One On One: "There are some great growth companies to own right now, at very attractive valuations"

Value investing has been in vogue for more than a year, but even so, new money has been pouring into the Liberty Growth Stock Fund, which now holds more than $1.9 billion.

Credit for much of the fund’s appeal goes to Erik Gustafson, a portfolio manager with Liberty Financial Cos.’ Chicago subsidiary Stein Roe & Farnham Inc. who has kept the faith in blue-chip, large-cap names such as Johnson & Johnson and General Electric Co.

Founded in 1958, Liberty Growth has consistently outperformed most benchmarks since Mr. Gustafson, 37, took charge in late 1994. For the 12 months ended Jan. 31, the fund lost 8.97%, still better than the 10.53% loss of the average fund in Lipper Inc.’s large-cap-growth universe. The five-year return was 19.39% annually, outpacing the Lipper average of 18.27% and the Standard & Poor’s 500 stock index return of 18.36%.

Born into a family of expatriate Americans in Germany, Mr. Gustafson came to the United States at age 12 and got a bachelor’s degree in English at the University of Virginia and a law degree and master’s in business administration from Florida State University.

He worked as a litigator for a Miami law firm for three years before joining Stein Roe’s Florida branch in 1992. He moved to Chicago two years later to take over the Growth Fund, and today he oversees more than $4.6 billion.

A frequent guest on CNBC, Mr. Gustafson is single and lives in downtown Chicago. He works out in the swimming pool at the swank East Bank Club and maintains a stellar 1 handicap in golf at the Bob O’Link Country Club in suburban Highland Park.

He was interviewed in early March, before the Federal Reserve’s decision at its March 20 meeting to cut interest rates again.

Q Are we in a recession?

A I believe many parts of the economy are in recession. The manufacturing sector is already there, and the service sector is headed there.

The Federal Reserve and Alan Greenspan were way too aggressive in raising rates last year, when there was scant evidence of inflation. They ended up stalling the economy. In retrospect, those rate increases were a big mistake.

I look for flat to negative gross domestic product in the first quarter this year, and it’s certainly possible that we could have two consecutive quarters of negative GDP. The risk right now is a deflationary spiral downward, and the Federal Reserve has been behind the curve in reacting.

I’m looking for a cut of 50 basis points in interest rates from the Fed on or before March 20, and then I think we’ll see another 25 to 50 basis points in cuts beyond that.

Q Will low rates be enough to revive consumer confidence?

A My crystal ball is as cloudy as anybody’s, but history does teach us that when the Fed lowers rates, stocks rise an average of 20% or more within 18 months. I think that if we have a recession, it will be short lived and shallow. As the Fed lowers rates, the economy should respond. But it should be noted that each recession and recovery is different.

Q Value funds outperformed growth funds last year. Are we finally in a value-dominant cycle now?

A Value stocks might well have a long up cycle from here. But it’s important to point out that we have an administration in Washington that is pro-growth and anti-tax, and that’s the kind of environment in which growth stocks typically perform well.

There are some great growth companies to own right now, at very attractive valuations. Growth stocks aren’t dead by any means.

On the other hand, it seems that most of the psychology among investors now favors the value space.

There is a lot of gloom and negativity in the growth sector. Out of this gloom will emerge some fantastic bargains.

There will be clear opportunities for investors willing to attempt to hit ’em where they ain’t.

Q Your portfolio turnover in 2000 ballooned to 75%. Apparently, you scaled back your technology holdings in a hurry.

A At midyear, we were more than 40% in technology. We have reduced our holdings to the point that tech is just 18% now, underweighting the S&P, which is 23% tech. Now tech valuations have fallen so far that we are finding the sector of greater interest again.

In the next quarter, I see us putting 10% or more of the portfolio back to work in tech.

We’ve been nibbling at Finisar, a fiber-optic manufacturer that has been killed in the past year, falling from $60 to $11 [it was trading around $13 last Thursday]. We think it offers tremendous value at this level.

Q Should we be surprised to hear you mentioning value? What kind of growth do you look for?

A You have to be valuation conscious in this market. The days of runaway multiples to revenues are long gone.

For the most part, I want to see sustainable top- and bottom-line growth of 15%. I don’t want to see cost-cutting or turnaround stories, however.

I’ll pay a premium to the market multiple for a company that is high quality and has shown it can sustain earnings growth.

Q You’ve been adding financials. You own Citigroup but not Bank One, which is down the street from your offices. Why?

A Bank One is a turnaround story more than anything. I do think that [Bank One CEO] Jamie Dimon will be able to fix the company, but for now I think Bank One’s chief attraction is to value investors.

Most banks can’t sustain 15% growth, yet Citigroup is a special case because of its broad platform in banking, brokerage and insurance under one umbrella worldwide.

I see Citigroup and AIG as the class of the financials group. Overall, financial stocks represent 16% of our portfolio now, and we think they’re a great place to be.

Q Unlike a lot of money managers, you’re bullish on retailers right now, particularly Kohl’s.

A We’ve owned Kohl’s for many years and think it’s the best-performing retailer around. They have a visionary management team. We also own Target and Home Depot.

Among food retailers, I think Safeway is the finest company in the U.S.

I don’t like the margins in groceries, but a company like Safeway has wonderful defensive characteristics that have served it well over the past year. Let’s face it, people eat in good times or bad.

Retailers typically do well in an environment in which the Federal Reserve is lowering interest rates. They carry a lot of inventory, and as rates come down, their inventory carrying costs come down.

Q Your focus has been on large-cap stocks in the Growth Fund. But many investors believe small- and mid-caps will perform best in the coming year.

A We’ve had five years of wonderful large-cap performance. I do think small- and mid-cap stocks will perform well. Small-caps, indeed, often perform best coming out of a recession.

We won’t change much, however, though we may take our market-cap average, which is at about $60 billion for the typical stock we own, down to about $40 or $50 billion as we nibble at some mid-caps.

Q Your holdings are actually quite narrow for a fund your size. What’s your strategy?

A We have just 38 companies in the Growth Fund. We are a concentrated fund. I don’t believe the way to make money is to be two miles long and an inch deep. We want to own just a few great businesses with a big enough investment in each that our shareholders can get a full bang for their buck.

Way too many mutual funds are overdiversified in the name of caution and timidity.

SNAPSHOT

Erik Gustafson, 37, portfolio manager at Stein Roe & Farnham Inc. in Chicago of the Liberty Growth Stock Fund and co- manager of the Stein Roe Young Investor and Liberty Growth Investor funds

Liberty Growth Stock Fund (assets, $1.9 billion): One-year return, -8.97%; five-year, 19.39%; 10-year, 17.20%

Lipper large-cap growth funds: 1-yr, -10.53%; 5-yr, 18.27%; 10-yr, 16.58%.

Returns as of Jan. 31; periods over one year annualized

Source: Lipper Inc.