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The market staged a vibrant rally in 2009, but some investors were left wondering whether stocks had recovered too far, too fast. Certainly, some of that skepticism has been reflected in a bumpy 2010 so far. With jitters surrounding possible sovereign debt defaults, major policy changes on tap, and fears surrounding the strength of the global recovery, uncertainty is king.
To gain some insight into the outlook for the economy and the markets, I spoke with Mary Chris Gay, assistant portfolio manager for Legg Mason Capital Management’s Value Trust Fund and famed investor Bill Miller’s co-pilot. The Value Trust Fund’s illustrious 15-year streak of beating the market came to an end in 2006, but after three years of underperformance, the team is back on top. The fund trounced the market in 2009, returning a stunning 40.64% for the year and crushing the S&P 500’s 26.46% return.
So what does the value-investing dream team think now? Gay says she thinks economic growth will surprise on the upside in 2010, and that stocks will have a generally good year. She says she thinks valuations are very enticing at current levels for large-cap stocks, as the uncertainty ruling the markets is creating opportunity. Gay also weighed in on the “new normal,” saying that she thinks long-term buy-and-hold will work for this decade.
Here is an edited transcript of our conversation:
Jennifer Schonberger: What’s your sense of the strength of the recovery in the U.S.?
Mary Chris Gay: ... The determination of strength of any recovery is directly proportionate to the downturn. Fourth-quarter GDP was 5.7%. Assuming it’s not revised, it is the largest increase that we’ve had in six years. On a full-year basis, we had a decline of 2.4% in GDP in 2009, which was the worst decline in 63 years. So we would not be surprised if this year, growth actually surprised on the upside. I don’t think that’s a consensus view.
Many are giving examples of lots of reasons why they think things could stall and we may have a double-dip. We believe that uncertainty is creating opportunity in the market. On balance, we think it’s going to be a very good year for stocks and challenging for bonds. Inflation is really low. We’ve got good economic growth, ample liquidity, and corporate profits are rising.
For the fourth quarter, 70% of the companies that have reported have posted better-than-expected numbers. This may be a record-setting earnings quarter. We had great earnings growth in the second quarter last year, but it was mostly due to cost-cutting. In the third quarter, we had the best numbers on record. That was encouraging because it was both bottom-line and top-line growth. So valuations are really attractive and there continues to be a high level of skepticism, which is exactly the kind of market that we tend to do very well in.
Schonberger: Are you at all nervous about the sovereign debt concerns? Do you think Europe’s debt problems pose a threat to the U.S. recovery?
Gay: It’s certainly part of the reason why the volatility has increased ...
If you look at debt as a percentage of GDP, the estimate right now in the U.S. from the CBO [Congressional Budget Office] is about 65% of GDP for 2010. That’s well below the estimates of 77% for Germany, 80% for the UK, and 180% for Japan. We believe this could be a fairly challenging year for the euro relative to the dollar, and that’s in part due to the uncertainty of what may happen with the Greece situation and the other sovereigns. But from the U.S. standpoint, we think we’re in very good shape and the valuations are extremely compelling -- especially if you look on a normalized earnings basis over the next couple of years.
Schonberger: So you’re not concerned about a spillover effect, then?
Gay: It’s important to keep an eye on and to be aware of, in terms of the implications for our companies. One important lesson we have learned, especially in comparing this crisis to every one we’ve had going back the Great Depression, is how much more globalized the economy is ...
Schonberger: If Europe’s woes call into question the strength of the global economic recovery, what would that mean for U.S. company earnings, given that nearly half of the S&P 500’s earnings come from overseas?
Gay: You’re right that when you look at earnings from the S&P [now], on average 27% of the revenues of the S&P are sourced outside the U.S. If you look at the estimates for global growth, throughout the developed world, growth estimates are somewhere around 2.5% for this year; the U.S. estimates are considerably higher than that. The eurozone is going to have a hard time getting a firm footing out of the recession and into the recovery, and that’s in part due to the structural issues that face all the different governments.
So we have gone through and looked at every name we own in Value Trust to determine our exposure -- where the growth is coming from and how it might be affected if there are certain slowdowns in other parts of the world. So, for us, if you look at State Street (NYSE: STT ) or Aetna (NYSE: AET ) , it has zero percent exposure from a revenue standpoint. But if you look at IBM (NYSE: IBM ) , it’s 58% outside the U.S. But then it’s important to break it down further and say, “How much of that is coming from developed worlds versus developing worlds?” Because you can still have strong earnings growth, especially if companies are sourcing that growth from the emerging parts of the world.
Schonberger: I recently spoke with Mohamed El-Erian of PIMCO, who says we’re in a new operating environment – “a new normal” -- as we undergo secular changes, de-globalization, and reregulation, and as such, investors should adjust their investing strategy. Do you agree?
Gay: While we wouldn’t argue that the “new normal” -- the 2% or so growth on a longer-term basis -- might not be the right number, we certainly don’t believe that near-term, we’re likely to see 2% growth. And I think even Mohamed will agree with that. When asked, “Does the strength of the current numbers make your forecast questionable,” he said no. He’s not surprised that we’re seeing big growth numbers, as you would expect at the early stages of a recovery. He was just saying that the sustainability of it supports his lower number.
I think that that certainly is one scenario that may happen. We just believe that it’s important to look at the historical relationship of innovation and population growth in the U.S.
Bill [Miller] is looking at consensus numbers. He’s looking at what historically has determined the strength of GDP following the downside, looking at relationships like the downturn in employment growth relative to the downturn in GDP, and saying that companies probably cut far more severely than is warranted given the downturn.
When you look back at the current environment, comparing it to even the early ‘80s -- when we had very high interest rates, high inflation, criticism of the U.S. deficits under Reagan -- it’s very similar to the criticism of Obama’s deficits today. Lo and behold, that was the beginning of one of the best times to invest in U.S. large-cap stocks, in part because of the level of innovation and new companies that resulted.
You could make the same low-growth estimates at the beginning of the ‘90s, but because of the innovation that resulted from the Internet and the impact it’s had on companies’ growth, productivity and efficiency was far greater than most were expecting.
We don’t know what the next industry is -- whether it’s biotech, pharmaceuticals, or alternative energy, which clearly is a big part of the stimulus package. There are a lot of incentives to start new businesses and hire people in the green jobs area. Whether it needs to be subsidized or whether they truly are viable companies remains to be seen. But many companies are involved in that, whether it’s General Electric (NYSE: GE ) , or Cisco (Nasdaq: CSCO ) , or a lot of utility companies. Our biggest holding, AES (NYSE: AES ) , which is a global power producer, is seeing very good growth -- not only in the U.S. as a result of these power projects, but also in emerging parts of the world that clearly need power to have a stable economy and grow.
Schonberger: So, then, you think long-term buy and hold would work this decade?
Gay: We do. In 2008, U.S. stocks went down. In 2009, it was almost a reverse – 90% to 95% of all stocks went up in the U.S. Obviously the more aggressive, more leveraged did better, and the more defensive didn’t fare as well. But in general in 2010, we think it’s actually going to be a year where valuation matters a lot. So what will distinguish the sustainability of growth, we think, will be stock-picking. That’s exactly the kind of environment the portfolio and Bill tend to excel in.
So we think that really good companies, especially if they have sold off like many companies have just in the last couple of weeks, are providing an opportunity to average down. When you look at forward earnings expectations with very reasonable assumptions over the next couple of years, it’s hard to believe that we’re going to see continued compression of multiples. We think that in retrospect, this time in the market will prove to be an exceptionally good buying opportunity for long-term, patient investors.
Schonberger: In terms of money flows, last year the individual investor came back into bonds, but not into stocks. What are you seeing from investors now? Are investors still scared?
Gay: I didn’t see the fourth-quarter numbers yet, but my guess is they’re not too dissimilar from the third-quarter numbers. Unfortunately, retail investors are still in that redemption mode -- at least from what we’re seeing. Anecdotally, we’ve spoken with a number of prominent equity managers, whose numbers were far better than ours, and they said they are also experiencing outflows.
Stay tuned for the second part of my interview with Mary Chris Gay, in which she reveals her favorite sectors and stocks for 2010.