“Be fearful when others are greedy. Be greedy when others are fearful.”
These are perhaps the best-known words of advice from the legendary Warren Buffett. Great investors must think alike, because Mary Chris Gay, assistant portfolio manager for Legg Mason Capital Management’s Value Trust Fund, is doing just that. While uncertainty rules the markets from on high, Gay and her co-pilot Bill Miller, the famed lead manager of the Value Trust fund, stand ready to pounce.
In many ways, Gay and Miller are the ultimate value investors. Value Trust beat the market for a whopping 15 consecutive years until 2006, when the team finally proved mortal. However, 2009 saw the pair returning from a three-year losing streak; the fund returned a dazzling 40.64% for the year, crushing a not-unimpressive 26.46% from the S&P 500.
So what’s their prognosis for 2010? I spoke with Gay, who says technology and financials are her favorite sectors, and that she doesn’t see a lot of value in the industrial-commodities sector right now. Here is an edited transcript of our conversation.
Jennifer Schonberger: What are your favorite sectors for this year?
Mary Chris Gay: We continue to have exposure in technology. That is a little controversial, because that area of the market did very well last year and has sold off this year. But when we look at the environment for technology companies, we believe they still represent among the best values. During the course of last year, we reduced our exposure for every single name except Microsoft
Schonberger: Do you still favor financials?
Gay: We do. In fact, it’s the next largest group in the Value Fund. We still believe there’s considerable upside. Sentiment is very poor right now, and has been [for some time]. There’s a lot of uncertainty because of the potential regulation changes, which we are paying close attention to. Valuations are very low.
If you look at the average multiple of JPMorgan, Bank of America, Capital One, or Goldman Sachs, they are now under about 7.5 times next year’s earnings, 6.5 times the following year. They are just very low. If you look at Goldman Sachs, when they reported numbers, their returns on equity were very strong. They had a drop in compensation. They had really good numbers on the investment banking side. Yet the company trades at about 7 times earnings ...
So if you look at the group, the numbers are very strong and improving. With the low level of interest rates, banks are essentially paying nothing or very little for funds and being able to earn on a very good spread. So they’re recapitalizing at a fairly fast pace. Balance sheets are improving, and there’s been a tremendous amount of capacity taken out of the sector because Lehman, Wachovia, Washington Mutual and Bear Stearns are all gone, along with the shadow banking system.
Schonberger: What are your expectations for the commodities sector now, especially in light of China, which has led the global recovery, and which is now tapping the brakes on growth?
Gay: We have exposure to almost every single sector, but the only position we have in the materials space is in Nucor
If you look at the valuation for the industrial-commodities sector as a group, on a price-to-book basis and as a growth-cash flow basis, they are still very expensive. Historically, if you look at their valuations today versus where they have traded at historically, they’ve only been more expensive 10% of the time. And that’s not to say they won’t get more expensive, because when we have momentum markets, we tend to see extremes. But we don’t see a lot of value in that space.
Schonberger: What do you think about housing?
Gay: We sold all of our housing stocks in Value Trust in the latter part of 2008, early part of 2009. But Bill actually has a fairly good position in the Opportunity Trust in housing. Many of the names are too small on a market-cap basis to be in the Value Trust today.
We believe there are still parts of the market, like Florida, Arizona, or Nevada, that will take time to work off excess inventory ... There might be shadow inventory that might come back on the market, but at the end of the day when you look at household formations in the U.S., there are roughly a million a year. If you look at new home construction, I think it reached as low as 300,000 or 400,000 -- it might be currently running at 500,000. At some point, if that is going to continue there is going to potentially be a shortage, because home ownership is typically one of the most important factors -- certainly for individuals coming in from an immigration standpoint.
... If you look at the housing numbers, on balance, they have certainly surprised on the upside. They’re not all positive, but on balance we’ve seen an improvement, and that’s been very encouraging. So if those trends continue, the housing stocks should do quite well.
Schonberger: Out of all of the companies you own in Value Trust, what are your top three picks?
Gay: IBM
AES
On a longer-term, secular basis, we still believe that Amazon is one of the best values. It’s difficult, because on a pure P/E basis, many would argue it’s expensive. But when you look at the opportunities, where it is in the low capital intensity, the high cash conversion rate, and the strength that they’ve had in growing in new markets -- whether it be cloud computing or the Kindle -- we believe it’s one of the most secularly advantaged companies in the market today.
For the first part of this interview with Mary Chris Gay, click here.
