Financial Wisdom

“Opportunities multiply as they are seized.”
~Sun Tzu, Chinese General, author of “The Art of War
No Downturn Lasts Forever

The financial markets have had their own problems over the years. A study by the International Monetary Fund detailed 125 separate financial crises worldwide since 1970. In the U.S., we’ve seen a stock market downturn an average of once every eight years since 1970. Before that, in a period dating back to 1800, the average time period between market crashes was 14 years, according to research conduced by Stanford University professor James Van Horne. Some experts, including Van Horne, blame financial and corporate deregulation for the increased tempo of market disruptions.

In any event, we know from history that periodic market panics and crashes are common occurances. We know that with careful planning and the right strategy, we can actually profit from the market’s bad news. All of this is not to imply the market’s plunges are harmless- to the contrary, those unfortunates who wind up on the wrong side of a market correction often see their net worth wiped out in a devastatingly short period.

Speculative bubbles have almost always been caused by excessive lending on farmland and real estate, which inflates prices until the inevitable adjustment that leads to bank failures. That’s been the root cause of crises and panics dating back to time immemorial. Following each successive market crash, the public has become as pessimistic as it had been optimistic before the downturn.

For whatever reason, people don’t tend to think long-term when making financial decisions. Perhaps it is human nature to want to get as much as you can as soon as possible, for immediate gratification. People often want to get it all when it’s available, and worry about the future later. That hasn’t changed for thousands of years, and it’s not likely to change soon.

Be Skeptical of ‘Experts’
The investing world has no shortage of experts who promised to “crash-proof” investors’ portfolios. In the recent past, they urged individual investors and institutions to diversify and buy into emerging markets such as China, Russia, and Brazil, and into commodities and leveraged hedge funds.

Far from protecting investors, this advice led to a bloodbath on Wall Street. When the panic of 2008 came along, emerging markets, commodities and leveraged hedge funds were among the hardest-hit investment sectors.

I would argue that planning your investment portfolio based on a doomsday scenario is extremely speculative and risky. Many of the forecasters who wrote books about how to crash-proof your portfolio against the coming cataclysm turned out to be wrong, and the investments they recommended fell far more than the broader market.

Commodities collapsed, with oil dropping from $150 per barrel to a low around $35 per barrel. As a sector, commodities lost twice as much as the stock market. The dollar, which was supposed to collapse got stronger and foreign currencies weakened. Even gold and silver, the much-heralded safe havens, declined.
If you want your money to work hard so you don’t have to, you need to look beyond the current tempest to build a lasting, sustainable portfolio.

This Week’s Stock to Watch:

Vanguard High Dividend Yield ETF (exchange traded fund) VYM: $24.60*

The Vanguard High Dividend ETF (VYM) invests in a basket of high yielding U.S. equities. Top holdings included beaten down bluechips like AT&T, Johnson and Johnson and Procter and Gamble Co. The fund currently yields approximately 5.7% and pays distributions to shareholders on a quarterly basis. With brand name stocks trading at extremely depressed prices, we view VYM as a solid way to own a diversified basket of these companies at bargain prices.

*Price as of3/10/09

The essence of a Fallen Angel (as opposed to other “value” investing opportunities) is the inherent quality of the underlying franchise. Without a high quality business underlying the stock, the shares are just fallen without being angels. We have defined quality in previous chapters to encompass several different factors. These include quantitiative metrics like balance sheet strength, and consistency of return on equity as well as qualitative strengths like competitive advanantage and management strength. The history of financial markets is riddled with examples of high quality businesses that have temporarily become “fallen angels” only to rise again. Several well known examples include Coca Cola in the early 1980s, Wells Fargo in 1990, and Apple in 2002. Investors buying at very depressed levels were able to earn above average rates of return on their investment for years to come.

Of course, business quality, isn’t just the purview of brand name blue-chip businesses. Smaller emerging growth companies that meet the quality criteria can be an even better place to look for fallen angels. Since large publicly traded companies are widely followed by analysts, owned by institutional investors, and have enormous share float, it generally takes an extreme event like a market panic or industry specific calamity to depress shares to fallen angel prices. Smaller businesses tend to have less analyst coverage, are less widely owned and have issued less stock. As a result, shares in these businesses tend to experience more price volatitliy which in essence provides for a more fertile hunting ground for the fallen angel bargain hunter.

Conscientious bargain hunters would do well to recognized the enormous opportunity provided by the market’s recent sell-off. We have put together a list of 10 fallen angels for the next 5 years. The list includes five larger blue chip companies along with five smaller businesses (market cap < $3 Billion) that meet our criteria for quality and value. The first five a large-cap behemoths. The next issue will feature five small fry that appear to be under-priced.

5 Blue-Chip Fallen Angels
1. General Dynamics (GD)
Down 54% from its 2008 high, General Dynamics offers a compelling long-term value opportunity in a quality defense contractor. The company has a history of consistently generating high rates of return on shareholder equity and is conservativly financed.

2. Google (GOOG)
Down 52% from it’s 2007 high, Google sports a pristine balance sheet, with zero debt. The company generates profit margins in the mid 20% range while returns on shareholder equity have averaged about 18% over the last several years.

3. Jacobs Engineering (JEC)
Down 58% from its 2008 high, Jacobs construction and engineering businesses are a likely beneficiary of the coming domestic infrastructure buildout. With little debt on the balance sheet and a history of generating strong returns on shareholder equity the company is well positioned to benefit as the business cycle shifts from the contraction to expansion phase.

4. Johnson & Johnson (JNJ)
Down 27% from it’s 2008 high, Johnson & Johnson offers investors a reasonably conservative way to play an eventual healthcare turnaround. The company has a long demonstrated ability of growing book value, consistently providing returns on shareholder equity greater than 25% annually.

5. Visa (V)
Down 38% from its 2008 high, Visa suffers from an image problem. Primarily that they are a credit card issuer, exposed to the kinds of financial risks facing other card issuers during a severe economic downturn. In reality, Visa is a payment processing firm with significantly less exposure to the economic contraction. The company generates net profit margins north of 20%, has very little long-term debt and holds a leading industry position.

When smart people do stupid things, they can lose lots of money. The same goes for smart companies. Opportunities arise if the mistakes are both correctable and recoverable. The vast majority of participants in the stock market are short-sighted. No matter how intelligent a person is, emotion controls investors’ reactions. Don’t believe it? Ask people why they invest in a particular mutual fund, and they will more than likely tell you it is because the fund is ranked as a top performer. The pressure to rank among the “best” funds causes short-sightedness, and managers get caught up selling shares on bad news. Instead of buying when companies are out of favor, many mutual funds do the opposite to “window dress” and create the appearance of holding only winning stocks. The costly mistake by managers to sell on bad news creates new opportunities for bargain hunters.

Another reason most mutual funds under-perform the market has to do with investors’ behavior. People often buy funds only after the market is hot, and has risen for some time. The massive influx of new money into successful funds causes managers to buy stocks that are no longer cheap. When the inevitable correction comes, investors often panic and liquidate their fund holdings, forcing managers to sell what may have become attractively priced stocks at or near a bottom.

TEN STOCKS FOR THE NEXT 5 YEARS, Part 2
Our list of ten stocks for the next 5 years includes several issues that were popular with mutual fund managers until last years crash occurred. When mutual fund shareholders began liquidating, fund managers were forced to sell everything, including the stocks they had the most confidence in…at any price in a down market. This issue we will focus on smaller businesses with strong recovery potential. Here are five to consider.

1. Hansen Natural (soft drinks, beverages) HANS: $36.60
Down from its 2007 high above $67, Hansen remains a high quality, conservatively financed growth stock. Currently trading at a forward P/E of 14 we believe Hansen will revisit its former highs over the next few years.

2. Skechers Inc. (Shoes) SKX: $8.02
Down more than 60% over the last year, we feel that the selling in this stock has been overdone. The business is expected to generate .33 cents in profit for 2009 and .90 cents in 2010. With analyst consensus for future growth at 15%, we view SKX as a strong recovery candidate.

3. World Fuel Services Corp (fuel services) INT: $34.39
World Fuel Services has already rebounded nicely from its 2008 lows. Still, we view this marketer of marine, aviation and land fuel products as a bargain at current prices. The company is expected to earn $3.38 per share by 2010 and should benefit from the eventual reacceleration of global economic growth.

4. Move, Inc. (real estate marketing) MOVE: $1.95
Move, Inc. operates web sites for real estate search, finance and moving. The company’s shares are depressed along with the real-estate market that they serve. Still, MOVE is expected to be profitable in ’09 and generate solid growth over the next business cycle. At current prices we see substantial upside.

5. Lincare Holdings (home respiratory services) LNCR: $21.36
Lincare is down more than 30% since its September ‘08 high. The company has a history of generating high returns on shareholder equity, strong margins and free cash flow. We see continued strong demand for the company’s services and view the current price as a good long-term entry level.
** All prices as of 4/20/09

I am the astronaut of boxing. Joe Lewis and Dempsey were just jet pilots. I’m in a world of my own.
~ Muhammad Ali

We can take heart in the knowledge that even the most experienced and celebrated investment professionals don’t always take their own advice when it comes to their personal finances. In a series of revealing interviews, The Wall Street Journal columnist Jason Zweig drove this point home.

John Bogle, the founder of Vanguard Funds, is famous for his belief that investors should rebalance their portfolios on a regular basis, selling what’s gone up and buying more of what’s gone down, using low-cost index funds. But Bogle admitted that he rarely touches his own portfolio and has gone years without changing his own asset allocations.

Harry Markowitz is a Nobel Prize-winning economist who analyzed the risk and return of a diversified portfolio. He told Jason Zweig, however, that he splits his own retirement contributions equally between stocks and bonds, failing to follow the investment formula that won him the Nobel Prize.

Most surprising was Zweig’s interview with Burton Malkiel, an economist at Princeton University and a prominent author on financial topics. Malkiel’s book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, has been an influential volume advancing the efficient market hypothesis since its publication in 1973.

Malkiel argued that prices of publicly traded assets reflect all publicly available information. By Malkiel’s reasoning, no one can outperform the market, because it is the ultimate model of efficiency. His theory suggests that a dart thrower using the stock listing in The Wall Street Journal may be as effective as the efforts of any professional money manager. Malkiel has advocated index funds that simply track various broad market exposure.

Zweig revealed in his interview with Malkiel, however, that the famed economist keeps about a third of his own money in individual stocks and actively managed funds. “I call myself a random walker with a crutch,” he said.
Like the rest of us, these veteran investment professionals and theorists are immersed in the world around them and see the opportunities and inefficiencies in the market with their own eyes. They don’t want to miss out any more than you or I should want to.

THIS ISSUES FALLEN ANGEL FOR CONSIDERATION
KBR Inc. (heavy construction) KBR: $17.31*

KBR is a global contruction and engineering firm. Shares of this company are down more than 60% from their 2007 highs. The company, spun-off from Halliburton in 2005, has $1.1 billion in cash on its balance sheet and no debt. Currently trading at a P/E of 10 times we think these shares offer 50%+ upside over the next 3 years.

* Price as of 5/5/09