Two managersÆ routes to favouring US blue-chips

The views of Legg Mason's Bill Miller, who pursues value, and ClearBridge's Scott Glasser, who goes after quality, intersect.

Two portfolio managers do not a consensus make. But it's a start. Equity portfolio managers in the US agree right now that high-quality blue-chips with multinational exposures offer the most compelling story in US equities.

Bill Miller and Mary Chris Gay pursue a value strategy at Legg Mason Capital Management in Baltimore. Scott Glasser is managing director at ClearBridge Advisors in New York, another unit of Legg Mason Global Asset Management. He screens stocks for quality. (ClearBridge, formerly Citigroup Asset Management, also runs other types of strategies for US equities.)

The approaches involve different views about what makes a stock attractive, but right now their investment philosophies have led to a convergence of beliefs about the type of stocks likely to outperform in 2010. They both like blue-chip multinationals, which is where value and quality are most likely to intersect at this point in time.

Glasser manages strategies focused on large-cap and large-cap growth stocks. He and his team look for a diversified pool of blue-chips with good valuations and real economic returns, and are 'benchmark-aware'. Miller and Gay run a highly concentrated portfolio of value stocks with a very long-term view, with earnings at the heart of their quant screens.

Glasser's strategy is naturally biased toward blue-chips. He is optimistic about these stocks for 2010, because the rally in 2009, although impressive, favoured low-quality beta stocks above all. The biggest gainers were smaller, leveraged companies.

Their rally ran out of steam in November as the recovery shifted to a new phase. For the foreseeable future, US stock prices are going to reflect the ability to keep cutting costs and access to credit, which naturally favours big companies. This is also being accompanied by a change in sectors, says Glasser, with last year's winners in consumer discretionary and financial stocks likely to cede ground to companies with more consistent and  predictable earnings.

He says the US is going to continue to experience sub-par economic growth, which also favours blue-chips. "We're partial to the argument about a 'new normal'," adds Glasser. "Consumers will remain focused on savings and must still de-leverage."

This argument favours multinationals with non-US sources of demand, lean operating structures, low inventories, diversified cash flows and consistent earnings. If the US economy grows more quickly than expected, these companies will be best positioned to take advantage; meanwhile, they can ride out the bumps. Low interest rates are allowing these blue-chips to acquire rivals or new assets and enhance their market position -- to wit, Johnson & Johnson's acquisitions in biotech companies, Disney's purchase of the Marvel Comics brand and so on.

Glasser says his portfolios had also been recently weighted towards reflationary trades, such as gold, energy and basic materials, but now these themes have been temporarily played out. "We've taken something off the table to manage our risk," he says.

Meanwhile at Legg Mason, Mary Chris Gay likens large-cap multinationals today to the 'Nifty 50' stocks of the 1970s, which were able to maintain a premium valuation in the wake of the oil crisis.

Bill Miller expects 2010 to be a good year for US equities, and value stocks in particular. "Credit spreads have returned to pre-Lehman [collapse] levels, but the stock market has not yet fully retraced," he says. "Valuation spreads are close to normal. The wind is at our back."

In particular, he sees many companies have reported earnings above expectations in the third quarter because they're enjoying growth from more than just cutting costs. Although many economists or fund managers worry about what might happen if the US Federal Reserve begins to tighten monetary policy, Miller sees any impact on stocks as a chance to become more aggressive and buy.

"The market expectation for the stock market is now 14x," Miller says. "With interest rates so low, a justifiable market multiple to get us back to fair value is 16-18x."

Legg Mason's biggest weightings now are to tech, consumer stocks and big financials, despite having been burned in this area by going in too early in 2008.

Most tech companies have good balance sheets, have an Asian or emerging-market customer base, offer affordable valuations and have high free-cash flow yields. In financials, Miller sticks to very big banks that have manageable levels of distressed credits on the books, fewer competitors and improving profits (before taxes and provisionings).

Miller is more sanguine about consumer stocks than Glasser, saying: "People are too pessimistic." Miller notes that wealthy people account for most of the spending in the US, so problems around lost jobs and home foreclosures is not going to have a lasting impact on consumption -- particularly after 2009's stock-market rally put money back in pockets.

Nor is he too concerned about the upcoming wave of mortgage resets, comparing the Alt-A sector to Dubai World or Greece -- "aftershocks" that will cause jitters but not derail the recovery.

Both Glasser and Miller say policy errors pose the biggest risk to US equities. The US could ignore the lessons of 1936-1937 and tighten the screws before the recovery becomes self-sustaining. Sovereign risk and the exit strategy from quantitative easing is a rising risk, particularly if the US or UK see their triple-A credit ratings come under questioning.

Miller compares the current situation to the 1982 recovery under Ronald Reagan. At the time, markets were sceptical about Reagan's willingness to use budget deficits to spur growth and figured the recovery would be weak and falter.

Here is another area where Miller and Glasser don't see eye to eye. Whereas Glasser endorses the 'new normal' theme supported by the likes of Pimco's Bill Gross, Miller looks at the 1980s when the doubters were proved wrong by eight consecutive quarters of strong GDP growth.

Says Miller: "This is a good example of how to profit from behavioural finance. People are anchoring their outlook on the latest information, dramatic events and recent turmoil; they are underestimating corporate profitability and GDP growth."

The two fund managers may have a different view of the world, but for now, they both see blue-chip multinationals as the best way to profit in 2010.

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