Connor Browne: Asset Allocation Is Key in Current Environment

by: Benjamin Shepherd

Stocks have rallied substantially since their March lows, but Connor Browne, co-manager of Thornburg Value ((TVAFX)), continues to uncover undervalued names that offer significant upside. Although the fund’s longtime manager Bill Fries has decided to step down, all indications suggest that the fund should continue to outperform under the experienced guidance of his successors and current co-managers.

Your fund focuses on three kinds of stocks: basic value names that trade below earnings power; consistent earners, or blue chips that trade at prices below historical norms; and emerging franchises, or companies that are carving out leadership positions in their industries. In the wake of the rally, within which category are you finding the most opportunity these days?

We usually expect our basic value and emerging franchise stocks to perform well in a rally, and that’s been the case so far in 2009. Consistent earners tend to be more defensive in nature and hold up well when the market is going down.

Right now we’re finding new ideas across the spectrum, though the portfolio is still quite a bit overweight on basic value names relative to consistent earners; we’ve taken advantage of opportunities in some cyclical businesses.

We usually expect our positions to achieve our price target within a year or two, but consistent earners and emerging franchise stocks tend to stay in the portfolio a bit longer.

The fund has substantial positions in financial stocks. What’s the logic behind this allocation?

Our financial weight stands at about 24 percent, almost 10 percent higher than the S&P 500’s allocation to this sector. That’s a bit frightening at first glance, but we’re comfortable where we are.

In the fourth quarter of last year and the first quarter of this year we established positions in fixed-income holdings from high-quality financials such as JP Morgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS) and US Bancorp (NYSE:USB). Down substantially when we made our move, these investments have paid off, and we regard this asset class as being less risky than financial equities.

We also have heavy exposure to the insurance industry. Among banks, diversified financial-services firms and insurance companies, the latter business is the most stable, particularly the large global primary insurers and reinsurers that aren’t involved in life insurance.

Amid the market turmoil the investment portfolios that insurers hold against liabilities came under pressure. As spreads widened on the investment-grade, fixed-income instruments that many of these firms held, book value came under pressure.

We preferred the biggest, safest names like ACE Limited (NYSE:ACE) and Transatlantic Holdings (NYSE:TRH) based on a couple of factors. For one, their businesses weren’t changing much and, outside of life insurance, the downturn wasn’t hurting their ongoing insurance operations. And ACE, which competes directly with American International Group (NYSE:AIG), has benefited a bit from its rivals’ woes.

When we bought into these stocks, the companies were trading at low levels relative to historic norms and our estimated trough book values, which were based on investment portfolio performance.

You’ve also added positions in some hard-hit regional banks. What’s your take on these holdings?

We were early in identifying Fifth Third Bancorp (NASDAQ:FITB) as a survivor and first bought the stock in mid- 2008. At the time the stock was trading at what we regarded as a low valuation, but the price sank even lower. I’m proud that in the darkest days we were able to make the right decision and add to our Fifth Third position at very low stock prices.

We had conducted our own rigorous stress tests on the bank’s balance sheet, subjecting its loan portfolio to aggressive loss estimates and analyzing the potential upside if it made it through to the other side. At the stock’s nadir our confidence in its survival was extremely high because the Treasury Dept had announced that it would scrutinize the nation’s largest 19 banks, including Fifth Third, and would make capital available to any institution that failed the stress test. We knew that as long as the Treasury Dept wasn’t lying, which you have to be a little careful about, Fifth Third would receive as much capital as it needed at $3.25 a share. At the time the stock traded at $2 a share, a level that was actually less than our downside scenario for the stock--we assumed that the deal would propel share prices to at least one times tangible book. To us that was a tremendously exciting opportunity.

More recently we’ve taken out a position in KeyCorp (NYSE:KEY), another Ohio-based bank whose loan portfolio has a lot of exposure to the areas that people worry about a lot. Even though the bank raised more capital than the Treasury Dept had prescribed, the stock price didn’t react to what we regarded as a major, positive event. Again, we closely scrutinized its loan portfolio to determine whether it would survive and attempted to quantify the stock’s potential upside. We concluded that even if we lost 50 percent of our initial investment, we had the opportunity to make at least two times more--our upside-to-downside ratio was four to one.

The portfolio also includes Comcast Corp (NASDAQ:CMCSA) and a handful of other telecom stocks, what’s your take on the NBC-Universal deal and the industry’s prospects in general?

We think the combination of media and content distribution makes a lot of sense, and the extent to which Comcast Corp would be able to do that with a 51 percent stake in NBC-Universal assets, that’s great. But we’re looking at the bulk of Comcast’s business--selling cable TV, high-speed Internet access and telephony to subscribers across the US.

TV is an integral part of the daily life of most Americans. If you look at statistics on how many hours of TV the average household watches each day, it’s clear that in the US we really like our TV. We pay attention to the risk associated with new technology and the gradual incursion of the Internet, but we think that the current model will endure longer than the market anticipates.

Comcast’s TV results are OK, but the stock price doesn’t reflect the steady stream of revenue and cash flow it generates by cross-selling all three of its services.

We actually own three pay-TV providers in the US, though for different reasons. Like Comcast The DIRECTV Group (DTV) falls into our consistent earner category. Although DIRECTV doesn’t offer telephone and Internet services, the company is doing a better job than anyone else in the pay-TV industry. In the most recent quarter subscriptions were up to almost 7 percent from a year ago, while the average customer’s bill increase a couple of points--all of that added up revenues for US television services that were 9 percent higher. Backing out the company’s Latin American assets, the US business alone is trading at a 14 percent free cash flow yield. And DIRECTV is aggressively buying back stock. We continue to believe that the business is terribly undervalued.

DISH Network Corp (NASDAQ:DISH), on the other hand, falls into our basic value category. The company had been hemorrhaging subscribers for quite a while, but at the time of purchase the cash flow it generated was enough to justify our investment. Some of the catalysts that we thought would turn around the business also started to play out; last quarter the company actually grew its subscriber base.

Health care stocks accounted for over 14 percent of the fund’s investable assets at the end of the third quarter. What do you look for when picking names in this sector?

We like biotechnology and pharmaceutical companies whose stocks are reasonably priced given the existing drugs it has on the market--anything from the pipeline is sort of a call option. We think we’ve found a bit of that in Gilead Sciences (NASDAQ:GILD), a company that has a very strong HIV franchise which will be under patent for the next ten years or so. European authorities recently recommended that HIV patients undergo treatment earlier in the disease’s lifecycle, and the US is likely to promulgate similar guidelines--a boon for the company. A strong pipeline of treatments for HIV, hepatitis and certain respiratory ailments could provide additional upside.

Actelion (OTCPK:ALIOF) is an emerging franchise holding that boasts a similar story. It has one main drug, Tracleer, which is used to treat pulmonary-arterial hypertension. That business is solid and justifies the stock’s current valuation, but the company has four or five exciting opportunities in its pipeline that could send the stock higher over the next 12 months.

What’s your best advice for individual investors at this time?

At any time the most important thing is to choose an asset allocation that makes sense for you and then stick with it. The worst mistake that anyone makes is selling stocks in a panic and buying when sentiment is peaking. The past two years were a good test environment for mutual funds that might be in your portfolio or on your radar. Thornburg Value finished 2008 down over 40 percent, but we stuck to our philosophy and approach, and the opportunities that the selloff afforded us have paid off.