Markets & Finance

Value from Top to Bottom


Lawrence Babin, manager of Victory Diversified Stock Fund/A (SRVEX), invests in large-cap, well-established companies across a broad variety of sectors. Babin uses a primarily a top-down investment approach, but supplements that with a bottom-up evaluation; that is, he keeps an eye for the most attractive sectors at any given time, then picks the best stocks within those sectors.

Stocks are selected based on cash flow, book value, prospects for future earnings, management quality, dividend growth prospects, relative historical valuations and positive earnings surprises. Although Babin originally adhered to a strict "value" orientation, his method has evolved, over his 13-year tenure with the fund, into a system that can be described as buying value -- and selling momentum.

The current year threatens to be the first calendar year in which the fund will have posted a loss. Year-to-date through October 19, the portfolio slipped 7.2%, although its benchmark, the S&P 500 Index, had declined a much-sharper 17.9%. In the difficult environment of 2000, the fund eked out a 1.4% gain, while the index sank 9.1%. But for every year in the 1990s, the fund delivered positive returns ranging from about 4% to about 35%.

Recognizing Babin's long-term solid performance and consistency of style, the fund has been designated a "Select Fund" by Standard & Poor's.

Palash Ghosh of Standard & Poor's Fund Advisor recently spoke with Babin about about the fund's investing strategy, top holdings and recent portfolio moves. Edited excerpts of their conversation follow:

Q: Are you a "growth" investor or a "value" buyer?

A: The terms "growth" and "value" have become somewhat meaningless, given the volatility of the market. When the S&P 500 and other indexes rebalance themselves, you often find that formerly "growth" names have become "value" issues and vice versa. This past June, many tech stocks entered the "value" segment, for example. However, having said that, we definitely buy value -- that is, we establish initial positions in companies that we determine are trading inexpensively relative to their historic valuations and relative to the market. Then, assuming we invested at the right time, the stock's earnings revisions move up, the market recognizes it and momentum investors start purchasing it. Then, hopefully, we can unload the stock at a premium valuation; by this point, the stock will likely be identified as a "growth" company.

We try not to listen to the noise of Wall Street and rely on original, independent research. We seek to determine what a company's earnings power will be, say, in a year. We compound that analysis by trying to understand what phenomena in the economy will drive earnings growth. As such, we definitely make sector bets. Having determined which sectors will prosper, individual stock selection is a residual decision. We think that the fortunes of an individual company are less important than the fortunes of a sector; which is itself less important than the health of the overall economy. Basically, we don't think that analysis of individual companies is that important -- people who spend all their time researching individual stocks often miss the forest for the trees.

Q: Are price-to-earnings ratios a meaningless measure?

A: Not at all, p-e is a very important valuation tool, but it depends upon the sector. For example, the pharmaceutical sector provides very stable earnings growth. Aside from Pfizer (PFE), which currently trades at a substantial premium, most drug stocks are currently trading at p-e ratios between 18 and 30. On the other hand, tech and auto stocks are wildly volatile; indeed many tech companies are losing money. But we look at normalized earnings over a long cycle -- one must make judgments and forecasts. We often buy stocks that are posting losses -- this portfolio is driven more by valuation concerns than the existing earnings story. For example, a stock may plunge 90% because it is showing losses, but we might purchase it if we think it will deliver strong earnings in the near future. As of Sept. 30, the portfolio's average p-e was 22.6, and average price-to-book was 2.9.

Q: How large is the fund in terms of net assets and number of holdings?

A: We have about $1.22 billion in net assets; we typically keep between 65 and 80 companies.

Q: What is your cash position?

A: As of Sept. 30, our cash position was about 7.8%, but since then we've reduced that to about 2.5% today, reflecting our decision to put our money to work after some caution and hesitation warranted by the terrorist attacks on Sept. 11. We feel that the worldwide coalition President Bush has put together against terrorism and the unprecedented unity of politicians in Washington were very bullish for the market.

Q: What are your largest individual holdings?

A: As of Sept. 30, 2001: SBC Communications Inc. (SBC) 3.3%; American Home Products (AHP), 2.7%; Schlumberger Ltd. (SLB), 2.6%; Caterpillar Inc. (CAT), 2.6%; Motorola Inc. (MOT), 2.5%; Pharmacia (PHA), 2.5%; 3M Corp. (MMM), 2.4%; Anadarko Petroleum Corp. (APC) , 2.3%; Alcoa Inc. (AA), 2.2% and Kimberly-Clark (KMB), 2.2%.

Q: American Home Products was a major holding of yours when we last spoke in April 1998, and it still is. Are you particularly bullish on pharmaceuticals?

A: American Home is a solid, stable drug company; we also hold Bristol-Myers (BMY) and Pharmacia from that sector. Valuations are quite modest for these drug stocks. They are trading at a p-e of about 20, which is a historic low for the sector. These are long-term, stable, solid core-type of companies with reliable earnings, strong financial conditions and a large, diversified portfolio of products. Moreover, the aging population is an outstanding demographic for drugs.

Q: How do you manage sector allocation in the fund?

A: We try to be fully diversified in all industry sectors -- relative to the sectors of our benchmark, the S&P 500, our allocation weights will range from a minimum of 50% to a maximum of 200%.

Q: What is your current sector allocation? Where are you most overweight?

A: As of September 30: technology, 21.5%; consumer staples, 20.0%; financial, 15.9%; capital goods, 13.0%; consumer cyclicals, 8.7%; energy, 8.0%; basic industries, 7.2%; utilities, 5.7%.

We are currently slightly overweight in technology relative to the index; however, keep in mind that tech is usually one of the largest sectors in the benchmark. We have been increasing our exposure to tech: at the end of June it was about 16.0% of the portfolio, today (Oct. 24) it's about 23%.

On a relative basis, our most substantial overweights are in capital goods and basic industries -- but these sectors represent quite small portions of the S&P 500.

Q: Year-to-date through October 19, your fund was down 7.2%, while the S&P 500 slipped 17.9%. In calendar 2000, your fund gained 1.4%, while the benchmark dropped 9.1%. To what do you attribute this outperformance?

A: Early in 2001, we made the right bet on the energy sector (we had a double-weighting there when oil/gas prices were up, then we cut our stake later to a market-weight). We also benefited by betting heavily on the property/casualty insurance group.

We have recently gotten good performance from some defensive stocks like SBC Communications, Kimberly-Clark, Bristol-Myers and Procter & Gamble (PG), which held up well in the third quarter. However, these defensive issues have started slipping in the fourth quarter. However, to offset that, our tech stocks have enjoyed a nice snap-back since the fourth quarter commenced.

Generally speaking, our portfolio is currently leveraged towards stocks which will benefit from the Fed's series of interest rate cuts and by the fiscal stimulus that President Bush will provide. As such, we are avoiding things like electric utilities and moving towards cyclical areas: capital goods, technology and basic industries. From Standard & Poor's FundAdvisor


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