It's Buy Time

Some of the best fund managers say stocks are now a bargain.

Jeremy Grantham, founder of money manager GMO, has a long record of making on-target market forecasts. During the height of the technology bubble in 2000, he urged investors to buy real estate and value stocks. In 2007, he said that sub-prime mortgages would collapse and investors should take cover in Treasury bills. Those calls proved remarkably prescient. So what should you buy now? Blue-chip stocks, says Grantham. The GMO chairman says that stocks are the cheapest they have been since the 1980s.

Grantham is not the only prominent investor pounding the table for stocks. Some of the most outstanding fund managers have turned bullish. The list of buyers includes Marty Whitman of Third Avenue Value and Mason Hawkins and Stanley Cates of Longleaf Partners.

Despite this optimistic chorus, millions of panicked shareholders have been dumping their equity funds, according to Morningstar. In September, investors withdrew $49 billion from funds — a record. The flow of withdrawals continued in October.

At a time when the economy is sinking, angry clients have been besieging advisors, demanding to sit on the sidelines in cash. But most clients should continue holding stocks. For 200 years, investors have earned big returns by buying U.S. stocks during downturns and holding patiently. The pattern is not likely to change now — no matter what the newspaper headlines say. “When stocks are down 40 percent, that is a great time to buy,” says Kurt Brouwer, chairman of Brouwer & Janachowski, a financial advisor in Tiburon, California. “Advisors need to communicate to clients that the idea is to buy low and sell high.”

Value Or Growth?

Advisors who believe the bullish case may be inclined to try aggressive growth funds now. These often skyrocket when markets climb. But aggressive choices also fall hard during downturns. To give clients a smoother ride, advisors should consider funds that take modest risks. Such steady portfolios can participate in bull markets — while avoiding the worst damage in downturns.

For many clients, funds that own blue chips may be the ideal choice. Big familiar stocks could prove relatively resilient in difficult markets. To bet on blue chips, consider Jensen, which holds the highest quality names. The Jensen portfolio managers only take companies that have delivered returns on equity of at least 15 percent for 10 consecutive years. According to academic research, businesses that thrive for a decade are likely to continue prospering in the future.

Only about 100 companies are profitable enough to pass the Jensen test. The portfolio managers screen the names on the list and select 25 stocks for the portfolio. Those in the select group tend to be dominant businesses with long records for increasing profits. Such companies have the ability to survive downturns. “Many of our companies should continue reporting growing earnings, even if the economy gets worse,” says portfolio manager Robert Zagunis.

Big holdings include Procter & Gamble and 3M. A particularly resilient choice is Stryker, which provides replacement systems for knees and hips. Demand for those products should continue growing steadily as the population ages.

Investors looking for blue-chip value stocks should consider Eaton Vance Large-Cap Value. Portfolio manager Michael Mach seeks market-leading companies with strong franchises and solid balance sheets. He prefers stocks that pay dividends — and increase them regularly. To limit risk, Mach diversifies by buying companies in a variety of industries. “Our goal is to protect assets in tough markets, says Mach.

A classic value investor, Mach aims to buy stocks with price-earnings ratios that are below the multiple for the S&P 500, which is currently around 13. When shares appreciate above the market multiple, he begins to think about selling. Big holdings include Hewlett-Packard and AT&T.

Small Cap Funds

Among the steadiest small-growth choices is Baron Growth. Portfolio manager Ron Baron buys companies that can report sustained growth for three to five years. His favorite companies are well financed and dominate their niches.

Baron often avoids technology stocks because the earnings can be unpredictable. Instead, he looks for steady performers that can improve over time. Many holdings are in business services and consumer goods; a strong holding is Lamar Advertising, which owns 150,000 billboard displays in 44 states. Because of tough rules limiting billboards, Lamar faces few competitors. “Lamar's cash flow will go down as the economy slows, but this company has plenty of resources to survive,” says Baron.

For a small cap fund that can thrive in a variety of market conditions, try Natixis Vaughan Small Cap Value. Portfolio manager Chris Wallis sometimes buys deep value stocks that sell for half of what their assets are worth. Under other circumstances, he takes companies with strong competitive advantages and the ability to grow. The resulting portfolio can include a mix of growth and value.

Lately, Wallis has been finding the best picks among stocks with solid growth prospects. A favorite holding is Pactiv Corp., which makes Hefty bags. The company's sales are relatively steady in recessions. Profits should be particularly appealing during this downturn because commodity prices have been collapsing, helping to reduce the company's costs. “Pactiv has predictable revenue streams and high returns,” says Wallis.

Another holding is SRA International, which designs systems used for defense intelligence. Wallis says the company has a healthy balance sheet and is poised to grow because of government contracts.

To buy foreign blue chips, try Harding Loevner International Equity. The fund avoids rapidly growing businesses, which are prone to disappointments. Instead, portfolio manager Simon Hallett looks for high-quality companies that can increase earnings 10 percent annually for years. Hallett concedes that some of his holdings may have trouble showing growth in the next year, but he argues that blue chips should revive when the economy recovers.

To avoid surprises, the portfolio includes big stakes in consumer staples and health care. “Even in a recession, consumers will continue showering, shampooing and shaving,” says Hallett.

Hallett likes global brands that are expanding in emerging markets. A long-time holding is Nestle, which derives one-third of its revenues from the emerging markets. Hallett says that sales of the food giant tend to grow a bit faster than the global gross domestic product. In addition, the company improves its margins through price increases and cost controls. Nestle and other blue chips may rarely produce much drama, but they can help funds like Harding to stay afloat in harsh times.

BULL MARKET FUNDS

To prepare for the coming bull market, buy these steady funds.

Fund Ticker Category Three-year Return Five-year Return % Category Rank Five-Year Return Maximum Front-End Load
Baron Growth BGRFX Small Growth 1.5% 8.0% 19% 0%
Eton Vance Large-Cap Value EHSTX Large Value 3.4 9.6 3 5.75
Harding Loevner International Equity HLMNX Large Foreign Growth 3.9 10.3 29 0
Jensen JENREX Large Growth 3.6 4.8 30 0
Natixis Vaughan Small Cap Value NEFJX Small Blend 6.1 10.8 14 5.75
Source: Morningstar. Returns through 9/30/08.
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