Buy or sell dice

Betting on Fundamentals

Given all the bad news roiling markets, investors are becoming increasingly fearful about investing in equities. But Shawn Price, manager ofTouchstone Large Cap Growth (TEQAX, 800-543-0407) , says it's still possible to make money in this perilous market by focusing on the fundamentals. Price's system of stock selection blends quantitative measures of volatility and risk with a keen eye for strong fundamentals. This approach has catapulted the fund to the top of Morningstar's Large-Growth category-Touchstone Large Cap Growth ranks in the top decile for the trailing 10-year period.

Is this volatile market environment here to stay?

Right now, I don't see any turns for the foreseeable future. People are fearful not so much because the data is scary, but because of the unknowns. Unemployment seemed like it was improving, but the US economy is not creating jobs, and the August report of zero job growth will probably be revised to negative growth. In addition, another election cycle is underway in the wake of the debate in Washington over our nation's debt. Our politicians seem more interested in taking partisan jabs at each other than actually trying to fix things. Europe is just as dysfunctional, with governments implementing massive austerity measures that are causing riots across the region. It will be at least another six months before we'll have any clarity on these developments. As such, I'm shifting my portfolio toward greater diversification among lower volatility stocks.

Nevertheless, there are opportunities for investors. For example, our portfolio has the strongest fundamentals on an absolute basis that it's ever had, as well as on a relative basis compared to the Russell 1000. Of course, companies are entering a period in which the comparison of their fundamentals will be against relatively strong numbers, as opposed to the dismal numbers posted during the recession. On the other hand, companies have reduced overhead by closing down unproductive facilities and instituting lay-offs. In many cases, firms cut back their expenses and then drew down their inventories. While it's good to get lean and mean, you can only cut so much. Now corporations need to demonstrate top-line growth by increasing sales while operating in an environment of low consumer confidence and high unemployment.

I'm not optimistic that these problems will be resolved in the near term, but that doesn't mean investors should idle in cash. If you hold substantial cash, you're almost guaranteed to have your wealth eaten away. We're printing money at an unprecedented rate, and once inflation rears its head it's going to destroy any cash holdings. Unfortunately, bonds are also not offering much as an asset class. In most cases, bond yields are below the rate of inflation, so they're an almost guaranteed loser. And commodities are just too frothy, particularly gold. At nearly $1,900 an ounce, gold is closer to the end of its bull run than the beginning. For the average investor, there's really only one attractive asset class at the moment-equities. Though the turmoil in the market may be terrifying, equities are the one asset class currently offering decent prospects without a guaranteed loss. But this difficult environment demands diversifying among stocks with the strongest fundamentals.

How has your portfolio coped with the recent volatility?

According to our Morningstar and Lipper ratings, we're in the top 4 percent of large-cap growth funds year to date. One of the reasons our system has held up so well is that we demand a fundamentally superior portfolio relative to the constituents of our benchmark index. For example, our average operating margins are slightly over 15 percent versus negative 7 percent for the Russell 1000. We have a reinvestment rate of 25 percent versus 19 percent, and year-over-year earnings growth of 109 percent versus 103 percent. These strong fundamentals have insulated our portfolio from the recent volatility.

Also, our system keeps us well diversified. We limit our bets by not allocating more than 5 percent to any one stock. Fortunately, we've found a number of compelling stocks. We have exposure to producers and manufacturers, materials, technology, energy, health care technology, and a range of other industries. This broad exposure keeps our portfolio from experiencing booms and busts based on individual sectors. During the past year, our focus on diversification and strong fundamentals has kept volatility down and produced gains relative to our benchmark.

Your fund has a heavy allocation to consumer cyclical stocks. How does this exposure dampen volatility?

In many cases, consumer cyclicals are naturally lower-beta investments. And when volatility creeps into the market, our system is designed to seek out lower-volatility stocks and sectors. Our portfolio currently has about 44 stocks, versus 37 one year ago. As the market became more treacherous, we diversified to spread the risk among more stocks.

Our system is statistically driven, so it's unable to be biased toward a particular stock or sector. The system doesn't know whether you're feeding it an Apple ( APPL ) or a Chipotle Mexican Grill ( CMG ). But statistically, the system will adjust beta upward or downward by highlighting particular sectors depending upon overall market conditions.

What are some low beta names you're system has recently led you to?

We hold natural gas pipeline and exploration company El Paso Corp ( EP ), specialty coffee and coffeemaker producer Green Mountain Coffee Roasters ( GMCR ), MasterCard ( MA ), Ralph Lauren (RL), Starbucks (SBUX), and Tiffany & Company (NYSE: TIFF). Overall, those are pretty tame names.

MasterCard may sound like a counterintuitive play with all of the deleveraging underway, but the company's numbers have been strong. The firm's margins are running at 34 percent, it has a tremendous reinvestment rate, a 23 percent return on equity, and a fairly moderate price-to-earnings multiple of 19. Analysts have been aggressively revising earnings estimates higher to 29 percent annual earnings growth. We all know about the consumer-deleveraging story, but we don't let that narrative get in the way of a sound investment opportunity.

The system has also directed our attention to cloud computing solutions provider Citrix Systems (CTXS) and network optimization software maker F5 Networks (FFIV). The common theme is that our system's been trading up for the lower beta names with strong recent earnings, qualities that it considers paramount.

The flow of money on Wall Street is being driven by fear, and consequently, risk aversion. Investors are pulling out of more volatile names and putting that money into government securities, lower beta stocks, such as the ones we're holding, or even sitting in cash. Investing is a very manic depressive sort of pursuit, so the money flow is obviously going to reflect that. When the market was still clearly on its bull run 18 months ago, our portfolio was chock full of high-beta and high-alpha stocks because the money flow was guiding us in that direction. As fear returned to the market over the past five months, investors started to abandon more volatile securities in favor of steadier fare. That behavior ultimately affects the alphas and standard deviations that drive changes in our portfolio allocations.

What's your best advice for investors?

Pay attention to overall fundamentals. There are companies on the market that are thriving and snatching market share from competitors that have fallen by the wayside. There will be companies that come out of this downturn stronger and healthier. The US economy won't just fold; the country will weather this difficult period. There are always opportunities to make money, even if you're avoiding the sexier stocks.

However, investors need to stay diversified. This isn't the time to make any wild bets in the market. Just spread your investments across a number of healthy companies.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Article Republished with permission from and

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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