Investing in a Recovery

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TIME: In a low-return world, by definition indexes will have low returns. Are index funds a bad choice now?

MAIDMAN: There are so many ways to index now, including exchange-traded funds, where you can get very specific with what you own. So I don't think it's completely out with indexing. I do think there's an issue with traditional cap-weighted indexes like the S&P; 500.

LEVKOVICH: I have a personal bias against it because you're basically saying you're satisfied with mediocre returns. But I've had that problem all along.

LOTSOFF: If I am right that we are in a much more challenging environment for corporate management, indexing is not going to be the best thing. You want to identify good managers who can navigate global competition, and you want to stay with them.

TIME: Among the broad asset categories stocks, bonds, cash, real estate which should you lean toward right now?

MAIDMAN: I would overweight growth stocks. I would underweight real estate fairly significantly, and I would include alternative assets, and I would overweight by lightening up on bonds.

TIME: When you talk about alternative assets, you're talking about...

MAIDMAN: Some private equity, but more things like fixed-income arbitrage, convertible-bond arbitrage, distressed securities, emerging market debt arbitrage. I deal with affluent investors, and these help returns without adding risk. You have to look at your time line. If you don't have 10 years, you should not be in LBOs and venture funds.

TIME: Bob, where do you think the best values are in a low-return world?

SMITH: The beginning part of the recovery has tracked what you would have thought. Aggressive-growth companies have done well: biotech, semiconductor companies, Internet companies stocks you thought were going to go out of business. And so have big companies whose stock has come down dramatically, like EMC and Ericsson. Now it's a more level playing field, and the premium for quality companies over average companies is very small. So I think you would want to buy quality. You'd rather buy Wal-Mart, vs. J.C. Penney or Dell, vs. Hewlett-Packard.

TIME: Are there sectors you like?

SMITH: I think you would still be steering away from noneconomically sensitive companies. You would rather own a Viacom than Procter & Gamble. P&G; is a great company, but as the economy starts to get better, you would rather have something that has some economic sensitivity to it. You would rather own a Merrill Lynch or a Morgan Stanley than you would a bank. Over the intermediate term, I like media stocks, like Viacom and Clear Channel, Univision. In retail, I like Target and Best Buy. Wal-Mart will be O.K. I like Citigroup a lot.

TIME: Whom are you avoiding?

SMITH: Old industrial companies. In past recessions you would look to these old companies because they have hidden assets. Now they all have hidden liabilities. The newer the company, the better shape you are in on pension and asbestos issues.

TIME: Are you moving more into dividend stocks?

SMITH: Over time that will be a good place. I don't focus as much on what the dividend is as what the potential dividend could be.

TIME: This year dividend payers have not done nearly as well as nonpayers.

LEVKOVICH: Over time they'll do better. One thing we look for is strong inside ownership. Family-controlled companies will be interested under new legislation to pay themselves.

TIME: Let's talk about your themes.

LEVKOVICH: I'll hit a couple of them. Long term, dividends are important. I think defense is another long-term theme. A Northrop Grumman is going to pop up as a beneficiary. But if I look at very specific ones, one of the very few areas where you can talk about pent-up demand is travel. Corporate travel, leisure travel have been put off by two wars, recession, a bubble bursting, SARS. The only thing that hasn't hit this industry is pestilence. There are very few new rooms coming on the market, so you have an industry that has pricing power. Here is an industry that just made money in one of the severest downturns it ever faced. Management got lean and mean. They're poised to benefit. Starwood is a good name in that area. When I look at momentum, I like Intel. When you're not building new capacity and there's still chip demand out there, you start tightening the supply; pricing goes up, and that's where the leverage in the industry is. One area that is very interesting in financials is property and casualty insurance. A lot of people see the premiums increasing. What's really interesting is what's going on on the liability side of the balance sheet. The U.S. Supreme Court's ruling on punitive damages is very positive to anybody who has to pay out claims, limiting the ratios of punitive to compensatory damages.