Portfolio Manager Perspectives

Jeff Benjamin

Some cost-cutting companies flying under investors' radar, says Robeco Boston Partners' Donovan

Feb 16, 2010 @ 3:18 pm

By Jeff Benjamin

Despite last year's rally, there remains a pocket of opportunity among those stocks that have lagged the overall market, according to Mark Donovan, manager of the $500 million John Hancock Disciplined Value Fund Ticker:(JVLAX).

The key, he said, is identifying companies that “really buttoned down their costs over the past couple of years,” but that have not yet been rewarded by the market for doing so.

“Anytime you're coming out of a recession you want to be exposed to operating leverage,” Mr. Donovan said. “These are the companies that tend to be the most economically sensitive.”

Caterpillar Inc. Ticker:(CAT) is an example of a stock that Mr. Donovan does not own because the forward price-to-earnings ratio of 21 suggests that the market is already anticipating the company's robust operating leverage.

Caterpillar's P/E is 50% higher than the S&P 500 average of 14.7.

“The bar has been set pretty high on Caterpillar,” Mr. Donovan said. “I want operating leverage only if people are still skeptical and not already paying a high price for the stock.”

The same operating leverage analysis applied to Equifax Inc. Ticker:(EFX) paints a different picture.

The company's 2009 revenue was down 6% from 2008 and the market has low expectations for 2010 revenues, Mr. Donovan said.

Equifax, which has a deep database of credit information on businesses and individuals, has a forward P/E of 13 and 10-year average P/E of 16.

“The bar has been set low for Equifax and that makes the expectations easier to beat,” Mr. Donovan said. “This is still a business in the trough of its cycle.”

Mr. Donovan, chief investment officer of Robeco Boston Partners, which manages $12 billion in assets, said the general valuations of stocks have compressed over the past year from some pretty wide-ranging P/E ratios.

“We've been through quite a roller coaster ride the last few years,” he said. “I'm not just talking about where the stock market closed every day, but to the degree with which valuations compressed and dispersed.”

In a compressed valuation market, individual P/E ratios of the companies making up a particular index will fall into the same value range.

But in a dispersed valuation market, the stocks deemed by the market to be safest are pushed to overvalued levels while the riskier stocks are getting less expensive.

“If investors see companies deemed to be in great stress, those companies will become very inexpensive, but at the same time they will pay any price for safety,” he said. “When people want safety they will pay a high premium for it, and that tells us when the market is on sale.”

A year ago the market was in such a dispersed state that Mr. Donovan said he had to “rethink our valuations.”

Over the past year, valuations have compressed to the point of a more balanced level, he said.

“There's always going to be a healthy population of names that deserve to be cheap,” he said. “But in markets like this, it's best to try and err on the side of quality.”

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives .


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