by Jeff Reeves | May 2, 2012 6:15 am
Everybody hated bank stocks in 2011, but everyone is wild about them in 2012. Citigroup (NYSE:C) is up 28% since Jan. 1, JPMorgan Chase (NYSE:JPM) is up 32% this year and Bank of America (NYSE:BAC) is up 50% year-to-date.
Should you buy in now, or should you sit tight? Is the tech sector — which is equally frothy right now — worth chasing? Is Europe going to sink all corners of the market?
These are the questions investors want the answers to as we enter the choppy spring and summer seasons for the market. So I went right to one of the most respected names in the business for the answers.
Thomas Villalta is lead portfolio manager for the Jones Villalta Opportunity Fund (MUTF:JVOFX). “Opportunity” is the key word there, since Villalta has shepherded his fund to an impressive 15% return year-to-date — easily beating all major indices and almost doubling the return of the Dow Jones Industrial Average.
I asked him some questions recently about the state of the stock market, and here’s what he has to say about where Wall Street has been in the past several months — and, more importantly, where it’s going.
I particularly liked his insights about how many investors’ “tendency to view an unrelated or tangentially related situation as representative of a current situation is a common behavioral error that individuals, professional and amateur, make.” That’s spot-on, and a reason many of us talk ourselves into making the wrong decisions.
Here’s Thomas Villalta’s insights, in his own words:
Q: Top holdings of JVOFX right now include BofA, Citi, JPM, Goldman Sachs, Wells Fargo and a handful of other banks. Walk me through these trades. Did you hold them during the mayhem of last summer, or did you buy more recently?
A: We held all of our financial holdings over the second and third quarter of 2011. In fact, we added to many of these positions, maintaining our relative weights. Our strategy — which is largely focused on identifying what we perceive as behavioral errors associated with certain stocks or sectors of the market — influenced our decision to purchase many financial stocks in late 2008 and early 2009. But while we believe we are relatively good at identifying stocks that trade at a discount to intrinsic value, we can’t always be certain that a cheap stock will not become cheaper. The market swoon in mid-2011 had the feel of the 2008-09 financial crisis. We believe many investors, professional and individual, were viewing the events in Europe through the prism of this recent market panic.
The tendency to view an unrelated or tangentially related situation as representative of a current situation is a common behavioral error that individuals, professional and amateur, make. In behavioral science, this is often referred to as a “representativeness” bias — a situation that individuals view as being representative of another unrelated situation.
But in this case, our research led us to believe that many of the more pessimistic eventualities that drove the downward movement in financial stocks were not as dire or would not have as significant of an impact as was implied by share price declines. As a consequence, if a 3% position in the portfolio fell to a 2.5% position (due to share price decline), we purchased more shares, in effect maintaining the 3% position. Indeed, in some cases we increased our percentage weightings in certain positions to take advantage of what we believed was very advantageous pricing.
Q: Performance year-to-date for your fund has been very impressive, with over 15% gains. The outperformance of banks has had a lot to do with that. Is the momentum going to stop soon, or is there room left to run for investors?
A: We think there’s significant room to run, and the recent pullback in financial shares, in our view, presents a very good entry point for investors seeking exposure to this sector of the market. We continue to believe that many of our financial holdings will drive performance in coming months, as concerns about European banking crisis effects are proven exaggerated.
Keep in mind that many of the largest banking institutions are trading at less than book value. While we don’t think we will see the high-teen or 20%-plus returns on equity that were prevalent prior to the financial crisis, we do believe that a 10% return on equity is achievable. Consequently, a multiple of 1.0 to 1.5 times book value is, in our opinion, appropriate and would imply significant additional upside.
Q: Other than the banks, what are some other stocks in your fund’s portfolio that you have the most confidence in going forward?
A: Technology and consumer-oriented businesses are very appealing to us at present. Microsoft (NASDAQ:MSFT), Hewlett-Packard (NYSE:HPQ) and Corning (NYSE:GLW) are, in our view, very undervalued. Hewlett-Packard in particular stands out, as many sell-side analysts are equating turnover at the top with organizational disarray. While we would certainly prefer to see better corporate governance at HPQ, and more stability at the top for this company, the individuals tasked with HPQ’s segments are very qualified and highly regarded. While we were not holders of HPQ when it traded above $40 per share, we do think the company is very appealing at prices in the low to mid-twenties.
In addition, we really believe that the U.S. economic recovery is beginning to take hold and become self perpetuating. U.S.-centric consumer-oriented businesses like Home Depot (NYSE:HD) and MGM Resorts (NYSE:MGM) are very good ways to participate in a recovering consumer.
Q: Let’s talk about the risks to the rally right now. What’s your biggest concern that could cause trouble for the market in the next several months?
A: First, let me note that I don’t view Europe as a significant risk in the intermediate term. Keep in mind that the U.S. economy is not as dependent on exports as countries like Japan, Germany and China. Moreover, concerns about Europe are, in our view, more than priced into the market. Any volatility related to Europe is, in our view, noise.
So … the real concerns are unknown “exogenous shocks.” Iran and other Middle East issues always pose problems, as their effects are not, in our view, priced into the market. A significant upward increase in commodity prices, whether it’s related to Middle East tension or increased global demand, remains problematic. While the world in general is becoming a more efficient user of energy, we still feel significant upward movements in energy prices are problematic for all economies — including the U.S. economy.
In 2008, we found that oil pricing that exceeded $145 per barrel became a significant drag on consumer spending (and likely contributed to the U.S. economy’s contraction in GDP). While we currently think oil prices can go higher than $145 per barrel before they become problematic — due to an increasingly efficient U.S. demand base — we’re not sure what the ultimate problematic price is.
Q: Longer-term, do you have any doubts about the sustainability of the rally? Is there any chance of a “double dip” or are we really on the mend, albeit slowly?
A: We do think we are on the mend. But, as you note, it has been a slow recovery. At some point the recovery will become self-sustaining and growth will beget more growth. I’m not sure if we are at that point now, but we are headed in that direction (we may be there now, but it is really only clear in retrospect). Again, commodity prices could impose a headwind, and we would caution investors to maintain some exposure to energy as a hedge (we currently maintain a market-like weight for this very reason).
Right now, I’m not concerned with a double-dip, as corporations are generating significant cash flow and have fortified their balance sheets. While they have been slow to hire, dragging out the recovery process, the upside is that they likely will be less inclined to layoff employees should we see a bump in the road, or a sustained rise in commodity prices.
Q: Do you place any stock in “Sell in May and go away” motto this year?
A: While that adage has served investors well over the past couple of years, we don’t think it’s something to count on. It may be a difficult summer, but we wouldn’t bank on it — especially given the pullback in April.
Q: I notice that the JVOFX fund has a pretty high expense ratio of 4.19%. Your performance has been such that investors recoup those fees, but some folks may be worried that in an off year they will feel the pain twice. In your own words, why is Jones Villalta worth the price of admission?
A: 1.25% is the actual net expense ratio for JVOFX. The 4.19% expense ratio you noted is our gross expense ratio. Our firm subsidizes expenses for the fund to maintain a ratio of 1.25%. It will be a great day when we are no longer writing checks to keep the fund’s expenses at the industry average!
Investors have a choice: They can pay a small price for a passive investment fund (like an index fund), or they can pay for active management. But they should be concerned about actually getting active management. Many funds that assert they are actively managed hold too many securities and are unlikely to outperform market benchmarks given their expense ratios. While many investors are well served by having a portfolio that includes both actively managed funds and index funds, as they can complement each other, we do think that when selecting active funds, investors should strive to seek truly active funds — not funds that are too timid to hold over-benchmark-weight sector positions or sizable individual positions.
Our fund is truly actively managed. We very often don’t look like our benchmark, the S&P 500 Index. This has allowed us to add value over time and is the reason that we’ve outperformed our benchmark since inception.
Outperformance, however, comes with a cost — both in terms of expense ratio and in terms of tracking error. We are not as cheap as an index fund, and there will be periods when we underperform. We are focused on the long term, and over the long term we’ve done, in our view, a good job adding value.
Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace??.com or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves did not own a position in any of the investments named here.
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