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4 Stocks To Take Advantage Of An Improving Economy

Randall A. Cain Jr., CFA

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4 Stocks To Take Advantage Of An Improving Economy

07/22/2013

Forbes

Forbes, Wallace 

Randell Cain, CFA, Portfolio Manager, Aston/Herndon Large Cap Value Fund

Randell Cain: The market that we've been in going back to mid-March of 2009 has really been almost one directional — and that's been up. This has been a very positive thing clearly for those who have been willing to stick out some of the negative sentiment and negative comments that have been made about the market. The gradually improving economy and the stock market being at very low levels in terms of valuation have provided some really neat opportunities.

We've been able to do fairly well for our clients in this environment and we still think that the market is well positioned where it is right now — although we do think there's a transition taking place. And the transition taking place is really one where the defensive orientation that investors have been taking has prevented them from investing in the more cyclical areas of the economy. As a result, certain sectors have become overvalued and getting too much attention. Other areas are still pretty attractive.

Wallace Forbes: Which areas are getting too much attention and which too little?

Cain: Well, the areas that we think garner too much attention for a variety of reasons including their defensive orientation and the yields associated with them are the utilities, the telecoms, some parts of consumer staples that are a bit more domestic oriented, healthcare, and predominately the large-cap pharma companies. And right now you're still seeing some residual effect of that with some of the financials — which are clearly doing better fundamentally. But we believe a lot of that good news has been priced in.

Forbes: So those are all areas that you feel are fully priced or overpriced?

Cain: Yes.

Forbes: What are the ones that look good to you?

Cain: Well, the ones that are looking good to us right now are those more cyclical areas such as energy, materials, technology, consumer discretionary and, although I've mentioned consumer staples, it's more the multinational names that are of interest to us there. Those five sectors are where you would see overweights in our portfolio, whereas the others would be underweighted and industrials being about market weighted.

Forbes: Very clear backgrounding. Now what specific stocks do you like or not like?

Cain: I would categorize it more in terms of the overweights and the underweights that we have. It's almost been like a barbell approach to some degree. While we're not as extremely overweight as we were at one time, we still have our most significant exposure in the energy space.

We're experiencing an improving economy domestically. Some people disparage the success we're having economically and call it, “The best house in a bad neighborhood.” I look at it from the perspective that at one time we were going into the recessionary period and you had the non-U.S. developed markets as well as developing markets that were then doing better.

We were considered to be more of the tail of the dog. Now it appears that we're kind of becoming more the dog and these other countries are lagging behind us and becoming the tail. Nevertheless, there's a yin and a yang in the fluctuation of the economies and, over time, the leader tends to pull the others in that direction.

To some degree, I believe the U.S. economy led the others into a recession and now I believe that the U.S. economy will gradually lead these other countries out. As a result, there are certain areas where demand will pick up.

You've already seen oil prices that have moved up probably much higher than what many other market prognosticators would suggest that they should be. But you haven't seen energy as being a market leader in terms of stock market performance. Some areas have been compromised a bit, such as the refiners, which had a really strong 2012. They started off the year well but they've given some back of late because of differentials between West Texas Intermediate — our domestic proxy for oil prices — and Brent — the international proxy. That spread has collapsed. What you see when that happens is that profitability goes down. In addition, there are concerns that that is something that may be more persistent with the refiners given that spreads were at one time quite wide.

Forbes: What stocks in this area do you like or dislike?

Cain: Well, the ones that we own there, Wally, are two holdings in the refining space: Marathon Petroleum (NYSE: MPC) and HollyFrontier (NYSE: HFC). The situation that we're looking at on a price to earning basis for them is not quite as attractive as in other areas. But we also look at cyclical companies on a price to cash flow basis. And in that respect we do see these companies as being attractive.

But the one thing about it, Wally, is that some people will categorize cyclical companies as being low-quality companies. A company that participates in a commodity area is a cyclical company. That doesn't mean it's low quality, it just means it may have higher earnings volatility. And with my engineering background, I didn't learn that volatility was necessarily a dirty word until I started dealing in finance. In engineering, volatility is a measure of standard deviation and how much move you have around a mean. It's simple math. It's not good, it's not bad, it is what it is.

And so when we look at these companies we take the next step of evaluating the companies. We try to vet them as companies by understanding their life cyclical within the market cycle. And as long as we're comfortable with that, the companies we're investing in are going to be a better compass on the other side of the cycle. Then we have less of an issue and we definitely don't go through and try to disparage it by calling it lower quality. We just try to get a sense of, “Are they priced to give us an opportunity to outperform?” And we think these companies are priced right now.

Forbes: And do you look at that coming primarily from the U.S. market that's going to be beneficial to them or is it more of an international market?

Cain: Well, what's of interest is you do have a case of where some companies are starting to export.

Forbes: Is that the case for these two?

Cain: Right, for these two but what I'm getting to is that there is the opportunity for some export of refined products. For the refiners, pretty much what they're making in processing, they're selling here within the States. But the issue becomes more from the macroeconomic vantage point of sentiment.

As investors get a greater degree of what happens ex-U.S., then the perceived demand associated with oil-based products will push up the price potentially. And in a more elevated fashion than just what's happening here in the United States. So when that spread starts to widen back out, investors tend to get more excited about the refiners because their profitability dynamic should change to the positive as well — which should give a lift to the price of the stocks.

Forbes: Any other areas that you want to touch on?

Cain: Another area that we are looking at on the commodities side is in the materials space. The metal companies have really gotten hit pretty hard in here and we've had some exposure with companies there. One of our holdings is Southern Copper Corp. (NYSE: SCCO). Where copper goes the economy goes. It's a leading indicator to some degree. This is a base metal and it has been driven by sentiment surrounding what's taken place in China. So the economic news about GDP growth there tends to have a much greater impact on pricing of copper — neglecting the fact that there are other parts of the world and also that this is a fundamental base metal used in the building out of countries' infrastructure.

Even if there's a short-term blip, if you're expecting for these economies to truly move up the economic curve and achieve certain levels of prominence longer term, copper is going to be a metal that is going to be used in that process.

Forbes: So take advantage of the price weakness at the moment and use it as a buying opportunity?

Cain: Like buying straw hats in the winter when you're not going to need it until spring or summer. But you buy it in the winter because they sell a hat that's worth a dollar for only twenty cents.

Forbes: Any other specific names that you like besides the three that you've mentioned?

Cain: Another area that we are overweight in is technology. Disk drive makers is one of the areas of technology that has come under pressure because the perception was, “These are just commodity companies and they won't fare very well with the diminished focus on hard drives and PC's.”

We don't own Seagate but we do own Western Digital (NASDAQ: WDC). Through sheer stock performance alone, at the end of the quarter it was the largest holding in our portfolio and it's one we've owned for years. It's been one we have made a significant amount of money on all because we've been willing to evaluate it as a company on the basis of the fundamentals that it's produced — not on the basis of general market prognosticators, or analysts, or investors saying, “It is just a commodity company doing hard disk drives and those are going to go away like the dinosaurs that are extinct.”

Instead, what we've found is that they have been able to broaden the appeal for their product going into areas such as storage and that it has continued relevance in the general marketplace. Something that was not necessarily that highly prized and investors focused on one area of weakness but neglected the full opportunity set. That's why we do find it valuable to do our own work. And yes, we can listen to the market in terms of information but never really too much in terms of opinion.

Forbes: Sounds very good, Randy, and thank you for taking the time to share your ideas with us.

Cain: Thank you, Wally. It's always a pleasure.