The Insightful Ken Heebner
Give Ken Heebner an A+ for prescience. When Kiplinger's interviewed the veteran mutual fund manager early this year (see The Savviest Stock Picker in America), he immediately began to riff about a problem that, at that point, had shown up on the radar screens of few investors: mortgages made to borrowers with weak credit standing. "The subprime-mortgage disaster is much bigger than anyone can imagine."
Heebner also predicted a bright side to the mortgage mess: It would slow economic growth and deter the Federal Reserve Board from raising short-term interest rates. That, in turn, would preserve the bull market.
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More impressive than Heebner's market call is the way he has shaped his funds. In particular, CGM Focus -- the only Heebner-run no-load, diversified fund that is open to new investors -- is insulated, he believes, from the impact of the subprime crisis on the U.S. economy and American consumers.
Instead, Heebner says, Focus "is dominated by the outlook for foreign business." About half of the assets in the concentrated, 22-stock, go-anywhere, do-anything portfolio were in foreign-based companies (as of June 30, 2007) and most of the U.S.-based companies derive a substantial portion of their sales and profits overseas.
CGM released second-quarter holdings for its four funds on August 24, so it seemed an appropriate time to check back with Heebner (to read the reports, go to cgmfunds.com). The focus of our discussion, at Heebner's Boston office, was the $3 billion CGM Focus (symbol CGMFX). Its performance has been off the charts. Year-to-date through August 23, the fund returned 28%, a cool 24 percentage points ahead of Standard & Poor's 500-stock index. Over the past five years, Focus returned 25% annualized, beating the S&P 500 by an average of 14 percentage points per year.
As you read this interview, keep in mind that Heebner is a frenetic trader. What he held as of June 30 he might not own three or four months from now. It's safe to assume, though, that stocks he mentions in this interview are still holdings as of today.
KIPLINGER'S: Ken, as of last December 31, you had fully 25% of Focus' assets in five investment-banking or brokerage stocks. Now you have no money in the group. What happened?
HEEBNER: This was all related to subprime. The subprime problem was a big problem for the hedge funds because hedge funds had made massive investments in debt based on subprime loans. I make a distinction between smaller hedge funds run by good money managers, and mega hedge funds who adopt a grotesque financial model.
Are the mega hedge funds more likely to be the ones that use esoteric strategies with esoteric instruments?
That's what they're saying but it looks to me that in reality all they're doing is employing five to one or ten to one leverage to create high returns. And they're investing in things that are not quantifiable such as CDOs (collateralized debt obligations) based on subprime loans). They were triple-A rated, but ultimately they were based on subprime, second mortgages and pay-option ARMs. So I became worried that this would cause the hedge fund industry to suffer.
Hedge funds are major customers of the brokerage firms, and that's a major reason why I owned brokerage stocks. I think the future of the hedge fund industry is uncertain. We don't know yet to what extent investments in mortgage vehicles or other aggressive strategies financed with high leverage is going to damage returns. But if the hedge fund industry were to shrink from $1.7 trillion to, say, $900 billion, that would be very negative for brokerage stocks.
At what point did it dawn on you that subprime was a problem for the investment banks and brokers?
I can't really pinpoint it. But I had been studying it and realized that they had massive investments in these CDOs and it made me nervous. Also, you had the private equity firms in trouble. Once the subprime mortgage crisis blossomed, it meant that the private-equity business was impaired because of the shutting off of the flow of credit. Private-equity firms use massive leverage and need credit. So these three main sources of high profits -- the CDOs, the private-equity firms and the hedge funds -- have been put into a questionable position.
Were you surprised by the violence of the recent stock-market correction?
I expected a softer landing. However, my view is unchanged about the stock market longer term and the global economy.
If you go back six months, we had an unemployment rate of 4.5% and the economy was growing. In a year's time, that would have brought the unemployment rate below 4%, creating stresses in labor markets, which would have caused the Fed to consider raising interest rates. We're now looking at a slower economy, one that will probably produce growth in gross domestic product of 0% to 1% over the coming year. That means we're not going to draw the unemployment rate down to that level and then we don't have to be concerned with Fed tightening. In fact, the issue today is Fed easing.
If the economy grows that slowly, won't earnings be under pressure?
That's an interesting question. This slowdown will affect the earnings for companies involved in the housing market, where things are going to get worse and stay bad for some time. It will affect, to some degree, consumer spending -- it's hard to know to what degree. I don't think the impact will be great enough to precipitate a recession -- that's why I say 0 to 1% GDP growth. I would look at periods like 1962, when the flattening of the economy was a wonderful period to buy stocks.
What's happened to the stock market already reflects a concern about the economy and I think that's in the price today. I think we've seen the approximate low of the market.
But what about earnings?
I'm getting to that. I've seen studies that say 45% of the S&P 500's earnings are foreign derived. Secondarily, when you look at the S&P, there are a lot of earnings that are independent of the consumer: energy, capital spending, defense, agriculture. So I see about a quarter to a third of the S&P as being vulnerable to weaker earnings.
And that would be the consumer and financial areas?
Financial is complicated. Insurance companies for the most part are not going to be affected by this; some banks will not be affected by this. Some will, those with vulnerable mortgages on their balance sheets, but most of these vulnerable mortgages are held by pension funds, by foreigners, by hedge funds. They're not held by the banking system. And the banking system would benefit from lower interest rates. The Treasury bils are already at 3.6%. That means there has been a steepening of the yield curve, which is gravy for the banks. So I think the impact on the financial sector is mixed.
You had 25% of Focus in investment banks/brokers as of December 31. That's a lot of the portfolio to replace. What have you done with the money?
It's gone into energy and infrastructure and global mining.
You rebuilt your energy position?
That's right. Energy is now 26% of the portfolio. Industrial raw materials -- we're talking copper, steel, coal, nickel. That sector is 24%. Infrastructure is 16% and fertilizer is 11%. These businesses will not be affected, in my judgment, by a slowdown in consumer spending and a continued decline in the housing market.
What percentage of your portfolio is foreign?
It's very hard to make this foreign-domestic distinction. Schlumberger (SLB), for example, is now based in the U.S., but a majority of its earnings are from abroad. I would say that this portfolio is dominated by the outlook for foreign business. For instance, Mosaic (MOS) and Potash Corp. of Saskatchewan (POT) are both fertilizer companies. Both are listed in New York. Mosaic is a U.S. company, and Potash is based in Canada. But the outlook for fertilizer is driven by foreign factors, not domestic. Frankly, I don't pay a lot of attention to the niceties of where a company is based. This portfolio rises or falls based on the outlook for foreign businesses.
Could you theoretically put 100% of your assets in foreign stocks?
Couldn't you call Research in Motion (RIMM), another one of your holdings, a foreign stock? It's based in Canada, after all.
Yes, but most people would say its business is in the U.S., with people carrying their Blackberries around. In any case, I'd say 55% of the portfolio is foreign.
What have you added to Focus since March 31?
Mosaic is one stock. We also added a couple of infrastructure companies, Foster Wheeler (FWLT) and McDermott International (MDR). As of June 30, they, along with Fluor, account for 12% of the portfolio. McDermott is in offshore oil platforms and boilers for power plants. Fluor (FLR) builds the whole power plant, and it builds refineries. And Foster Wheeler is pretty similar. The big businesses for all three companies are energy and power plant construction.
It's a fertilizer company, the old International Minerals and Chemicals. Management got such a bad reputation they changed the name.
But it's good enough for you to buy it?
Sometimes you have to. First of all, when you're dealing with a commodity, the price of the commodity is totally dominant, and you can be more tolerant of weaker managements. And there are only two that I can buy, and if I want to participate in this area, that's where I have to go.
Any other new additions?
Cummins (CMI) is new. I'm calling it an infrastructure company. It's known as a leading manufacturer of heavy-duty trucks. But the company is in power generation and a leader in environmental modification of diesel-engine exhausts, which is a huge growth area. So it's electric power generation, domestic and foreign, and heavy-duty truck engines.
The big growth is in foreign sales. Cummins is a leader in China and India.
One last question. It's about how people should use your fund. Morningstar, for instance, often says that investors get scared off by the volatility of your funds, that they often buy into them after they've had big runups, then bail out after those inevitable sharp downturns. What do you tell investors about how to use your funds?
It is very clear that on a day-to-day basis my funds are more volatile than other funds. The volatility flows from the concentration. If you own just 20 stocks, it's going to be a lot more volatile than a fund with 100 stocks.
I've always been puzzled. Leaving out Morningstar, the whole financial community wants to own funds that don't deviate much from the averages, and they think that that's an attribute. But the question I have about that is, how are you going to beat the market if you own the market?
For more of this interview, see Ken Heebner's Take on Real Estate.