(FORTUNE Magazine) – Born in Brooklyn, raised in the Bronx, and working in Manhattan: No doubt 41- year-old Warren Shaw of the institutional investment firm Chancellor Capital Management is a New York City aficionado. That might explain why underneath his soft-spoken manner lies the aggressive soul of one of Gotham's great stockpickers. Over the past three years his $5.5 billion portfolio has achieved an average annual return of 20.5%, vs. 14.7% for the Standard & Poor's 500-stock index. Shaw's strategy is to turn up dominant companies with high-powered earnings growth and to buy only when the price is right. In an interview with FORTUNE's Susan Kuhn, he talks about the market's next move and reveals his latest finds.

Are you finding cheap stocks in this market? In the past few quarters I had been very optimistic. But now I feel a mounting concern that we are going to see a 10% to 12% correction in the market in the next several months as the economic recovery pushes interest rates higher. So to reduce that risk, I have been raising some cash reserves where possible, from zero to 5%. I also have adopted an alternative investing strategy. I am rotating away from stable, defensive growth stocks like food and health care companies and moving into stocks that benefit from an economic rebound.

So what's hot now? I favor three industries, which in total represent 30% of my equity holdings: retailing, banking, and high technology. In retailing I concentrate on specialty companies that have the opportunity to dramatically expand their share of the market. As an industry, retailing is not a growth business. But it is highly fragmented. Furthermore, retail stocks take off early in an economic expansion, so now is the time to buy. Nordstrom is exceptionally attractive today. It is really a play on demographics. As baby-boomers age, they want greater service, more selection of apparel, and high-quality goods. Those are hallmarks of the Nordstrom approach. The department store is well known on the West Coast but is now expanding nationwide, including the Northeast. The company has the potential to generate $100 million in annual volume per store. That's the size of a small company. I think earnings per share, $1.42 in the fiscal year ended January 31, will be $1.90 in fiscal 1992 and $2.30 in 1993. The stock sold recently for $45.75.

Any other choice retailers? I like warehouse companies, but many are too expensive today. One that is still attractive, though, is Price Co. Until recently the stock was disappointing because the company wasn't growing as fast as its peers. But over the next two years management expects to increase the number of stores they open from ten to 12 per year to 15 to 20. I think we will see earnings grow at a 20% annual rate. At $59.50 per share, the stock trades at 19 times my August 1992 earnings estimate of $3.10 per share. The P/Es on these retailing stocks may seem high, but they are quite reasonable relative to the expected growth rates.

Tell us about banking stocks. I think the natural trend toward consolidation and nationwide banking will strengthen banks. As they accumulate more customers in different businesses across different regions, their risk profile will be dramatically reduced.

How do you play the consolidation theme? I buy banks that are looking to increase their market share, diversify their loan portfolios, and achieve cost savings. I am buying strong companies that will be the acquirers. My favorite stock is BankAmerica. At $42 a share, it is currently selling at a 50% discount to the market. I think it is ideally situated to become a nationwide bank because it has a strong capital structure. With the Security Pacific merger, it will certainly expand its presence on the West Coast. Earnings per share should grow at twice the market pace, say 15% to 20% annually. The best part is, you are being paid up front to wait for that. The stock is currently yielding 3%, in line with the market average.

Who might be next in the acquiring game? PNC Financial, a Pittsburgh bank, is a superregional that is in a good position to be an acquirer. It has had trouble with bad real estate loans, but I think it will benefit from the economic recovery. PNC serves an industrial region, and I think the recovery will be manufacturing-based. The stock recently traded at $39.50 a share and could reach $50 in the next six to 12 months. It trades at less than ten times my 1992 earnings estimate of $4.25 per share.

How do you invest in high technology? I prefer to buy companies that produce software or provide services. Growth is difficult to pin down in hardware, because the product cycles are so volatile. One favorite is Aldus, which produces graphics software for desktop publishing and slide presentations. The company should increase earnings 25% or more per year for several years. The stock sold recently for $34 a share, 14 times my 1992 earnings estimate.

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