‘93/’94 Year-End Review and Outlook : 4 Strategies for the New Year : Veteran Money Managers Share Investment Recommendations

How can you construct a winning investment portfolio for 1994, given the many cross-currents in the markets and the economy? Four veteran California money managers offer their outlooks--and specific investment recommendations.

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Stay Long in Bonds: On Wall Street and on Main Street, the big question for 1994--some would say the only question--is whether the Federal Reserve will raise interest rates for the first time since February, 1989.

With the economy finally in a real recovery, most experts are convinced that the Fed is about to perform its usual thankless task of taking the punch bowl away just as the party gets going.

William Gross, who helps direct $50 billion in bond investments for Pacific Investment Management in Newport Beach, agrees there’s a good chance the Fed will be obligated to act in 1994. But he says the implications aren’t quite as dire as many investors may be assuming.

“Even if they raise rates, I have a hunch it isn’t going to be dramatic,” Gross says. “They don’t need to raise rates much to achieve their effect,” he says--which is to signal the markets to tighten credit a bit, thereby keeping the economy from advancing too fast and kindling inflation.

At most, Gross thinks short-term interest rates will climb about one-half point in 1994. That would boost the yield on three-month Treasury bills from 3.06% today to the 3.50% to 3.60% range a year from now.

If longer-term bond yields follow short rates up by even a mere half-point, current bond owners’ principal value could be significantly eroded for the first time since 1987. But Gross says the good news may be that long-term yields will be stable or fall further by the end of ‘94, even as short rates rise.

Why he’s optimistic about long rates: While short-term rates respond to short-term economic forces, long-term yields are mostly a function of Wall Street’s perception of future inflation trends, Gross notes.

If the market believes that a Fed move to nudge up short rates will help keep inflation low (3% or less per year) in the long run, the current 6.35% yield on 30-year Treasury bonds should look quite attractive to investors, he says.

So long-term T-bonds and long-term bond funds are his favorite fixed-income investments for ’94. If long rates just stay relatively stable for the year, Gross says, they will provide a much better return than yields on money funds and other “cash” investments--even if those cash yields rise from the current 2%-to-3% to about 3.5%.

Betting heavily on cash in ’94 “will be an expensive wait,” he predicts.

Perhaps surprisingly, Gross is negative on intermediate-term bonds, especially two- to five-year Treasury issues that have been favored by many conservative small investors. He believes yields on those issues will follow short rates higher, slicing into the principal value of current issues in that maturity range--to their owners’ dismay.

Besides long-term Treasury bonds, Gross advises yield-needy investors to consider mortgage-backed bonds (such as GNMAs) and tax-free municipal bonds.

Yields on mortgage-backed issues were kept artificially high in 1993 (7% or more); investors avoided those bonds because of the threat of prepayments, as homeowners refinanced in record numbers. But refi activity should slow this year, Gross says, sparking new demand for mortgage bonds.

In the muni market, yields remain very attractive, he says. Long-term California bonds pay 5% to 5.5% tax-free, equivalent to Treasury yields between 7.7% and 8.4% for a couple in the 34.7% federal/state combined marginal tax bracket (those with taxable income of $61,241 to $91,850).

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Stocks Still Look Good: Don’t believe the bears who say the stock market is overvalued after three years of gains, says Jerry Dodson, manager of the Parnassus stock mutual fund in San Francisco.

“It’s not overvalued--it’s fairly valued” relative to the strength of corporate earnings, Dodson insists. That’s high praise coming from a money manager who never likes to overpay.

Dodson, whose $85-million fund is labeled “socially conscious” because he screens investments for “enlightened and progressive management,” drove Parnassus to a 16% gain last year, after a 36.8% return in 1992.

This year, he thinks he can achieve double-digit returns again, if he’s right in assuming that rising corporate earnings will attract more people to stocks as the economy grows.

While Dodson concedes that interest rates probably aren’t going lower in an improving economy, he believes it’s too early for the stock market to lose its composure over a possible rise in rates.

“I don’t think we’re going to have much inflation, because American industry is much more productive than it used to be, and that means costs are under control,” Dodson argues. If inflation remains tame, he says, there’s no reason to fear a surge in interest rates--which means the stock market will be free to ponder the good news of the recovery.

Among industrial stocks that Dodson says should get a kick from the economy, he owns Acme Metals ($18 as of Friday), which makes steel bands used in packaging and shipping; Raymond Corp. ($16 3/4), a producer of factory and warehouse forklifts; and truck-engine maker Cummins Engine ($53 3/4).

He’s high on technology as a way to play the economy’s growth, as well. Though Apple Computer ($29 1/4) has been trounced in recent months, Dodson believes the company’s new “Power PC” computer, to be introduced this spring, will be “a very significant product.”

Dodson also owns laser maker Electro Scientific Industries ($15 3/8) and a small company called Genus Inc. ($3), which produces equipment used to manufacture chips.

As for income-oriented investors, he suggests they take a second look at some utilities and financial-services companies whose dividends are high and whose share prices may be unduly depressed by worries about higher interest rates.

Dodson includes California S&Ls; Ahmanson ($19 5/8) and Great Western Financial ($20) in that camp, as well as Brooklyn Union Gas ($27 3/8), and ONEOK ($18 7/8), a Midwest natural gas distributor.

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Stocks Should Beat Bonds: Robert Rodriguez is betting on a healthy year for the economy in ’94. For the two mutual funds that he manages--a stock fund and a bond fund--the improving backdrop probably means more opportunities to make money in stocks than bonds, he says.

But in both markets, he is warning shareholders, “I think it’s going to be a relatively difficult year.”

Rodriguez, who manages the FPA New Income and FPA Capital funds in West Los Angeles, expects short-term interest rates to creep up in ’94. But Rodriguez isn’t willing to bet that long-term yields can avoid going along for the ride.

He figures that major pension funds--under pressure to earn higher returns--are likely to shift more of their assets from bonds to stocks as the year progresses and the economy improves. That will put additional upward pressure on long-term yields, Rodriguez says.

If 10-year Treasury note yields rise just one full point from the current 5.80%, he says, the decline in the price of current notes will almost completely negate the 5.80% interest earned for the year.

To avoid getting clobbered by a rise in long-term rates, Rodriguez is keeping the average maturity of FPA New Income’s bonds at just under three years. A shorter-term portfolio will suffer proportionately less of a decline in principal than a longer-term portfolio, given the same rise in rates.

His biggest investments are mortgage-backed bonds on mobile homes. He reasoned in 1993 that mobile-home owners would be less likely to refinance their mortgages even as interest rates fell--and that proved correct, Rodriguez says. He has earned high yields on those bonds--more than 8%--and avoided seeing them called away.

In 1994, Rodriguez is sticking with mobile-home bonds, sprinkling in some high-yield corporates and moving gradually into two-year Treasury notes for safety. Overall, he expects his $115-million bond fund to produce a total return (yield plus price change) of just 4% to 7% in 1994--far less than the 10% earned in ’93.

He is much more excited about the stock market. His stock-picking produced an 18% return for the $150-million FPA Capital fund in 1993, and he thinks he can do close to that in 1994.

While many investors worry that a sharp market pullback is imminent, Rodriguez says they are missing the boat. “I see too many stocks that have already gone through corrections,” he says. He has been able to find enough cheap stocks to cut his fund’s cash reserve from 10% of the portfolio to 3% over the last five months.

He, too, likes the prospects for many financial services firms. He has been buying mortgage financiers Countrywide Credit ($25 1/8) and Green Tree Financial ($48).

Similarly, Rodriguez believes that stocks of companies whose fortunes are dependent on the beleaguered California economy are near their bottoms, because he expects the state to begin recovering in the next two years. He likes names such as clothing retailer Ross Stores ($13) and Northern California savings and loan Bay View Capital ($21 1/8).

Finally, he is betting on technology, but via stocks that others might regard as “mostly mundane” companies, including electronics distributors Marshall Industries ($50) and Anthem Electronics ($28 7/8). If mundane can be used to describe a stock that goes from $38 to $50 in one year--as Marshall did in ‘93--he’ll take that every time, Rodriguez says.

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Buy Overseas--On Pullbacks: Investors may have to keep reminding themselves in 1994 what economic growth ultimately means: higher corporate earnings worldwide, says Lynn Danielson, chief investment officer at Northern Trust Bank of California in Los Angeles.

“We’re in the bull camp on earnings,” she says, and that translates into an optimistic outlook on the stock market for ’94.

Danielson expects operating earnings for the average U.S. blue-chip company to rise at a double-digit rate in ’94. If that is on the mark, she believes stock prices overall could advance another 10%--though not necessarily in a straight line--as investors respond to rising earnings.

So she’s advising clients to keep half their stock portfolios in large U.S. companies that should benefit from faster growth and the other half split between international stocks and smaller U.S. stocks.

Among major U.S. firms tied to the economy’s prospects, Danielson likes General Electric ($104 7/8), steel maker Nucor ($53) and specialty chemical firm Morton International ($93 1/2).

Smaller stocks on her list include computer parts maker Solectron ($28 3/8); carpet firm Shaw Industries ($25 1/2), a play on the strong housing market; and W. W. Grainger ($57 1/2), an industrial parts distributor that Danielson calls the “7-Eleven for industrial America.”

Internationally, she says she will add to clients’ holdings in Mexican and Japanese stocks this year. Smaller emerging markets--such as Thailand, Turkey and Indonesia--remain attractive for the long term, Danielson says, as their economies continue to boom.

But after the spectacular stock price gains in many emerging markets in ‘93, “some of those markets may not be the place to be in ‘94,” Danielson warns. “We’re telling people to be careful. You want to buy on pullbacks.”

For conservative California investors who need the income or relative safety that bonds provide, she says tax-free municipal issues still are the smartest bet.

Muni yields remain historically high compared with taxable yields (such as Treasury yields). That means muni investors are amply rewarded for accepting the risk that rising market interest rates could erode some of their principal, Danielson says.

What’s more, she expects 1993’s high pace of new muni issuance by state and local government in California to trail off in 1994. As supply is dropping, demand for the bonds should increase, she says, because more high-income Californians will realize that their federal tax rates have gone up--and that tax-free bonds are among the few tax shelters left.