Legg Mason sees start of a new bull market

Technology stocks now make up about one-third of Legg Mason's $304 million Value Fund.

Mary Chris Gay is the Baltimore-based co-manager of the $304 million Legg Mason Value Fund.

Gay joined Legg Mason's research department in 1988 and became part of Legg Mason Capital Management in 1989. She was initially an analyst on the research team and followed gaming, lodging and entertainment stocks. In 1998 she was named portfolio manager for the institutional pooled products, which allow investors access to the investment portfolio and process implemented by the Legg Mason Value Trust. In 2006, she was named assistant portfolio manager to the Legg Mason Value Trust, which has Bill Miller as the lead manager.

She shares with AsianInvestor her views about the US equities market.

Are we at the beginning of a new bull market?

Mary Chris Gay
Mary Chris Gay
Gay: We believe that the rally that began in early March could be the beginning of a new bull market. The critical question is whether the economy begins a sustainable period of growth later this year or whether this is a just a solid rally in an ongoing bear market. We believe that the move that we have seen, which has been led by the classic early cycle stocks -- like financials, housing and retail consumer discretionary names -- is a very encouraging sign that may signal the end of a long period of economic decline that began back in December of 2007. 

If you went back to March 2007 knowing what you know right know, what would you do differently?

In a completely unconstrained product with clear foresight of what would happen over the next two years, in March of 2007, we would have sold everything and shorted the market. 

More seriously, the Value Fund is a long-only fund with a long-term time horizon invested mostly in large-capitalisation US companies. We typically are fully invested and hold very little cash and cannot short in the fund.  Knowing the severity of the downturn and the duration and magnitude of it, within our investment mandate we would have been much more conservatively positioned and focused on the same valuation methodologies that have led to our strong long-term returns.

How are you positioned these days? In which sectors and companies are you overweight? How much cash do you hold in your portfolios? Has your turnover increased in recent months?

In order to ensure that the portfolio is well positioned even in a bear market, we've upgraded the portfolio both in terms of quality and liquidity, reduced concentration, and broadened industry exposures. The widespread selloff in the fall and early in 2009, depressed valuations broadly, leading to a rare opportunity to increase the sector diversification of the portfolio without sacrificing the potential upside, thereby enhancing the risk-adjusted returns. At the same time, companies with stronger capital positions, greater franchise value, and more attractive growth potential have sold off just like their lower-quality peers, providing investors a rich ground for bargain hunting. In addition to increasing our exposure to quality names, we also decreased exposure to political risk by closing positions in names that might be subject to regulatory changes that we cannot anticipate or control.

We do not necessarily compare our weights to the benchmark, as the classification can be arbitrary. In today's market, sector bets become less important because all sectors came under severe pressure, and their valuations suggest significant upside potential. Where we have increased weighting, is in quality names, which are the cheapest they've been in many years. Mega-cap stocks, which tend to have better quality, are attractively valued versus the broad market, as the relative valuations of the largest 100 companies by market cap are well below historical norms.

We remain fully invested. Ample empirical evidence suggests that equity offers better long-term returns than either cash or bonds. Today's low interest rate environment has especially reduced the appeal of holding cash, while the low stock valuation has attracted long-term investors such as Warren Buffett to equities.

We are patient investors with target holding period of between three to five years. Because of the current market opportunities, we became more active recently, adding 15 new names into Value Fund in the fourth quarter and another 5 in the first quarter of this year. However, our long-term investment philosophy remains unchanged and the total number of names in the portfolio remains within the long-term average of 30 to 60 stocks. 

What changes have you made to the portfolio recently?

Technology is now our largest sector in the portfolio making up roughly one-third of the fund. This is the largest weight we've had in quite a number of years. We were fortunate to have a fairly significant weight in technology back in 1998-1999, in part due to the changes that we made to the portfolio in the mid-nineties that led us to some of the cheapest names within that sector, but as the valuations in those names began to reach levels that we believed were unsustainable we cut that sector back down to a low of about 2% by the autumn of 2002.

What names do you like within the technology sector?

In terms of valuations, eBay continues to be among the largest names within this space followed by CA, Yahoo, Cisco, IBM, Google and Hewlett Packard. We believe technology will continue to benefit given the strength of their balance sheets and strong free cash flow. In fact, if you look at the average free cash flow level for the market, it's about 11.5%. For the technology sector, it's roughly 50% higher than that. If you look at names like IBM or Hewlett Packard, they are trading between 50 and 100% below where we believe their fair value is.

What's your outlook for financial stocks?

If you look at the returns from the financials and banking sectors, which have had a powerful rally off the bottom, that rally has happened from the extremely depressed levels at the start of the year. In terms of historical perspective, however, this has been one of the most extraordinary rallies for this group. Financials and banking stocks remain the source of greatest controversy in our view and also potentially the greatest opportunity.

Have you made any changes in terms of your financial holdings recently?

We made some changes in the first quarter. We eliminated a long-term position that we've held for over a decade in Citigroup. One of the biggest risks that we see in the overall market is political risk and we sold these names in an environment where there was a call for the nationalisation of both the Bank of America and Citigroup. Given the depressed levels that financials were trading at and the high degree of uncertainty we decided to trade into names like Wells Fargo and some insurance names such as Aflac and Prudential. The financials have been the strongest group in the market since the March low.

Turning to the insurance stocks -- Aflac and Prudential -- both are down about 60% from their highs. They trade at single digit multiples and they have returns on equity between 13 and 15%. They have great management teams and limited to moderate risk exposure, a strong annuity market and very good capital flexibility. In terms of the thought processes that lay behind selecting these names, we felt it was a unique opportunity to add insurance to reduce the risk of the overall portfolio in financials, but also to increase the return opportunity.

Value investing has fallen out of favour over the last few years. Is it poised to make a comeback?

After three years of very difficult returns for valuation-driven strategies, first, because of the price momentum dominance in the market and then the stock market panic, value has once again begun to do better. Consistent with this we believe the recovery that we've seen in the Value Fund is in part because of our intense focus on value. So, as the US and the global economies continue to stabilise and risk aversion decreases, we believe capital will continue to return to both the credit markets and the equity markets and that should be a good environment for valuation-based strategies.

In periods of financial distress opportunities are created, especially for valuation-driven managers. This goes back to the 1950s. Since we started managing money 27 years ago, in every period where we've had dramatic disruptions in the market we've been able to take advantage of them and position the portfolio in order to produce substantial excess returns.

In terms of risk management, what can we learn from last year's experience?

Last year was a once in a generational event, a low probability high impact event that devastated wealth on a global scale not seen since the 1930's. One lesson learned is that such events do happen and that recognising these early is crucial to preserving wealth and to risk management. Financial crises of this magnitude are transmitted through the banking and financial system, and almost always result from an unforeseen drop in asset values. In this case it was housing, from which it spread to almost all assets around the world. The key lesson is to monitor systemic risk factors such as asset prices, credit spreads, imbalances for the developing signatures of potential severe disruptions and to be able to move decisively and early when they begin to become evident.

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