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Fund manager Tom Villalta details his fund's objectives, and tells MoneyShow.com about some behavioral mistakes that investors typically make. He also explains why he sees potential in US stocks, even in the face of European developments.

Kate Stalter: Today's guest is Tom Villalta of the Jones Villalta Opportunity Fund (JVOFX). Tom, we've talked before, but for listeners who missed the earlier interviews, repeat for us: What is the fund's objective?

Tom Villalta: The fund's objective is to manage a portfolio of mid- to large-cap domestic stocks. Our goal is to outperform relevant benchmarks, such as the S&P 500, over the long term.

We are a truly active manager, so our goal is really not to emulate an index or be a closet indexer, but to actually take meaningful positions in individual holdings, sectors, and industries, and we will look quite different from other mutual funds.

Kate Stalter: Let's talk about how you identify some of the holdings. Maybe you could tell us about some of the sectors that you like right now, how you've identified these.

Tom Villalta: Sure. First, I might say that philosophically speaking, we approach this subset of the market quite a bit different than others.

Generally speaking, the way that we view mid- to large-cap stocks is that many of these companies have significant followings by research analysts, whether they be sell-side analysts, they might have 30 or 40 analysts that cover a stock, or whether it be buy-side analysts, where there might be a couple buy-side analysts that are covering a particular stock for addition to their institutional portfolios.

So we don't think that the edge that investors have in this market is an informational edge. In other words, you're not going to unturn any stones that haven't been unturned by others before.

So what we're focused on is really attempting to identify the behavioral errors that investors make in the market, because we believe that many of the inefficiencies that you see in the subset of the market-in other words, the reason that we see values trade so erratically from day to day and month to month-accrue mainly to behavioral errors that individuals make, not the informational errors that investors are making on the part of the valuation of the securities.

So it's quite a bit different than others, in that our starting point is really to identify undervalued stocks, but also to identify undervalued stocks where there is a behavioral element that we think is at play, that is skewing investors' impressions of the companies.

Kate Stalter: Can you give us an example of what that might be?

Tom Villalta: Well, at the present time I don't think you're going to find as loathed of a group in the US market as financial stocks. And certainly, you know these are stocks where there is a significant amount of angst on the part of investors that comes from just general loathing from politicians, or from Wall Street, or from individuals on Main Street, or from regulators.

In addition to that, you've got an environment whereby many of the financial stocks have been working off a bad loan base over a number of years. And there's a common behavioral error, which is called representativeness bias, whereby many individuals will take a short time series of data and try and extrapolate out a longer view. And we think this is an error that's in place with regard to many of the financial stocks that are in the market-although we like certain ones, in particular, more than others.

But we do believe that investors are approaching this set believing that the earnings that we've seen over the last few years are representative of what we can expect to see from these firms in the future. And we don't think that's necessarily the case with most of the financials in the market.

In other words, we believe that the earning power of these companies is much more than what they're earning today, and that we'll see them build on their earnings power over time as they work through bad loans and write-offs related to the financial crisis.

Kate Stalter: What other sectors are you seeing right now, where there's either potential that you've identified, or maybe that analysts are overvaluing?

Tom Villalta: We like consumer discretionary as well. We think that a lot of individuals are looking at Europe's problems through the prism of the 2008 and 2009 financial crisis, and believe that the impact on the domestic economy is going to be similar. We don't think that's going to be the case; we think that what's happening in Europe is material to the US, but that it's going to be a much more muted effect on US demand, especially consumer demand.

And the main reason for that is that, by and large in the US, we produce and consume a vast majority of the goods, probably close to 85% of GDP, which is significantly different than some countries like China or Germany or some other European countries that are more export-oriented, and export a much more significant proportion of their GDP.

So that's good and bad. On the negative side, we tend to run high trade imbalances, which could have an effect on the dollar over the long term. But on the positive side, what happens in other countries from slowdowns generally has a more muted impact on the companies that are domiciled in the United States.

That's not to say that some companies aren't going to feel the effect, because certainly there are some companies that have significant operations that export significant amounts to other countries, including Europe. But by and large, most United States companies are going to be a bit insulated from the problems in Europe just because most of the GDP in this country is consumed within this country.

So a good example that we see value in right now is a company called MGM Mirage (MGM), which is a mid-cap stock. Many people are familiar with it because they own most of the properties on the Las Vegas strip, and a number of casino properties throughout the world. But largely much of their revenue base is in the United States.

Obviously, they took a hit during the financial crisis and the ensuing recession. They've been kind of growing out of that and improving many of their metrics, including revenue per available room and other metrics associated with the performance of their individual hotels in Las Vegas, which is a primary earnings generator for them.

We think that's going to continue. You're able to buy to a company for a fraction of its book value. That has very good assets, very high quality assets, and that it's also a bit of an inflation protector for individuals, too, since hotels and casinos are able to increase room rates on a daily basis.

Kate Stalter: Tom, let me just wrap up today by following up a bit on the discussion of behavioral finance. As we've seen from this discussion, there are some ways that perhaps institutional investors are taking account of that, but what can individuals do? How can they be aware of these pitfalls as they make decisions?

Tom Villalta: I think the best way is just to be familiar with the common errors that we tend to make with regard to our own behavior. I mean, it really starts with understanding the type of things that we do. We tend to take a short time series of data, and we tend to extrapolate out a much longer view than it's appropriate.

You could see that at play at the end of the 1990s with the telecommunications, technology, and media bubble, but again, with regard to the real estate bubble, as well. We have a tendency as individuals to look at shorter time series of data, and extrapolate out much longer views.

In addition, we have a tendency to anchor to a lot of different data points, including most recent prices. So we think a common phenomenon that's happening today is that we believe the value of a lot of companies in the US market is much higher than what the underlying market values are today, and what many analysts believe they are.

But most analysts tend to anchor their expectations to current prices. So this is oftentimes why you'll see analysts bring down their price targets for companies when their stock prices fall. It might not be because of underlying fundamentals, but simply because recent prices are an anchor for most analysts.

So understanding many of these types of behavioral errors are the key element to really understanding how we make mistakes and how to avoid mistakes.

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Tickers Mentioned: JVOFX, MGM

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