Time to live large
Value investor Randall Eley says his big-cap strategy makes sense in a shaky market.
By Randall Eley

(FORTUNE Magazine) – "MY MOTHER WAS ESSENTIALLY MY FIRST CLIENT," SAYS Randall Eley. Nearly 20 years later, Eley has transformed his family's homegrown investing club into an institutional investment firm in Springfield, Va., with nearly $2 billion in assets. The Edgar Lomax Co., named for his late maternal grandfather, still welcomes family money (his mother and siblings remain shareholders), but it mostly attracts retirement savings from big clients such as the state of Maryland and the city of Detroit. And Eley's Edgar Lomax Value fund (LOMAX) has a total return of 48% over the past five years compared with a 5% loss for the S&P 500. FORTUNE's Julie Schlosser recently asked Eley to discuss his love of large-cap stocks, his bearish view of the broader market, and why he's been buying shares of troubled pharma giant Merck.

You were a corporate lawyer specializing in bond offerings for nine years. How did working with fixed income affect you as an equity investor?

Being a bond lawyer helped me develop an appreciation for investing in large-cap stocks. I liked working with FORTUNE 500 companies because their bonds were more likely to be paid.

What criteria do companies have to meet in order to land in the Edgar Lomax Value fund portfolio?

We use the S&P 500 as our sphere of stocks to choose from. You have to be large cap to get our interest. To get on a list of stocks that we will study in great detail, companies typically have to have a low trailing price/earnings ratio. They also must have been profitable over the past ten years. It's meaningless to us if a company has put in very good earnings for the past 12 months yet has lost money for the past seven to eight years before that. Or if you find there were so many write-offs that only pro forma earnings exist. Your P/E ratio must be in the bottom half of the S&P 500 or your yield must be in the top half of the S&P 100. The S&P 500's trailing P/E ratio is in the neighborhood of 20 right now. By contrast, the average P/E of the stocks in our portfolio is about 15.

Is this a particularly good time to be focusing on large-cap stocks?

Well, I am convinced history repeats itself. Over the past two calendar years, you had strong, rising markets with smaller stocks leading the charge. In my experience, no one group of stocks can continually outperform all the other stocks in the broad universe unless their earnings are growing at a proportionally higher rate. That's not happening with the smaller stocks right now. So I think it is an especially good time to be in large caps.

You've been saying for some time that the market is overvalued. How far do you think it will come down?

I think the Dow is trading at a price-to-book ratio of about 3.3. Historically, over the past 85 years, that ratio has averaged around 1.8. I'm not predicting that the Dow is going to be cut in half. But I would not be surprised over the next three to five years to see stock indexes fall while at the same time book values increase. I think we'll see a meeting somewhere in the middle.

What is your favorite stock right now?

As far as undervaluation, at this point I think Merck (MRK, $32) is the story, even after its strong run-up recently [following the vote by a Food and Drug Administration advisory panel recommending that the company be allowed to resume sales of painkiller Vioxx]. With a price/earnings ratio between 11 and 12, we project an annual return of at least 8% over the next five to seven years. Our projection for the S&P 500 is, at best, around 5% annually.

Aren't you worried about litigation issues related to Vioxx?

I am always concerned about litigation, but I'm not worried. The best investment opportunities almost always come from problems everybody can see. Everybody can see there is a litigation issue. But I have not seen any evidence indicating that anyone is going to be successful in court proving that Merck management attempted to develop a drug to kill people. Or that after developing a drug they hoped would enhance the quality of human life, they learned the drug had terrible side effects and simply decided to hide it to make some quick money. The courts will decide. The FDA advisory panel has already spoken on the issue. Whatever happens from here, whether the FDA specifically approves the drug going back on the market or not, it has become much more difficult for anyone to get awarded substantial punitive damages. You now have a highly respected panel of doctors in this country saying, We see good uses for Vioxx that we believe override the risks. I don't think Merck can ask for better witnesses in court.

You've been reducing your positions in financial stocks. Which sectors of the market look inviting to you now?

We choose our stocks company by company, not by sector. That said, once we finish constructing a portfolio, inevitably we find that certain sectors will jump out as more undervalued than the others. Right now the utility sector stands out. I think most investors are not buying utilities because earnings growth has not been exciting in that area. However, we think that investors are going to be sorely disappointed when the S&P 500 does not produce the 20% earnings growth it has generated over the past year. Right now the market is undervaluing dividend yield in favor of unsustainable earnings growth. It gives us a chance to buy these utility stocks at average P/E ratios of around 17.

Isn't that a higher valuation than you usually like?

It is, but these companies are producing a product with relatively inelastic demand. So whenever we go into the next recession, the deterioration in earnings they see is likely to be much less than for the rest of the S&P 500. They are likely to be more stable.

Which utility stock do you like the best?

I especially like Southern Co. (SO, $32), a financially strong electric utility in the Southeast that's been in our portfolio for years. It has a history of producing dependable earnings, and right now it trades at a P/E of 15 and a price-to-book ratio of just 2.3, and pays a dividend yielding 4.5%.

What do you like to do when you're not studying stocks?

I love reading biographies. My favorite was one on John Rockefeller that I read after college. I'll never forget reading about his discipline for keeping financial records and saving. Likewise, I'm happy to build my business quarter to quarter and year to year. But I think I got that more from my parents than from historical biographies. My mom always taught us the importance of saving, and my dad always wanted us to be entrepreneurial. âñ