe these shares are underpriced relative to their future free cash flow.

As a secondary objective, we monitor the portfolio on an aftertax basis and consider the federal income tax consequences of buy and sell transactions.

Q: What are your largest holdings?


As of Dec. 31, 2004, our top 10 stocks comprised Microsoft (MSFT ), Citigroup (C ), Exxon Mobil (XOM ), Johnson & Johnson (JNJ ), Pfizer (PFE ), Altria Group (MO ), Cisco Systems (CSCO ), Fannie Mae (FNM ), American International Group (AIG ), and Commerce Bancorp (CBH ).

These holdings represented 32.8% of the fund's total assets. The fund had 112 stocks as of Dec. 31, 2004. We typically range between 80 and 100 holdings in the portfolio. Sometimes, we will take small positions in mid-cap stocks we find attractive.

Q: What are your top sectors?


As of Dec. 31, 2004: financials, 31.1%; technology, 16.5%; health care, 14.8%; consumer cyclicals, 14.6%; consumer staples, 8.1%; and energy 7.1%.

Q: Are your largest holdings necessarily your favorite picks?


Not necessarily. For example, Exxon-Mobil is a major component of the S&P 500 Index, but it's only a 1% overweight position in our fund. On the other hand, Commerce Bancorp is not even in the S&P 500 Index, but it's a significant position in our fund. As a result, a holding like Commerce has a greater impact on our performance than Exxon would, though its absolute weighting is smaller.

Q: Your largest sector is financials, which are quite vulnerable to rising interest rates.


We're overweight in financials relative to the S&P 500 Index, but that doesn't reflect any overall sector view. It's driven by the fact that we're finding many undervalued individual companies within that sector. We own stocks like Everest Reinsurance Group (RE ) -- a reinsurer -- and General Growth Properties (GGP ) -- an REIT [real estate investment trust] that owns malls. Neither of these companies are in the S&P 500 Index, but they're great businesses whose shares, we think, are undervalued.

We tend to favor companies that dominate niche businesses because they can usually create some kind of competitive advantage that will benefit shareholders over time.

With respect to higher interest rates, many investors have sold off their financial holdings, and this created buying opportunities for us. The Fed's commitment to tightening is no longer "news." The markets are moved by surprises, not by widely anticipated events, so we aren't too concerned with short-term rates going up.

Q: How does the tax-efficiency aspect of this fund work?


We seek to minimize the taxable distributions the fund pays to its shareholders by being careful about the investments we select and how we trade them. If a fund trades rapidly and generates lots of short-term capital gains, the shareholders will have to pay significant taxes, creating a wide gap between the fund's pretax and aftertax returns. Our strategy is to minimize that gap.

For example, we own NVR Inc. (NVR ), a homebuilder that chooses to not pay a dividend but repurchases about 5% of its shares outstanding each year, which works like a "dividend" to its holders. We like NVR as a long-term holding that can deliver a strong aftertax return.

By contrast, D. R. Horton (DHI ), a rival homebuilder, does pay dividends but is a less tax-efficient investment than NVR.

Q: How do you offset capital gains?


Periodically, we have to offset capital gains with losses. If we decide to sell a stock and expect to realize a gain, we would incur losses to offset the gain. As such, we don't hurt the fund's overall performance.

Over the history of the fund, we have never, in the aggregate, realized any gains or paid any capital-gains distributions. Even though we have realized gains on individual stocks we have sold, we offset those gains by taking losses, so the fund in the aggregate has not realized any gains.

Q: Can you discuss a recent new purchase to the fund?


Although it was already highly priced, we bought Apple Computer because we're excited about the huge potential of its iPod/iMac franchise and its influence on the company's PC business. We think investors may actually be underestimating iPod's promise.

Q: Can you discuss one of your favorite holdings?


U.S. Bancorp (USB ) has publicly committed to paying out 80% of its earnings to shareholders in the form of dividends and share repurchases. We think the stock is undervalued, and we like the fact that management made such a public commitment to shareholders.

Q: What are your sell criteria?


We typically sell a stock when it becomes overvalued, or if we can find a more attractively priced holding to substitute an existing holding.

It's more common for us to trim existing positions, rather than make outright sales. Our fund had a turnover rate of 83.17% in 2004, which is somewhat higher than our long-term average.

Q: Can you cite a stock you sold off recently and why?


We sold Harrah's Entertainment (HET ), the casino hotel operator, when it reached and exceeded our sales target.

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