Downside in markets always worse than predicted

Harry Cohen and Scott Glasser are co-portfolio managers of the ClearBridge US Appreciation Fund, which is part of a range of products offered by Dublin-domiciled Legg Mason Global Funds. They share with AsianInvestor their thoughts on the global credit crisis and what they expect to come out of it. Cohen is a senior portfolio manager and the CIO at ClearBridge Advisors, while Glasser is a senior portfolio manager and the co-director of research.

As of December 2008, the $3.8 billion fund had Wal-Mart Stores, Travelers Companies, Johnson & Johnson, AT&T and Exxon Mobil as its top five holdings. The fund was down 28.98% in 2008. Its benchmark, the S&P 500, was down 37% last year.

What is the investment culture at ClearBridge?

Cohen: The investment culture of ClearBridge is one of stock picking, careful research, and diligent research. The ClearBridge culture is very research driven, but we also put a little top-down experience on that. It's an informal culture on the floor. We're all on one floor, in and out of each other's offices. It's a flat organisation. There's lots of collaboration, there's lots of interaction between the different groups, between the different portfolio management groups, the research analysts and portfolio managers. Certain people have different views, that's fine, that's what you want. 

 What is your investment philosophy?

Cohen: We love companies that have terrific balance sheets. Why does a terrific balance sheet make a difference? Because you don't want to have to worry about a company having economic problem, having problems during an economic downturn such as we're having now. You don't want to have that company having to come to market under adverse conditions to raise capital.

You want a company that can withstand all kinds of economic conditions. That leads to another kind of quality that we look for. We love companies that are high in quality, not only balance sheet, but the products they make. We love companies whose products tend to get consumed, and they don't have to reinvent demand every quarter. So we prefer a personal care company to a company that makes heavy, heavy equipment. Doesn't mean we'd never own a heavy equipment company, but it would have to be under special circumstances. 

As the core of our portfolio, we love companies that are dominant in their industry, superior balance sheets, and make products that people want or need. 

Valuation is the first step, recognising the company, analysing it, making sure in fact it fits into the parameters that you've set. For us, it is a quality bias. And then the second step is making sure that it's available or it's a stock that can be purchased at a reasonable price. 

We don't like paying up for stocks. We're the opposite of momentum players. Momentum players will buy stock after they're up and maybe even because they're up. We try to wait for periods of weakness to do our buying. Probably our biggest weakness is in raging up markets. We will either sell a stock too early or not buy a stock that maybe will continue going up. 

Where do you see opportunities in the current environment?

Cohen: We think we should be using periods of weakness to buy the kind of great companies that we like, with the ability to pay a rising stream of dividends, great balance sheets. And we think that's the most likely scenario. We think it's more a matter of time rather than price. We're trying to use periods of decline to add to existing holdings, where we have the most conviction. It's across sectors. In terms of ideas, it's not any one sector where we're concentrating on, it's not any one sector we're finding our best ideas.

What are the changes that may result from what happened in 2008?

Cohen: More regulation, for sure. The (US) government will effectively own some financial institutions. You're going to see, hopefully, a change in values in the country, where people aren't prized for making massive sums of money, but rather, as Martin Luther King said, the content of their character. And, he said the colour, not the colour of their skin, but the content. I'll say, not the colour of their money, but the content of their character. And I'm hoping more people, instead of half the Ivy League classes coming to Wall Street seeking money, maybe they'll go into teaching and medicine and engineering. We think society is on the cusp of a pretty important set of changes in values.

In terms of what we do day-to-day, you're going to see a great change in the financial services industry, consolidation in the industry, the way that financials and banks make money, the amount of leverage in the system. All those things are going to change dramatically. 

We think at the end of all this, you'll create a more normal environment, in terms of quantitative funds, hedge funds, mutual funds. The amount of leverage will be substantially reduced. 

What reasons are there to be optimistic despite the crisis?

Glasser: Credit is starting to flow again and we have witnessed debt deals getting done at all levels. Also the commercial paper market is functioning and the government programs that support that program are likely to be extended. From a company perspective, earnings and outlooks from the first quarter were horrid, but analysts have really started to dramatically discount their expectations for 2009 and somewhat for 2010. There is some hope for a rebound in the second half of 2009 but my point of view is that is unlikely to happen. Clearly the government is committed to spend (fiscal stimulus) and provide support to the banking system at almost any cost. This takes away the worst case scenario of systemic failure. But, the effects of the support and spending will take time to work through the system.

What important changes need to happen in the financial system?

Glasser: The most important change will be a much needed reassessment of risk levels and a reduction of leverage in the system. Market participants had become accustomed to chasing smaller and smaller returns with higher and higher levels of leverage. The bursting of the credit asset bubble is sure to lead to lower levels of leverage in the future and a more sceptical view towards funds that are stretching for returns. And we have also learned that asset classes are more correlated than commonly expected, especially when markets are global, markets are collapsing and capital is scarce or being recalled from sponsors.

Some fund managers have been blamed for not forecasting the crisis.

Glasser: I think that many fund managers knew something wasn't right or that a crisis was likely but significantly underestimated the scope and depth of the crises. Most failed to act or insulate their portfolios, believing that they understood the downside. Also, some managers were unwilling to reduce absolute exposure for fear of being significantly underweight relative to their benchmarks.

In most bear markets, the downside is always worse than predicted. Also, the massive deleveraging, specifically in the hedge fund community, has exacerbated the situation. This is where the experience levels and judgement of the portfolio managers can help navigate the potential minefields and was critical to the ClearBridge US Appreciation Fund in positioning the portfolio.

When do you expect the crisis to be resolved?

Glasser: Our working thesis for the markets is that the US markets has made a significant bottom that may or may not be tested again. In some cases, the markets make lower lows. However, we don't expect significant new lows in the market. This is based on studying the history of significant market declines over the last decade in the US. We believe that we will continue to be in a highly volatile period marked by strong up and down moves with little overall progress. In essence, a sideways move within a range.

We believe that once the market is able to get a better estimation of the depth of the recession, it can start to make some upside progress. We are not there yet but remain hopeful that this will occur during 2009.

Against the current negative backdrop, what are you doing with your own portfolios?\

Cohen: In terms of buying activities, we favour companies that we believe have the ability to pay a stable or rising stream of dividends. Indeed, historically dividends have provided around 40% of the long-term returns on equities. Secondly, in the 1970s, dividend-paying stocks were the only asset class that kept up with the rampant inflation that was prevalent at that time. And thirdly, numerous academic studies have noted that companies that consistently grow their dividend are better allocators of cash. In other words, they make better decisions in terms of reinvesting spare cash in corporate projects and the result is higher returns and better growth.