Large Caps, Larger Potential


"Think of stocks as a partial ownership in a business," advises Richard Cervone, managing director and portfolio manager of the Putnam Investors Fund (PINVX). That's a key to the strategy he recommends -- and practices in running the fund. He seeks out undervalued large-cap companies with managements dedicated to serving shareholders and outperforming the Standard & Poor's 500 index (the fund was 2.5% ahead over the last year).

Cervone sees high oil prices as "one negative offset by a lot of positives" for the current market. And he points to financial services as one sector with undervalued stocks he likes, especially Commerce Bancorp (CBH), Capital One Financial (COF), and Countrywide Financial (CFC).

Among consumer stocks, Cervone cites as favorites Autozone (AZO) and Harley-Davidson (HDI). He compliments Autozone for favoring profitability over expansion -- and thus avoiding the overextension some retailers fall victim to.

Cervone made those and other points during an investing chat presented Mar. 10 by BusinessWeek Online on America Online, in response to questions from the audience and Jack Dierdorff and June Kim of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

Q: Rich, this market is up and down, down and up -- what do you see in the outlook?

A: Well, the markets are always volatile, and maybe more so lately, but there are a few key things to focus on lately. The economy's in great shape, we have great job growth, it's accelerating a bit, corporate balance sheets are very strong, credit costs are low, and interest rates are very low, so I think things look very good economically.

High oil prices are something to watch, but that's one negative offset by a lot of positives. The day-to-day volatility is something that we shouldn't be overly concerned with, but rather focus on the strength of the market and the strength of the fundamentals.

Q: How about the energy sector generally? Any favorites?

A: Yeah, the No. 1 issue is what's going to happen with the price of oil. In the short run, we're looking at a situation where they could remain at these elevated levels. But we still believe it's up from its long-term value, so we believe prices will drop. Go with your strong performers, like Exxon Mobil (XOM), because even in the decline, those stocks should hang in there. Some good stocks should remain up, and there are some excellent companies and great buys in the sector.

Q: What about pharmaceuticals? Would you be a buyer of Pfizer (PFE) at this time?

A: I think I would. I think the industry is pretty risky, and I think that risks have always been present. It's the risk that something goes wrong with one of your drugs, like Vioxx. These are businesses that also have to replenish their product pipeline. The opportunity now is that most investors are very negative on the sector. There are good reasons for that -- fundamentals are pretty weak.

We own Pfizer, and I own Merck (MRK). I would characterize them as somewhat above-average risk, but if you're willing to take a three- or four-year view, you'll probably end up with a pretty good return, longer-term. The dividend yield on both of these stocks is nice, too.

Q: Is Microsoft (MSFT) ready to start moving north?

A: We think it's a solid business and a moderately undervalued stock. We do own it and think it will be a good holding going forward. That said, it's a large company now, and its periods of 15% growth are over. What you see now is an adjustment by investors -- people have to get used to these companies growing at much slower rates. Cisco (CSCO) and Microsoft are both pretty cheap, but they'll never be turbo-growth stocks again -- maybe 10% plus or minus. You'll also see more dividends on these stocks, so essentially these are going to be different investments going forward.

Q: What are some of the undervalued companies you've been finding?

A: We're finding a lot of value right now in the financial services sector, and we think it's a classic situation related to the Fed tightening. Three of our top holdings are in that sector.

Commerce Bancorp is a bank that has been growing its branches at about 20% a year and [has] earnings growth north of 20% as well. Capital One Financial is also exceptional -- they trade at a little more than 10 times what we think they'll earn this year. Countrywide Financial is also becoming a real powerhouse in the mortgage business. They make a lot of money servicing mortgages. They have a small S&L and a broker-dealer they've just started. So they've diversified their earnings stream and are well positioned.

Autozone has had a tough period over the last year with weak same-store sales, which have actually slightly improved lately. The company generates incredible cash flow and is very focused on profitability over expansion. That's a smart strategy for a retailer, because one risk you often face in retailers is overextension. We think the revenue will pick up, and it's a very cheap stock with a management team very dedicated to shareholder value.

Q: What sectors besides financial services catch your eye?

A: We're finding pretty good value in the tech sector these days. A number are down right now. We have large holdings in Cisco and Microsoft, and we also think Dell (DELL) is fairly attractive right now. I'd say tech stocks are only moderately overvalued right now, because even though valuations are growing, companies are continuing to put money into IT spending and will do so for quite some time. I'd add Symantec (SYMC) as another.

Q: Given the relative underperformance of large caps, how has the Putnam Investors Fund been doing?

A: The fund has done quite well, about 2.5% ahead of the S&P 500 over the past year and 2% over, annualized over the last three years. Again, while large caps as a group haven't done well, there are certain stocks that have. We look for those undervalued ones and attempt to deliver investors a return marginally higher than the S&P 500 over the long term.

Q: You talked about Autozone in the consumer area -- any other consumer stocks you like now?

A: Yeah, Harley-Davidson (HDI) we think is a very good idea here. It's a great company, and everyone is aware of their franchise. Since the growth rate has slowed a bit, the stock has gotten cheap. The company has no debt and a nice helping of cash on their balance sheet. They grow their dividend, buy back stock every year, and are very opportunistic when the stock's down.

Q: What are your thoughts on DuPont (DD) stock? I have a fairly large amount and don't know whether to hold or sell. Ditto for IBM (IBM).

A: We think that whole area's fairly expensive right now. They've had a very good run, with good fundamentals, but we'd generally avoid that whole area right now. I think if I were going to own DuPont, I wouldn't own a lot. You could potentially sell some DuPont and buy some of those I mentioned earlier. I think IBM's reasonably attractive here. Pretty low risk, and we actually own it in the Investors Fund.

Q: How about the metals? Alcoa (AA)?

A: We think Alcoa's a reasonably interesting stock here. It's got about 20% to 25% upside to fair value, and we do own it in the Investors Fund.

Q: What sector should do well, considering the falling dollar

?

A: We don't spend a lot of time thinking about the dollar. Clearly, anybody who exports is in a better position, but we really try to focus on the business fundamentals, apart from currency. I wouldn't invest in stocks based on that. If you have a view on currency, you're probably better off playing that directly by owning other currencies.

Q: How about Texas Instruments (TXN)? And the chip sector generally?

A: We don't think that stock's all that compelling. In the area, we'd rather own Intel (INTC). We also own Sandisk (SNDK) -- that is very undervalued. We'd prefer to own those two over TXN. We underweight the chip sector vs. technology in general. Apple (AAPL), despite being up significantly over the last year and even though it's risky, has a lot going its way. The impact of the iPod, the introduction of the Mac mini -- consumers are going to be very receptive to purchasing Apple products. We'd rather own Apple than many of the semiconductor companies. This is in addition to the names in tech I've already mentioned.

Q: What do you think about Best Buy (BBY) and eBay (EBAY)?

A: We own both stocks. We just started buying eBay. We've been buying it in the low 40s, high 30s. We also own Best Buy -- they represent very good value. A fairly well-run company, though volatile quarter to quarter. They do have a solid competitive position going forward, though, and we believe the stock's cheap right here.

Q: Do you like anything in real estate?

A: We do -- we own one REIT. While the sector's fairly fully priced, we do own General Growth Properties (GGP). They own malls throughout the U.S. They have the best management team in the business, a great collection of assets, and as a whole are very committed to shareholder value. The shares are moderately undervalued here, with a decent dividend yield, 10% growth in FFO [funds from operations], mid-teens or slightly higher dividend growth over the next five years -- and you have the makings of a solid pick over the next five years.

Q: Is there anything you've been selling lately -- and why?

A: We trimmed some. Express Scripts (ESRX) because it has had a large move and is fully valued. As the undervalued stocks move up, we reinvest the proceeds. We've also trimmed some Altria Group (MO). We still own it, still think it's attractive, but have lightened up as it's moved higher. We've also trimmed some Ace Limited (ACE), an insurance company that has had a big move lately.

Q: Does the Putnam Investors Fund aim for growth or income or both?

A: It's really a fund that focuses on total return. We just try to outperform the S&P 500 by generating a return in excess of that index. So, you could think of that as growth and income.

Q: Are there any other stocks you really like?

A: Sure. We've covered a lot of my favorites, but we think the homebuilders, especially NVR (NVR), are very attractive. This company is very well run. All of their land is purchased through options. Management stock buyback is high. These continue to be very cheap stocks, and while we believe a slowdown is inevitable, some of this has been priced in. There's still a lot of upside.

Lennar (LEN) is our second pick. This is a sector that's not very well understood. It has always been cyclical, but the major homebuilders are far better run than they have been. There's much less financial and operational risk than there has been in the past, and that justifies a higher valuation in their shares.

Q: So what general strategy would you suggest for investors in the current market?

A: We think the best strategy is to think of stocks as a partial ownership in a business. Focus on learning about the business and the value that's there. Get a good sense of a fair value from there, buy when the share price is below that value, and focus on better companies with good management with dedication to shareholders. That will generate value for you over time.


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