By Geoff Colvin, senior editor-at-large
FORTUNE -- It's time to remember one of investing's eternal truths: Trouble can be an investor's best friend. America's economy is limping, China's is complicated, Europe's is shrinking -- and the wisest investors say, "Bring it on." They understand that most investors get discouraged by today's headlines and flee assets they should embrace, like equities and real estate, while piling into assets they should avoid, like low-yielding bonds. The misguided herd creates opportunity for the savvy few, who can buy alluring investments at bargain prices. At least that's the theory. Making it work requires expert insight, and most of us lack the time and training to identify overlooked gems with confidence.
So we asked five expert market observers to share their wisdom. Stephen Auth is the chief investment officer in charge of equities at Federated Investors and has more than three decades of experience on Wall Street. Justin Leverenz is a senior vice president at Oppenheimer Funds and runs the highly successful Oppenheimer Developing Markets Fund. Savita Subramanian is the head of U.S. equity strategy for Bank of America Merrill Lynch. David Herro is the chief investment officer of international equities at Harris Associates and the manager of the top-performing Oakmark International Fund (OAKIX). Dan Fuss, who has worked on Wall Street for five decades, is the vice chairman of Loomis Sayles & Co. and the manager of the Loomis Sayles Bond Fund (LSBDX).
Here are edited excerpts of their discussion with Fortune's Geoff Colvin:
Uncertainty abounds. Where can an investor turn for a little comfort?
Herro: This uncertainty is actually good for an equity investor, especially one who has a value bent, as we do. So we'd rather be buying stocks at low prices. And in order to get quality at low prices, economic uncertainty and macroeconomic instability are actually very good for us. So if you have a medium- or long-term investment horizon -- which, I would argue, is what investing is all about -- this is a very good time.
Justin, the emerging world is where you spend a lot of time. Do you find comfort for investors there?
Leverenz: I agree that controversy represents meaningful opportunity. It really is an entry point for investors rather than speculators. I think that that's not broadly true in emerging markets. I think China is perhaps the one really significant area of controversy. There is a lot of concern about political transition. There is enormous concern about where normalized growth will be after a decade of double-digit growth and a lot of concern about accounting difficulties, corporate governance in China. And there are some really wonderful companies. So I like China within the emerging world.
Steve, you look broadly at everything that's available. Where do you find a little comfort for investors?
Auth: Well, right now I don't find a lot of comfort. We're actually fairly near-term bears -- the first time we've pulled back on equities since 2008. We are nervous that the U.S. economy is slowing. It's coming at the same time that you've got a slowdown in China and Europe heading into recession. So near term, we're telling people to be cautious. However, we still think we're in a secular bull market for equities, and we think the second half of 2013 could be pretty good. We're going to have a lot of pent-up demand released on the economy, presuming Washington finally comes to a long-term agreement on tax policy and entitlements. Europe probably enters a recovery mode. And we've started to buy China for the first time in two years now.
Savita, U.S. equities are your focus. How do things look to you?
Subramanian: In the U.S., equities with any width of foreign exposure have sold off significantly over the year and are now trading at a pretty attractive valuation. So I think this is actually a good entry point for buying some of the global cyclicals that could be a lot cheaper than they were a year or two ago.
Some people overlook the fact that you can be a very global investor through U.S. equities.
Subramanian: Exactly -- 40% or more of sales of U.S. companies are derived from overseas. They're actually a pretty globally diversified equity market.
Dan, bonds are your focus. The big question: The conventional view has been that interest rates must go up, and they keep not going up. When will they?
Fuss: Oh, I wish I knew. I mean, let's face it, bonds are priced in general higher than a kite. So common sense tells you that when and if the major central banks back off, rates will probably go up. There are some arguments for lower rates in the future, but the net outcome -- I think the strongest argument -- is for higher rates. Maybe not like the late '70s -- I hope not -- but a secular uptrend in interest rates. Now, that's the bad news. It's also the good news. You only know how to do this when you're out and about long enough, particularly with bonds. You say, "Take your focus away from the lousy income today and the horrifying capital loss that might be in front of you, and focus on the good news." And the good news literally, depending on how you run the portfolio, is hopefully interest rates will go up in the future and reinvestment returns will rise. And you're dealing with very specific risk in the meantime. And that's the nature of bonds today. Bonds by their nature are not exciting. I mean, stocks are exciting. But you can make darn good money in bonds if you think ahead.
This issue of what's going to happen with interest rates is important for a lot of investors who want yield. They would love to have higher interest rates. Steve?
Auth: We've been telling our investors that the next place you're going to lose a lot of money is in Treasury bonds. It's probably going to take a few years to get there, though, because you've got a Fed that is determined to keep rates low for a while. So we think the selloff of bonds is still out there somewhere, but probably not in 2013, frankly. But at some point. And if you take a three-year view, for us it's just not the place you want to be. You're going to lose money there.
Right. Savita, this is another thing you've got to pay attention to.
Subramanian: Oh, sure. I think a backup in rates would actually be good for the market, but it could hurt some sectors. The ones I worry about most in the S&P are utilities and telecom, which are actually trading at pretty ridiculous multiples at this point. I mean, it kind of feels like the bond bubble moved into the equity market and pushed up the valuations of the bond proxies, which are regulated utilities, telecom, tobacco stocks. These are all quite expensive. And I think that they could sell off pretty dramatically if we get a meaningful increase in interest rates.
Let's get a little more specific. Justin, why are you so bullish on China?
Leverenz: There are a lot of misconceptions about China -- political and economic misconceptions -- and the sense that there's got to be consequences associated with a very rapid increase in credit, that there's got to be a property bubble there. But that obscures the enormous progress that China has made and will continue to make. It will grow 5, 6, 7% compounding for a decade, and that means an additional half a trillion dollars of output, which no other country in the world can offer.
David, you've gotten attention for investing in European banks, which most people thought were to be avoided at all costs. How's it working out?
Herro: There was this assumption that these banks were worthless because France, Spain, and Italy were going to default on their debts. Now, I never thought that Greece was going to make it out of the woods, and who knows about Portugal? But Ireland looks like it's making progress. And to assume that Italy would default was just incorrect. For a lot of the quality European banks, their only crime was that they're based in Europe and they may have held sovereign debt of Italy or Spain. You could've bought them at 25% or 30% of book value. Take Intesa Sanpaolo in northern Italy, which has mortgages with extremely low defaults. These were safe, boring banks that were driven to unbelievably low prices because of the whole fear of the sovereign debt crisis. In order to make that investment, you had to believe that the relatively safer sovereigns weren't going to default, and that was our belief. You know, in the last four or five months, they've bounced 50, 60%. It's not over yet, but I think Europe is almost out of the woods.
Steve, where would you guide investors looking for growth, as distinct from yield?
Auth: Well, one place we look to is U.S. industrials, because we think there is a kind of manufacturing renaissance going on in the U.S. The advantage that we have over the next three years is relatively cheap energy relative to the rest of the world. U.S. labor has gotten relatively less expensive. So we like companies such as Caterpillar (CAT). That's a big, globally competitive company, which has been affected by the slowdown in China. And when the world starts to look like a better place in the second half of the year, we think stocks like that could run up. So we like global cyclicals for growth with that emerging-markets exposure. In the U.S. we like banks with heavy mortgage exposure because we see the housing business coming back pretty strong. For instance, SunTrust (STI) is pretty interesting and trading at a very cheap valuation.
Savita, where do you see growth?
Subramanian: Right now one of the sectors that has kind of morphed from the über-growth sector of the late '90s to more of a cash-return, stable-growth vehicle is technology. That's one of my favorite sectors. It's cheaper than it was at the beginning of the year. So some of those blue-chip techs -- and also blue-chip pharma. Their pipelines are refilling. The stocks are very cheap. And the dividend investors that are going to have to come out of utilities and telecom when rates start to go back up -- that's the place they're going to go to. So we like that sector as a kind of dividend-growth play: the Pfizers (PFE) and Eli Lillys (LLY) of the world.
Subramanian: Yeah, sure, exactly. Big-cap, old-fashioned technology companies that have gotten cheaper and cheaper and cheaper. There are fears that they're ex-growth, but, you know, just like anything else, I think they'll participate in a cyclical recovery just as much as any other stock.
Auth: I'd just throw in one point on Apple (AAPL). You know, it is a controversial stock because it has so many growth drivers ahead of it in its expansion into the corporate world and into the international world. And it's a wonderful company. The issue for me on Apple is that most of its profits come from the phone division, and the margins are just spectacular. So I think you could have a case where Apple as a company is successful, but they get margin pressure, particularly with the Samsungs of the world coming into that smartphone market. And so one of our stocks in tech that we like is Qualcomm (QCOM), which I kind of view as the arms manufacturer selling bullets to companies in a shooting war -- Apple and Samsung. They win either way, and I don't have to worry about who wins the smartphone war.
Justin, what are some companies that you like now?
Leverenz: I think the Indian software companies have become not structural growth companies like they were 10 years ago but much more cyclical. I own Infosys (INFY) and Tata. They're wonderful companies with massive opportunities in terms of expanding up the value chain and competing with the Accentures (ACN) and the IBM Globals (IBM) of the world.
In China, the company I would mention is Baidu (BIDU). I think it's a really terrific opportunity here. It is a business like all search businesses around the globe that's got natural monopoly tendencies. Baidu is a company that you can acquire today on 15 times next year's earnings. I think it could easily grow 25% to 30% compounded in the next five years, so the math is reasonably compelling.
David, besides investing in big banks, you invest in a lot of small, global companies that most Americans have never heard of. Who do you like?
Herro: Well, in our small-cap strategy, for instance, there's a Japanese company called Hirose Electric. It makes connectors for consumer electronic gadgets. It's very profitable. They're good capital allocators. It sells at a low price. And again, being in Japan is conducive to low valuation.
Savita, I want to ask you, then, about the asset-allocation question, because for individual investors today it is really a huge issue.
Subramanian: I'm a big fan of equities at this point. That's basically the exact opposite of what all of the Wall Street strategists are recommending today. One of the things that we track on a regular basis is the average equity allocation of Wall Street strategists to equities in a balanced fund. And what's remarkable is that, if you look over the last 30 years, Wall Street strategists have never been, in aggregate, as bearish on equities as they are today. They're recommending an allocation of about 44% to equities, where the benchmark has been roughly between 60% and 70% over the last few decades.
Fuss: I was faced with asset allocation yesterday morning as chair of the committee that does that for some funds, where we have maximum 70% equities and minimum 30% fixed. We're at 30% fixed, 70% equities. I would say, all other things being equal, go max equities and minimum bonds.
Auth: One thing that makes Wall Street so bearish is what I call the double top on the S&P. And no one wants to talk about it, but guys come to my office all the time, and they all believe that we can't get through the double top. I'm referring to the 1550 top in 2000 and then March of 2007. And, you know, if you look at the valuation of the S&P today compared with when it hit that top in 2000, the U.S. GDP is 50% larger and the global GDP is double. I think there's going to be a little bit of a battle to get through it, but I think when we do, you'll see Wall Street get more bullish. You know, there's a market in 10-year futures on the S&P. It's a swap market. And if you go out today and try to buy the S&P 10 years from now, you can buy it at 10% below current levels.
Subramanian: I think that everybody is spooked by the fact that for the last 10 years if you bought equities, you would have made no money essentially. But what everybody forgets is that we're living in the tail right now. So if you go back historically and look at the equity market, you had a 6% chance of losing money over a 10-year time horizon. The problem is that we're living in that 6%, and that's what everybody remembers. But the truth of the matter is that you've got probability on your side, you've got valuations on your side, and earnings continue to hit new highs.
Any more best ideas to share, if we haven't touched on them?
Auth: I'll add two other quick names: Air China. That's another stock that's underperformed. As China does recover, it's levered to that recovery, and it's growing share, and that's still a big growth business out in Asia. We also like Siemens (SI) as a big German recovery story and a global player.
Herro: If you dig down in equities, what are some of the cheapest areas? In Japan companies like Toyota (TM), Daiwa (DWHAY), and Canon (CAJ) are blue chips that people can easily buy. Some of the European financials that still haven't rebounded, like Credit Suisse (CS), which has a great private bank platform that generates good annuity-like cash flows. Another European blue chip to like is a company like Daimler, which has a global presence, not only with Mercedes luxury vehicles but in commercial vehicles. So I think these are the types of things investors should be looking at: quality that's out of favor and selling at low prices.
This story is from the December 24, 2012 issue of Fortune.
The vaunted international stock picker David Herro is betting big on banks in France, Spain, and Italy. But he doesn't call himself a risk-taker.
By Mina Kimes, writer
FORTUNE -- David Herro seems awfully relaxed for a man who has more than $1 billion invested in European banks. It's a sunny morning in late May, and I'm sitting across from the boyish 51-year-old fund manager in his downtown Chicago office. He's MOREJun 14, 2012 5:00 AM ET
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