Large-Caps at Not-so-Big Prices
For all the confusion about which way the market is going, there are still attractive stocks to buy, in the view of Taylor McGowan, vice-president and portfolio manager of investment firm Farr, Miller & Washington. In any case, says McGowan, "we don't spend too much time trying to determine the position or direction of the whole market."
His firm seeks industry leaders on a bottom-up basis, basically large-cap stocks at a reasonable price. Among its recent acquisitions is Education Management (EDMC ), which McGowan says is growing three to four times faster than others in the for-profit education market. And he's adding to his outfit's position in American International Group (AIG ), on the theory that its $40 billion loss in market capitalization is out of proportion to an accounting error of less than $3 billion.
Beyond those specific stocks, McGowan says he's spotting buys in health care, tech, consumer cyclicals, and financial stocks such as big banks Bank of America (BAC ), Citigroup (C ), and Wells Fargo (WFC ).
These were a few highlights from an investing chat with McGowan presented June 2 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. AOL subscribers can find a full transcript at aol.businessweek.com/chat.
Q: Taylor, how do you see the market at this point in history? A:
Q: Taylor, how do you see the market at this point in history?
A:At Farr, Miller & Washington, we're bottom-up stockpickers -- thus we don't spend too much time trying to determine the position or direction of the whole market. However, the p-e multiple of the S&P 500 has fallen to less than 17 times forward earnings, a level slightly above the often-cited long-term average multiple of 15 times. These aren't bargain-basement valuations, but they appear appropriate, given the low level of interest rates.
Q: What do you make of the rally in the bond market, with the yield on the 10-year falling to 3.9%? Do you pay attention to bonds? A:
Q: What do you make of the rally in the bond market, with the yield on the 10-year falling to 3.9%? Do you pay attention to bonds?
A:We definitely pay attention to bonds, for two reasons. First, the bond market affects the stock market, and second, we have plenty of clients with balanced accounts. We're definitely nervous about the movement in the 10-year Treasury.
We're nervous because the yield curve, which is the spread between short-term interest rates and long-term rates, has flattened out significantly. History is a good guide -- if the yield curve becomes inverted, we're very likely to have a recession. The buyers of long-term Treasuries are clearly signaling that they're not concerned about inflation and that economic growth may be slower going forward.
Q: On a bottom-up basis, what's most important to you now? And to what kind of stocks does that lead you? A:
Q: On a bottom-up basis, what's most important to you now? And to what kind of stocks does that lead you?
A:We're fairly consistent in terms of what we look for in a company. We look for companies that are industry leaders in attractive industries; companies that have solid historical financial track records -- specifically, companies that grow sales and earnings per share well above the average company in the market. We also look for companies that have solid balance sheets, create high returns on capital, and have significant free cash flow.
Finally, we try to buy these companies at reasonable valuations. We continue to find attractive investments in the health-care sector, we're finding attractive stocks in the tech sector, in consumer cyclicals, and even the financial sector.
Q: Are you making any new purchases? Or adding to existing ones? Just want to see if you're in a buying mood these days. A:
Q: Are you making any new purchases? Or adding to existing ones? Just want to see if you're in a buying mood these days.
A:We're still finding attractive stocks to buy at these levels. We've recently purchased a company called Education Management (EDMC ). They're one of the leaders in the for-profit education sector. The entire sector was hit with negative news recently regarding aggressive marketing tactics, especially some of Education Management's competitors. The entire education stock sector has sold off. EDMC is probably the most conservative way to play this trend in for-profit education, however, given that it's still growing at three to four times the rate of the rest of the education market.
In terms of positions we're adding to, we're adding to our position in American International Group (AIG ). We believe that the sell-off that has accounted for over $40 billion in market cap is way overdone for an error in accounting that was far less than $3 billion.
We're also adding to Waters (WAT ), which we've owned for several years. The stock isn't inexpensive, but they missed earnings in the first quarter, and we believe it's a good buying opportunity. Finally, we're also adding to our current positions in Colgate-Palmolive (CL ), First Data (FDC ), and IBM (IBM ).
Q: You used the phrase "even the financial sector" -- what do you like (or dislike) there? You cited AIG. A:
Q: You used the phrase "even the financial sector" -- what do you like (or dislike) there? You cited AIG.
A:Well, we're definitely committed to the financial sector for the long term. We like the large-cap, diversified banks, such as Citigroup (C ), Bank of America (BAC ), and Wells Fargo (WFC ). These stocks are all offering dividends between 3% and 4% and trade at p-e multiples that are discounted relative to the market.
Still, we're concerned about the sector overall because of the flattening yield curve, which makes it harder for these companies to grow earnings. In addition, we have concerns about the status of the housing market in the various coastal areas. We believe that a significant slowdown in these areas could significantly affect bank earnings. Therefore, we believe this is an especially good time to own a larger, more diversified, more conservative bank in the sector.
Q: What about tech? A:
Q: What about tech?
A:The tech sector has actually experienced the greatest amount of p-e multiple compression of any of the major sectors that we follow. As a result, tech valuations are beginning to come back into line with reality, in our view. We like Dell Computer (DELL ), IBM, First Data, Microsoft (MSFT ), and we're still buying some Nokia (NOK ). Tech sector p-e multiples have now come down to where they're trading, on average, at only a slight premium to market. We feel this is fairly appropriate.
Q: Beyond big-bank dividends, what do you recommend for investors particularly seeking income? A:
Q: Beyond big-bank dividends, what do you recommend for investors particularly seeking income?
A:First, I'll state that it's a terrible time to need income-creating assets. The U.S. 10-year Treasury yields 3.89%, barely above the level of inflation. Most other long-term investments are pegged to these rates. To achieve more than a 4% return, you have to take on extra risk.
For our clients at Farr, Miller & Washington who need income, we combine long-term municipal bonds yielding 4% (relatively attractive on an aftertax basis). For those needing the stability of bonds but who don't necessarily need income today, we've been buying shorter-maturity bonds because this end of the yield curve is more attractive than the longer end. You can get 3.3% buying a one-year Treasury, which compares favorably to the 3.89% that you would receive on the 10-year Treasury.
Q: What do you like among consumer-cyclical stocks? Some analysts like staples much better than discretionary now. A:
Q: What do you like among consumer-cyclical stocks? Some analysts like staples much better than discretionary now.
A:We've actually historically favored the consumer cyclicals. We like the blue-chip, stable nature of their businesses. Our portfolios continue to own a good amount of cyclicals, because the consumer-staple stocks have done well and are expensive, historically speaking. We continue to like Staples (SPLS ), Kohl's (KSS ), and we're actually buying some Wal-Mart (WMT ). We've been buying Wendy's (WEN ) as well, though they're beginning to look a little pricey.
Q: Earlier you mentioned health care -- which ones do you like? Do you own any of the big pharmaceutical makers? A:
Q: Earlier you mentioned health care -- which ones do you like? Do you own any of the big pharmaceutical makers?
A:We do. We continue to own Pfizer (PFE ), we also own Lilly (LLY ). We own Johnson & Johnson (JNJ ). Our feeling on the pharma industry is that the stocks are too beaten up at this point. We believe the current valuations are discounting worst-case scenarios for many years to come. Long-term investors should be rewarded by owning the industry leaders in the pharmaceutical sector.
We also own Medtronic (MDT ), a medical-device company. We own Stryker (SYK ), an orthopedic company, and we own Waters (WAT ), which makes equipment used by the pharmaceutical industry for research and development. From a big-picture perspective, we continue to like the secular demographic trends that continue to drive the health-care sector and will do so for years to come.
Q: How would you define your firm's strategy -- growth at a reasonable price? A:
Q: How would you define your firm's strategy -- growth at a reasonable price?
A:Yes. Our strategy can be defined as large cap at a reasonable price. We're buy-and-hold investors -- we spend an enormous amount of time doing due diligence on stocks before we buy them, and then we plan to hold them for four to five years.
Q: What looks good to you among diversified industrials, and why, in the current economy? A:
Q: What looks good to you among diversified industrials, and why, in the current economy?
A:We still like United Technologies (UTX ). We still like a small company called Teleflex (TFX ), and we actually still like General Electric (GE ). In general, we don't like the industrial companies that are highly cyclical. The companies I just mentioned are certainly cyclical, but they're diversified enough that a cyclical downturn has less of an overall impact on share growth than, say, a basic materials company.
We like United Technologies because of its elevator business, which we think is excellent. We think they have good aerospace business. General Electric is really half finance business, and we really do like that half. GE's doing an excellent job repositioning its portfolio, selling slower-growth businesses, and buying higher-growth businesses in the health-care and media arenas.
Teleflex is more of a turnaround story. It's a small company that had a fantastic earnings track record that was broken a year and a half ago. They're in the midst of repositioning their portfolio to attractive end markets such as health care. In addition, Teleflex generates an enormous amount of free cash flow.
Q: In the fallout from French and Dutch votes on the EU constitution, the euro has been dropping -- would an end to the dollar's decline help your investments? Or influence any decisions? A:
Q: In the fallout from French and Dutch votes on the EU constitution, the euro has been dropping -- would an end to the dollar's decline help your investments? Or influence any decisions?
A:We don't make our decisions based on our view of the currency market. That market fluctuates too rapidly, and it really won't really have an impact on our long-term investments. We do think that the vote against the constitution indicates that the euro isn't going to be replacing the dollar as the reserve currency of choice any time soon, however. So it was a significant event. This will have a positive impact in that foreign governments will continue to need to buy our Treasuries, which will continue to keep interest rates low.
Q: A few analysts hiked their price targets for Google (GOOG ) this week to $300 and higher. Does this remind you of the Internet bubble? A:
Q: A few analysts hiked their price targets for Google (GOOG ) this week to $300 and higher. Does this remind you of the Internet bubble?
A:Yes, it does. The recent price action in Google has certainly surprised a lot of people. The company came public less than a year ago, at less than $100 per share. Now analysts are putting out $350 price targets. We believe Google is a fantastic company, but we don't believe it's an attractive long-term investment at current price levels.
We're also reminded of the tech bubble because the analysts who are covering these stocks appear to have an incredible amount of power in terms of moving the stock in one direction or another.