Celebrate Diversity

{Q} Why aren’t return assumptions very high right now?

{A} Economic globalization, relatively high [stock and bond] valuations, competition, and diminished pricing power for many industries suggest that return assumptions for investments in general probably need to be ratcheted down.

One of the most important pieces of asset allocation is rebalancing. You need to rebalance so you can capture some of those returns and again maintain an efficient portfolio.

{Q} When do you rebalance?

{A} We generally rebalance on an annual basis if necessary. For example, over the last couple of years, we have increased our allocation to international stocks and alternative investments—namely, gold and commodities—at the expense of domestic bonds and stocks.

{Q} What opportunities do you see in domestic equities?

{A} Generally speaking, from a capitalization standpoint, we think that in today’s environment, small-cap stocks have gotten expensive on a valuation basis. Many of the large-capitalization names are cheap both on a relative and absolute basis. From a sector standpoint, we clearly have been very biased in the energy space, which goes back some time for us. That’s really predicated on a fragile supply– demand imbalance, geopolitical risks, and the emergence of developing economies’ thirst and need for energy.

{Q} What have you avoided?

{A} We’ve been cautious in a couple areas. First, in technology. We believe that technology has become a commodity, and that much of technology has lost its pricing power. So we’ve become very, very stock specific in that area. The other area we have concerns about is the consumer discretionary area. That’s based somewhat on our concern of leveraged consumer balance sheets. Clearly, higher interest rates and higher energy costs have and will cut into discretionary spending.

{Q} What are your particular regional favorites?

{A} There are several. In the large-cap arena, Medtronic (NYSE: MDT), Wells Fargo (NYSE: WFC), and 3M (NYSE: MMM) are names we have owned for some time.

From a thematic perspective, if you think about where consumers are spending their dollars, certainly health care stands out. Spending as a percent of gross domestic product has been rising and continues to rise, and demographics certainly would argue for more money being spent on health care. Medtronic seemingly will benefit from such trends.

In the small- and mid-cap area, SurModics (Nasdaq: SRDX), which is involved in surface modification solutions and stem cell research, and Vital Images (Nasdaq: VTAL), which is a provider of advanced visualization and analysis solutions, fit well into our health care theme. On the industrial side, Pentair (NYSE: PNR)—we think the water business is a defensive growth business—and MTS Systems (Nasdaq: MTSC), an engineering playground, are beneficiaries of improving global economies. Finally, in technology, Digital River (Nasdaq: DRIV) has been a favorite due to its unique position in providing e-commerce solutions.