Barrons had interview with Barrow, head of Vanguard's Windsor II fund. some good stuff in the article, presented below:
On the Hunt
Many invest like VW drivers using big-truck mirrors. Jim Barrow prefers the view ahead
By ERIN E. ARVEDLUND
AN INTERVIEW WITH JAMES BARROW -- In Texas, quail hunting is gentleman's sport. The hunter follows pointer dogs on foot
over rolling brush or hill country. He creeps along quietly, waiting patiently for the dogs to flush out a covey of birds. And when the
winged creatures finally dart up into the air from underfoot, the expert hunter gets a bead on a single bird, instead of making the
fatal, novice mistake of "flock-shooting." Those hunters who remain calm during the covey's frantic rise can bag doubles, and even
rarer triples.
It's understandable, then, that James Barrow hunts quail avidly. He's also a renowned value investor, and uses the same strategy for
managing his portfolios, picking his shots carefully while others are panicking.
Barrow oversees a fund that's one of the most widely held in 401(k) plans: Vanguard Windsor II, a large-cap fund with roughly $18
billion in assets.
Vanguard subcontracts stockpicking work to outside managers, and the majority of the fund's money is run by Dallas
money-management shop Barrow Hanley Mewhinney & Strauss. Barrow, 62, has been in the investment-management business since
1965 and with BHM&S since 1979. The fund manager, who received a B.Sc. from the University of South Carolina, resides with his
family in Dallas.
Vanguard Windsor II, which ranks among the nation's 20 largest stock funds, has returned an annualized 9.28% over the past decade,
and beaten the Standard & Poor's 500 nearly ever year, according to Morningstar. Keep reading to learn Barrow's views on value
investing, and how he avoids "flock-shooting" in the current market environment.
Barron's: Jim, whither value investing and value stocks after three years of a bear market?
Barrow: On March 10, I noticed that there was about 17 times the trading volume on the downside, versus the upside, for the day.
Nobody in the news said anything about it. A few days later, I went to my bond guys, and I asked them, 'What was the low in the
short market?' And it happened to be that day -- two days before the market got to its multiyear low, with the Dow at around
7,400. It struck me as a turning point. I'd been saying in the fund's annual report that the level the market reached in October would
hold. In fact, we have been testing that bottom.
There's a lot of negativism. One of my analysts was recently in New York
City, and she said everybody was 80% in cash, and scared to death, a sign
of a typical market bottom. And in New York, you guys feed off
yourselves. Down here at least, people say, 'Yeah, the market's terrible,
huh? But at least I had a great golf game last week, or I went fishing or
bird hunting.' So, was I surprised the market bounced 1,000 points since?
It happens when people are that depressed. It reminded me of the way a
lot of people invest, like they're driving in a Volkswagen with big truck
mirrors. They see more clearly where they've been than where they're
going. We made a decent enough bottom, especially in October 2002,
which was driven by the rating agencies.
Q: What about the credit-rating agencies?
A: It started with Enron. The rating agencies got scared to death they'd be sued over it. They had access to and could
force disclosure of all those off-balance-sheet transactions and they didn't. Now, they're acting the opposite way,
being overly paranoid. So that's what helped the market bottom in October. We've also got new legislation on
corporate disclosure, a new Securities and Exchange commissioner and a new board at the New York Stock Exchange.
Q: Are there one-time growth stocks that you now consider values? And what happens to value after years of
outperformance?
A: I think the question is: What happens to growth? The great hope is that capital spending will lead us out of
recession. Capital spending is only one-third of spending. Consumers represent two-thirds. So my guess is that capital
spending won't lead us out, the economy is not operating even close to capacity, and we've got no incentive to spend.
And this war is discouraging the heck out of corporate executives to spend money or to take any risks at all. You can
smell it, and you can taste it. Big companies tell me they have lots of projects sitting in the wings, but they don't
want to hire.
So if you're a growth-stock investor, how do you get spending to go back up? I don't think it's possible for spending to get back to 1999 and 2000. That was Mount Everest,
and we're never getting back to that. And what about capital spending among tech companies? I'm not coming up with much.
Q: So you're staying away from technology stocks. These days, then, what's a value stock?
A: I've got a whole portfolio full of them! I don't have a single screen, but for example, Microsoft. While I don't own it, once in a while I look at Microsoft, and say: 'Here's
one of the great companies in the country, and they just started paying a dividend.' At the right price -- say, 18 a share, which would also imply a P/E of around 18 times
earnings -- I could do something with that. I can't come up with that for Cisco. It's still trading at 30 times earnings, and those earnings aren't going anywhere.
In the last year, I have been buying drug stocks, which certainly used to be growth stocks. I've been buying fallen angels, which I tend to buy anyway. In Windsor II, I have
good-sized holdings in Baxter International, Bristol-Myers Squibb, and Merck. Those are certainly growth companies. They're trading at 10 to 12 times earnings, and while
they may not grow for the next two quarters, I don't care. I don't need to be there the second the earnings change. It's better to be there a little early.
Bristol has really been beaten up. The write-off for Imclone is in the stock. They have a real problem with management. They're cleaning up the accounting. Why would you
want to own Bristol? You get a 5.5% current yield, and the company maybe earns $1.50-$1.60 a share this year and over $2.00 in a few years. I'm willing to hold a ragged
company like that for a few years, with the idea that it can move from 20 to 30. That's a 50% move. I'm getting paid to hold it.
Q: What about the financial stocks? You've owned those for a long time now.
A: If it's cheap and it's down, I own it. I own Allstate, Bank of America, Citigroup and J.P. Morgan Chase. You name it. Some have been okay, Bank of America has been the
best of that group, because there have been no surprises. It's selling for a little less than 70 and is supposed to earn a little over $6 a share this year, so it's pretty cheap. This
fund's got a record that's bettered the market ever since it started, because we buy cheap stocks and don't have a lot of volatility.
Q: What's going on at J.P. Morgan, one of your picks?
A: J.P. Morgan has been the worst. They had exposure to the business cycle to begin with, because they make business loans. In investment banking and brokerage, they don't
really have a strong market share, so all of their banking has to be losing money. So then they decided to prostitute the balance sheet a little bit, to get business, and doubled
the bet. Then they got involved in a big venture-capital operation and doubled the same bet again! So they got derivatives and bad business loans, brokerage and venture capital,
and quadrupled the bet. They're not different bets, they're the same. They've taken careful aim, and shot themselves in the foot. They didn't miss. When do things improve?
They're under pressure and they've got leadership problems.
Q: The stock's gone from 35 to 25 in the past year. You're not buying more?
A: I don't like to double down the way they did! I have enough anyway. At one time, it was a very large position, because of all the mergers. That's the difference between the
way we invest and the way J.P. Morgan Chase invests. What they did is like playing blackjack, getting a pair of fours, and doubling down!
Q: Tell us about some of your other financial holdings.
A: Allstate probably has six to eight more quarters of up earnings. I think the company [is going to] earn $3.50 a share or more this year; it has some current yield; and the
stock could go to 40 from 33 now.
The biggest positive is that State Farm has been losing so much money. That should help Allstate. State Farm and Allstate are the two big players in homeowners and auto
insurance.
Now to Citigroup. There's been lots of volatility and some controversy, but it's trading at 12 times lagging earnings and 8 times next year's earnings. That's pretty cheap.
Q: What's the average for your whole portfolio?
A: For Windsor II, the price-earnings ratio is about 12 times earnings expectations for this year, for the whole average
weighted portfolio. And the price-to-book is 1.7 times. The median market cap is around $25 billion, so we own
relatively large stocks.
Q: What about the autos?
A: I don't have any exposure. That industry bothers me. The unfunded pension cost is one worry, and the completely unfunded post-retirement health-care cost is another
worry. As a matter of fact, Ford and General Motors would have been better off if they had just financed [consumers' purchases of] Toyotas, as opposed to building cars! They
really haven't made any money in the manufacturing of autos for the past 50 years.
Q: Why do they keep making cars, then?
A: It's a guy thing! Men have a thing about cars.
Q: Ha! Well, maybe that's the case; I have a 1985 Saab with a lot of body filler in it.
A: But at least it's paid for!
Q: True. Okay, so back to the financials.
A: We have a lot of relatively boring stocks, including some financials. There was a time when clients would call me up and say 'Buy growth stocks!' In 1999 and 2000,
investors cashed out in droves and put all their money in a large Denver fund complex. I was on an airplane one time from New York to Dallas. I heard one of the flight
attendants chatting with her friends and she told them, 'I'm putting half my money in the S&P 500, because it's risk-free, and the other half in Janus Fund, because it's got a
35% annual return.' I remembered that for a long time. Because the S&P 500 is not risk-free. A lot of money was lost, real money.
Q: So investors had a misunderstanding about risk?
A: Some of the losses were caused by malfeasance at the corporate level, but an awful lot were caused by things that didn't make sense on a price basis. JDS Uniphase was the
biggest stock, in terms of initial weighting in the S&P 500. It went in at a 1.3% weighting. Everybody investing in the index bought it. It was trading at 135 times revenues
when it went into the index. We couldn't even model what growth would have to be to justify the price. The stock's come down from that, to around 0.1% of the S&P. That
means every index fund in the United States lost 1.3% on that single investment. It was simply not worth what it was selling for. My guess is, the S&P shouldn't have put it in
at that kind of price. What are the people doing who determine who goes in S&P? They're always chasing the new group.
Q: You like financials, and the S&P's heaviest weighting now is in the financials! Does that worry you?
A: It's been that way for a long time. It's a combination of insurance, banking, brokerage, and other categories lumped into financials.
Q: A little more about technology stocks. Do you own anything remotely resembling tech?
A: We look at tech stocks all the time. I can't come up with anything exciting. But they're not in our valuation universe. Many aren't self-financing, most don't pay dividends.
I don't have to have dividends, but I like them. So I've stayed away. The closest I've gotten was buying Cendant. It's doing okay now. I own some Tyco, which I bought after it
broke apart. I didn't participate in the first 75% of the stock's drop.
Is that technology? I can't tell. I bought Cendant because if any business is going to benefit from the Internet, this is it: They rent timeshares and sell airplane tickets and hotel
reservations, and they also are the biggest realty outfit in the country. You can put that and the mortgage-origination business on the 'Net.
It's been an unpopular stock, and there's been a lot of throwing of rocks at company. But I like it right now. Cendant's chief, Henry [Silverman], finally responded by doing
things that we like, changing the accounting, instead of being a deal junkie, thinking about paying a dividend and paying down debt. At 12 a share, with earnings of $1.40-$1.45
this year and plans to take out a third of its debt in the first year, and another third in the second year, I can't see why it won't go up. He promised there aren't going to be any
restatements or changes in accounting. It's going to all be as expected.
We own Tyco just on the hope that [CEO Ed] Breen can resurrect confidence in the company. He's certainly making moves in the right direction. He's got a good board for a
change, and he's got a reputation as a real straight guy.
Q: Was the news about Tyco's bad accounting in the fire-safety business the last shoe to drop?
A: We've known for a long time that that's a business where you can account for things in a million ways. Everybody in that business is doing things in an aggressive manner. It
bothers me a little, but it's not the whole company by a long shot. The assumptions that the acquisition of a new customer, and average life of a new customer, is 9.7 years,
well I can't imagine that's true.
Tyco's earnings are likely to be $1.40-ish a share this year, down from about $2 a share going back a year ago, but it's cleaner. And it seems you get a reasonable rebound in
earnings from this level going out for three to four years, back up to maybe earnings of $2 a share. So its got upside potential to the mid-20s, if you have patience. And we
have that kind of patience, because our turnover's not real high and we buy things with the idea that we're looking two or three years out. I'd rather have it work in a week, but
it doesn't happen like that very often.
Other fund managers have real high turnover rates, but what kind of investors are they? We have companies that come here, they want us as a shareholder because we tend to
hold for a long time. I'm not that sensitive about quarterly-earnings reports. I almost never ask a management, "What are you going to earn next quarter?" You want a general
idea of what a level or earnings power might be under certain conditions. But the idea that you know the whisper number is not something we think is important. We're not
momentum players.
Q: Are companies more reluctant to talk now, in the era of Regulation Full Disclosure?
A: Some are paranoid. And it probably means the management isn't old enough, and legal counsel's not old enough. How could a really big company tell you what they were
going to earn? If they could, that meant they were manipulating the earnings. How would you know if you ran General Motors what you'd earn the following year? There are
sales, taxes, the union contract, all sorts of things to consider.
Q: What valuation metrics do you look for?
A: We build a portfolio that has low price-to-earnings, low price-to-book ratios and a high current yield. The P/E tends to be about at a 20%-30% discount to average P/Es, and
price-to-book ratios about 60% of the average, and yields anywhere from 100%-200% above the S&P.
We like the dividend component for two reasons: One, obviously, the shareholder gets the dividend. But the main reason is that a portfolio that's got a very good yield will be
less volatile, and that lets us sleep a little better at night. There's a good correlation between companies that pay a dividend and how well those companies reinvest the capital
they keep. We like dividends even better than a stock buyback. Because by the time the program is finished, frequently they don't do it. In case of dividends, there's a notice in
The Wall Street Journal saying the company didn't pay; it's public record.
Q: Does the big comedown in the market mean you're buying anything new that you've never really invested in before?
A: Cendant and Tyco were new for me. Henry Silverman starts talking about paying a dividend, and Bill Gates used to be violently opposed to dividends, now he's paying one
on Microsoft. Dividends have come into vogue. Two years ago, people said 'Don't talk to Barrow, he's an Old Economy guy, he actually likes dividends.' I don't care about how
I get my return, as long as I get it.
Q: Let's talk about oil stocks. Why haven't they moved up as the price of crude has risen?
A: I haven't the vaguest idea. The earnings have been better than expected; the dividends are fine, the multiples are low, the capitalizations are large, the stocks aren't volatile.
It's not like the service companies, which are expensive. We own Occidental Petroleum, ChevronTexaco, ConocoPhillips. We don't own Exxon Mobil. It's expensive. It's a
well-run company; it's just an expensive stock.
Q: A lot of money managers feel like they have to own Exxon Mobil; they're afraid not to.
A: Sure, what they can do is put 3.7% in that stock and then be neutral to the index and [they] don't have to worry about it. But I don't do that; that's like kissing your sister.
Buy what you like when it's cheap, and if you don't think it's cheap don't buy it. Exxon Mobil's not cheap, but it's a helluva good company. The chairman, Lee Raymond, lives
around the corner from me. He's a real tough businessman. He runs it well; he doesn't get excited about the big oil finds, but how the nickels and dimes work out. If it doesn't
make sense he doesn't do it.
BP, or British Petroleum, I own also. The stocks I own tend to have lower multiples and slightly higher yields. BP's CEO, John Browne, is a cost-cutter and we like their deep
Gulf of Mexico play, a program in 10,000 feet of water.
Q: Tell us about some growth stocks you've bought recently.
A: I bought a good-sized piece of cruise line company, Carnival. I figured the war in Iraq would depress the stock, and with the addition of new boats, they have capacity
coming on. The most damning thing to the stock right now is high fuel prices.
But longer-term, we don't look at Carnival as being in the cruise business, per se, but in the hotel business. It runs floating resorts, and we think it will take market share away
from hotels. Big conventions can be held on these ships. If a company wants to get everyone together for a meeting, the guys won't be able to sneak off to play golf. They
can't get away!
Q: Why not Royal Caribbean?
A: I own that, too, but in my mid-cap fund. I own Carnival in Windsor II, the large-cap fund. It's just that simple.
Q: What about Vanguard Variable Annuity Fund, that's another fund that's 100% Jim Barrow-run, correct?
A: Yes, its holdings are pretty much identical to those in Windsor II. There might be one or two names that are different.
Q: What about utility stocks?
A: We like them. Public Service Enterprise Group is one we've owned. When they broke apart recently, because of the necessity to raise equity capital, we bought a lot more of
it. And the deals being done in 2003 are priced very well, very low.
I just looked at the number of new issues that came to market. There have been only four or five IPOs, but they had one thing in common: They were all up from the issue
price. Why? The deals were priced to satisfy the buyers, whereas before, the bankers were kowtowing to the sellers.
Even past the IPOs -- look at the secondaries. They're up, too, because they have to be priced for the buyer. That's really different from three years ago.
I've also been buying Baxter International. It's gotten crushed. We think this healthcare-equipment provider got itself into some trouble; earnings have been disappointing, and
management has gotten too aggressive financially. The stock went from 60 to 20, so we thought it was an appropriate time to buy. We started buying at 25, so it's come down
from there, but I like where I am. If it goes lower I'll buy some more. They'll earn $2 a share this year, and have a 3% yield, even though it's not sexy. |
