Thursday, May 4, 2006

The Sweetest Spots on Earth

News Article
May 4, 2006

Business Week Online

The Sweetest Spots on Earth

Eric Barden of Texas Capital Growth & Value Fund sees more gains ahead for small stocks, European companies, and cyclicals

Eric Barden and Mark Coffelt can steer Texas Capital Growth & Value Fund (TCVGX ) to invest in companies of any size, style, or nation of origin. With a world of choices, they have a sizable exposure to international stocks, from Europe to emerging markets. The managers also believe small stocks will keep edging out large ones, thanks to stronger earnings growth and easy access to financing.

Barden and Coffelt look for stocks that are inexpensive compared with their intrinsic value. Top holdings of their fund as of Mar. 31 range from energy company Peabody Energy (BTU ) to staffing outfit Manpower (MAN ) to outdoor-gear marketer Sportsman's Guide (SGDE ). Also in that mix are foreign holdings Korea Electric Power (KEP ), Fresenius Medical Care (FMS ), Nomura Holdings (NMR ), and Rio Tinto (RTP ). In addition, they're betting on growth in Austria and Germany via the iShares MSCI Austria Index (EWO ) and iShares MSCI Germany Index (EWG ).

Co-founded by Barden and Coffelt in 1995, Texas Capital Growth and Value boasts a four-star overall rating from Standard & Poor's. The fund has posted 10-year annualized returns of 14.8% through Mar. 31, vs. 8.95% for the S&P 500 index and 11.93% for its style peers. On a five-year basis, the portfolio's 20.58% annualized return handily beats the benchmark's 3.97%, as well as its peers' 8.85%.

Still, its 1.68% expense ratio is above the 1.45% category average, according to Morningstar (MORN ). The fund also charges a 5.75% front-end sales load.

Barden recently spoke with BusinessWeek Online reporter Marc Hogan about small-caps, energy stocks, and where the market may be headed. Edited excerpts from their conversation follow:

First, tell me about the philosophy of the fund. How does being a multi-cap affect your strategy?
We're a little bit different from most funds in that we don't restrict ourselves to any one particular area of the investment universe. Our primary job for shareholders is to maximize the risk-adjusted return. If this means that we need to have greater exposure to international stocks or small stocks -- or value, or growth -- then that's what we intend to do.

The first thing we do is try to ascertain where the maximum area of strength is in the market: Where's the sweet spot? Then we put our CFAs to good use and try to identify companies within that area that are trading at an adequate discount to intrinsic value.

A homebuilder, for example, at 10 times earnings may be relatively expensive to where that company has traded in the past. By the same token, an HMO company might naturally trade at about 20 times earnings. We're looking for companies that we think are undervalued relative to where they've been historically and relative to what their peer group or a private-market buyer may pay for that company.

So, where's the sweet spot right now?
International. Cyclicals, specifically energy and industrials. And basic materials. If you're not participating in those areas of the market, you're really not going anywhere. Within those sectors, our sense still is that the broad market is definitely outperforming the large-cap stocks, so we are fairly light in what most people would consider the blue-chip stocks (see BW Online, 04/17/06, "Blue Chip Blues").

Does that mean you prefer small stocks?
The primary driver for small-cap or broad-market outperformance relative to the blue chips is how available credit is. How accessible is easy financing for small-cap companies? It's not about interest rates, it's about the quality spreads, or the difference between high yields and Treasuries.

Basically, the benefit to being a blue chip is when times are tough, you can still get financing. Right now, even though interest rates are going up, there's still an abundant amount of liquidity out there. There's really no more efficient entity in the world at translating that liquidity into earnings growth than a small-cap company.

The small-cap story today is about earnings growth relative to large-caps, and that earnings growth is primarily a function of how easy it is for smaller companies to get financing relative to the larger companies. In today's environment, if your credit rating's low, you're still going to get financing.

Won't the Federal Reserve's interest-rate moves have some impact?
We don't really think the Fed matters to that dynamic. It's all about the spreads. When the spreads widen, that's the type of environment where the psychology will definitely be more constructive for blue chips and more problematic for small-caps. But that's going to be very near to a bear market. Large-caps outperform in the tough times. The Fed's taking their foot off the accelerator, but they're not slamming on the brakes.

Energy and commodity prices are rising. How does that affect your outlook?
Well, we definitely want to own energy stocks. We don't see that trend going away anytime soon. Analysts are still somewhat behind the curve in terms of anticipating earnings strength in the energy sector. We'll probably see $80 a barrel before we see $60.

The problem for me is that there's no real increase in supply on oil. You've got prices that are extraordinarily high by historic standards, but we still can't get past 85 million barrels a day in terms of production. As long as that's the case, and as long as demand continues to be so robust, the price has got to go up.

I've got a list of your top holdings. Which ones do you consider particularly noteworthy, and why?
Generally, we're going to like all of them for basically the same reasons. Right now the market wants earnings growth, so there's earnings growth at all these companies. On average, the portfolio's got a 37% five-year historic growth rate and a [price-earnings ratio] of 14. That's the profile we're looking for: undervalued growth stocks.

The top holding right now is Peabody Energy. That's really driven by the Powder River Basin coal. There's a preference for Powder River Basin production right now because it's lower sulfur content. The increase in sulfur-dioxide credits has made it much more expensive for utilities to burn high-sulfur-content coal, and that's driving demand into the low-sulfur-content coal-producing regions.

What do you like about iShares MSCI Austria Index, another top holding?
I love Austria. It's one of my favorite markets in the world. It's giving me developed-market stability, in terms of the political institutions being really established, but it's more emerging-market-type growth. It's more a function of what's going on in Poland and the Czech Republic.

European companies are finding labor to be much less expensive in some of these emerging regions, so they're moving a lot of their production toward Austria and some of the border regions. Austria is really at the crossroads. Germany is on one side, and the Czech Republic and Poland are on the other.

We also own iShares MSCI Germany Index. I'm really excited about Germany as well, because I think it's embarking on a process that's very similar to what the U.S. went through in the early '90s, in terms of downsizing. It's going to become much more productive as an economy over the next couple of years. Europe over the next five to 10 years is really going to be an area of strength in the global market.

Any other trends or sweet spots that we haven't touched on?
I love a lot of the health-care companies long term, but they're not working very well in this environment. Health care is going to be something that performs a little better in a defensive market, similar to consumer staples. We're very underweight consumers in general, both consumer staples and consumer discretionary. That might be the Achilles' heel of this economic environment.

The next big rotation, though, could be the financials. Historically, financials start to do very well once people perceive the Fed's about done [raising interest rates]. I don't know if it's one, two, or three more, but we're obviously closer to the end than to the beginning. At some point you would expect financials to outperform.

How about your market outlook for the rest of the year?
I think the S&P 500 is undervalued. Right now we're in the general proximity of the lowest valuation levels that we've seen in the last 10 years, so I don't see how anybody can call this market overly expensive. Certainly, it's been cheaper before, but not in the last 10 years.

My sense is that earnings growth continues to come in stronger than what people were anticipating. And I wouldn't be surprised to see 1600 by the end of next year on the S&P 500. Generally, I think things are a lot better than people think they are.

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