Portfolio Manager Perspectives

Jeff Benjamin

Bad press makes bank stocks a good buy, says equity researcher

Applied Finance Group's Resendes claims it's nearly impossible for BofA and others not to make money at current borrowing rates

Jan 18, 2011 @ 11:10 am

By Jeff Benjamin

There are currently “too many positives” to not be invested in the stock market, according to Rafael Resendes, co-manager of the Toreador Large Cap Fund Ticker:(TORLX) and co-founder of The Applied Finance Group Ltd, an equity research firm. And that exhortation includes purchasing shares of some much-maligned banks.

While acknowledging the elevated levels of “event risk around the world,” Mr. Resendes said the existence of an “accommodative Fed, a divided Congress, and room for economic growth” will continue to support equities.

“It is more likely now that an event around the world would make markets sell off, and there's not much of a cushion for error,” he said. “And it's a little tougher to find big pound-the-table buys at this point.”

However, he added, a disciplined focus on valuation has identified some attractive names in the large cap space.

He cited Bank of America Corp. Ticker:(BAC) as one of the largest positions in a portfolio of just 45 stocks.

“It's hard for banks not to make money when they're borrowing at zero,” he said. “And there is an inordinate amount of negative market sentiment built in to a lot of these larger banks.”

As an equity research firm, The Applied Finance Group strives to evaluate companies on a level economic playing field, with focus factors such as cash generation, competition and future risk versus beta.

In 2006, the Toreador fund was created to apply some of the research to actual fund management.

With just $35 million under management, the fund has yet to hit a lot of investor radar screens. But the strategy appears to be working.

So far this year the fund is up 4.3%, and it gained 13.7% last year.

This compares to the S&P 500 Index, which gained 2.8% so far this year and was up 12.7% last year.

Mr. Resendes said the portfolio utilizes the fundamental research methodology, but is built on a strategy of three main pillars.

There is a focus on identifying management teams that have a track record of creating value.

“Management must be able to reinvest cash at rates of return above the cost of capital,” Mr. Resendes said.

Second, there is a focus on “acceptable earnings quality, with no channel stuffing,” he explained.

And finally, Mr. Resendes said he avoids overpaying by looking for reasonable expectations built in to the share price.

“The stock price is nothing more than expectations about the future,” he said.

For example, in July when Google Inc. Ticker:(GOOG) shares dropped to the $430 range, Mr. Resendes saw a market inefficiency and swooped in to make Google the fund's largest position.

The stock, which has been trimmed by Mr. Resendes but is still among his top five holdings, has soared to more than $620 per share, representing a 45% gain from the low.

“In our opinion, at close to $400 per share, the expectations built in to Google were very attractive,” he said.

A key component to the strategy is the element of economic margin decay, meaning that over time it is normal for the amount of return on capital to decay. And that should lead to a certain amount of portfolio turnover, he said.

“We have a very disciplined process in terms of how we do things,” he said. “Just as it is important to identify an under-valued company, you also want to identify an over-valued company.”

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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