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Stewart: Blue Chips and Financials Look Attractive

Christine Benz

Christine Benz: Hi I'm Christine Benz for Morningstar. Stocks have been on a terrible losing streak recently. Here to provide his perspective on what's going on in the market as well as whether it has presented any opportunities for him is Sam Stewart. He is the chairman and Founder of Wasatch Advisors.

Sam thanks so much for joining me.

Sam Stewart: It's a pleasure.

Benz: So, Sam, I think you're in a good position to assess what's going on in the small- and mid-cap space; that has been an emphasis for your firm for most of its life. I'd like to hear from you about why small and mid-caps have been so hard hit?

Stewart: Well, I think it's worth taking one step back before we talk about small and mid-caps and think about the overall environment in which stocks are functioning and that is we're in this slow, difficult climb out of the financial meltdown that we experienced a couple of years ago. From the start, we have said this is going to be a tough, rocky climb with the kind of the two steps forward, one step back and nothing that we've seen in the economy has contradicted that viewpoint. I think what's happening in the stock market is the inherent optimism of investors occasionally pulls ahead of where the economic fundamentals can support, and then when the fundamentals are revealed, to be just so-so, then investors get pessimistic.

Obviously, in the very short run, the thing that has driven the sell-off is this downgrade, and I would say to investors that I think this is more like a psychological impact on the market than anything really substantive. But small and mid always tend to be like the end of the cliff. So, you get some of your big, stable companies like Wal-Mart or McDonalds, and they are going to be down 2%, 3%, 4%, 5%, or something like this. And by the time you get out to some of the smaller-cap companies, you are seeing moves that are down 20%-25%. I think that is just inherent in the nature of a small company. Big companies tend to be diversified, so they've got a lot of different things going and they can never be too strong. Yet the flip side of that coin is they never be too weak.

Smaller companies tend to focus on narrower lines of business and so here in reality your business might struggle or investors worry that their business might struggle, because they are just not as diversified. So, I don't think there's anything particularly unique to small and mid-cap companies in this decline that is different from any other decline. I think in general, these stocks exhibit a higher beta, and we're just seeing a higher beta in action right here.

Benz: Right. So was it your view, and I know you're a bottom up investor, but was it your view coming into this sell-off that small and mid-caps were less attractively valued than the large caps?

Stewart: That's a tough question, Christine. If you look at the statistics, what we see is that in general the valuations of smaller and mid-cap companies relative to the larger companies, even coming into this downturn, were somewhat elevated relative to history. Now, one can make all sorts of arguments about why that elevated valuation is actually justified, but I do think the relatively rich valuations of these smaller companies have definitely contributed to the sell-off.

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Benz: Okay. So, I guess the question is going forward, if you're putting money to work in the market these days and if so on your strategic income fund which is kind of an all-cap portfolio where are you finding things to buy?

Stewart: Well, the most interesting names to me fall into two buckets. One, bucket is the blue-chips and that is very different from the small and mid-caps. But basically what you have in the blue-chip stocks is they came through the dot-com bubble, and people just rushed to these stocks. So, you had a Wal-Mart selling I believe maybe at 50 times earnings back in 2003. And people saw that this isn't really a dynamic role, it's a steady-Eddie. The multiple has gradually come down 50, 40, 30 and now you are in the neighborhood of 10 times earnings for Wal-Mart. And these big companies have really not moved for years and years. So, even with the sell-off being more severe for the smaller companies, the big companies are still relatively attractive.

The other part of the market that is interesting, for strategic income in particular is the financial area, and I'm sure everybody that reads any sort of headlines knows that financial stocks have really been crushed. And there are some good reasons that many of our financial stocks have sold off, but I believe we're in a baby with the bathwater situation where, yes, there are some financial stocks that probably deserve to trade even lower than where they are, but there are some other ones that are pretty attractive. So, in strategic income we've kind of got to balance from between some traditional big blue-chips and some of these smaller special-situation finance companies.

Benz: Can you give us an example of a finance company that you like that's kind of a baby that has been thrown out with the bathwater?

Stewart: Yeah. I'll give you a couple of names, one of them is Northstar with the ticker NRF and it is a commercial real estate mortgage REIT. It is one of the few commercial real estate mortgage REITs that survived through the recent financial crisis. The dividend is currently about 12%. Northstar just raised some money in the low-$4 range of the stock cut under $3 on Monday. I think it's maybe back up to $3.50. But the firm has a 12% dividend yield; it has some dry powder to put to work. It has been successful in working through the commercial loans that it has on their books, and I think it's a solid management that has demonstrated their stripes.

Another name is CapitalSource Bank with the ticker CSE, and it is a regional bank in terms of deposits. California is where it's located, but it's national vendor. You read in headlines about banks struggling to grow their loans; CapitalSource has been growing its loans at a 10%-15% clip because they have this national lending franchise. It's selling below book value, and the bank holding company has excess capital where it just made a commitment to distribute to shareholders. So, those are two very interesting smaller-cap financial situations.