Heebner comments about the big picture

N THE HOT SEAT
Portfolio manager casts an optimistic eye on economy

July 6, 2008

Ken Heebner, a portfolio manager at Capital Growth Management in Boston, has delivered some of the best investment performances of any manager in America. He often operates as a contrarian, avoiding technology stocks in the late 1990s and betting early against mortgage companies several years ago. Heebner, 67, spoke last week to Globe reporter Ross Kerber on where the economy is heading.

There's a lot of pessimism about the economy. What's your take?

My view of the world is quite different. I think people are very concerned about our economy, they're starting to realize there could be higher inflation to come. The consensus is that we'll bring the rest of the world into our recession. But my view is we've probably seen the weakest period of economic activity. The economy may not be robust in the next year, but it's seen its low point and at some point will move higher.

That's reassuring, but how can this be?

I understand how serious the housing problem is. But it's not as broad a problem as widely perceived. It's reduced everyone's sense of financial well-being, but a third of homeowners don't have a mortgage, and the vast majority of people made down payments and have fixed-rate mortgages, so there's no financial strain. For them, the only impact is the psychological impact of declining housing prices. So therefore I don't think this is as big a deal as everyone else does. We've passed the point of maximum distress.

What evidence is there for that?

First, on manufacturing, the Institute for Supply Management's index seems to have reached a low of 49, and when this gets to 45, that's a recession. Additionally, the Fed started aggressive ly easing interest rates, and the impact of those eases will start to be felt. But I think the driver of the global economy is the developing countries, with a population of 3 billion. China, Russia, India, Brazil, and a lot of smaller countries. If you add up Japan, Europe, and the US, you're talking about a little less than 1 billion people, and you have 3 billion people going strong.

But those 3 billion have less money and less GDP. How will that drive the world economy?

These people don't have the roads, the airports, the infrastructure - and the building of these creates big demand for industrial raw materials and energy in all forms. In a nutshell, these foreign countries place a high priority on growth. The broad pattern is they're more concerned about maintaining growth than other factors, be it pollution or inflation.

Globe columnist Steven Syre has twice named you fund manager of the year, and Fortune magazine recently dubbed you "America's hottest investor." So can you talk about what you are buying and selling?

The only two stocks I've made references to [owning] in the last few months are Petrobas [Brazil's Petroleo Brasileiro SA] and Schlumberger [an oil-services company]. I'm changing the portfolios so frequently.

What do you expect US growth rates to be? And inflation?

Our economy will surprise us on the upside, growing between 2 to 4 percent over the next 12 months. I'm a bull on the US economy. Clearly housing has been a negative, but there's only four states where they walked housing prices to Never Never Land, and now it's coming back to a realistic level. Because of increasing demand from these developing economies, I can see, three years from now, inflation approaching 10 percent.

How can you be such a bull on the economy and say inflation could be such a potentially big problem?

I didn't say it's a big problem. In the 1970s and 1980s, when inflation was high - we made good money investing in stocks in that period. I'm running a portfolio. I'm not running the country. The challenge inflation presents is that price-to-earnings ratios tend to decline. So when you invest money, you want to have enough growth to offset that compression.

What impact will the outcome of the US elections have on the market?

[Barack] Obama says he wants to eliminate the Bush tax cuts and take the maximum marginal tax rates to 39.6 percent, then institute some Social Security taxes - and says he'll increase the capital gains rate, now 15 percent. That would tend to be a negative factor. It's hard to quantify, but when I think what effect the election could have on the investment world, taxation is where there's a clear difference [between the candidates]. But it would probably be easier for Obama to say, let's drill offshore for oil. That would be a huge benefit to oil-services company stocks. . . . I do think Obama's going to be elected president of the US, and the Democrats [will] win a huge victory in November.

What do you think has been the biggest surprise in the markets this year?

There was a general fear that we would fall into a recession and it hasn't done that. We've gone sideways. The big surprise is that the economy has held up as much as it has. People are overlooking the fact that we're having a huge boom in the farm economy. Also, the energy area is very positive. And I further expect the weak dollar to energize our exports and manufacturing industries. Our natural competitive strengths, our innovation and creativity, remain unique skills in the global economy. We're going to start to export cars, we'll start to export steel.

What are the biggest areas of problems for the US economy?

The brokerage firms were enjoying huge profitability because of the boom in private equity and hedge fund trading, and they won't have that. Higher inflation is always bad for insurance companies, and the banking system still has all the bad mortgage loans eroding its base. It may be a year more of that. They still have a lot more mortgages to write off.