Despite a relatively buoyant economy, U.S. equity markets have been on a roller-coaster ride this year, thanks to stubbornly high oil prices and steadily rising interest rates. Yet fund managers are looking beyond the gloom and maintain there are many attractive opportunities.

“There has been a pullback since the beginning of the year — much of it because of oil prices, which rose 30% through to the end of March,” says Mary Chris Gay, senior vice president at Baltimore-based Legg Mason Capital Management, who works closely with Bill Miller, portfolio manager of CI Value Trust Sector Fund. Interest rate jitters have also driven down many sectors, she notes, on concerns that the U.S. Federal Reserve Board will tighten rates another 25 basis points in June, pushing the overnight rate to 3.25%.

“If you step back from the stock-specific volatility we are seeing in the U.S. market and look at the underlying fundamentals, we are very optimistic about the outlook for the economy,” says Gay. “There are no big imbalances.” Cash on corporate balance sheets is at record levels, she notes, and “earnings quality is the best it has been in 15 years, according to Empirical Research Partners.”

She points to other positive signs, such as expectations of share buybacks, and growing numbers of private equity funds that are pursuing opportunities. “The surprise this year could be that it is a surprisingly good time for equities.” She says market conditions are similar to what occurred in 1995, when the Federal Reserve Board engineered a “soft landing,” and large-cap growth stocks came back into vogue.

While the Legg Mason team monitors macro-economic trends, it takes a bottom-up approach and focuses on 36 stocks it believes are trading at a discount to what they are worth. It also tends to be contrarian and takes positions when investors stay away because of uncertainty.
One typical holding is UnitedHealth Group Inc., which was acquired in mid-1998 when it fell on news that the Clinton administration intended to bring in legislation that would have changed the economics of managed care. Miller estimated the stock could double its then-US$9 a share (on a split-adjusted basis), but management delivered even greater efficiencies than expected. Shares are now trading at US$98. “Returns on equity are close to 40%, compared with 12% in 1998, and operating margins have gone to 11% from 5% as a result of changing the business model,” says Gay. “We own it because it continues to trade at a 20%-25% discount to what we believe it is worth. Each year it has incrementally added value.”

Another favourite in the unhedged fund is Eastman Kodak Co., which was acquired in late 2000. “It’s a name with a disconnect between the perception and the reality of where the company is going. Even if there was a recent setback in earnings news, we still believe its fair value is significantly higher than where it’s trading,” says Gay, noting that, at US$24.50, the stock is selling at 10 times 2005 earnings.

The company had a rough start this year, with first quarter consumer film sales falling 29% world-wide. But she attributes this to inventory reductions, especially in the prized Chinese market.

“On a fundamental basis, it appears that the company is under-valued. It’s declining in the more mature markets, but its capital investment is being deployed in Asia, which is the engine of growth for many technology companies.” Bought in the mid-US$40s, Gay believes it should return to that level within 12-18 months.

Rhonda Dalley, manager of TD U.S. Equity Fund, concurs that rising interest rates and high oil prices have created headwinds for the U.S. economy. “They have also been headwinds for any sort of multiple expansions,” adds Dalley, vice president at Toronto-based TD Asset Management Inc.
“I’m not expecting multiples will expand, but the market will move more in line with earnings growth, which could be 6%-8%, plus a dividend yield of 1.5%-2%.” At present, she describes the market multiple of about 16-17 times earnings as “pretty good.”

As merger activity continues, Dalley notes share prices have remained stable. “We’re not seeing the lofty premiums companies paid in 2000. As a result, the acquirers’ share prices are not being hurt,” she observes. “Prices are hanging in nicely.”

@page_break@A growth-at-a-reasonable-price, bottom-up investor, Dalley runs a 95-name fund that is unhedged. The top 10 names, which account for 22% of the fund, include about five names that are industry leaders and boast excellent management teams. “It’s not hard to justify liking them because the fundamentals are so good,” she says, referring to names such as General Electric Co. “But at best, they offer fair value.”

The other top five names are regarded as supplemental. These firms have seen their share values fall because they either missed their earnings estimates or suffered from poor execution. “It’s hard to put money into companies where things are not going smoothly, but this is where opportunities lie.”

For instance, two years ago, she acquired Darden Industries Inc., the restaurant chain that includes the Red Lobster franchise. The firm’s shares had fallen to US$19 because it had an earnings miss and traffic was lagging. “But these issues were temporary.
It came up with a new menu and new management, and now everyone loves it.”
Darden, which is still in the fund, now trades at US$31.25.

In a similar vein, she bought Boston Scientific Corp. earlier this year. The firm is the market leader in drug-coated stents, but investor concerns about its growing competition pushed its share price down to US$29 from US$40.

“That is valid. It won’t have this field to itself forever,” says Dalley. “But in the short term, its only other competitor is Johnson & Johnson, which happens to be capacity constrained.” While others may join the field by 2008, the firm is expected to “coin cash,” Dalley says, noting it should generate more than US$5 billion in free cash flow until then.
“We’re counting on management’s execution of the current pipeline and the smart use of that cash.”

At 13 times 2006 earnings, she adds, “We’re getting paid to see what management does with this money.” In the expectation that the firm will acquire smaller medical device makers, she believes the stock could rise to the high US$30s, although she won’t give a time frame.

Another favourite name is Merrill Lynch & Co.
Inc. A leader in brokerage services, it stands to benefit from a continuing strong merger and acquisitions environment, says Dalley.

“It is also less exposed to the slowdown in fixed-income business as interest rates start to rise. And it has a very large buy-back program,” she adds, noting the firm recently
announced a 25% increase in dividends.
Finally, its valuation, at 1.5 times book value, is close to its 10-year low. “That sounds like a good investment at this level.” In the fund’s top 10 for about a year, the stock is now trading at US$54.

There is a puzzling dichotomy between the economy and markets, notes Heather Peirce, manager of AIM American Growth Fund, and vice president at Toronto-based AIM Funds Management Inc. “The economy is growing nicely, inflation is low and businesses are throwing off excellent cash flows,” she says, adding that firms are also increasing dividends and buying back shares.

A bottom-up, GARP investor, Peirce runs a concentrated portfolio of 38 names, in which the top 10 account for 40% of the fund. One favourite is Costco Wholesale Corp., a leading retailer she acquired three years ago at US$39. “It’s cash-flow positive and announced a buy-back program a few weeks ago,” she says, noting management intends to boost operating margins to 4% from 2.8%. “It has a strong management team; they are great buyers.” Peirce, who recently added to the position on weakness concerning low margins in the gasoline industry, notes the stock is now US$43 or trading at 16 times 2006 earnings.

Another top holding is Millipore Corp., a biosciences firm, whose technology is used in many applications including the manufacture of injectable drugs. “It is the market leader in the area of monoclonal antibody production,” says Peirce, noting it makes oncology drugs such as Avastin for Roche and Genentech. “The barriers to entry in this business are extraordinarily high.
When they are ‘speced’ in to a product, companies such as Roche are unlikely to change because of high FDA manufacturing regulations.” But Pierce did not buy into the stock until early this year, when the firm hired Martin Madaus, a former Roche executive with a history of boosting profitability. “We believe the firm will improve operating margins. It has operated in the mid-teen range for a long time, and should be in the mid-20s,” she says. “I expect an eight-point improvement in the next five years.” Acquired at US$45, the stock is now trading at US$50. Pierce says the stock could be worth US$70 in three years.

Peirce also likes IAC/Interactive Corp., an Internet firm best known for owning expedia.com, ticketmaster.com and hotels.com. “It has strong management and an entrepreneurial culture,” she says. Many of its businesses still have to tap their full potential; for instance, expedia accounts for only 2% of global travel markets. “This has incredible ramifications for growth in the next decade,” she says. Acquired three years ago at US$24, the stock is still at that level, which Peirce attributes to concerns about the travel industry. Its price/earnings multiple is 22 times, “yet it is growing faster than the market,” she says. “I see no reason why it can’t be US$30 in the next 12-18 months.” IE