BARRON'S COVER
Too Far, Too Fast
By LAUREN R. RUBLIN
Our panelists foretold the recent rally. Now they say the market has gotten ahead of itself. Their picks, pans -- and sage advice: Stake a claim in gold.
IT'S A PANDEMIC, ALL RIGHT -- A PANDEMIC of bullishness that is sweeping stock markets here and elsewhere around the world. The Standard & Poor's 500, to take the example nearest to home, has rallied more than 41%, to 945, from its intraday low of 666 in March, in celebration of the fact that our financial system somehow survived the swinish behavior of the past six years. Asian markets have caught the bug, too, and are off to the races on hopes that a global economic recovery will spur demand for
the stuff the region's factories make.
Commodities appear to be infected with a strain of the same ebullience; how else to explain why oil has more than doubled in price in the past four months, to $72 a barrel?
Even the members of the Barron's Roundtable aren't completely immune, although a round of phone calls to our distinguished panelists in the past two weeks confirms they've contracted a less virulent strain. Many predicted at our Jan. 5 confab that the stock market, oversold and under-loved, was due for a major bounce. Now they think stock prices have overshot corporate fundamentals and a correction is in order, but
it won't take the Dow Jones industrials, the S&P and other market measures back to the March lows. That's because the economy could get a much-needed boost in coming months from the massive fiscal and monetary stimulus unleashed to support it.
Down the road many of our 10 investment experts fear there will be a bitter price to pay for today's spending, in the form of hyperinflation and a run on the dollar. Hence, their fondness for that great inflation hedge, gold. In the near term, alas, the only other corrective for the debt-fueled binge of the past decade would be a great cleansing of the economy and the markets, and that's not something politicians -- or the folks who elect them -- want to bear.So, where does that leave us? With POSP, or plain-old stockpicking, as Mario Gabelli likes to call it. And in that, our panelists don't disappoint.
The pages that follow are filled with their best investment ideas for the back half of 2009, including some energy and technology stocks, a few financial shares, several emerging-market funds and much, much more. You'll also find a statistical update on their January picks, for which they should take a collective bow. For the details, please read on.
FRED HICKEY
Barron's: You really nailed it in January, Fred, when you predicted a 40%-50% rally like the "little bull market" that followed the Crash of 1929. Please tell us history won't keep rhyming.
Hickey: The parallels are eerie so far, but what happens next is complicated. The market has rallied about 40% off its lows, led by the riskiest stuff. A selloff is coming because the fundamentals don't match Wall Street's perception. Retail sales were terrible in May; two-thirds of companies reporting came in below forecasts. The rebound in stocks has been based on inventory restocking, but end markets haven't improved.
That's because consumers are afraid to spend.
The savings rate rose to 5.7% in May, a 14-year high. Gasoline is up in recent weeks by about 40 cents a gallon. People are losing their jobs. Housing prices haven't stopped falling. Mortgage delinquencies and foreclosures are up. One of every 10 homeowners is in trouble. A year ago we were handing out $90 billion of rebate checks; that's over, too.
If things were to follow the "little bull market" pattern, stocks would fall to single-digit price/earnings multiples. That would mean 4,000 or 5,000 on the Dow, versus 8,800 now. But that won't happen; the variables are different today.
Fred Hickey's Picks
6/10/09
Company
Ticker
Price
PRECIOUS METALS
Market Vect Gold Miners ETF
GDX
$40.80
SPDR Gold Shares ETF
GLD
93.86
Agnico-Eagle Mines
AEM
56.57
Yamana Gold
AUY
10.16
TECHNOLOGY
Microsoft
MSFT
22.55
Verizon Communications
VZ
29.53
Source: Bloomberg
That's a relief. Isn't it?
In the 1930s the money supply was falling even as the Federal Reserve cut interest rates. Now not just the Fed but other central banks are pumping money into the system like madmen. China's money supply has grown by 25%. The money isn't going into the economy; it's going into asset prices. Oil has doubled from a $32-a-barrel intraday low. Copper is up 80%. Russian stocks have rallied 80%. The situation is reminiscent of the past 14 years, when the Fed primed the pump and created bubbles everywhere.
Recently there have been some signs the insanity might be ending: The dollar has fallen, and yields on U.S. Treasuries have risen dramatically. But to short assets in the next six months would be suicidal. I haven't been short since October, even though the long-term direction is down. How much longer will the Chinese be willing to sit on $800 billion of Treasuries and $2 trillion of mostly dollar reserves and watch our currency drop and our government spend $2 for every $1 it takes in?
At the moment, the alternative might be worse.
Not printing money and letting the system cleanse itself would be very painful. It would mean a great recession -- not something politicians like. Therefore, the discipline will have to come from an external source -- the Chinese. Ultimately, the dollar will collapse and we will be forced to defend it, as happened in the 1930s. Or, we will have horrific inflation. But we have put off the day of reckoning.
In that case, tell us what to buy in the next six months.
Buy value, and protect yourself against the threat of the dollar's collapse and the return of inflation. I've been riding the gold wave for a decade, and the major secular bull market in gold isn't over. I'm twice as adamant now as in January about the need to own gold. I continue to like the mining companies. The GDX, or Market Vectors Gold Miners ETF [exchange-traded fund], is a diversified fund of some 30 mining stocks.
I still like Agnico-Eagle Mines , and bullion, which you can own through the GLD, or SPDR Gold Shares ETF. My favorite gold miner is Yamana Gold . It is based in Canada but operates in Brazil, Mexico and Chile. It trades on the New York Stock Exchange. It rallied to 11 a share from 4, but is down from a year-ago peak of 19, even though the price of gold has recovered to almost $1,000 an ounce. The P/E is reasonable. The company has new mines coming on, and it is benefiting from lower costs.
Which tech stocks do you like?
Microsoft is unloved at 22, because of competitive threats from Google [ticker: GOOG] and an antitrust problem with the European Union. It is the best play in the tech world right now. It trades for 12 times earnings, something you don't ever see. The catalyst for the stock is Microsoft's best upgrade cycle ever. In the next 12 months the company will introduce about a dozen new products or upgrades. Windows 7 will ship on Oct. 22. It will kick off an upgrade cycle for the whole computer industry.
The other safe way to play tech is Verizon Communications . It will offer the Palm Pre in about six months, and new Nokia phones, and probably the iPhone. Just as eyeballs excited everyone in 2000, earlobes should excite them today. Verizon has 87 million wireless-communications customers. It has the biggest network in the country, and the best. The company has mostly built out FiOS, its fiber-optic telecom service. It yields 6.3%. Microsoft and Verizon are a lot safer than trying to catch Apple [AAPL] at $150 a share.
Thanks for the update, Fred.
MARIO GABELLI
Barron's: How does the rest of the year look to you?
Gabelli: The U.S. consumer remains hamstrung by his balance sheet, the stock market and housing. He's two-thirds of the U.S. economy. About 11% of Americans are unemployed, going to 12% or 13%. The consumer sector isn't providing the necessary ballast in the short term.
The economy is benefiting from the absence of a drag from inventory reduction. Once the stimulus package kicks in, the recovery will have legs. The remaining drags are oil is up to $71 a barrel, and interest rates are starting to rise because of the bond vigilantes. But, on balance, the economic stimulus is coordinated and global, and powerful. The U.S. economy will continue to improve in 2010, helped by an uptick in auto spending and improvements in housing and capital investment. Exports could improve as the dollar weakens. There is upside leverage in earnings, partly due to cost cuts. In January I said the stock market would end the year up zero to 5%, and I'm sticking with that forecast.
We won't try to dissuade you.
The secular themes are the U.S. deleverages and transfers its wealth to China. As a result, the strong get stronger. That is true in the auto sector, where General Motors [GMGMQ] and Chrysler now will follow the Toyota [TM] model in supporting one strong dealer in a given market. As capital is reduced in the industry, the remaining, entrenched capital will produce above-average returns. Another example, in markets like Las Vegas, is Wynn Resorts [WYNN], which delivers a quality product and has an OK balance sheet. It will gain a share of the upper-end customer.
Mario Gabelli's Picks
6/10/2009
Company
Ticker
Price
Legg Mason
LM
$24.24
O'Reilly Automotive
ORLY
37.44
Viacom
VIA/B
23.13
U.S. Cellular
USM
40.91
Source: Bloomberg
Is that a recommendation or an observation?
It's a comment. You see it on Wall Street with the strength of Goldman Sachs [GS] and Morgan Stanley [MS]. In a flat stock market, the emphasis is on POSP, or plain-old stock picking. Other themes include eco-friendly energy, and more deal activity. The fifth wave of transactions is starting. Deals were done in the 1960s to offset economic cycles. In the 1980s it was to energize lazy assets. The 1990s had serial acquirers and technology mergers. More recently, private-equity deals dominated. This time, the impetus will be global growth.
Companies will buy growth on Wall Street. NetApp [NTAP] and EMC [EMC] are engaged in a bidding war for Data Domain [DDUP]. Pepsico [PEP] is buying its major publicly traded bottlers.
So you're buying shares of takeover candidates?
In some cases. I still like the stocks I recommended in January. Among new names, Legg Mason sold its brokerage to Citigroup [C] in 2005, and bought Citi's money-management arm. Legg is selling at 24. There are 143 million shares outstanding, and the company has to issue another 23 million in connection with an equity instrument that matures in 2011. Assuming 166 million shares, the company has an enterprise value of $3.7 billion. It has about $2 billion of cash and $2 billion of debt.
CEO Mark Fetting is doing a terrific job of overseeing the different businesses, which include Legg Mason Capital Management, run by Bill Miller, and other fund groups run by Chuck Royce, Buzz Zaino, Whitney George and others.
The biggest, based on assets under management, is Western Asset Management, the fixed-income specialist. The businesses have benefited from coordinated marketing.
What is the outlook for earnings?
Ebitda [earnings before interest, taxes, depreciation and amortization] will be $800 million to $1 billion in three or four years.
Legg could earn 80 cents for the year ending March 2010 and $2 the following year. You have focused management, an improved balance sheet, the elimination of problems that were bogging the company down, and products that could enjoy significant growth. You could get a double in the stock.
I recommended O'Reilly Automotive , an auto-parts retailer, in January, and nothing has changed except the stock, which is up to around 37.50 from 31. The integration of CSK Auto, which it bought last year, is going well. In real estate, O'Reilly is getting better locations at more reasonable prices, to buy or lease. The company could earn $2 a share this year. There are 250 million cars on the road.
The guy who owns a 14-year-old car trades it for a nine-year-old car, and that guy trades his car for a six-year-old car. That is good for O'Reilly, the leader in the business.
How about another idea?
Sumner Redstone controls Viacom through the A shares, which we own. We also own the B shares, which are more liquid but have fewer votes. There are 610 million shares, and the B shares trade for 23. I have been following this company for 36 years. Sumner took control in the mid-1980s. Viacom owns cable networks such as MTV, and Paramount Pictures. Today there are seven or eight motion-picture studios. A round of consolidation will occur in the next six to 12 months because of the costs of financing, prints and advertising, the benefits of globalization and such. We hear talk of something going on.
Paramount will merge with someone -- maybe Sony Pictures or Universal Studios. This year Viacom could earn about $2 a share, going to $2.40 next year. It could be a 20% grower for three or four years. It sells for 6.5 times Ebitda, and capital spending is de minimis. The company is a terrific cash generator and the balance sheet will improve. They might buy back stock.
Next, U.S. Cellular has 87 million shares, and 71 million are owned by Telephone & Data Systems [TDS]. U.S. Cellular has 6.2 million wireless customers, in contrast with Verizon and AT&T [T], which have 80 million-plus each. Sprint Nextel [S] has about 50 million, and T-Mobile 30 million. A next-generation technology is LTE, or long-term evolution. Smaller companies like U.S. Cellular have to take advantage of it or sell out. U.S. Cellular will earn $2.50 a share in 2009 and grow by 15% a year for the next three or four years. It has a hidden asset in that margins are well below the industry average. Capital spending is flattening, and the balance sheet is in good shape. The stock is 43, and the value of the company is close to $100 a share.
TDS elected two directors that we proposed.
You could influence the sale of U.S. Cellular?
The Carlson family has been running TDS for almost 30 years. They have a strong economic interest, but an even bigger voting interest.
There was speculation that U.S. Cellular had a buyer a year ago, but the company still doesn't acknowledge that. At some point Telephone & Data will have to harvest this asset.
Thank you, Mario.
FELIX ZULAUF
Barron's: What is the view from Europe, Felix?
Zulauf: The structural forces in the global economy are unchanged from the past few quarters. A long-term imbalance remains between overspending in the U.S. and over-producing in China. The financial crisis was the start of a move to greater balance that implies lower growth for both sides. The deleveraging process also continues in many economies, with the exception of the U.K.. This process has only started. It will run for several years. We are shifting debt from the private sector to the government sector, which will lever up. These structural forces will continue to be a major restrictive factor in the world economy. In the cyclical arena, things look a little better, but not as good as you might think from the media reports.
So, fewer green shoots?
The green shoots are primarily the result of inventory restocking. Inventories have been cut around the world, and in Asia they have been cut to the bone. Now production is ramping up to get in line with demand. Inventories are being restocked in many industries. The process is far along in technology, but way behind in capital goods. The U.S. economy will look a little better in the next two to three quarters, due to inventory restocking and fiscal stimulus. But the improvement won't continue after mid-2010, when the economy turns bumpy again.
In Europe, Germany has structural problems, but virtually no cyclical imbalances. It is one-third of the European economy. The weaker parts of the Eurozone -- Portugal, Ireland, Greece and Spain -- are trapped in a Euro-denominated system and should devalue their currencies to help their economies. They can't, and therefore will deflate. They'll be the poor guys for the next 12 months. The U.K. hasn't even started to adjust. Consumers there continue to borrow and spend. In the next year they will go through the same thing U.S. consumers have gone through.
Felix Zulauf's Picks
6/10/09
Company
Ticker
Price
EMERGING MARKETS*
iShares MSCI Emerg Mkts Index
EEM
$33.57
iShares MSCI Hong Kong Index
EWH
14.26
iShares MSCI Singapore Index
EWS
9.45
NATURAL RESOURCES*
SPDR S&P Metals and Mining Idx.
XME
41.76
Oil Services HOLDRs
OIH
111.18
Energy Select Sector SPDR
XLE
52.97
Gold (per ounce)**
954.00
*Buy after 15% correction from current prices. **Buy when price drops back to around $850.
Source: Bloomberg
What about Asia?
Asia is the major beneficiary of the inventory-restocking cycle here. It will have the best production numbers, much as it had the worst declines before. The pick-up will run into the middle of next year. China is the big exception.
China decided to breach the global economic slump by subsidizing production and employment. It is playing a dangerous game.
The real danger comes from mid-2010 through 2011. This won't be a conventional business-cycle expansion, but a bumpy road. The economy will look like a square-root sign followed by corrugated sheet iron. The good news is the potential collapse of the system has been avoided. It was an open question for a while.
What does a corrugated-sheet-iron economy mean for the markets?
Governments and central banks will continue to support the economy. Short-term interest rates will stay low. Government-bond yields are rising for cyclical reasons. Around the start of this year, 10-year Treasuries were yielding 2.25%.
Now yields have risen to 3.94% and could go to 4.5%. They won't go beyond that because the economy won't be robust. The bond market is normalizing after the threat of systemic collapse. Bonds aren't attractive.
Investors are underinvested in equities. Money-market funds are bigger than ever when expressed as a percentage of global equity capitalization. That money is yielding virtually nothing, and a lot of it is in the hands of professional portfolio managers who have to perform
Eventually it will get redeployed into equities, which means economic and market developments for a time will move far apart. The market undershot into March, and will probably overshoot in the first half of next year. The first rally is just about done. The market might climb into July, but it will correct in the fall, with stocks retracing maybe 50% of the recent advance. That will provide an opportunity to buy for a rally next spring or summer. That's the whole mini-bull market. Economic conditions won't support more than that.
Are you still looking for a low in 2011 or 2012?
Yes. We'll enter another bear-market cycle. I don't know how low it will go. In March the market made a cyclical low in valuation, but it wasn't a secular low. When the market makes a secular low, lack of interest in equities will be high.
Previously I advised buying financials and metals. Now the financials are done, perhaps for a couple of years. Bank balance sheets aren't repaired. It's just camouflage. Today I like emerging markets and natural resources -- after a correction of 15%. Investors believe in the long-term prospects for emerging markets, due to demographics and structural issues. That's where the money will go that is on the sidelines.
Among ETFs I like the iShares MSCI Emerging Markets Index, the iShares MSCI Hong Kong Index and the iShares MSCI Singapore Index. In energy I like the SPDR S&P Metals and Mining Index, and in oil services, the Oil Services HOLDRs and the Energy Select Sector SPDR . Again, buy on corrections. Also, you have to own gold because governments have no solution but to reflate.
Currencies will be debased, and gold will go higher. But don't buy bullion until it drops to around $850 an ounce. It is $950 now.
Thanks, Felix.
OSCAR SCHAFER
Barron's: What do you make of this market, Oscar?
Schafer: I'm surprised the S&P 500 is up 40% from its March low, because the companies we speak to have seen their business go down and stay down. In many cases, April was even worse than March. In addition, there has been a huge increase in bond issuance. The government has done a great job of liquefying the system, but that hasn't led to a lot of lending.
How, then, do you explain such a powerful rally?
We've removed a depression risk and are dealing with a recession. A huge amount of money on the sidelines has gone into stocks and other assets. Many people think the stock market is a discounting mechanism, and the recovery in the economy will be like past recoveries. But I don't see it, given the leverage around the world and continued declines in home prices in the U.S. and other developed nations. You could make a bullish case for 1% to 1.5% growth and 3% or 4% inflation, but that may not justify a 40% increase in stock prices.
Oscar Schafer's Picks
6/10/09
Company
Ticker
Price
Metavante Technologies
MV
$27.22
SHORT
Plum Creek Timber
PCL
34.21
Source: Bloomberg
So you're expecting a correction?
There may be a setback as interest rates rise and housing refinancings slow. The maximum impact of tax rebates probably has been seen.
The economy will grow slower than anticipated, which will surprise people, and therefore the discounting-mechanism aspect of the stock market will have to be rethought.
Nevertheless, we still find good ideas on the long and short sides of the market. Whereas [veteran hedge-fund managers] George Noble, Art Samberg and Jim Pallotta are leaving the business, I'm just beginning to enjoy it.
Glad to hear that. What are you finding?
Metavante Technologies [MV] recently announced it will be acquired by a larger competitor, Fidelity National Information Services [FIS], in an all-stock deal. The combined company will trade as Fidelity Information Services. It will have a pro forma market capitalization of $7.5 billion and will be the largest provider of transaction and processing services to financial institutions.
The transaction preempts industry and customer consolidation and could generate significant shareholder returns. Management expects to realize about $260 million in annual synergies, creating $1.7 billion in shareholder value. The transaction also will allow both companies to cross-sell to each other's customers. The combined company is in a much better position to take advantage of secular growth trends in process-outsourcing by banks, as well as the global shift to card-based payments from cash.
Just to clarify, you're buying the combined company through Metavante, the seller, not FIS, the buyer.
Yes. One share of Metavante trades as if it is 1.34 shares of Fidelity. After the transaction, the combined company should trade higher. The new FIS could trade for more than the current seven times Ebitda and command a higher free-cash-flow yield than today's 11%. Historically, payment processors have traded for 18 to 22 times free cash flow. Eighty-six percent of Fidelity's revenue is contractual and recurring and should grow by 6% to 8% a year. You're also getting a free call option on an eventual sale to a large software provider such as IBM [IBM], Oracle [ORCL] or Hewlett-Packard .
How about another idea?
Plum Creek Timber is overpriced. This REIT [real-estate investment trust] is the largest private owner of timberland in the U.S., with about 7.4 million acres in 19 states. The stock is trading for around 30 times consensus 2010 earnings estimates, and nearly 20 times estimated Ebitda.
At 35 a share, the market is valuing Plum Creek at more than $1,100 per acre. The company has tremendous assets and a high-quality management team, but investors are mispricing timberland as an asset class and Plum Creek as a stock. Our target price is $10 to $15 per share, or $600 an acre. Investors have bid up timberland prices to irrational levels. In the past decade pension funds and endowments flooded into this very small market as they sought to be like Harvard and Yale, early and successful investors in timber. Accordingly, timberland values have doubled in five years and nearly tripled in 10.
Buyers are getting a long-term, illiquid asset at a 2% yield, with the hope that some land will be more valuable to a real-estate developer down the road.
It could be long road.
Timber has a seductive investment pitch. It grows organically. It grows while you sleep. It's an inflation hedge, and it's uncorrelated with other asset classes. The reality is the underlying cash flow is highly dependent on cyclical industries like housing, paper and newspapers. It is also tough to hedge inflation when you are a buying at an inflated price. This is the greater-fool theory at work.
Historical returns are excellent, however.
Timberland returned 18.5% in 2007 and 9.5% in 2008, when other asset classes were down more than 40%. When investors attempt to monetize the great returns they saw on their statements, it will create a race to the exits. Plum Creek has done a phenomenal job of recognizing and taking advantage of this asset bubble. It has been a net seller of timberland for the past three years. But the company's earnings quality is low, and its capital-allocation policy is aggressive.
How so?
The core business of harvesting timber has been operating at break-even levels, while all the free cash flow is generated by selling assets.
Liquidating your productive asset isn't a sustainable strategy. Many Wall Street analysts ignore the fact that timberland sales run through the income statement while timberland purchases run through the cash-flow statement.
If you put a 10 to 15 multiple on mid-cycle cash flow of 65 cents a share, you're looking at single-digit equity valuations. It would take unprecedented demand from real-estate developers to make up the difference. In six of the past seven years, Plum Creek paid out more cash in dividends and share buybacks than it has generated. Management achieved this in part by adding leverage. This isn't a sustainable strategy, either.
Thank you, Oscar.
SCOTT BLACK
Barron's: What's ahead, Scott?
Black: The S&P 500 is trading for about 940. Analysts expect it to earn $54 this year. Strategists are using $43. On a bottom-up basis the market trades for 17.5 times earnings; top-down, it trades for 22 times. Either way, it is pretty expensive. Investors are chasing any glimmer of hope, such as fewer jobs lost in May, even though the unemployment rate climbed to 9.4%. There was a lot of cash on the sidelines. The train started pulling out of the station in April, and a lot of people missed the passenger cars, so they jumped on the caboose.
Are they about to fall off?
The market is ripe for a pullback, though it won't retest the 666 low. We screen 11,000 U.S. equities. With the exception of special situations, the market is picked over. The economy hasn't bottomed. Most of the $787 billion in stimulus money went to transfer payments and tax rebates, and hasn't found its way into job creation. The savings rate has climbed to about 5.7%. That's good for America in the long term, but not in the short.
On the positive side, Fed Chairman Ben Bernanke has done a good job. He got the federal-funds rate down to 25 basis points [a fourth of a percentage point]. He is probably the most valuable player on the American executive team.
Public policy under the Bush and Obama administrations isn't good. The money should have gone to restructure the mortgages of people underwater on their homes -- 21.8% of the nation's 93 million homeowners. Instead the government threw too many freebies to AIG [American International Group], Goldman Sachs and such. It had no business saving AIG. It should have isolated the toxic assets and put them in a Resolution Trust-type entity.
Scott Black's Picks
6/10/2009
Company
Ticker
Price
Boardwalk Pipeline Partners
BWP
$21.12
Cal-Maine Foods
CALM
23.22
Source: Bloomberg
What's done is done. Let's look ahead.
The economy will recover in the fourth quarter because there has been so much fiscal and monetary stimulus. But the recovery won't be strong because of our structural problems. Given the unfunded liabilities of Medicaid and Medicare, and ongoing deficits, the U.S. is going broke. In the short term I'm not worried about inflation. Nor do I see a run on the dollar because it is still the reserve currency for the world. There will be a run on the dollar in the long term, however, if we keep printing money. The Fed has expanded its balance sheet to $2.12 trillion of obligations, up from $930 billion a year ago.
It had to rescue the patient.
The patient was on life support last fall. The Fed and Treasury have done a good job of restoring confidence to the markets.
I've got two stocks, both dividend-oriented, because you ought to have some protection if the market pulls back. Boardwalk Pipeline Partners is about 73%-owned by Loews Corp. [L], which is controlled by the Tisch family. It sells for about 21, there are 177.8 million shares outstanding, and the market cap is $3.77 billion.
Isn't this a master limited partnership?
Exactly. It pays a dividend of $1.94 a share and yields about 9.2%. Historically, MLPs have yielded about three percentage points above the 10-year Treasury yield, which is now 3.94%. Book value, excluding goodwill, is $17.12. The stock sells for 1.2 times tangible book, which isn't expensive. The company has all new plant and equipment. It operates three major pipelines running more than 14,200 miles in the Southwest and Southeast.
My earnings forecast is lower than the Street's. Revenue will rise 20% this year, to $942 million. Margins of 35.2% get you to $332 million in operating income. Interest expense is $137 million, and profit before taxes, $195 million. Earnings, fully diluted, will be $1.10 a share. The debt-coverage ratio is excellent at about 3.9 times. In the past few years revenue has grown by 11.9%, compounded, while the dividend has risen about 10.5% a year. Plus, Boardwalk has good bank lines of credit.
What sort of return are you expecting?
The stock could rally to 28. That's 33% appreciation plus a 9% yield -- or an expected total return of 42%.
My next pick is Cal-Maine Foods . The stock is 24.81, there are 23.8 million shares and the market cap is about $590 million. Cal-Maine is the No.1 egg producer in the U.S., with a 15.8% market share. In the May 2008 fiscal year, it sold about 678 million dozen eggs -- 535 million dozen were produced in-house. They have 22 million hens, whose laying life cycle is about two years. The stock fluctuates with the price of feed -- corn. In the past year it has been as high as 48.80 and as low as 17. Earnings fluctuate, too. The company earned $6.40 a share in fiscal 2008, and we estimate they did $4.15 in fiscal '09.
Take us through your model.
I see revenue of $1 billion in the coming year, up about 4%. Gross margins are 27.5%, or $275 million, and SG&A [selling, general and administrative expenses] is $95 million. The net debt-to-equity ratio is only 16% and interest expense is $6 million. Add it up and you get pretax profits of $174 million. Taxed at 35%, that's net income of $114 million, or $4.80 a share. The stock sells for 5.2 times earnings.
That's ridiculous. Return on equity is 31%, and they will generate about $120 million in free cash. The company pays out a third of income as dividends. The current dividend is $1.72, the yield,7%.
About 85% of Cal-Maine's customers are retailers; the biggest is Wal-Mart Stores [WMT]. If Cal-Maine earns $4.80 a share in fiscal 2010 and trades for just eight times earnings, you've got a $38.50 stock, plus the yield.
You've been a buyer of energy and financial stocks. What is the outlook for both?
In energy, you have to separate oil from natural gas. There are so many gas-producing shale plays in the U.S. that we have a gas glut here. Gas is about $3.70 per million Btu and hasn't rallied with oil. I don't expect gas prices to spike, but XTO Energy [XTO] recently noted the forward strip [forward price curve] is north of $6 for next year and $7 two years out on expectations the economy will revive. When that happens, oil supplies will tighten. Crude could trade above $100 a barrel in 12 months, versus $71 now. It is better to own pure energy-and-production companies such as XTO, Whiting Petroleum [WLL] and Apache [APA] than the ExxonMobil s [XOM] of the world, which have refining assets. We own offshore drillers such as Diamond Offshore [DO], Atwood Oceanics [ATW] and Ensco International [ESV].
In financials, regional banks have run up. Most are selling at or near book value and are under-reserved. They own lots of residential mortgages and the housing market is getting worse. A few look attractive, such as Prosperity Bancshares [PRSP] in Houston and Bank of the Ozarks [OZRK] in Arkansas. The earnings power of the bigger banks was based for a long time on proprietary trading. With less leverage and deal activity, earnings power will be diminished. Also, many super-regionals are under-reserved. That tells me S&P 500 earnings are overstated.
Thank you, Scott.
ABBY JOSEPH COHEN
Barron's: The S&P 500 has hit Goldman Sachs' year-end target of 940 with seven months to spare. Now what?
Cohen: The concept of fair value can change based on assumptions about the market's fundamentals. In January, even with a gloomy outlook for the economy and corporate profits, stocks were too cheap. In March, using an economic and profit forecast not too different from January's, our models suggested the S&P was undervalued by 40% or more.
At this point people should stop worrying about what letter of the alphabet the recovery resembles. Is it going to be a V-shaped recovery, or U-shaped, or the dreaded W? The pattern to think about is a staircase. When you look at the recovery phases from real bear markets -- those associated with real recessions -- they look like a staircase. First there is an upward step, a sigh-of-relief rally, which we've just had. Then you're stuck on the step awhile. Think of these steps as trading ranges.
You can also fall down the stairs.
The likelihood of that happening has declined as the possibility recedes of the system going down a "black hole." Both the actions taken by the Federal Reserve and the stimulus package have gained traction. Also, market volatility has declined. Investors feel more comfortable.
Equity issuance is up dramatically, as well, and demand is good.
Abby Joseph Cohen's Picks
6/10/2009
Company
Ticker
Price
Hess
HES
$59.98
Lenovo Group
992.Hong Kong
HKD 3.02
Source: Bloomberg
In November, December and January, almost all the issuance in the fixed-income market had some sort of federal-government guarantee. In the past few months there has been a significant increase in issuance by entities without guarantees. Yield spreads have declined from record levels, another sign of diminished anxiety. At the turn of the year Treasuries and gold were viewed as the only safe havens. As nervousness recedes, investors have come back into equities and commodities, and out of Treasuries.
What is fair value for the S&P 500 now?
Our economics department is forecasting a sluggish recovery in GDP. It will turn positive in the third quarter but grow by only 1% or 2%.
Given lackluster profit expectations, our six-to-12-month S&P outlook is 950 to 1,050. Goldman is forecasting S&P 500 earnings before provisions of $63 in 2009 and $71 in 2010.
Regardless of the number, there is a discontinuity in the data. Some S&P 500 companies have disappeared, and recent quarters have seen extraordinary write-offs. There will be a major inflection point for earnings in the third or fourth quarter. Our analysts believe risk may be to the upside -- that is, profits may grow faster than previously forecast.
Are you upbeat about the bond market, too?
The picture is mixed. In the past two years the normal relationships between issuers of different quality were torn asunder. Between 2004 and 2007, lower-quality issuers were able to borrow money for not much more than higher-quality issuers, and it wasn't just in corporates. Last year the relationships flipped, and yield spreads over Treasuries widened to unprecedented levels in low-quality corporates and municipal bonds. Recently there has been a move toward more normalcy. Corporate bonds are still appealing, but are no longer as attractive as they were early in the year, as they have had good returns, and Treasury yields no longer look so low.
How about some investment ideas for the second half?
Our energy team recently raised its price forecasts for crude oil and other energy commodities. This lifted the earnings prospects for integrated oil and refining companies. Crude is expected to reach $80 per barrel next year and $100 in 2011 due to demand recovery in the face of non-OPEC supply contraction. Hess benefits from the rise in prices and its ability to deliver growth in production while others are supply-constrained. The shares are down about 50% from year-ago levels. This year the company could earn $1.03 a share. Next year earnings could surge to $5.30, suggesting a P/E ratio of about 11 at current prices.
Lenovo Group , known for personal computers including the Thinkpad, originally an IBM product, is expected to benefit from recovering global demand. Lenovo's market share is about 27% in China, where growth is expected to rebound due to economic stimulus, demand for 3G netbooks and subsidy programs. Our analysts expect a global PC-upgrade cycle in 2010, bolstered by aging corporate PCs and Microsoft's introduction of Windows 7. Lenovo had large losses early this year and has restructured. It could break even in fiscal 2010, which began in March, and earn three cents in fiscal '11. The P/E is about 13. The stock has doubled since March to 3.02 Hong Kong dollars, but is 45% below year-ago levels.
Thank you, Abby.
BILL GROSS
Barron's: Treasuries have entered a bear market and other bonds look rich. What's an investor to do?
Gross: Treasuries offer paltry returns relative not only to other types of bonds, but also other asset categories such as stocks, commodities or real estate. The 10-year is yielding 3.88%, and even the 30-year bond, at 4.68%, doesn't offer much relative to the potential for greater inflation in 2012, '13 and '14. Treasuries have had an enormous problem this year in terms of supply: There will be $3 trillion of gross issuance and $2 trillion of net issuance, four times last year's number. That's one reason yields have gone up.
Did the government have a choice but to issue this debt?
None at all. But the danger in injecting so much money to support the financial system is that the hangover, when it comes, could be worse than the original problem. The Fed is buying $400 billion of Treasuries. That leaves $1.6 trillion of the net $2 trillion to be purchased by you, me and the Chinese.
Agency mortgages have done so well since January that they don't make much sense, either. They yield around 4.50%. High-yield bonds, corporate bonds and even municipals and TIPS [Treasury inflation-protected securities] have some attraction, but they too have done well in the past five months.
Bill Gross's Picks
Price/Yield
Investment
6/10/2009
Citigroup 8.3%, due 2057*
$86/9.6%
Barclays 14%, due 2049**
110/11.4%
*Will convert within a month to Citigroup stock at $3.35 a share. CUSIP: 173094AA1. **ISIN: XS0397801357.
Sources: Bloomberg; Pimco
Where does that leave you?
The one area that remains attractive is the hybrid-preferred market. These are similar to TARP preferreds -- bank preferred stock the government bought with TARP [Troubled Asset Relief Program] money. The hybrids were issued to the public; they're really subordinated debt.
I like a Citigroup [C] issue with an 8.3% coupon and a maturity of Dec. 21, 2057. The catch is that Citi plans to redeem it in two to three weeks with common stock priced at $3.35 a share. The offer has been outstanding for maybe two months, but the conversion is shifting into high gear. This is more of a stock play than a bond play. It's an arbitrage play. There is 15% appreciation potential relative to the current price of the common stock, which trades around 3.44.
What others appeal to you?
Barclays [BCS] has an attractive subordinated preferred with a 14% coupon and a 2049 maturity.
It can be bought around 110, so the current yield is 13%. We have been buying it recently. That's an excellent yield for an A-rated security. So, yes, there are sporadic values, but high-yield and corporate bonds in general, and Treasuries and even mortgage securities, are mediocre investments at the moment. An investor probably should expect 4% to 5% to 6% returns from the genre -- nothing super.
Thank you.
ARCHIE MacALLASTER
Barron's: Your usual optimism has paid off, Archie, at least since March. Are you still finding what to buy?
MacAllaster: The market was cheap in January, and it is almost the same price now. This is the worst market I have seen in more than 50 years in the business. But a lot of stocks are near a bottom based on multiples of future earnings.
Some companies have even started to raise dividends instead of cutting them. The savings rate in the U.S. has risen. A lot of money was extracted from the market as people started losing much of their net worth, so there is a lot available to come back in. What we don't know is how big the deficit will grow, and what kinds of problems that poses for the economy, the dollar and the world itself.
Archie MacAllaster's Picks
6/10/2009
Company
Ticker
Price
Bank of America
BAC
$11.98
Protective Life
PL
12.66
Source: Bloomberg
Most people will disagree with me about the financials, but they still are cheap. You'll do well if you can hang on for two or three years.
Bank of America [BAC] trades for 12 a share. The 12-month range is 2.50 to 39.50. The bank earned 44 cents a share in the first quarter and probably won't do more than a dollar for the year. The dividend was cut to four cents from $2.56. Bank of America has the largest deposit base of any bank in America: more than 10% of all deposits. It used to make more than $4 a share and sell for 52 to 53, and yield 5%. The whole banking business will have to be run on a different basis, and relative to three or four years ago, Bank of America will be overcapitalized. In two or three years it will earn three bucks a share, and sell around 30. It might pay a dividend of $1.50 a share.
Are you a fan of the CEO, Ken Lewis?
They would be crazy to fire him. The company will have an enormous earnings base, including Countrywide Financial and Merrill Lynch. Bank of America is a good speculation.
My second pick is Protective Life.It has been around at least 100 years. Like other life insurers, it has had problems with its investments; book value was cut in half in the past 18 months. The company sold 13.5 million shares at 9 apiece last month, raising about $120 million of new capital. There are 85 million shares outstanding. In the past five years earnings have varied between $3.37 a share and $4.05. Last year they showed a net loss due to the re-valuation of investments, but operating earnings were $3.37 a share. This year the estimate is about three bucks -- the worst operating results in six years. The company cut its dividend but still pays 12 cents per quarter. The yield is around 4%. The stock trades for about 12.50. That's four to five times earnings, and around book value. In two to three years the stock could be 30 a share.
Financial stocks have had a pretty good rebound, but insurance companies such as Lincoln National [LNC], Hartford Financial Services [HIG] and Protective Life are cheap. If the stock market gets a lot weaker they will have trouble, but they are selling around book value, compared with a traditional valuation of closer to two times book. The other banks I like are Wells Fargo [WFC] and JPMorgan. The big banks will be more heavily capitalized, and make a smaller return on capital, but the returns will be decent.
Thanks, Archie.
MARC FABER
Barron's: What a rally, Marc. Are stocks due for a rest?
Faber: The S&P 500 has risen more than 40% from its March 6 low of 666. It could correct soon, maybe from higher levels. If it rallies to 1,000-1,050 by July, that could be the high for the year because the index is not inexpensive.
But we don't see new lows. The 666 low is likely to hold, as is the Nov. 21, 2008, low of 741. The market won't fall below 800 for the time being.
It is hard to know what happens in the next year because so much economic and financial volatility has been created by huge fiscal deficits and expansionary monetary policies.
Governments can support economic activity through fiscal deficits. What concerns me down the line is the likelihood of much greater inflation because of all this stimulus. At some point the Federal Reserve will have to increase interest rates to combat inflation, and it will be very reluctant to do so.
But that's not today's problem.
Today the economy looks to be stabilizing after falling off a cliff. It probably troughed in February or March. Replacement demand is kicking in, but we won't return to the peak activity of 2006 any time soon.
If things deteriorate, the Fed will print more money. Mr. Bernanke talked a few years ago about dropping dollars from helicopters to stimulate the economy. It would be wrong not to take this statement seriously because that is the thinking among policymakers in the U.S. It is a disastrous policy but it can really make stocks go up -- commodities, too. Since the lows in December, oil is up more than 100%. A lot of liquidity has flowed into commodities, which is a sign investors are concerned about the value of paper money.
Emerging markets have been especially strong. Are the gains justified?
The opportunities are far better than in the U.S. When hedge funds and funds of funds had massive liquidations last fall, Asian markets such as Taiwan, South Korea and Japan fell to generational lows. Investors should use setbacks in these markets to accumulate shares. Many stocks are yielding between 6% and 10%.
Secondly, the world is undergoing a major shift in consumption. In March car sales in emerging economies began to exceed those in developed countries. China, Brazil and India have become important simply because of the size and growth of their populations.
Marc Faber's Picks
6/10/09
EMERGING MARKETS
Ticker
Price
SINGAPORE
Parkway Life REIT
PREIT.Singapore
S$0.96
ARA Asset Mgmt
ARA.Singapore
0.60
Hyflux Water Trust
HYFT.Singapore
0.52
Raffles Education
RLS.Singapore
0.68
Kingsmen Creatives
KMEN.Singapore
0.43
THAILAND
MCOT
MCOT.Thailand
18.50 baht
Dynasty Ceramic
DCC.Thailand
17.90
Airports of Thailand
AOT.Thailand
27.75
Thai Airways Int'l.
THAI.Thailand
14.00
JAPAN
Mitsubishi UFJ Fincl
8306.Japan
¥640
iShares MSCI Japan
EWJ
$9.42
RESOURCE
6/10/09
COMPANIES
Ticker
Price
Xstrata
XTA.Switzerland
13.60 CHF
NovaGold Resources
NG
$4.66
Natural Gas (per MMBTU)
3.71
6/10/09
SHORT
Yield
10-Year U.S. Treasury notes,
when the yield falls to 2.8%-3%
3.94%
Source: Bloomberg
There has been renewed interest in asset plays of all types. Stocks like Newmont Mining [NEM] and Freeport-McMoRan Copper & Gold [FCX] have soared. Along the same lines, there is renewed interest in Asian real estate, which isn't expensive. Prices are lower than they were in 1997. I like Asian REITs [real-estate investment trusts] such as Parkway Life in Singapore and ARA Asset Management, a Singapore property-management company. Hong Kong and Singapore will benefit from greater regulation of the financial markets in the U.S. and Europe. Also, the U.S. has large and highly sophisticated military installations in Singapore, and it doesn't want to antagonize Singapore.
That should bode well for Singapore-based companies.
Demand for water is a big theme in Asia. Singapore's Hyflux Water Trust pays out income earned from operating water-treatment plants.
Education is a growth industry, as well, and Raffles Education should benefit. Also in Singapore, I like Kingsmen Creatives, a marketing and communications-design company. In Thailand I like MCOT, a media conglomerate, and Dynasty Ceramic, which makes floor tile, as well as two airline-related companies -- Airports of Thailand and Thai Airways International. In Japan I like Mitsubishi UFJ Financial and the iShares MSCI Japan fund.
You've been a big fan of resource companies. Are you still?
Mining companies such as Switzerland's Xstrata are good trades. The company got hit hard last year because it operates on leverage, but the concern was overblown. I like NovaGold Resources.Barrick Gold [ABX] tried to buy them for about $15 a share a year ago. There was no deal and NovaGold fell below 2, although it has rebounded to 5.50. NovaGold has enlarged its asset base significantly. Today it is even more valuable than $15. Natural gas is a buy here. It is extremely depressed and at a record low compared to oil.
I would short U.S. Treasury bonds when the yield declines to 2.8% to 3% on 10-year notes.
Thank you, Marc.
MERYL WITMER
Barron's: Is this still a good market for stock-pickers?
Witmer: I see some stocks to short, and some decent longs, but a lot of our focus has been in the debt arena recently. The stock market seems about right, but you have to be prepared to buy on the downdrafts and sell on those days when the market goes up dramatically. The volatility is being driven somewhat by the popularity of leveraged exchange-traded funds. On the economy, I spoke with a CEO who met recently with a large group of CEOs. The consensus among this group was that things have stopped going down, but growth is questionable.
The stock market's behavior is suggesting otherwise.
The market went down too much, and now it has retraced much of the downdraft since the beginning of the year. We like Microsoft at 22 a share. The obvious reasons to buy it are its bulletproof balance sheet and lots of earnings.
It could have $3 a share of net cash as of June 30, the end of its fiscal year, and earn $1.71.
The Street estimates earnings of $1.90 in fiscal 2010. Net of cash, it is trading at 10 times earnings. It is very inexpensive. Three things have gotten my attention beyond the P/E and the cash. Microsoft is in front of a product cycle in its client division, which sells personal-computer operating systems. Microsoft is coming out with Windows 7 for the 2009 holiday season. Win 7, as they call it, has gotten great reviews, and the company has bent over backward to damp expectations about upgrade revenue. It could surprise on the upside, as corporations didn't upgrade en masse to Vista, the prior operating system.
Meryl Witmer's Pick
6/10/2009
Company
Ticker
Price
Microsoft
MSFT
$22.55
Source: Bloomberg
Rumor has it Win 7 is better than Vista.
It is much better. It doesn't take a lot of memory, and can go on an inexpensive PC.
Microsoft probably will stop supporting the Windows XP operating system within six months of the release of Win 7, which encourages upgrades at many companies. Second, Microsoft, was never known to focus on costs, but now it has a laser-like focus. This may lead to upside surprises in earnings, return on capital and employee productivity. As further evidence of its newfound respect for capital, it held back on rebidding for Yahoo! [YHOO].
Any chance it'll try again, now that Yahoo! is cheaper?
It doesn't have to, because of the third thing that excites us: a new search engine, Bing. The look is clearer than Google, and you can preview search results by hovering your cursor over the link. It saves you from clicking pages and waiting for them to load. Most important, shopping on Bing is great because of a cash-back rewards program. Rewards tend to run from 5% to 10% of the purchase price of an item, and you get Bing cash, which you can use on many sites.
The early results are good; Bing's market share is up to 11% just five days after the launch.
Figure Microsoft earns an adjusted $2.05 a share in fiscal 2010. Unlike Google, it expenses options, so the earnings are real. Say it deserves to trade at 13 times earnings. Add back the $3 in cash, and a dollar or two for the Xbox division, and you get a target price of 31.
There is further upside if Bing gains momentum.
You could make 40% or more.
That's sweet. Thank you, Meryl.
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