All eyes turn to the FED

US economic growth rebounded at the start of 2006, following a weak last quarter of 2005. This has not stopped concerns being expressed about the economy, however, particularly over a slowdown in consumer spending and weakening residential property sales. In February, for example, new home sales fell by the highest percentage in more than nine years. Nevertheless, with interest rates rising in March under new Federal Reserve chairman Ben Bernanke, the economy is growing at 3 to 3.5 per cent. This is regarded as the sustainable trend rate. The US stock market has lagged other markets over the past couple of years, but some fund managers suggest this means it offers greater value. Over one year to 6 March 2006, the S&P 500 index returned 17.98 per cent. The return was 45.24 per cent over three years and -4.45 per cent over five years. Many of the funds in PWM’s table have outperformed the S&P 500 index over these time periods. The SGAM Equity US Relative Value fund, for example, has out-preformed the index over one and three years. The fund’s manager, Diane Jaffee, describes her investment approach as looking for value stocks that are poised for growth. In evaluating stocks for the portfolio, which usually holds between 30 and 50 companies, Ms Jaffee judges them against five criteria. “Generally, the stocks we select meet at least three of the criteria,” says Ms Jaffee. These criteria are:

• Price to cashflow equal to or lower than the market average;
• Price to sales equal to or lower than the market;
• Price to book equal to or lower than the market;
• Price to earnings equal to or lower than the market;
• Dividend yield equal to or higher than the market.

“We believe that by taking this approach, it has enabled us to avoid stocks like WorldCom and Enron,” states Ms Jaffee. Four of the criteria use past looking data. The only forward looking data is for the price to earnings ratio. This evaluates the consensus assessments for earnings forecasts for the next 12 months. In deciding whether to invest in stocks, Ms Jaffee evaluates criteria relevant to each company’s industry. “If a company meets one criteria that is appropriate for its industry then it will be considered.” The next step is to analyse the stocks that have met the conditions. This includes looking for a catalyst for change. This may be cost-cutting or restructuring to improve a company’s cashflow, new products or new markets. “Companies need at least one catalyst to get into the portfolio,” she says. “We then decide if the company’s share price will appreciate by 30 per cent over the next two years. This is where the growth element comes into our investment process. “We arrived at the 30 per cent figure because it is what is required to be in the top quartile for performance. Since 1926, the US stock market has had an annual average return of 10 to 11 per cent. To be in the top quartile, a fund needs to return around 13 per cent a year so we aim for 15 per cent a year.” Once a stock gets within 10 per cent of its target price, Ms Jaffee starts selling. “The aim is to buy value stocks and sell growth companies to a growth manager. “There is also a strong sell discipline if stocks do not perform as well as expected. If stocks underperform by more than 10 or 15 per cent then it will come under review to see if the market knows something we did not. This usually results in the sale of the stocks.”

‘Mr Bernanke’s first major challenge is to slow the economy and the housing market without croaking either’ - Mary Chris Gay, Legg Mason Value fund

Even though the fund takes a bottom-up stock picking approach, Ms Jaffee says it still has risk controls on its sector weightings. The minimum weighting is 50 per cent of the S&P 500 weighting and the maximum weight is two times. Ms Jaffee expects earnings growth among US companies to slow from their recent double digit increase. “But we still expect earnings growth of 5 to 10 per cent.” She is encouraged by the fact that US companies have strong cash flows. “Over the past few years, the rate of dividends and share buy backs has been at the rate of 5 to 10 per cent.” Double digits Mary Chris Gay, manager of the Legg Mason Value fund, believes the S&P 500 should deliver double-digit returns in 2006. The first two months of 2006 was only outperformed by the same period during 1998 and 2004 out of the past 10 years. In January and February 1998, the S&P 500 index returned 8.40 per cent while the first two months of 2004 delivered a return of 3.25 per cent. The start of this year saw a return of 2.93 per cent. “The S&P 500 finished 1998 up 28.58 per cent while the return in 2004 was 10.88 per cent,” says Ms Chris Gay. “We believe something in between those two figures, tending more towards the lower end, is a reasonable expectation for 2006. “We remain constructive on the outlook for the US economy and equity market. We have learned nothing at the start of the year to suggest that 2006 cannot produce low double-digit total returns for investors.” Ms Chris Gay expected GDP growth to rebound strongly in the first quarter of 2006 to between 4.5 to 5 per cent. But she believes this will overstate the strength of the economy because of a relatively weak fourth quarter in 2005, a record warm month in January and the one-time post-Katrina hurricane reconstruction and recovery activity in the Gulf coast region will inflate GDP data. “We expect GDP growth to slow to around 3 per cent as the year progresses,” says Ms Chris Gay. “If we are correct that the Federal Reserve is near the end of its tightening regime, we think that would be good news for homebuilders and other interest-rate sensitive groups, as well as for the market as a whole. “If the Federal Reserve becomes too focused on fighting wage or commodity inflation and overdoes it on rate hikes, the housing sector could be a principal victim. Because of the prominent role that housing values play in the health of household balance sheets and net worth, we do not think it would be the only victim.” She adds: “Threading this needle will be Mr Bernanke’s first major challenge. He needs to slow the economy and the housing market without croaking either.” Seeking growth Katherine Collins, manager of the Fidelity Funds America fund, describes her investment approach as seeking growth stocks at reasonable prices. “We analyse the fundamentals, where stocks have attractive valuations and if there is a catalyst that will increase the share price. Some stocks may look expensive on a valuation basis but the strong fundamentals mean they offer growth potential.” Ms Collins argues that the advantage she has over other funds in the sector is the research capability at Fidelity. “We analyse between 1300 and 1400 stocks, which is 95 per cent of the market. This is an in-depth analysis of each of these stocks.” The fund has outperformed the index over one, three and five years. She moved to London recently but says this also offers research advantages. “I talk to non-US managers about international stocks so I can compare them to companies I am thinking of buying in the US.” Even though the US market has generated positive returns, Ms Collins says the S&P 500 is 20 per cent cheaper than three years ago because of the increase in earnings. “The average price to earnings ratio has declined from 20 to 15 times earnings.” Ms Collins says that she is cautious on the outlook for consumer spending, however. “We have tried to protect the portfolio against a slow down in consumer spending by investing in retail stocks that can improve their position through internal changes. “The share prices of these stocks can improve in spite of the macro economic environment. We have done the same with bank stocks. We look for companies less sensitive to movements in interest rates.” Ms Collins says there are two main themes she is currently pursuing. “We like innovative companies. There has been a dearth of innovation over the past three to four years but this is beginning to change. An example would be Apple, whose innovation has begun to take off. “The other main theme is industries with commodity products but where the supply and demand dynamics are changing. There are particular investment opportunities where there is restricted supply such as refinery or construction material companies. These stocks can be more volatile, however.” Beating the index The Goldman Sachs US Core Equity fund takes a quantitative investment approach. Nick Phillips, head of third party distribution in Europe for Goldman Sachs Asset Management, says the fund aims to deliver a return of around 1.2 to 1.5 per cent above the S&P 500 index every year. This is reflected in the fact the fund has out-performed the index over the past one, three and five years. The advantage of this fund over many actively managed competitors, says Mr Phillips, is the consistency of performance and the long-term outperformance over the index. Mr Philips says despite the quantitative approach, the fund analyses the same themes as actively managed funds. “The quantitative equity team has analysed factors that drive share price performance,” says Mr Phillips. “Six themes have been identified, which are valuations, profitability, earnings quality, management input, momentum and analysts’ sentiment.

‘If stocks underperform by more than 10 or 15 per cent then it will come under review to see if the market knows something we did not. This usually results in the sale of the stocks’ - Diane Jaffee, SGAM

“These are given different weightings to reflect their importance, which change slightly over time. These themes are analysed by the quantitative model every day to evaluate future share price performance. This enables us to analyse 3000 companies on a daily basis.” In determining the weightings, a number of factors are examined, including their volatility, diversification from other themes and the turnover of stocks within each theme. “Valuation, based on historical returns, would be 22 per cent of the stock selection process. As a result of this theme’s high volatility, however, its current weighting is 11 per cent of the decision-making process.” The other weightings are 11 per cent for profitability (with an historical range of 11 to 18 per cent), earnings quality is 18 per cent (16 to 19 per cent), management input is 18 per cent (18 to 20 per cent), momentum is 21 per cent (18 to 21 per cent) and analyst sentiment is 21 per cent (19 to 21 per cent). Daily analysis Mr Phillips argues that the daily analysis of companies and proprietary risk model enables the team to identify changes in volatility quicker than actively managed funds. “We aim for a tracking error of 2.5. If volatility falls then we reduce the number of stocks in our portfolio. The fund currently has 137 stocks. We have had up to 200 stocks in the portfolio.” Robert Burdett, co-head of Credit Suisse Asset Management’s portfolio service, says it still has an underweight position in the US but this has been reduced recently. He says this is because valuations of US stocks are becoming “more interesting”. He says this has been caused by the economic cycle and as a result of other regions, notably Asia and emerging markets, outperforming the US over the past few years. This has increased the attractiveness of the US market on a relative basis. “A great deal of focus is on Mr Bernanke to see how he manages inflation and economic growth through movements in interest rates.” Among the funds favoured by Mr Burdett are Findlay Park US Smaller Companies, Legg Mason’s value fund, managed by Ms Chris Gay, and SocGen American Growth.

Collins: we look for innovative firms