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A look at the market - with an eye on values

Watch out! That's the word from three values-investing panelists who came to share ideas with us recently in Boston. They piqued our interest with their thoughts about the stock markets (overvalued) and real estate (ditto). But what really caught our attention was the interplay of their social values with their unique approaches to investing. For example:

Investors will have to move beyond traditional diversification to manage risk in new ways.

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Think commodities.

Today's investing environment is a "row," a fundamental change from the '80s and '90s when it was a "sail."

Intrigued? Our panelists all managed to weather the market downturn with remarkable buoyancy. They are: Jerry Dodson, president of Parnassus, one of the world's first socially responsible mutual funds; Ed Easterling, who manages a family of hedge-fund portfolios called Crestmont Holdings; and Jane Siebels, who runs a values-based investment firm, Green Cay Asset Management. Here is an edited transcript:

The markets have roared back in the last few months. Can we breathe easily or have investors become too optimistic?

Jane Siebels: Euphoria is very hard to judge, but I think we're into the euphoric stage.

Jerry Dodson: It's a strange market. The bubble is going on in the technology and other more speculative stocks, but there's not a bubble in many of the basic economy stocks. Also, earnings are improving as the economy gets better. And, of course, when you talk about a P/E [price-to-earnings] ratio, and the E goes up, that means the ratio goes down. So I think that there are a lot of dangers out there. But I also think there are some areas where you can be relatively safe.

But if the economy is doing better, doesn't that mean better times ahead for stocks?

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Ed Easterling: Most people don't realize that the economy and corporate earnings grew by almost the same amount during the period from the early '60s to the early '80s [and] from the early '80s to 2000. So in both of those nearly 20-year periods we had the economy and earnings basically go up threefold. It's just that in the first period, the stock market was flat, in the second period it went up 10-fold. And it's a function of interest rates and inflation. From where we sit today, we're in a period of very low inflation. So, from here, we either go back up into inflation, we go down into deflation, or we keep low inflation for a long period of time. But all of those mean that it's going to be hard to have a stock-market P/E expansion like what we had during the last 20 years.

You all sound rather gloomy. What should the average investor do?

Easterling: I would say that the most important decision for the average investor is to hire independent advice and above-average talent. In the '80s and '90s, when we had a generally rising [stock] valuation level, we had declining interest rates, and a confluence of other events that helped, ultimately, to create a bubble. It essentially was very much of what I call a "sail" environment. Because you just put your sail out, rode it, and, on a dip, opened the sail a little bit more. We've really moved to much more of a condition that I consider a "row" environment, like rowing a boat, which was like the '60s and '70s, where you had to actively manage investments, not just sail. And so for investors now, it means being much more adept, much more active, in the way that money is managed and to not have the expectations of the returns that were there in the '80s and '90s.

Siebels: I've had an incredible mentor in Sir John Templeton. And the biggest think I took from Sir John is that you can't do what everybody else is doing. You have to think independently, you have to - not be a contrarian [exactly], but look at stocks or look at the economy differently from everybody else in order to get the edge to outperform. Because if you do what everybody else is doing, you are going to perform exactly like everybody else.

Jane, you play both sides of the street: buying - going long - in areas you think will rise, and selling - going short - in areas you think will fall. Where are you looking now?

Siebels: There are areas that we find to be tremendously interesting, both on the long and the short side. On the long side are commodities. You have this tremendous economic powerhouse out there called China that is taking up so much of the world's iron ore, copper, aluminum. In the next five years, they're going to be big purchasers of oil, and so on and so forth. And these are stocks that, up until a few years ago, had been in a 20-year bear market. And there are only four firms that have global commodity analysts that are really calling commodity stocks around the world. And so, there's a tremendous opportunity there because no one's been looking at them for so long.

Now, on the other side, if you go to the cocktail parties, everyone is talking about - what? - how much money they've made on their house. [Then] you start looking at the demographics, you start looking at the possibility of interest rates actually rising, you look at the amount of money that's on adjustable rate mortgages now. And you can really see that there is a good chance that, at some point, real estate could be topping out.

And if you look at the United Kingdom and Australia, you can see that these things are even magnified further. You know this bubble is going to burst.

Jerry, you recently announced that you're going back into stocks even though the market is overvalued. Explain.

Dodson: Starting last summer I concluded that [stock] valuations were way too high. And I also concluded that the market was probably going to go down - about an 80 percent chance is how I assessed it.

Not only were valuations very high, there was a huge speculation element in the fund, because margin debt on the Nasdaq was at all time highs. So that meant that people were borrowing money to invest in highly speculative Nasdaq stocks, which is usually a sign of a market topped out. Also, insider selling had reached an all-time high. And when the people who know the most about a company, namely its top management and its directors, are selling the stock, that makes me very nervous.

So we went into cash, about 85 percent. So for 2003, we were up 16.5 percent. For a normal year, I think 16.5 percent sounds pretty good. But when the S&P is up 26 percent, that means we underperformed by 10 percent.

Now, the question came after six months [and a robust rise in the stock market]: What do we do? Well, George Soros, who I don't agree with very often, said something to the effect that the market is definitely overvalued, but that doesn't mean it can't get even more overvalued. And I think that's the dilemma I faced.

So I took a second look. The insider selling is still going on, the valuations are still high, the Nasdaq is high. However, the economy looks stronger than it did six months ago. So we went back to the drawing board and, look, we're finding some very good values in certain sectors. Healthcare is one area. Pharmaceutical [companies] are another area, some finance [firms]. And our idea is that, if the market keeps going up - which it may - we would get reasonably good returns. On the other hand, if the market goes down, we would probably not go down as much. So that's the strategy that we've taken, and we're now about 65 percent invested [in stocks].

Should the average investor do the same?

Dodson: I'd say keep half your money in cash. Because there may be some very good buying opportunities before the end of the year. But you also want to hedge your bets, and if you're picking a mutual fund - I hope you're picking the Parnassus Fund - or another good fund, but a very conservative fund. Stay out of the technology sector and the high fliers. If you're picking individual stocks, look at the P/E ratio. If it's up at 100 times earnings or 50 times earnings, I'd say stay away. If it's below 20 times earnings, consider it. I'd also look for a company that had fairly consistent returns. Also, I would consider dividend-paying stocks under the correct markets, as they tend to go down less in a market crash.

Ed, you manage risk by looking for absolute returns. What do you mean by that?

Easterling: This is actually a fundamental concept. Most managers, especially ones who categorize themselves as large-cap value or small-cap value [specialists], their objective is to deliver returns consistent with that sector. So their goal is to get returns relative to something. Absolute returns is an approach that says regardless of what happens to the market, your objective is to make a profit. It's a much more complex process, because in the relative case you're picking a basket of securities that is intended to perform like another index. In the other case, you are trying to realize returns that absolutely perform, regardless of what happens in the market.

Is the average investor really going to use the fancy hedging techniques your managers do?

Easterling: During the '80s and '90s we saw a proliferation [of mutual funds], and now people have become asset allocators. The next evolution will be a proliferation in risk-control products. And so, 20 years from now, I would say that investors will be talking about the way that they're managing risk and the way that they're managing absolute returns in their portfolio. And there will be the products and the services available to do that.

All three of you don't just look at financial performance but also social values. How do you do that?

Dodson: We tend to take a number of principles into account. The most important principle is how a company treats its employees. Sometimes as a screening device we use Fortune's annual "100 Best Companies to Work For." The second is the environmental policy, which means different things to different people. We look for things like recycling, low emissions, etc. The third area is community relations, and this would include charitable contributions, participation in the community.

We also have negative screens and we're very product oriented - more product-oriented than other social investment funds. Take a company like Coca-Cola, which many social investment funds put in their portfolio because they have some positive things, such as good employee and community relations. But for us, Coca-Cola does not have a positive social impact.

Coke is just slaking thirst?

Dodson: Maybe it's slaking thirst. [But] people could choose plain water or something healthier ... and sometimes they go into the developing world. They take away sales from a nutritional drink, which is usually fruit-based. So it's not a positive impact on society.

Jane, how did you become involved in social investing?

Siebels: The catalyst for this was, unfortunately, the death of my father, who was of "the Greatest Generation" and a grain dealer. He never asked me how much money I made when I came home to Iowa, but he would always ask me if I was treating my customers fairly, if I was honest, and all that. So I sat down and said, "What can I do to incorporate this into my Green Cay's philosophy?" I thought the best way to do that was not only to have socially responsible consultants look at the companies, but also have ethics professors look at the companies, people who are concentrating on these values. So that's what we do.

We have some ethics professors who receive our list [of companies that Green Cay might short] and then we'll rate them according to values. Some of the professors specialize in corporate boards, some are specializing in management and management compensation. They all have their different strengths and their way of looking at things. That was the interesting thing. With Enron, WorldCom, Dynergy, and Tyco, each of them was shorted on a different value.

You were shorting Enron while everybody else was buying?

Siebels: Enron was ranked very highly for bad values by the socially responsible consultant because what was going on in India with a plan that would never be economically viable. One of the ethics professors who really concentrates on accounting, on things like class action suits, legislation, also picked up Enron, but that was because of what they were doing in California. They were lobbied to build a plant, received permission, then sold the rights, which, according to their balance sheet, didn't make sense. So he said, "there's something wrong here."

And WorldCom?

Siebels: Worldcom was a board issue. A different ethics professor in that case pointed out that, basically, the board didn't have very good knowledge of telecommunications and there were all kinds of questions. So that was the trigger.

You also invest in foreign countries that have far fewer environmental and labor protections than the US. Is that ethical?

Siebels: One of my big pet peeves is people saying, for example, "You should not invest in Colombia, because they are all drug lords." Whoa! Yes, there are drug lords in Colombia, but if we don't invest there, they won't even have an alternative. We found a company in Colombia, Carrulla, which was a family-owned supermarket chain. It took more than 10 percent of its pretax profits and put it in a foundation to provide scholarships for the employees. And we're talking the grocery packers and the checkout women. It rose to such an extent that 80 percent of the children of the workers of Carrulla were going to college on Carrulla scholarships. That's a Colombian company. Now, I'm not supposed to invest in that?

Ed, you pick people instead of stocks?

Easterling: People make a difference. And so I stepped back and said, "How do we get a people edge since we're based in Texas?" There are well over 200 hedge funds now in Texas. So if our objective was to find a dozen or 15 blue-chip quality funds, why not stay in our backyard and identify funds by referral, not by scanning a database?

So we're picking people who have the respect of others, whether investors or managers. You not only spend more time with them, but also without ever asking for a reference, you can talk to other managers, other investors, to understand who they are, beyond being investors. When we talk to them we can find out: Who goes to church together? Who carpools with whose kids? Who knows each other personally?

Sometimes churchgoers and big donors to charity turn out to be frauds. How do you avoid them?

Easterling: Sometimes these blowups occur because people make mistakes, or because they didn't appreciate the risks inside their portfolio. It's not enough just to have a personal value side, to have a company that has great values but poor fundamentals. The key is the combination of the two. That gives you the powerful force.

Are you socially responsible?

Siebels: To be labeled as a socially responsible investor in the hedge-fund community is the kiss of death. (Laughter.) So it has really been tough for us. We actually use "values investing."

Easterling: I guess I'd use the same term that Jane was using.

Dodson: Ethical investing or values-based investing? It really doesn't matter to me as long as you're taking a viewpoint that the companies you invest in have a positive social impact.

For further discussion, tune in to the Monitor's webcast of the panel's public presentation at The Mary Baker Eddy Library (

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