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A Bull Among Bears

Steven Goldberg

A T. Rowe Price manager concludes that most of the damage is behind us and is raising his stake in stocks.



Not everyone is bearish.

David Giroux, manager of T. Rowe Price Capital Appreciation, which, notwithstanding its name, could accurately be labeled a widows-and-orphans fund, sees plenty of reasons to be bullish. And he's backing up his views with actions -- he is buying stocks.

Giroux isn't acting on a hunch. He and T. Rowe analysts have torn apart a generous sampling of the worst toxic paper on Wall Street. "I can't tell you how much time we spent," he says.

The upshot: He's convinced that major investment banks have already taken the bulk of the write-downs related to subprime mortgages and other bad debt on their books. "I think we're in the sixth or seventh inning on this," Giroux says.

As a result, Giroux doesn't think the economy, which may already be in recession, will tank for an extended period. Because stocks tend to bottom roughly six months before the end of a recession, Giroux has turned bullish.

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In the context of his conservatively managed fund (symbol PRWCX), that means raising his stake in stocks to "well above 60%" -- a higher percentage than at anytime in the past three of four years. "We went from ultra bearish to ultra bullish as the market corrected," he says.

Among his recent buys are Merrill Lynch (MER) and Morgan Stanley (MS), which were both hit hard during the selloff. He has also bought more conservative fare, including California utility Sempra Energy (SRE).

Giroux is bullish for several reasons, but what's truly fascinating is his analysis of the tainted securities on the balance sheets of the big investment banks. Start with collateralized debt obligations (CDOs), which are often loaded with subprime mortgages. "These have been written down to 25% of value," Giroux says. "I don't know if the right number is 20% or 30%, but I don't think it's 10%, and I'm sure it's not zero. You don't lose all the money in CDOs. There's some recovery value even in defaults."

Loans used to finance takeovers are much sounder than the market believes, Giroux says. A chief reason: Even if the company goes bust, the loan holders are at the front of the line to collect what's left -- ahead of even bond holders. He was so impressed by the value he perceived in these loans that he bought some for the fund.

Top-rated commercial mortgaged-backed securities, which the banks also hold, are much sounder, Giroux says, than subprime mortgages. This triple-A-rated paper is structured so that it won't suffer losses unless commercial real estate losses top 30%, which seems highly unlikely. These can be profitable "even if you have a horrible real estate market." Giroux says.

Write-downs in investment banks, he says, peaked in the quarter that ended November 30. Write-offs were lower for the quarter that ended February 29. And he expects these charges to shrink further in the current quarter.

Meanwhile, Merrill and Morgan Stanley both trade at just 1.5 times book value (assets minus its liabilities.) Normally, the stocks trade at more than two times book. "And these are usually incredible stocks coming out of a recession," Giroux says.

Capital Appreciation isn't just any fund. Launched in 1986, it has lost money in only one calendar year, 1990, when it slipped a mere 1%. Giroux, 32, has been manager only since the middle of 2006, but he's been at Price since 1998. I believe Price gave extra-careful consideration to the person named to manage Capital Appreciation -- with its storied history of avoiding yearly losses.

The fund has produced solid gains -- solid enough to make it a fine holding for any investor, not just the most conservative. Over the past 20 years, it has returned an annualized 13% -- an average of two percentage points per year ahead of Standard & Poor's 500-stock index.

Yet it's far less volatile than the S&P 500. The fund typically has about 60% of its assets in stocks, with the rest spread among bonds, convertible securities and cash. It has lost 4% this year through March 20.

Giroux has other reasons for being bullish. The S&P index trades at about 15 times "the most bearish view" you can find of estimated 2008 operating earnings. Stocks haven't been that cheap since 1994.

Since World War II, the average recession has lasted ten months, and the current one probably began late last year or early this year. So we're at or near the bottom, Giroux says.

Giroux says the one thing that could upset his rosy scenario is a return of 1970s-style inflation. "If inflation takes off, all bets are off," he says. "But the odds are stacked in our favor."

Steven T. Goldberg (bio) is an investment adviser and freelance writer.



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