A time to hedge

For the first time since the last bear market ended in 2002, a broad swath of professional investors are reevaluating where to put their money.

They are moving away from the high-flying investments that have rewarded them handsomely for years and are now seeking out something they had come to despise: quality.

Brett Gallagher, co-head of global stock investment at Julius Baer Investment Management in New York, is dumping once-trendy stocks from far-flung places like India, betting instead on developing economies with what he considers better long-term prospects. He’s avoiding regional banks with lots of exposure to consumer loans, preferring bigger global players. Also off his radar: anything favored by fast-money hedge funds — “renters, not owners,” he scoffs. Instead, he likes more staid stocks, such as General Electric Co.

“It is clear which stocks have an investor base and which are powered by near-term speculation,” Gallagher said. “For anyone who is an investor as opposed to a renter of stocks, upgrading to quality in the portfolio is going to pay benefits.”

Money managers are concluding that it’s time to cut back on their holdings of the volatile and increasingly speculative investments that until recently had been soaring — gold, industrial commodities, real estate as well as small stocks and many developing-country stocks.

“Starting in 2002 and 2003, it was ‘the riskier the investment the better.’ Now, the tide has shifted,” said Jeff Schappe, chief investment officer of BB&T Corp.’s BB&T Asset Management in Raleigh, North Carolina.

As the era of cheap borrowing ends and the economic climate grows more conservative, investment pros are betting that higher-quality investments will fare better in a slower economy — and suffer less if there’s a bear market. But they don’t all define “quality” in the same way. Here is a look at some of their strategies:

“Pick less volatile stocks

Money manager Janna Sampson of OakBrook Investments in Lisle, Ill., trimmed holdings of stocks such as McDonald’s Corp. and Waste Management Inc. that were up sharply and might not fare as well if economic growth slowed. She cut back on H.J. Heinz Co., because it was up on speculative buying, not on fundamentals, after an activist investor pressed for strategic changes. She shifted money into stocks that haven’t been as sought-after and for which expectations are lower, such as Kimberly-Clark Corp. and Microsoft Corp.

In April, Susan Malley, president of Malley Associates Capital Management in New York, pulled back from the bets she had made on economic growth last year. She reduced holdings in smaller companies and in those closely tied to economic expansion. Among them: oil drillers such as Diamond Offshore Drilling Inc., and technology companies such as communications-chip maker Broadcom Corp., and software maker Cognos Inc.

She shifted toward larger oil-industry stocks, including Schlumberger Ltd. and Baker Hughes Inc. and boosted exposure to companies with steady sales streams, such as PepsiCo Inc., Kellogg Co., CVS Corp. and Procter & Gamble Co. Although they tended to be laggards until recently, these so-called Big Uglies look safer and more stable now, she said.

Gallagher notes that stocks such as U.S. Steel Corp., Apple Computer Inc., copper-producer Phelps Dodge Corp. and chip-maker Advanced Micro Devices Inc. all have seen rapid buying and selling in recent months. He sees that as a sure sign of excessive interest by hedge funds, the fast-trading investment pools that cater to deep-pocketed investors.

Because fickle hedge funds can suddenly dump large amounts of shares — making stock prices fall sharply — he is bullish on stocks in which trading has been quieter. He likes GE, United Parcel Service Inc. and PepsiCo — companies whose fundamentals he believes make them good long-term prospects.

“Beware Consumer Stocks

BB&T’s Schappe has a secret weapon to track consumer demand: his father, who sells real estate in mobile-home parks in Punta Gorda, on Florida’s west coast.

“A year ago, we liked consumer discretionary stocks a lot more,” Schappe said. But his research showed loan delinquencies on the rise, and his father reported that his customers’ buying power was weakening.

To cut its exposure to discretionary stocks — those that rise and fall with consumer spending on nonessential goods — BB&T trimmed holdings of handbag retailer Coach Inc. and women’s clothing retailer Chico’s FAS Inc. It also pared holdings of computer-chip makers such as Broadcom and National Semiconductor Corp.

“Consumers have pretty much tapped out of their home equity, and that cash register has shown signs of going silent,” he said. “We are tending to focus on businesses that sell to businesses.” To that end, he boosted investments in companies such as Boeing Co., Oracle Corp. and Caterpillar Inc. — companies with large-scale contracts and good global growth prospects.

“Think Big, Not Small

The Russell 2000 small-stock index more than doubled during the current bull market, hitting repeated record highs, while the Dow Jones Industrial Average rose roughly half as much and never hit a record. Now, the tables may be turning.

Small stocks typically do best when economic growth is accelerating, because small companies are more nimble and can grow faster. But they also tend to be more dependent on bank loans, making them suffer more when rates rise and economic growth slows.

For some time, analysts have been urging investors to return to once-popular big stocks that had languished and become cheap, and now some investors are listening to that advice.

“A good proxy for quality is size,” said Schappe. Even fund managers at his firm who specialize in small stocks, he said, “are buying larger small stocks.”