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Jeff Molitor oversees fund managers running some $175 billion for giant Vanguard Group in funds that are hot -- such as Vanguard Capital Opportunity (VHCOX) -- and those that are not -- Vanguard Windsor (VWNDX) and Windsor II (VWNFX). How does a professional fund evaluator size up today's scene -- the tribulations of value-stock pickers, the market's thirst for momentum stocks, and investors' renewed interest in small-caps? I asked him about all that and more when I spoke to him by phone in his Malvern (Pa.) office. Here are edited excerpts of our conversation:
Q: Fund holders right now are grappling with their taxes. When you are selecting and reviewing investment managers, how much attention do you pay to how well they limit investors' tax bills?
A: We certainly take a look at it. And if it were a situation of all other things being equal, we would prefer someone who had a more tax-efficient approach than less. But we [at Vanguard] have our tax-managed portfolios, which really allow investors to get exposure to different sectors of the market, whether it's U.S. large-cap, small-cap, or even international, in a tax-efficient manner.
Q: Primecap Management, which runs Vanguard Capital Opportunity Fund for you, had a huge score with its big holding in Ortel (ORTL) when Lucent Technologies (LU) recently agreed to buy it. How does a firm like Primecap discover a company like Ortel? Less than a year ago it was at $6 a share, and now it's at $160.
A: There are other companies where [Primecap has] done the same thing.
Q: Such as?
A: Centocor, which was purchased by Johnson & Johnson (JNJ) not long ago.
Q: What do they know that we don't?
A: What it comes down to is understanding of what's going on in an industry and who the players are -- [which is] old-fashioned, on-your-own, fundamental research. They don't look to Wall Street to call them up and say, "Here are the names. Do you want to buy?"
Q: Last year, you added a second, independent manager to run some of the money in Windsor Fund. It's still suffering. Are there more changes coming for Windsor?
A: The whole idea was to maintain the character [of the fund] with a little bit less edge. One of the clear issues is that [deep-value] stocks are still down, so there's no reason to make any further changes at this point.
Q: Well, looking at that part of the market, value and deep-value stocks, does the fact that it has been beaten up so much and for so long make you, as an intelligent investor, want to put new money into it?
A: If you look at the end of the 1973-74 market, up through about mid-1989, that was a really strong phase for value investing. Since then, with a couple of pauses, it's almost [entirely] a growth-stock market, and it really has pushed on the growth pedal over the last two or three years. And just thinking as a contrarian, do markets still go in cycles? Is traditional value investing dead? I think we'd say probably not.
As to where the market goes from here, you look at where you get the generation of returns out of equities. You get it from dividends, which aren't that much in the market right now. You get it from earnings growth, and you get it from valuation change. It's possible you could get more valuation change, that is increases in [price-earnings] ratios on growth [stocks], but if you're getting the earnings off of value and you don't have to worry as much, you wouldn't want to leave yourself underexposed to it.
Q: In other words, despite their horrible showing, you wouldn't want to leave yourself light on value stocks?
A: Right.
Q: How about overweighting value stocks?
A: It depends on the individual. Going on a contrarian bent, maybe this is the time to [buy value]. But you theoretically could've said that over the past couple of years and been wrong.
Q: Have value investors lost their way?
A: I don't know if [it's that] or it's more the view of investors on the margin [who ask] why take the risk on something that isn't doing well? Why shouldn't I go for something that really has this growth element? If you look at 1999, it was the single biggest year for momentum [investing] in history.
Q: How do you measure that?
A: You look at the difference in return between the top decile in terms of stocks that have very high price momentum, vs. those that have the lowest decile. And it's the biggest gap ever. If you wanted to invest in what was going to work, you bought what had worked.
Q: So, General Electric (GE), Cisco Systems (CSCO), all those.
A: Microsoft (MSFT), Qualcomm (QCOM).
Q: It was a painful year to be a contrarian.
A: Yes, plus there was another element out there in the market. Remember the phrase in the book The New New Thing about the power of pure possibility? That was infectious for a number of investors in the sense that earnings weren't the issue so much. If you look at the Russell 2000 [index of small-cap stocks], the stocks that did well there were the ones that had losses, not the ones that had earnings. It was kind of [about] the power of possibility and what happens to a company in terms of what it can possibly do, whether it's on the Internet or whatever, then what happens when it actually starts getting some earnings.
Q: I wish somebody would look at me that way -- the power of pure possibility!
A: You wouldn't have to worry about cash flow. Your personal multiple would just keep climbing.
Q: Let me ask you about small-caps. They've also been in tough territory. Is there any reason to suspect that is changing?
A: A lot of it gets back to where are earnings ultimately going to be generated and at what price. The expected earnings growth numbers that I've seen for the small-caps are much higher than what I've tended to see for large companies. Yet the aggregate numbers are that the Russell 2000 is at a discount to the Standard & Poor's 500 [big-stock index].
Q: Meaning?
A: So you combine those two things -- higher earnings growth yet a lower multiple -- and that's one of the reasons I think you're seeing small-cap stocks starting to have a pretty good run. How long it lasts, no one knows.
Robert Barker covers personal finance in his weekly column, The Barker Portfolio, for Business Week from Melbourne Beach, Fla. And he appears every Friday on Business Week Online EDITED BY DOUGLAS HARBRECHT
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