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How to Invest in the Fed's Slow-Growing Economy

Richard Satran

What if the "breakout" economy does not deliver faster growth and the "new normal" of slow growth and ultra-low interest rates is here to stay? Kevin O'Brien, who manages the Prospector Opportunity fund, says he sees "a lot more reasons" to believe the economy will maintain the status quo for some time to come.

Investors are watching the Federal Reserve for any disturbance in the established pattern of low interest rates now in its fifth year. The market has been shaken recently by concern that rates will rise as the inevitable full-strength recovery arrives. O'Brien says there are no strong signs that a big change is in the works that would lead to such a momentous Fed shift.

"We are not seeing the usual upward move of an economy going through a recovery," he says. "There is not the super-robust growth like we had in the past after a recession. It's just not happening that way, and if you invested as if it were, you've probably ended up losing out."

Some famed fund managers agree that companies have grown soft on easy money, and that makes it hard to buy into them. Mohammed El-Erian, Pimco's chief executive, and hedge fund manager Stan Druckenmiller have both complained of what El-Erian calls "zombification."

[Read: Pimco's El-Erian Says Zombies Threaten Markets.]

In an interview, O'Brien says it might be best to lean out a bit by ignoring the hot stocks of the day and taking a longer-term view. "You can still find companies that are doing well," he says. "They are just not the growth stocks or the large companies with deeply undervalued assets that a lot of fund managers like."

Don't go big in a slow-growth economy. O'Brien and Druckenmiller, both value investors, agree on one big point. They both say there is not a lot of upside in large-cap stocks. Druckenmiller cites that as a reason he pulled out of his fund business two years ago after many years of double-digit gains. He told investors at the time that it was difficult to find large investments for his big fund. In an interview published by Goldman Sachs in Europe last week, he said he is unable to find a "competitive advantage" in this Fed-managed environment. In his case, as a manager of the $12 billion Duquesne Capital, it was particularly hard to find the big investments he needed.

As a manager of a smaller fund with less than $100 million under management, O'Brien is buying into smaller, regional financial companies and consumer-staple producers. His fund has not kept up with the booming stock market this year, but it's the first time it has trailed the Standard & Poor's 500 index since 2007. So far this year, the fund has returned 13.91 percent through June 19, versus 15.37 percent for the S&P. Over the past five years, Prospector's 8.53 percent annualized gain easily tops the 2.24 annualized return for the S&P. Morningstar gives the fund a four-star rating and a low-risk rating.

The problem with large, multinational companies, O'Brien says, is that they are more exposed to the weakness of the macro economy, and particularly the slowing of government spending in the United States and elsewhere.

The largest companies derive a disproportionate amount of revenue from government spending, O'Brien says. But public-sector spending is shrinking so fast that economists figure the U.S. growth rate might be 50 percent higher (3 percent versus just 2 percent) if government spending simply kept pace with the private sector.

O'Brien doesn't expect that pattern to change anytime soon. Even if the private sector strengthens, governments' high debt levels throughout the world will keep a lid on spending.

"There is too much debt out there. Consumers have brought down their debt levels, but government still has too much. They have been big spenders on a lot of things, and they've curtailed that in Europe and the United States," he says.

[Read: 12 Reasons Not to Fear a Market Bubble.]

Sequestration in the United States and fiscal caution throughout Europe have replaced the spending spree governments went on to revive the global economy after the 2008 financial collapse. China's spending has also been curtailed amid fears over inflation and rising debt.

When they do spend money, governments often sponsor infrastructure improvements that boost demand for materials and goods made by cyclical companies. That hasn't happened. The two purest cyclicals in the 30 Dow Jones Industrial Average stocks, Alcoa and Caterpillar, are the only ones showing a decline, with losses of about 5.5 percent this year versus the Dow's 16.89 percent rise.

Managing expectations and investing for the long term. The stock market's big gain this year worries some people who see prices getting ahead of earnings potential. O'Brien says that as a fund manager, he prefers to lean out of the bull market by finding less economically sensitive stocks. "Of course, what matters is how they do in the long term," he says. He cites Warren Buffett's strategy of investing in steady, plodding companies that generate cash.

O'Brien likes consumer name brands, especially those with potential to spin off new products under the same brand. He has invested in Church & Dwight, which has a stable of consumer products it has extended into new products, which has been a relatively low-cost income booster. The company has taken Arm & Hammer baking soda into cleaning products, toothpaste and deodorizers. Another of his favorites is PepsiCo, which has used the same strategy in pushing new products like chewable forms of its Gatorade drinks.

O'Brien also follows Buffett's strategy of buying insurance stocks for steady and reliable returns, especially in the property and casualty area, which has low exposure to long-term bonds seen as risky in the current environment. Life insurers tend to be bigger investors in long-term markets because of their longer, annuitized payouts.

How the fund stacks up. The Prospector fund is "above average" in terms of performance, says Todd Rosenbluth, director of fund research at S&P Capital IQ. "They invest in the kind of companies that do well regardless of the strength of the economy because people will still eat and drink and smoke and go to the doctor and keep living in the real world."

[See: 7 Mutual Funds That Make Huge Bets.]

But Rosenbluth says S&P's view is that the economy will pick up momentum. "You might want to start mixing in some cyclicals" to participate, he says. Still, "if you take a long-term view of the economy being stable but growing at a 1 to 2 percent clip, you want to be in funds like Prospector," he adds. One reason to do so is that these funds tend to be good dividend payers. He says Cullen High Dividend Equity Fund, Dreyfus Appreciation Fund, and Invesco Growth and Income are other good funds for this environment.

Prospector performed relatively well in the 2008 downturn with a 19 percent drop that was about half the benchmark's loss, says Rosenbluth. O'Brien says his fund's focus on risk will be important going forward. "I would be the first to admit that we could not do as well in a booming market and economy," he says. "But that's not how we are seeing it play out."

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