Bargains in Consumer Discretionary

Courtney Dobrow: Well, digging into the portfolio a little bit, you have a pretty significant consumer discretionary exposure in the fund, and few of the new names in the portfolio this year are retail names; Gap and J.C. Penney. I'm curious to hear your theses on both of those.

Stan Majcher: Sure, I think, when you look at the Mid-Cap portfolio, about 20% is consumer discretionary, and I think people extrapolate that to, "Well, we must have a certain opinion on the economy."

Personally, I'm a believer that it's very difficult to predict what the economy is going to look like--things like interest rates, commodity prices--economies are very difficult to predict with consistent accuracy. We don't necessarily have a position whether the economy is going to boom or bust, which surprises people when they see 20% in consumer discretionary.

What we're focusing on is really, what are the normal earnings power of these companies, and what if we're wrong, how significant of evaluation risk are we taking? So, the companies that you mentioned, Gap, J.C. Penney, that makes up actually a healthy portion of that consumer discretionary weight. There is a number of other companies in there that are actually fairly similar.

About 75% of that 20%, or about 15% of the portfolio, is trading at about 11-12 times current earnings. So, I would describe that current retail or consumer environment as not particularly strong. Actually, I think most people would characterize it as fairly weak. But they're trading at multiples below the market, and the earnings power of the company today are depressed. So, if you believe that it even gets marginally better, those companies are significantly undervalued versus the market.

The ones you specifically mentioned Gap and J.C. Penney, an added benefit of those is, they trade at reasonable multiples of current earnings, lower multiples of what we think normal earnings power is, and they also have very good balance sheet. So, in the case of Gap, there is a couple of dollars a share of cash with no debt. In the case of J.C. Penney, there's couple of billion dollars of cash on the balance sheet. Their leases are at very low rates, so they own a lot of their properties. The properties that they don't own, they lease at very attractive rates. So, their balance sheet is actually much better than it looks like on the surface.

Those companies buy back stock, which in the case of Gap is doing it in a significant way. The stocks are even more undervalued than they are today. So, in a nutshell, why we own those stocks specifically in consumer discretionary, we don't have to take a position on what happens with the economy or the consumer. As long as it stays similar to how it is today, we're buying at significantly depressed prices versus the market.

Dobrow: Switching to financials; it's obviously a significant part of the index and of the fund. I think you're about equal weighted right now. It looks as though you've been emphasizing regional banks and insurers. Can you talk a little bit about the positioning there?

Majcher: Sure. Obviously, as a value manager, when there's a crisis of any type--in the late '90s, it was energy, where we added significantly to energy--given the financial crisis, we added a lot to financials during the financial crisis. What we find with the regional banks and the insurance companies, particularly the regional banks is, they are a valuable part of the economy. We really need a vibrant regional banking system.

What we find is that the reason the stocks are depressed is because there is uncertainty about the earnings. We think that it's reasonable that these companies should earn a decent ROE because they are a viable part of the economy. And so what we think investors are skittish about is that a lot of these companies are earning very low rates of return today. Profitability is very low because they're taking significant provisioning expenses for loans.

We think over time that provisioning goes the other direction, people will realize their normal earnings power and the stocks are trading at eight or nine times earnings. So, huge discounts for the rest of the market--something that in the foreseeable future we see returning back to normal levels of profitability. Stocks in the case of the regional banks, as well as the insurance companies, are trading at or below book value. So, we think historically if you have invested on those type of investments theses, you do fairly well in financials.

Dobrow: Technology, not typically huge area for value managers. I've talked with some folks who have mentioned a lot of traditional growth names that are sort of become available in the value space. Have you found that to be?

Majcher: If you look at technology, the last time it was a booming industry, it was the late '90s Internet. So, for the last decade or so, or even longer, it's been really out of favor for most of the market. Why do we like technology? We can find some stable businesses in there, with very strong recurring cash flow, particularly in software, where the balance sheets are very good.

So, companies have net cash on their balance sheet; they're not very cyclical, and so we find companies trading at 9, 10 times earnings that have great balance sheets and low risk of issues with the free cash flow variability--so very stable businesses at very low prices that trade at discounts because they're grouped in the technology business.

If you were to find that same stability of cash flow with those balance sheets somewhere else, you'd have to pay a very high price.

Dobrow: So, being in the mid-cap spaces, is M&A activity something that you're thinking about?

Majcher: We think about it, we don't necessarily take it into account when we're making an investment. We're basing it as if a company is stand-alone. You never really know how likely it is, but when you look at acquisitions in technology, there are a lot of efficiencies that can be gained by one company buying another company, taking costs out, running it over a similar platform, running it over a similar salesforce. So, there are a lot of opportunities for mergers and acquisitions activity. We think some of our companies are likely candidates. We have seen some of that in the companies that we own. So, we think it's a benefit, but it's not the primary reason we own the stocks.

Dobrow: In terms of valuation, the portfolio looks pretty cheap right now. I just wanted to get your thoughts on how you feel it's positioned?

Majcher: Sure. It trades at a significant discount. What we look is normal earnings. So, we don't use this cyclical boom or the bust. We think the portfolio trades at about nine times. When you look at all of the statistics for the portfolio, not only is it trading at a single-digit multiple of earnings. The balance sheets of the companies are very good about 20% of the portfolio has actually net cash on their balance sheet. So, we think that's an added benefit. Not only you're getting low risk securities, but at very attractive valuations.

Dobrow: All right. Well, thank you for being with us here today.

Majcher: Thank you.

Dobrow: I'm Courtney Dobrow with Morningstar.