Af­ter suc­cess in emerg­ing mar­kets, at­ten­tion turns to U.S. in­vest­ments

The Washington Post Sunday - - BUSINESS - IL­LUS­TRA­TIONS BY JOE CIARDIELLO

Doug Rao, man­ager of theMar­sico Flex­i­ble Cap­i­tal fund, calls it a “go any­where” fund. The fund in­vests in com­pa­nies across the globe, across all mar­ket cap­i­tal­iza­tions and in a va­ri­ety of cap­i­tal struc­tures. Rao says he sim­ply in­vests “where we think the great­est op­por­tu­ni­ties for cap­i­tal ap­pre­ci­a­tion are.” And in 2010, that was emerg­ing mar­kets. The fund— which had about 30 per­cent of its hold­ings in emerg­ing­mar­ket stocks in early 2010— surged 36 per­cent in 2010, beat­ing the S&P 500 by 21 per­cent and other large-cap growth funds by 20 per­cent, ac­cord­ing toMorn­ingstar. Where will he head in 2011? Rao says the fund is mov­ing its in­vest­ments away from emerg­ing mar­kets and back in­toU.S. com­pa­nies. WP: What mar­ket and eco­nomic themes did you base your in­vest­ments on in 2010, and howdo you see those play­ing out in 2011?

The theme in 2010 was that the fi­nan­cial cri­sis in theWestern world was aWestern-world cri­sis. The emerg­ing mar­kets, while ob­vi­ously im­pacted, sim­ply slowed down. We po­si­tioned the fund for a pretty ro­bust re­cov­ery in the emerg­ing word. We thought theU.S. would do okay and re­cover, but we thought the re­cov­ery would be slow and muted in na­ture be­cause of the de-lever­ag­ing of the con­sumer.

How­ever, we were not in the dou­ble-dip crowd. If you look at the sig­nif­i­cant eco­nomic con­trac­tion that took place post-Lehman, it was a mas­sive fear­ful re­sponse byU.S. con­sumers, who slashed spend­ing in the area that was eas­i­est to slash spend­ing: durable goods, or big-ticket items. You need some level of con­fi­dence to want to ac­quire them. If you look at hous­ing and au­tomak­ers, half the jobs we lost were in those two in­dus­tries. To

repli­cate that con­trac­tion in the econ­omy would be nearly im­pos­si­ble.

That gets us into 2011. We’re feel­ing much more con­struc­tive on theU.S. re­cov­ery in 2011 be­cause we are see­ing con­fi­dence come back. We think the 90 per­cent of Amer­i­cans who are and have been em­ployed are go­ing to open their wal­lets this year, and that will drive GDP in 2011. We’re see­ing a fairly sig­nif­i­cant uptick in cars pur­chased, al­though hous­ing is still in the dol­drums. WP: What else makes you up­beat about do­mes­tic ver­sus emerg­ing-mar­ket stocks?

I try to go to China at least two times a year, and I was there six weeks ago. They have been con­sis­tently concerned about theU.S. not do­ing enough to stim­u­late the re­cov­ery and the pos­si­bil­ity of a “ lost decade” sim­i­lar to what hap­pened in Ja­pan.

I think we al­ready had the lost decade in theU.S. The mar­ket to­day is in the same place it was in 1999. We think the S&P can earn close to $100 this year, which means earn­ings have dou­bled but the mar­ket’s flat.

Mean­while, we are be­com­ing more concerned about in­fla­tion in the emerg­ing world. In part be­cause of quan­ti­ta­tive eas­ing, there’s an in­crease of prices of com­modi­ties that puts in­fla­tion­ary pres­sure on emerg­ing mar­kets, which is com­pounded by their own loose mon­e­tary pol­icy. We think In­dia, China and Brazil will spend the year fight­ing in­fla­tion, which is not the best back­drop for eq­uity in­vest­ing. I should add that, sec­u­larly, we are bullish on emerg­ing mar­kets. We think it’s a won­der­ful en­vi­ron­ment forU.S. multi­na­tion­als, and the num­ber of house­holds who are en­gaged in cap­i­tal­ism con­tin­ues to rise ev­ery day.

Our port­fo­lio has moved away from emerg­ing mar­kets and more to­ward eco­nom­i­cally sen­si­tive stocks in theU.S. Emerg­ing-mar­ket stocks have gone from 30 per­cent of our port­fo­lio in late 2009 to 15 per­cent now. U.S. stocks have gone from 40 per­cent in early 2010 to 65 per­cent to­day, and cash and fixed in­come have come down.

I think theU.S. has been do­ing a good job at re­struc­tur­ing. You have to ap­pre­ci­ate the irony— TARP is go­ing to turn out to be a sig­nif­i­cant pos­i­tive for theU.S., but nei­ther the Repub­li­cans nor the Democrats want any credit for it. The dif­fi­cult choice turned out to be a right one: They’re go­ing to make money on most, if not all, the in­vest­ments. WP: So what sec­tors in the U.S. are ap­peal­ing to you? Your largest hold­ing as of Nov. 30was U.S. Ban­corp.

It ap­pears the re­cov­ery in theU.S. is broad­en­ing in na­ture. We’ve been in­vest­ing over the last six months more ag­gres­sively into theU.S. bank­ing sys­tem. Ev­ery­body has been ter­ri­fied of fi­nan­cial andWall Street re­form leg­is­la­tion. We look at com­pa­nies in that space and the con­sol­i­da­tion that’s taken place, and we thinkU.S. fi­nan­cials are un­der­owned and un­der­loved.

We are also at­tracted to com­pa­nies that can cre­ate ef­fi­cien­cies for cor­po­rate Amer­ica, and in­dus­tri­als and technology are two sec­tors that dove­tail nicely into that theme.

I’d say we’re avoid­ing con­sumer sta­ples with­out very strong brand pro­files. We’re also avoid­ing health care. We be­lieveWash­ing­ton will do some­thing about the en­ti­tle­ment deficits, which will re­quire cuts toMedi­care andMed­i­caid. WP: You men­tioned you have less fixed in­come in your port­fo­lio now. Is that mo­men­tum of in­vest­ment in fixed in­come shift­ing?

The bal­ance sheets of busi­nesses in theU.S. are ex­tra­or­di­nary— they have more than $2 tril­lion in cash on their bal­ance sheets. I’ll high­light Or­a­cle, one of the stocks we own in an­other fund, to show you the value of be­ing an owner [of the stock] ver­sus buy­ing the debt. Or­a­cle bought Sun Mi­crosys­tems, and they paid $5.5 bil­lion for it. They think they can gen­er­ate $2 bil­lion in op­er­at­ing profit from it. That’s a 30 per­cent re­turn even with­out rev­enue syn­er­gies. They is­sued debt at 3.85 per­cent to fi­nance that. Who would you rather be— an owner of the eq­uity or a lender of that debt?

Peo­ple are very fear­ful of theU.S. mar­ket. Ev­ery­one is run­ning away from TARP. Peo­ple are skep­ti­cal of the re­cov­ery. Out­flows from the eq­uity mar­ket have been sig­nif­i­cant, and in­flows to fixed in­come have been strong. We’re hard-pressed to see how you could get a real re­turn on your in­vest­ment in be­ing too skewed to fixed in­come. WP: Howdo you de­cide when to sell an in­vest­ment?

All of our funds here are driven by forced dis­place­ment. If there’s a bet­ter idea and we’ve run out of up­side on an in­vest­ment, if it’s hit a price tar­get or the the­sis isn’t work­ing out, that’s when an idea gets sold. WP: What do you see as the pri­mary risks to the mar­ket/econ­omy in 2011?

If both Repub­li­cans and Democrats are go­ing to try to find wins rather than com­pro­mise, par­tic­u­larly as it re­lates to the deficit, that would be a sig­nif­i­cant neg­a­tive. It’s a real over­hang for the con­sumer. They have no sense as to what their ul­ti­mate tax bur­den might look like. Some level of cer­tainty is bet­ter than whatwe have to­day.

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