Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest :: January 2009, Part 4

This Week’s Entries :


In the final Barron’s Roundtable installment, Scott Black, Marc Faber, Mario Gabelli and Oscar Schafer take the floor to discuss the stocks and sectors that may reward investors.

Here is the 3rd and final segment of the annual Barron’s January “Roundtable,” featuring some of the best minds in the investment business.

Much has changed, and not for the better, since Barron’s 2009 Roundtable was called to order January 5. That lovely little rally that ushered in the new year? Kaput. Merrill Lynch’s marriage to Bank of America? Going great, if you ignore the fact that the government had to climb into bed with the newlyweds. Corporate earnings? Feh. The job market? What job market?

Yet even amid growing evidence that the economy’s travails, and the stock market’s, are far from over, one thing is constant: Our panelists – money managers and market mavens extraordinaire – remain convinced that savvy stock-pickers can prosper by doing their homework and going against the crowd. In this week’s issue, the final four get their say on the stocks and sectors that may reward investors in the year ahead, even if the big picture does not brighten.

A noted art collector, Scott Black of Delphi Management has turned Graham-and-Dodd-style investing into a science. Scott looks behind the numbers – all of them – to find mispriced companies that offer super-high returns on equity, discounts to book or break-up value, and other attractions not apparent in their shares. This year he is bullish on Oracle, General Dynamics and an infrastructure play, among others.

What is the difference between a bear and a realist? If there is one these days, Marc Faber does not know it. A man of the world – after all, he has seen most of it – the Swiss-born, Hong Kong-based investor and provocateur thinks Uncle Sam’s penchant for printing money will lead to disaster. En route, however, certain Asian stocks, blue-chip techs and bombed-out resources shares just might double or triple. As for Treasuries, short ‘em. Still.

Oscar Schafer of O.S.S. Capital Management is one of the shrewdest money managers in New York, where the competition is not exactly wanting. Oscar has made his name, and his and his clients’ money, through scrupulous research into the products, financials and managers of companies that intrigue him with their investment potential. In this week’s issue he expounds on a clever way to buy Time Warner’s entertainment assets, and heaps praise on Wyeth – and its possible deal with Pfizer.

Something old, something new and something chocolate. That sums up Mario Gabelli’s rollicking presentation, which concluded our annual Roundtable. A money manager with a lengthy and enviable track record, Mario drove home the charms of O’Reilly Automotive, a new pick, and John Malone’s Liberty Entertainment. He also revisited the bullish case for candy king Cadbury, with samples for everyone. Broadly speaking, he expects President Obama to go to work soon on a job-creation program, or what Mario calls a No Adult Left Behind Act. It is an interesting idea, like many you will read about in the pages that follow.

Barron’s: Scott, what are you recommending for 2009?

Black: The market is a random walk. I cannot tell you if it is going up, down or sideways, only that the economy has not bottomed. Real GDP will be minus 2% to minus 3% this year. Much of the recovery is contingent on public policy. If we get fiscal stimulus, the economy will start to revive in the second half of the year. Stock markets discount events, so stock prices probably will be higher by December 31, as will volatilitiy.

I have four high-return-on-equity companies with sustainable earnings power. They will generate strong free cash flow and have strong balance sheets. I like an Obama infrastructure play in California; if Congress passes an infrastructure-spending bill, earnings could explode. And I have an asset play that earns only 10% on equity, but it is so cheap, it is ludicrous.

With that preamble, give us the names.

Black: Oracle closed Friday [January 2] at 18.41. It has 5.1 billion fully diluted shares, and a $94 billion market capitalization. Sales were $22.6 billion for the fiscal year ended May, with $1.30 a share in earnings. In the first half of this fiscal year, sales were $10.9 billion and earnings $3.3 billion, or 63 cents a share. In the second half, revenue could rise 3%, and with operating margins of 43%, profits before taxes are $5.27 billion. Taxed at 27%, earnings per share are $1.39. Adjust earnings for the cost of stock-based compensation, they are $1.33. The stock trades for 12.3 times calendar 2009 estimates of $1.49. ROE is 32%.

Oracle has earned 30% on equity, with no net debt, for about 10 years. It generated $3.25 billion in free cash in the first half of fiscal 2009. It is a money machine, and it makes money on software-maintenance revenue.

Larry Ellison [co-founder and CEO] is tough and demanding. About 50% of sales come from the Americas, 34% from Europe and the Middle East and 15% from Asia-Pacific. The company does not hedge currencies, so if the dollar sinks against the euro, it will benefit. Oracle’s biggest competitor in database-management software and middleware is IBM.

Hickey: Microsoft is a big competitor in database-management software.

Black: Oracle’s customers are mostly Fortune 1000 companies. The need for financial consulting has increased, benefiting their business. In fiscal 2010 the company could earn about $7.8 billion and generate more than $7 billion in free cash. They have $6 billion remaining of an $8 billion authorization to buy back stock.

Fred, do you like Oracle?

Hickey: It is not a bad place to hide. On the negative side, almost all the growth is coming from acquistions. On the positive side, the price of competitors has come down.

Black: Most of the large acquisitions are behind them. There are not many big players left. Acquisitions are beneficial. They were weak in China before buying BEA, which had a better organization. They made the head of the BEA office head of Oracle in China, and now have better penetration in China with the Oracle platform.

Earlier today I said the U.S. should increase defense spending. Defense goods are manufactured here, which helps employment. General Dynamics is a great company, selling at one of the cheapest valuations in years. The stock is 59.76. There are 392 million fully diluted shares, and a $23.4 billion market cap. The dividend is $1.40, for a 2.3% yield. Revenue likely was $29.3 billion in 2008, up 7.5%. They could earn $6.15 to $6.20 a share.

What kind of backlog do they have?

Black: The funded backlog is $49.7 billion. The total backlog is $60.5 billion. Gulfstream [business jets] could be vulnerable, but it is not too vulnerable at $21.5 billion of funded backlog.

Schafer: It is extremely vulnerable.

Black: That backlog does not include leasing companies, because sometimes those orders are canceled. GD aims to provide 13% to 15% annual returns to shareholders, so if the yield is 2%-2.5%, earnings could grow 11% to 13%. There are four business segments. Aerospace is Gulfstream. Combat Systems is the Stryker and Abrams expedition-fighting vehicles, plus ammo. The Marine division is Bath Iron Works, which builds destroyers, and nuclear subs in Groton, Connecticut. Information Systems and Technology is the largest business, at 34.6% of revenue. It consults for the CIA, the Department of Defense and others.

Last year General Dynamics acquired Jet Aviation, based in Switzerland, which has about $1.5 billion in revenue and 10% to 12% operating margins. If GD’s total revenue of $29.3 billion grows about 6.1% and they pick up Jet Aviation’s $1.5 billion, that gets you to $32.6 billion. Margins could decline due to changes in the mix of business, leaving operating income of $3.98 billion. There is some net interest expense. The company has net cash of $478 million. Taxed at 32%, GD generates about $6.75 a share in earnings. The P/E is 8.8.

How does that compare with peers?

Black: Lockheed Martin and Raytheon sell at much higher multiples. General Dynamics’s ROE is 19%. The company will generate $2.52 billion in free cash this year. As for Gulfstream, the company does not take trade-ins anymore. And, it requires deposits on new planes, starting with 10% of the total, with progress payments due as the plane is being built. By the time a plane is two-thirds completed you have paid for 65%-67%. Most people are not walking away from $30 million deposits.

Schafer: You can sell your place in the queue to someone else, who might have been an incremental buyer.

Black: The most vulnerable business is the low end. Production rates came down on mid-sized jets, the G150 and G200, which are made by Israel Aerospace Industries, via joint venture. But they represent less than 15% of the EBIT [earnings before interest and taxes] of the division. The build rate for large jets will increase next year. Gulfstream’s backlog is 53% international, 47% domestic. Two-thirds of buyers are private companies and individuals, versus the big corporations of 10 years ago. Governments like Saudi Arabia represent only 5% to 6% of the business.

My next pick is an old favorite, XTO Energy, in Fort Worth [Texas]. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion – slightly higher than the Street’s – which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for 2009. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You have got asset and earnings protection. And they are in every major field in the U.S. – the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year’s earnings will be down?

Black: No, because they hedged 2010, too.

Oscar has recommended Endo Pharmaceuticals Holdings in the past. It specializes in pain management – appropriately, since we suffered so much pain in 2008. It closed Friday at 26. There are 120 million fully diluted shares and $3.1 billion in market value. There is no dividend. The company has cash and equivalents of $659 million, or $5.49 a share. In addition, they have auction-rate preferreds. They can borrow up to 75% of the value of the preferred at zero percent interest, unlocking its value. Next year they will be able to borrow up to 100% from UBS, which sold it to them.

Endo has earned more than 22% on equity every year since 2002. For 2008 I am estimating revenue of $1.25 billion and $2.22 in earnings per share. They have two major drugs. Lidoderm is a topical treatment for post-shingles neuralgia. Sales grew about 11% in the latest quarter and will slow to 7% or 8% in the future. Oxymorphone HCL, also known as Opana ER, used for acute pain, is the second drug. It is growing off a small base. Sales jumped 73% in the latest quarter, but that will not continue. They also sell Percocet, which is stagnant at roughly $31 million in revenue, and they have a treatment for migraines, Frova, which is a 6%-7% grower. Using a weighted average, top-line growth is about 11%, which means 2009 revenue of $1.39 billion. Operating margins will increase to 31%, which gets you profits before taxes of $451 million. On a 36% tax rate, after-tax profits are $289 million, or $2.50 a share. The stock sells for 10.4 times estimated earnings. They should generate about $313 million of free cash.

Are these prescription or generic drugs?

Black: They are all prescription. Sales of their regular drugs are growing by 10% or 11% a year. They also inherited a company with no pipeline that now has four or five things in the works, but do not expect anything to hit until 2010. There will be no pickup from new drugs in 2009. The company is dependent on Lidoderm for 62% of sales. They have five patents, and the last does not expire until 2015. The first could be challenged in 2009, but it would be 30 months before they lose exclusivity on it.

Because Endo has so much cash, it probably is looking to make acquisitions. [The company announced January 5 it will acquire Indevus Pharmaceuticals.] Endo has a new CEO, David Holveck.

Schafer: He is a superb manager who came from Johnson & Johnson.

Black: There is much more attention to strategic planning. They want to pick niche markets for R&D [research and development]. They are looking at urology and oncology, especially things like bladder and ovarian cancer. They have an internal salesforce of 800 people, and 275 contract salespeople. The one potential negative is that with Medicare Part D, and new managed-care initiatives, they might not have the ability to raise prices as they did in the past. But over all, you are paying about 10 times earnings for a company with 23% ROE, strong free-cash generation and a good management team.

Schafer: And when you take out the cash, you are only paying 8.5 or 9 times earnings.

Black: Ameron International is an infrastructure play. It should do well, but if we get an infrastructure bill from Mr. Obama, it could really take off. The company is based in Pasadena, California, and is trading at 63.30. There are 9.2 million fully diluted shares, a $582 million market cap, and a $1.20-a-share dividend, for a 1.9% yield. Ameron net cash of $87 million, or $9.46 a share. The company makes fiberglass-composite pipe, used in shipyards and oil platforms. That business has held up well, especially in Asia. Ameron also is the biggest manufacturer of large-diameter concrete pipe for water transmission. In Arizona, Nevada and California, a lot of shovel-ready water projects are waiting for a go-ahead. Ameron makes wind towers, too, and infrastructure products. It owns 50% of Tamco, which makes steel rebar for highways, bridges and overpasses.

Sales grew about 11% a year from 2003 to 2007, and earnings climbed from $3 to $6.77. Book value is $52.65 a share. There is negligible goodwill. For fiscal 2008 revenue was about $659 million, and earnings $5.40 a share, down from $6.10 in 2007. Revenue growth this year, not including new infrastructure programs, will be zero to 4%. With no growth, income from continuing operations would be $660 million, and earnings per share around $5. On 4% revenue growth, they would make $5.40 a share. Return on equity could be about 9.5%.

Without an infrastructure-spending bill, where will the money come from to fund existing projects? The states are under terrible financial pressure.

Black: Ameron has a good backlog. For each $100 million incremental increase in revenue under an infrastructure bill, based on 22% margins, they would make $15.3 million after taxes. Tamco would be running at full capacity. Ameron has come down from a high of 138. While it is up from the absolute low of 32.50, it is cheap based on both tangible book value and expected earnings. It is an interesting way to play a pickup in infrastructure in California and the West.

My last pick is an asset play, atypical for Delphi. ROE is only 10%, but the stock, StealthGas, is cheap. The company owns tankers that transport liquefied petroleum gas, or LPG. It is based in Athens. The stock is 4.73, there are 22.3 million fully diluted shares, and a market cap of $105 million. It pays a 75-cent dividend, for a 15.8% yield, but they may not continue to pay it. Some shareholders think they should buy back shares or knock down debt instead.

Schafer: What is the book value?

Black: Book is $14.23 a share and there is no goodwill, so price-to-book is 0.33. For 2008 I figure they earned $1.35 to $1.40 a share on revenue of $112 million. The company already has contracted for 67% of its voyage days for 2009 and 34% for 2010.

Schafer: How much stock does management own?

Black: About 6.5 million shares out of 22 million. The company has 39 boats. Day rates should come down a bit, to $7,000 from about $7,600. They get $21,000-$22,000 a day on three of their product carriers, so total 2009 revenue could be $124 million. Operating expenses will go up. We assume a 5% increase, to $5,760. They have $241 million of debt. Subtract about $94 million in expenses from $124 million in revenue, and you get estimated earnings of $30 million, or $1.35 a share. Street estimates are $1.42 to $1.45. Analysts have a higher revenue estimate. The stock sells for 3.5 times my earnings.

StealthGas specializes in short-haul, or feeder, boats. They come into a harbor in, say, Singapore or Thailand or the North Sea and offload their cargo. Four customers account for 60% of revenue: Shell, Statoil, Petredec and Vitol. Many contracts are for three or four years. The company’s net debt-to-equity ratio is 0.71 to 1. Management says it has access to credit. Borrowing is done ship by ship.

Gabelli: What does a new ship cost?

Black: A new LPG tanker is about $18 million, and a product carrier is about $57 million. The fleet is only 10.8 years old. On a scrap-value basis the LPGs are worth about $500 million and the product tankers, $60 million. That is $560 million, less net debt of $225 million, for a total of $335 million or $15.09 a share, conservatively. After this year StealthGas will be cash-flow positive because it has finished building its fleet. That is it for me.

Thanks, Scott. Marc, your turn.

Faber: I am not optimistic about the global economy. The next Madoff case – the next Ponzi scheme – is the U.S. government. It will go bust. It is only a question of time. The fascinating thing about asset markets today is that everything is connected – the dollar, the economy, equity and bond markets, currencies. When one thing moves, so does something else. That makes the market ideal for short-term traders. Last year it was easy to see that the dollar was oversold and pound sterling was overbought, that the yen was relatively cheap and financial markets were expensive, that the economy would worsen and commodities would come under pressure. Today the private markets are deleveraging, governments around the world are throwing money at the system, and there is huge volatility. Everybody says stocks are cheap because they are down 50% from the peak. But Japan was at the same level four weeks ago as in 1981. Korea was at 1988 levels. These markets are relatively cheap because in 20 years there has been progress. If the U.S. went back to 1990 levels, the Standard & Poor’s 500 would be at 300.

It is not impossible.

Faber: That would be an interesting entry point. Having said that, the market gave back in the 14 months ended November 21 as much as in 1973-74. Stocks became oversold. People may interpret the coming fiscal and monetary reflation as slightly more favorable, and stocks might rise. You can have a horrible economic backdrop and markets that move up.

Also, the worse the crisis, the greater the polarization between good companies and those that do not have money to do R&D and expand market share. And by the way, it is a grave error to support weak companies like General Motors. In a deflationary crisis you want to get the supply down as quickly as possible.

How you play this market depends on your time frame and objectives. If you want to build some exposure in Asia, buy high-quality companies that will survive. In Singapore, that includes Fraser & Neave, United Overseas Bank and OCBC, which is run by an American, David Conner. In Hong Kong, I like Swire Pacific and Sun Hung Kai Properties. Asian banks never understood CDOs [collateralized debt obligations], so they did not buy a lot.

Schafer: Nobody understood them.

Faber: Asians might go to casinos and gamble, but in their businesses they are ultra-conservative. In Thailand, buy Bangkok Bankand, Glow Energy, and in India, Icici Bank and Infosys Technologies. Banks in Singapore sell for 1.3 times book. In Thailand they are below book and have relatively high dividends. If all these companies drop another 50%, which I would not rule out, buy more.

Black: What are their approximate P/Es?

Faber: Maybe 10, 12 times earnings, but who knows what earnings will be?

When market volatility goes up dramatically, you want to be in defensive groups like pharmaceuticals and food. When volatility diminishes, you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today’s low levels. If you are optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Black: Rio Tinto’s balance sheet is not in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum earlier today. I would add Alcoa.

Zulauf: You are not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market that exceeds everyone’s expectations.

In a recovery driven by easy money, zero interest rates and fiscal deficits, emerging markets – the most cyclical part of the global economy – can rebound. There is 50% upside in the Morgan Stanley India Investment Fund, the iShares MSCI Brazil Index, the Templeton Russia and East European Fund, the Greater China Fund, the iShares FTSE/Xinhua China 25 Index and the Turkish Investment Fund. Everything is bad in Japan, but they are used to it for 20 years, so Japanese stocks might not go down more.

Next, the Treasury market will not continue to rally. The inflection point in long Treasuries may have arrived. The yield on the 30-year bond is back up to 3%. The U.S. Treasury market is the short of the century. You can short it through the TBT [ProShares UltraShort Lehman 20+ Yr ETF.] It goes up in price when bonds go down and yields go up. As an ultrashort fund, it moves 200% inverse to the move in Treasuries with maturities of longer than 20 years.

MacAllaster: That is leverage.

Faber: We are used to leverage. It may take two years to work out. On the long side, the Nicholas-Applegate Convertible & Income Fund trades around 5. The junk-bond market and convertible securities could rally substantially, as corporate bonds have done. The Federal Reserve’s move to buy up assets will lead others, including Bill Gross at Pimco, to front-run the government and buy the same assets. High-yield bonds and mortgage-backed paper could rally.

I agree with Felix’s bullish view of gold, except that gold prices might not go up until later in the year. The price was up 5% in U.S. dollars and much more in other currencies in 2008, and people may sell it first to buy something lower-priced. Felix pointed out that gold-exploration companies have been decimated by the financial crisis. I see the potential for a huge rebound. A lot of exploration companies are selling for 2 or 3 a share, which is like buying an option with a very, very long expiration date. If the global economy improves, they can probably produce. If not, prices will go ballistic because there will be no new supply. Gabriel Resources, in Canada, trades for 1.60 Canadian dollars. Newmont Mining owns a sizable stake.

Zulauf: Valuing such companies is difficult. They will either work out and you will make five or 10 times you money, or they won’t.

Faber: One day the price of gold will be higher than the Dow Jones. The CRB, a broad index of commodities, fell for 20 years in nominal terms, from 1980 to 1999. It is now up 12% and is still inexpensive. The Dow and the S&P are up substantially from the 1980s or early 1990s. Everyone thinks fiscal and monetary measures will work to fix the financial system. I do not. They will be disastrous and fuel inflation. But the supply of oil, gas and copper is relatively limited compared to paper money you can print.

Recently I bought some U.S. stocks for the first time in a long time. If you buy Intel, Cisco, Yahoo!, Oracle and Microsoft, you will do much better in the next 10 years than you would with Treasuries. These stocks will double and even triple – before going to zero.

On that note, thank you. Oscar?

Schafer: I am not sure what the market will do in the next six to 12 months, but my picks will do well in the next 12 to 24 months. The first two are health-care names with pipelines so strong that patent cliffs – or key drugs coming off patent – will be a temporary problem. I have followed Shire for over 10 years, recommending it here before. It is a specialty pharmaceutical and biotech company focused on ADHD [attention-deficit hyperactivity disorder], and gastrointestinal and human genetic therapies. Given its leading position in ADHD, there has been concern about the sustainability of the franchise with the expiration of Adderall XR’s exclusivity in April 2009. Adderall XR generates about $1 billion in annual revenue, at attractive gross margins. Many are skeptical Shire can replace lost Adderall XR sales in the next two years, but new and existing products are growing. Shire has what is probably the best pipeline in the industry.

What is in it?

Schafer: Vyvanse is a replacement for Adderall XR. It has potential in the adult market. Also, it has a more stable pattern of onset and is longer-acting than Adderall in children. It could be a $1 billion or $2 billion product, though not right away. The market also is not appreciating the benefits of Shire’s acquisition of Transkaryotic Therapies, which has one of the strongest pipelines in the rare-disease sector. Incentives to develop orphan drugs include longer exclusivity, tax credits, faster approval times, attractive reimbursement policies and strong margins. Transkaryotic could launch at least one product a year.

Shire’s American depositary receipts sell for 45. The company will earn more than $3 a share this year, and in 2010 less than last year. It will generate lots of cash. After the patent expiration of Adderall XR is lapped in 2010, earnings will grow by double digits, as products in the pipeline come to fruition. Shire could be worth more than $60 a share. In addition, it is an attractive acquisition candidate.

Has it had any offers?

Schafer: People snooped around in England in 2006 and 2007, but nothing was announced.

Abby recommended Wyeth earlier today. I second that. It is a diversified pharmaceutical company with underappreciated assets. It is facing a near-term patent cliff from products including Effexor XR and Protonix, in its traditional pharma business. Expirations could cost it a billion dollars in earnings before interest and taxes.

But Wyeth has other core businesses: It is one of the top five biotech companies in the world, as well as a leading consumer franchise in brands such as Advil, Centrum and Robitussin. It also has a leading animal-health business. Growth in these businesses, and cost-savings initiatives, should allow Wyeth to maintain earnings through patent cliffs and set the company up for growth thereafter. It has $15 billion in cash. The stock price took a hit last year, partly on the market’s decline, and disappointing data on an experimental Alzheimer’s drug, bapineuzumab, which Wyeth is developing with Elan. I am not hopeful bapineuzumab will ever be approved, and it is not in the stock price. We took advantage of the decline to purchase stock around 32.

Where is it trading now?

Schafer: Around 38, or a little more than 10 times our estimate of about $3.50 a share in earnings in the next few years. The biotech business has two leading franchises: Enbrel, for rheumatoid arthritis and psoriasis, and Prevnar, a vaccine to prevent pneumococcal bacteria in children. Prevnar could be a blockbuster and will be used to treat adults starting in 2010. The biotech business will overtake core pharmaceuticals as the leading revenue generator in the next few years. The non-pharma businesses all deserve higher multiples than pharma. On a sum-of-the-parts basis, Wyeth is worth in the low-50s.

As large drug companies replace blockbusters facing patent expiration, the industry will consolidate. Wyeth is a potential target because of its attractive valuation, strong balance sheet and biotech franchise. A terrific new CEO, Bernard Poussot, took over in January 2008. He has been with Wyeth for more than 20 years. Someone could pay 55 a share for the company, sell off the consumer and animal businesses and pay off the debt in less than two years. The pipeline is attractive. [According to media reports Friday, Pfizer is in talks to buy Wyeth for more than $60 billion, some $8 billion above Wyeth’s market cap at Thursday’s close. Oscar praised the potential combination, noting it would solve many of Pfizer’s problems and get the company into the biologics market, which it has been looking to enter. “Bernard Poussot is one of the best CEOs in the industry, and Pfizer’s Chairman and CEO, Jeff Kindler, is a great leader,” he said, adding “the merger would be a match made in heaven.” Oscar thinks Pfizer could pay “well in excess of 50 a share” without overpaying for Wyeth, which closed Friday at 43.74.]

Lender Processing Services provides banks with software that helps them service or foreclose on mortgages. It is the #1 player in a niche industry with high barriers to entry, recurring revenue and earnings, limited capital requirements and attractive margins. In 2007 Lender Processing generated $1.7 billion in revenue and had 25% operating margins. The shares sells for 29.

MacAllaster: What is the multiple?

Schafer: About 10.5 times 2009 guidance, though an annuity-like business such as LPS should trade at a much higher multiple. The business is likely to benefit from the current turbulence in the housing market and financial industry. LPS is more levered to rising default and foreclosure activity than mortgage-purchase activity. The volume of mortgage defaults and foreclosures will accelerate well into 2012. LPS will benefit not only from higher volume but market-share gains, as financial institutions decide to outsource their growing overflow of foreclosures.

LPS stands to benefit from the home-equity crisis, as well. Traditionally banks have used credit-card systems to process home-equity lines of credit. However, home-equity lines have grown in volume and in dollars, and require more robust services such as regulatory reporting, which LPS’s platform can perform well. Once LPS signs a large bank client, new wins will follow. LPS stands to benefit from the rising rate of mortgage defaults and the increase in refinance activities. Recent efforts by the government to lower mortgage rates to more than 40-year lows should bode well for both refinancing and new-purchase volume.

And earnings growth?

Schafer: The company expects EPS to grow 12% to 15% in the next few years. But earnings could grow by 15% to 20%, based solely on increased foreclosure volume among existing customers. If it wins new customers or financing volumes rise, earnings could grow in excess of 20%. The stock is worth 50 a share, or 16 times our 2009 estimate. This is a perfect case of a company’s fundamentals improving and the stock going down because a large shareholder had redemptions in the fund and sold.

MacAllaster: This is a good company.

Schafer: My final pick is the Time Warner “entertainment tub.” We created it by shorting 0.25 of a share of Time Warner Cable for every Time Warner share we own. In less than a year as CEO, Jeffrey Bewkes has set in motion the spinoff of Time Warner Cable; cut costs by merging New Line Cinema into Warner Brothers; eliminated corporate overhead and spearheaded a reorganization of AOL. There is a strong likelihood he will sell or spin off AOL in the next six months.

Under Bewkes, Time Warner has become intensely focused on shareholder returns. It will receive a $9.25 billion dividend in the next few weeks after the spinoff of its cable assets. We have created the entertainment business for 7 to 8 a share, or for five times 2009 EBITDA [earnings before interest, taxes, depreciation and amortization] and under 10 times earnings. After receiving the dividend, Time Warner will be levered at a modest 1.6 times EBITDA, and gross cash will account for 40% of the market cap. At today’s 7.61 a share, the company could use the entire cable dividend to repurchase shares, dropping the P/E to seven and lifting earnings to $1 from 70 cents a share.

Time Warner’s best-in-class businesses, including Turner Broadcasting, HBO and Warner Brothers, are dramatically undervalued. In Turner’s case, approximately 70% of revenue comes from recurring non-advertising sources, and the broadcaster is benefiting from a viewership shift away from broadcast networks to cable. Advertising on Turner costs 30% to 50% less than broadcast TV, and Turner has been raising prices to narrow the gap. Time Warner will fare better than almost all its peers. Yet it trades at a discount to other large media companies. The stub could go from 8 to 12.

Black: Who is going to buy AOL?

Schafer: Maybe no one, but an AOL-Yahoo! merger makes sense.

Thanks, Oscar. Mario, you are on.

Gabelli: Barack Obama will be president in two weeks. He will articulate how he is going to create jobs. Government spending will go to workers and business. Infrastructure spending will mean not only bridges but broadband and a smart grid. The uptick rule [regulating short sales of stocks] should be reinstated. Hedge funds should be regulated and transparent about their leverage. Under current regulations, companies can be taken over by entities that buy their debt without reporting ownership. There should be transparency about this to eliminate backdoor raids.

There are 250 million cars on the road in the U.S. The average age per vehicle is roughly 9.5 years. The sweet spot for repairs is six to nine years. Last year I talked about Genuine Parts. Now I am recommending O’Reilly Automotive, an auto-parts distributor that sells to the do-for-me market. It has 135 million shares, trading at about 30. Debt is $650 million. It closed a deal in July to buy CSK Auto, which gives it a presence in the West. Combined revenue is $5 billion.

What about earnings?

Gabelli: They could go from $1.50 a share in 2008 to $1.80 in 2009. Annual earnings growth is 14% or 15%. They will have no debt in four years, when they will earn $3.25 a share. There is a 6.75% note convertible into common with a 2010 put date that sells around par. It is an intriguing investment.

Telephone & Data Systems sells for 32 a share. There are about 115 million shares outstanding – 53 million common, 55 million special common, six million that get 10 votes apiece. It is believed TDS got a fully financed bid at a 50% premium to its then-price of 65. Only two companies could do it: AT&T and Verizon Communications. On January 9 Verizon closes on its purchase of Alltel for seven or eight times EBITDA. AT&T recently announced the purchase of Centennial Communications for 7.5 times EBITDA. TDS owns 70 million of U.S. Cellular’s 87 million shares, equal to $26 per TDS share. TDS is a double, maybe a triple.

Today I brought you chocolate bars and gum [distributes around room]. Since we met last, Cadbury has spun off Dr Pepper Snapple. Mars teamed up with Warren Buffett to buy Wrigley. The global confectionary market is $140 billion – $78 billion is chocolate, $44 billion candy and $20 billion chewing gum. Cadbury has 10% of the non-U.S. chocolate market, and through Dentyne, 27% of the global gum market. There are 337 million American depositary receipts, trading for 36. They have $2.4 billion of debt and $15.8 billion, or £10 billion, of enterprise value. Earnings this year will be 36 pence, and next year, 42. The stock sells at a modest multiple of earnings. As Cadbury focuses on revenue and margin expansion, earnings could grow by 15% a year.

Why did the the stock lose 33% after you recommended it here last year?

Gabelli: There was no buyout deal. The confectionary business is in flux. They could merge with Hershey or do something with Kraft Foods. Cadbury has excellent global distribution. It is not going to stand on its own. You could make 40% or 50% on Cadbury.

Zuluaf: This is horrible chewing gum.

Gabelli: We like Dr Pepper Snapple, too. It sells for 16. There are 253 million shares, about $3.6 billion of debt and $8 billion in enterprise value. They could earn $1.75 a share for 2008. Results will be flat this year. The company sells concentrate and is a bottler. It could get bought out, and even if it does not, the business generates cash.

Ascent Media has 13.4 million A shares, 660,000 B shares, and a $320 million market value. There is $356 million in cash, so you are getting the company at a discount to cash. Ascent specializes in platforms and techniques for enhancing digital technology and media. It has about $50 million of EBITDA. Apply a multiple of four and you get $200 million, or $15 a share, on top of $25 of cash, for a total price of $40. John Malone controls 31%. The company, spun out of Discovery Holding in September, could be an acquisition vehicle. Liberty Entertainment is another Malone company, with 517 million shares. Debt is $2 billion, and they have $700 million in cash. Liberty was a tracking stock. Malone is spinning off its assets, including DirecTV, into a new company. Liberty trades for 18, but you are getting $22 a share in net assets, plus $10 from a spinoff, plus indirect control of DirecTV.

Schafer: Have Malone’s stocks done well?

MacAllaster: They’ve been awful.

Gabelli: Discovery Communications and DirecTV have done well. Like Oscar, I like Time Warner. As he noted, you get a quarter of a share of Cable for every share of Time, and the Cable dividend will help Time reduce debt. Time Warner’s earnings will be down this year, but the company is a terrific cash generator. Its businesses generate about $7 billion to $8 billion of EBITDA. In three years it will have no debt, $1.5 billion of cash, and earnings of close to $1.20 a share. At 10 a share, plus the cable stub, it is an interesting buy.

Maine & Maritimes is a utility. On the border of Maine and Canada there is a lot of wind, but it is landlocked. The company is working on approvals to construct a transmission line. Rates of return are about 13%. MAM will be able to distribute wind power through independent service operators in New England, plus there is the basic utility. The wind business will be unlocked by Obama’s investment in the grid and green power. The stock is 37. There are 1.7 million shares. The existing business earns around $2 a share, but the interesting play is their partnership with Central Maine Power, another utility, to build a 345-kilovolt transmission line. This will connect the power from where it is generated to the New England grid. Maine & Maritime’s share of the cost is $180 million. It will add significantly to the company’s earnings power, bringing earnings to $4 per share.

Alberto-Culver, the hair-care company, spun off Sally Beauty Holdings about two years ago. Alberto holders got $25 a share in cash and a share of Sally. Alberto trades at 25. There are 98 million shares. They have $438 million in cash and no debt. They just spent $81 million to buy Noxzema from Procter & Gamble. They have 14.5% of the facial-cleanser market. Today people are not replenishing products until they get to the end of the bottle. Like everything else, business stopped in the past three months. Revenue should be $1.5 billion for the Sept. 30 year. EBITDA is about $210 million, and earnings-per-share, $1.35. Earnings can grow 10% or 12%, but the product line fits with a larger company.

Energizer Holdings makes batteries. The price of zinc collapsed to 54 cents a pound late last year from $1.95. They consume about 70 million pounds of zinc. It bought Schick and then Playtex about a year ago. For the Sept. 2009 year they will have $4 billion of revenue, growing 3% or 4%. Ebitda will be about $750 million, down from $850 million. Consumers are running down their inventories, even of consumables, and earnings will drop to about $5 a share from $6.12. From the lower base, they will grow 20% a year for the next five years. The company will pay down $2.8 billion of net debt. The stock trades for 58. Three years from now it may be 130 or 140.

Thank you, Mario, and everyone.


Do not be fooled by bear market rallies. It is way too early to get back into U.S. stocks.

Events have proved out most all of arch-bear Gary Shilling’s prognostications. He certainly got the big picture right – deflation is here – without leading one down blind paths along the way. Thus, to our simple way of thinking, he deserves a continued hearing until he proves that he has lost it. The article subheading encapsulates his thinking just fine: Do not be anxious to wade back into the market waters. Most notably, Shilling continues to like Treasury bonds despite 30-year yields falling below his long-time target of 3%: “The big rally is over. But with 2% deflation, a 3% yield becomes an attractive 5% real return.”

A year ago I wrote about 13 investment themes for 2008 based on my view that we were on the verge of a deep and painful recession. I hope you took my advice, because all 13 of the predictions turned out to be true. While I do not recommend specific stocks or funds in this column, nearly all of my investment themes can be acted upon using exchange-traded funds and other securities.

One of the themes I have been harping on, since September 2005, has been that the housing bubble would burst, just as the dot-com bubble did. My advice was to sell your second home and clear out of all housing-related stocks and bonds. Since 2005 home building stocks like Lennar Homes, KB Homes and DR Horton are down more than 80%. Even if you waited until 2008 to short the SPDR S&P Homebuilders ETF (XHB), you would be 33% richer today.

In line with my prediction that housing’s collapse would ignite the recession, I recommended dumping discretionary spending stocks. Today people are not buying expensive cars or Coach (COH) handbags. Suddenly tap water is flowing more freely than bottled water. The holiday shopping season killed retailers. Many began slashing prices even before Christmas in a desperate attempt to clear inventory and raise cash. Circuit City, Gottschalks and KB Toys have filed for Chapter 11. Had you shorted Vanguard’s ETF that tracks consumer discretionary stocks (VCR), you would have made 40% in 2008.

I also warned against junk bonds and leveraged loans, Chinese stocks and commercial real estate. Selling commodities was one of my best calls. I specifically warned against the bubbles in oil and copper. Crude oil as measured by the United States Oil ETF (USO) was down 55% in 2008, and shares of Southern Copper (PCU) fell 54%.

The dollar has been a favorite topic of mine. Last January I predicted that the dollar would rally later in the year, and it did, starting in July. Conversely, I told readers to sell U.S. stocks in anticipation of a spreading financial crisis and global recession. The S&P 500 index dropped 39% in 2008, and foreign markets collectively did as badly.

My final strategy, which I call “lucky 13,” was to buy Treasury bonds. Longtime Forbes readers recall my love for 30-year Treasurys dating back to 1981, when they yielded 14.7%. At the time I said, “We are entering the bond rally of a lifetime.” In 2008 they returned 42% including interest, as their yield dropped from 4.5% to 2.6%.

What is in store for 2009? There will be a continuation of the financial crisis, the worst since the Great Depression. Washington will be tied up bailing out banks and underwater home mortgages. Expect meltdowns in securities backed by credit card debt, home equity, student and auto loans as well as commercial real estate.

There is a chance that federal bailouts and President Obama’s stimulus maneuvers will be enough to bring an end to the recession by early 2010. Otherwise, it will persist and qualify as a depression. Either way, 2009 will be a dismal year for businesses and most stock investors.

S&P 500 earnings will drop to $40 in 2009.

Do not be fooled by bear market rallies. It is way too early to get back into U.S. stocks. S&P 500 earnings will drop to $40 in 2009. Apply a generous bear market multiple of 15 to this and you end up with the S&P at 600. That is 25% below today’s price.

Housing prices could fall another 20% before they hit bottom. Consumer discretionary stocks also have further to fall. Oil may be close to a bottom, but copper still looks ripe for shorting as the worldwide recession deepens. Commercial real estate is just beginning to buckle, so stay away from REITs, which will face cash crunches in 2009.

Avoid emerging markets, especially China. China’s fiscal bailout contains lots of smoke and mirrors, and social unrest is mounting. We may be seeing the final days of the Mao dynasty.

I am bullish on the U.S. dollar, as it is the safe haven in a sea of global turmoil. And I am not giving up on Treasurys despite the fact that the 30-year plowed through my long-held target yield of 3%. The big rally is over. But with 2% deflation, a 3% yield becomes an attractive 5% real return. So hold on to your Treasury bonds. You can also lock in good yields on top-flight corporates and munis today, but do not be surprised by some ratings downgrades.


Maximum fear breeds maximum opportunity if you are rational and long term in your outlook.

Fundamental value investor John Rogers had an inkling some market nastiness was in store a year ago. He just way underestimated how nasty. He is, of course, not alone there. As with most investors of his ilk, he sees a lot of opportunity amongst all the casualties. He is sticking with some of his former recommendations which did far better than the general market last year, indicating he must be suffering from some shell shock.

A year ago I was so negative that I called my January 28 column “That Seventies Show.” My view was that we would see another bear market as gut-wrenching as the one in the mid-1970s. It was worse than I expected. In a 22-month period ended in late 1974, the market fell 47%. Although it has recovered somewhat, our current angry bear fell 52% peak-to-trough in only 13 months. There was a 7-trading-day stretch in early October that sent stocks down 22%.

When the stock market goes from confidence to pessimism, it tends to overshoot. That is exactly what has happened, and it has turned me very bullish. I have said it before: Maximum fear breeds maximum opportunity if you are rational and long term in your outlook.

I have worked hard to find quality companies whose prices offer a margin of safety. But what I have learned in this once-in-70-years economic crisis is that even high-quality companies can morph into struggling ones when credit markets freeze.

Last year I recommended 22 stocks, and all but 5 went down. If you bought every one of my picks you would have lost 31% (after a haircut for estimated transaction costs) versus a loss of 25% if you had invested in the S&P 500 on the same dates.

But last year just did not make sense to most people in my profession. Look at what has happened to General Electric, one of the few blue chips with an AAA rating. In 2008 GE was squeezed when it could not access credit markets for its short-term debt, as it routinely has for years. GE’s stock fell 54%.

When a financial fortress like GE gets into that kind of trouble, it is no wonder that the value stocks I had in my portfolio turned in a disappointing performance. I have taken my lumps on the companies that seemed unlikely to survive and held on to those I felt would make it through this recession. Ultimately, when the market recognizes that my survivors will do just that, I believe those stocks will shoot the lights out.

To varying degrees my three worst picks from 2008 all illustrate the issue. My biggest disappointment was Journal Register, which was wiped out by year-end. An ill-timed acquisition in the soon-to-be-decimated Detroit market brought this once healthy media company to its knees. The added debt and deteriorating revenues proved debilitating.

Wallboard and construction materials company USG also followed 2008’s misery road map. When I wrote about the stock at $36, I thought it was strong enough to handle the housing downturn. Moreover, so long as its operations were generating cash, it could be an opportunistic buyer of its shares or other competitors’. Eventually, however, as demand for its products kept falling, the company’s cash flows went negative for a longer time than anyone expected. Loss through December 31: 78%.

Except for USG and Journal Register, I think you should hang on to all of my 2008 picks (which I still have in managed accounts). That would include the real estate broker and manager CB Richard Ellis Group (CBG), which dropped 82% since I mentioned it in May. Evaporating real estate deals and the chill in the capital markets have been a double whammy for this firm. Things got worse in November, when it raised roughly $200 million through an equity offering in order to service future debt out of an abundance of caution. This dilutive move caught investors off guard. I believe CB Richard Ellis will survive and recover.

Two of my better-performing picks from last year were in health care. Baxter International (BAX) outperformed for me in 2007 as well. Last year it was off 8% in a market that was off 39%. Baxter focuses on lifesaving products, such as IV bags for hospital patients and Advate, an injection for hemophiliacs – who could easily bleed to death without it. That makes it a firm that is well insulated in a recession and a solid grower in normal times.

Another health care stock that outperformed was Laboratory Corp. of America (LH). It fell 12% after I wrote about it in August; in that span the S&P 500 was off 30%. When you go to the doctor, you will often take a lab test. Indeed, laboratory procedures drive 75% of health care spending. LabCorp is a leader in this business, and I still own it for its steady cash flow, sturdy balance sheet and great management.

My best stock of the year versus the S&P was Private Bancorp (PVTB), a middle-market commercial lender in Chicago. It gained 4% after I mentioned it in September and is now below my recommendation price. I think it is an even better buy now.


The stocks that got clobbered most late in a bear market are the most likely to do well in the early stages of the next bull market.

Money manager and financial columnist Ken Fisher may be best known for his outspoken mostly-bullishness. This worked well for him ... until last year. He also likes to trot out obscure market statistics, which occasionally are helpful. Here he brings up a statistic which looks particularly interesting, although it is somewhat qualitative in nature: Stocks which hold up well during the first part of a bear market but then lag in the later stages lead the charge during the subsequent bull market, and outperform for a long time after that as well.

This year has gotten off to a bad start, with the S&P 500 (as of January 20) down 10.7% to 805. This just makes me more determined in my bullishness. I like stocks for 2009 precisely because they did so badly in 2008.

Did we hit absolute bottom November 20? Maybe, but I cannot be sure; no one can be sure when a bear market is really over. Those who think they have some formula for precisely calling bottoms are fools. What I am pretty sure of is this: When the market rebounds, a lot of its gains will take place in a very short span (like two months or less), and people who are too cautious will miss most of these gains.

Bear markets have been typically followed by bull markets in a V-shaped pattern. The steeper and bigger the decline, the sharper and bigger the subsequent bull move. The few exceptions to this pattern in the past century have involved the emergence of completely different bad forces than the ones that created and contributed to the bear market.

For example, stocks rallied 324% from July 1932 to March 1937. After a recession-induced big bear market and partial recovery over the next 21 months, stocks encountered an entirely new kind of trouble in 1939. War in Europe sent the market down even lower than the recessionary low of early 1938.

That could happen again, with the economic equivalent of an asteroid coming out of the blue. But, absent such a surprise, we should get the normal V pattern. Its upward swing will swamp any late-stage bear market vicissitudes as they always do.

How were my results last year? In line with the market’s – which is to say, not good. Starting with 1996, Forbes’s statistics department has prepared an annual accounting of each stock-picking columnist’s picks versus the S&P 500. Over those 13 years my column has lagged the S&P 500 three times, and 2008 was one of them. The others were 1997 and 2002.

During 2008 I recommended 57 stocks. Equal money in each of my picks when first published less a 1% haircut for transaction costs would have lagged equal amounts in the S&P 500 by 1.1 percentage points (without a commission haircut).

That lag came from the first column (January 28), which had my two worst stocks. AIG collapsed 97% because of losses on credit default swaps at a time when accounting standards demanded quicker recognition of such losses. Brazil’s Aracruz Cellulose lost 84% as demand for its pulp shrank in the face of recession.

My picks were a hair ahead of the S&P until Dec. 29, when Rohm & Haas shriveled amid fears (unfounded, it now seems) that Dow Chemical might not complete its takeover of this company. Despite this setback, Rohm & Haas was my best pick, up 36%. Other double-digit winners for me last year were NTT Docomo, the Japanese phone company; Logitech International (LOGI), a maker of cordless PC devices in Switzerland; Repsol, the Spanish oil company; and Travelers, Wal-Mart and John Wiley & Sons.

What stocks from last year’s picks are still worth holding? An almost universal stock market fact that few know and you will likely not have read anywhere, ever, is that categories of stocks that fared better than the market in a bear market’s first half but lagged badly in its later stages tend to lead the next bull market bounce and for a long time. History holds almost no exceptions to this. This group now includes energy, materials, industrials and consumer discretionary.

So for this year I recommend carrying over eight of my 2008 picks. Four are in basic resources: Cameron International (21, CAM), Royal Dutch Shell (47, RDS.A), Dow Chemical (14, DOW) and Arcelor Mittal (23, MT). There are two in industrial products: CNH Global (14, CNH), a Dutch firm that makes earthmoving equipment, and Textron (12, TXT), a diversified company that makes everything from golf carts to Cessna jets.

Despite the recession, I recommend you stick with two of the consumer stocks from my 2008 roster. Mohawk Industries (35, MHK) makes carpets and Daimler (29, DAI) makes Mercedes cars. These two should do well on the right side of the V, which will begin for stocks a good 6 to 12 months before the economy hits bottom. Remember that the stock market is anticipatory. If you wait until the economic recovery is here, you will miss most of the action on Wall Street.


Greenspring Fund fared far better than most in last year’s market bust. Now its managers are looking to busted convertible bonds for another solid performance.

Last fall, during the most vicious part of the meltdown, we featured an article on veteran convertible securities fund manager John Calmos. He said of converts: “This is the most undervalued I have ever seen the market. It’s unbelievable.” Some of the anomolies noted by Calmos are still around in some form, in large part due to continued position liquidations forced by withdrawls from hedge funds which pursue convertible arbitrage strategies.

It is hard to invest in individual convertible securities. Calmos’s Convertible Fund charges a front-end 4.75% load. The lesser-known no-load Greenspring Fund, featured here, is currently invested approximately 1/4 in “busted” convertible bonds – converts where the underlying stock has fallen so far that the value of the conversion option is close to zero. The fund is also invested in junk bonds and off-the-radar smaller stocks. So the fund is far from identical to Calmos’s; nevertheless an interesting opportunity. The fund was down only 12% last year.

Charles (Chip) Carlson is a bargain hunter. The morning after Christmas the manager of the Greenspring Fund headed to the mall to stock up on discounted pants and shirts. At his 11-person firm in Lutherville, Maryland, near Baltimore, a vice president waters the plants. When the fund splurges for Friday lunches, it usually orders out from a deli that offers 20% off. “We only buy what we need,” says Carlson.

Such thinking has enabled Carlson and his investing partner, Michael Fusting, both 48, to shine. Their fund has returned an annual average of 7.7% during the last 15 years, versus the S&P 500’s 6.5%. All of that excess return and then some was earned last year, when Greenspring was down 12% to the overall market’s 37% shellacking.

“It should be better known,” says analyst John Coumarianos of Morningstar, which accords Greenspring five stars.

Carlson, the ever enthusiastic good cop, and Fusting, the skeptical bad cop, are parking 23% of Greenspring’s $315 million in so-called busted convertible bonds. (Another 26% is in junk bonds, 38% in mostly obscure small and midcap stocks and 13% in cash.) Carlson and Fusting do not advertise and instead rely on word-of-mouth and fee-based advisers to recommend their no-load fund. At 1.03% a year in fees, it is not particularly cheap, but you would have to do a lot of work to manage a portfolio heavy in convertible securities on your own.

Convertibles are bonds or preferred shares that can convert into common stock at a predefined price. Smallish firms favor them as a way to issue debt while paying out lower interest than they would need to offer to lure investors to straight bonds. The downside: They have to share the gains if the company does well. If the issuer’s stock price rises to the conversion threshold, holders of the convertibles will sooner or later swap the bonds for stock and dilute the existing shareholders. (The bond investors can take their time converting if there is no deadline and if the bond is paying a nice yield in the meantime.)

Newly issued convertibles trade like a blend of stocks and bonds. Over time a convertible may veer off to one side of the bond-equity spectrum. If the underlying stock does extremely well, the convert’s fixed-income attributes diminish in importance and the convert becomes just another way to own the stock. Example: the Chattem (CHTT) bonds issued in 2006, trading at $1,110 per $1,000 of par value and convertible at any time into 17 shares of Chattem, currently worth $1,088. This convertible bond moves up and down almost in lockstep with the common stock.

If the underlying stock does badly, on the other hand, the conversion feature becomes irrelevant and the bonds trade on their fixed-income value: the right to collect $1,000 at maturity and a semiannual coupon payment in the meantime. The disappointed holders of these securities use the adjective “busted” even though the issuer may be in fine financial shape. Example: Sepracor (SEPR) zero coupon bonds of 2024 pay no annual interest and are priced at $937.50. Sepracor stock has sunk like a stone since the bond was floated in 2004.

The Sepracor bonds can be converted into 15 shares of stock, a laughable idea, given that this many shares are currently worth $195. But even if you consider the embedded call option worthless, you might find the bond a safe and attractive bet. Sepracor, which makes the prescription sleep aid Lunesta, is sitting on $787 million in cash and investments, versus debts of $617 million. Since the bonds can be put back to the issuer at par in October, their effective maturity is eight months. Greenspring owns $14 million (par value) of this bond.

A big part of the reason many converts are on sale is that convertible arbitrage hedge funds, formerly responsible for most of the market’s trading activity, have been forced to dump converts at fire-sale prices (see “Seeking Converts”). What is more, once a bond issuer’s stock price falls well below its conversion value many investors lose interest.

According to Fusting, that has already happened. “The downside is basically wrung out,” he says.

When on the prowl for bargains, Fusting and Carlson dissect converts themselves rather than rely on rating agencies. The raters, they say, too often ignore – or even mislabel – safe investments. Example: They often label all senior secured debt from an issuer identically, regardless of when it matures.

Greenspring focuses on bonds maturing quickly so issuers do not have a lot of time to sour. The bonds in its portfolio mature in 1.4 years on average.

In September Greenspring bought busted converts, issued by Digital River (DRIV), for 98 cents on the dollar. That price gave the bonds an 8% yield until Greenspring exercised a put option in December. Meanwhile, Digital River was a safe credit, sitting on $600 million in cash and only one debt – the $195 million convertible bond issue.

With busted converts, surprises can be good news. Greenspring was holding some of Mentor’s busted converts with a conversion price of $29 per share when Johnson & Johnson made a $31 buyout offer in December. The stock price shot from $16 to $31. The bonds Greenspring bought for 97 cents on the dollar rose 5% above par. That created an annualized return somewhat higher than the 15% the Greenspring managers had expected.


The spot price of natural gas in the U.S. has fallen from a commodities mania high of $13+ per million BTUs a year or so ago to a commodities bust price of less than $4.50. Opportunity? Certainly more so than a year ago. How to play the opportunity, if you believe it is worth playing? A couple of reasonable suggestions herewith.

Here are two helpful and diverse charts and some thoughts to begin this week from an investor’s point of view.

First, if you are looking for deep discount value, take a look at the 2-year chart below, compliments of Yahoo! Finance, of the US Natural Gas ETF (UNG) and see if you notice what I notice.

The 200-day moving (the red line) average is slightly below $39 and the ETF shares are selling at just above $18, the lowest price this ETF has ever traded at. Natural gas spot price per unit is trading now around $4.38. This is a 7-year low.

What does the spot price mean?

The spot price of Natural Gas is the current price at which Natural Gas can be bought or sold. It is the wholesale price that is quoted if you wanted to buy Natural Gas today. The price is quoted per Million BTUs of energy.

The more dramatic chart is this year’s spot price of natural gas which has fallen by 2/3. Last July, the spot price for gas was a shocking $13 and now it is down to just over $4.30.

Besides UNG, other ways to play the idea of an impending rally in natural gas would be to buy the largest independent natural gas producer in the United States, Chesapeake Energy (CHK). CEO Aubrey McClendon was recently interviewed on CNBC. Due to many factors, including the fact that he had purchased CHK shares on margin, he had the mother of all margin calls when the stock plummeted from $74 a share. We are told he sold $31 million shares at around $18 per share and by the rules he cannot buy back until April of this year.

McClendon believes that natural gas will be the “go-to” fuel for the Obama administration in their effort to reduce America’s dependence on foreign oil and to reduce carbon emissions during the process of creating power and fueling vehicles.

As of December 31, 2007, CHK had 10.879 trillion cubic feet equivalent of proved reserves; and also owned interests in approximately 38,500 producing oil and natural gas wells.They recently had no trouble raising new money to pay off some expiring credit facilities.

The book value per share of CHK is over $27.35 and its balance sheet shows cash of almost $2 billion. One concern is the high debt ratio (0.874) and total debt (most recent quarter) of $14.35 billion. Their operating cash flow of $5.85 billion should be more than adequate to service that debt. McClendon said that natural gas producers like CHK do “very well during times when prices are this low” and they have hedged the majority of their production at around $7 per MMBTU through most of this year. That is encouraging when natural gas currently is at $4.38 per MMBTU.

If you want a rich dividend and a mix of natural gas and oil production, consider BP (BP), the former British Petroleum, which reports earnings on February 3rd and also owns a 25% state in CHK. With a 7.7% current dividend yield (at $42.79 a share currently) this is an attractive possibility. Its current P/E ratio is just below 5 and the future P/E is a little over 8.

If you are interested in BP, it would be discreet to wait to see how the earnings report goes and how it impacts the stock. It would not surprise this writer to see the stock price test the 52-week low of $37.57.

Any way you slice this pie, you know it is a resource that the world cannot live without. Production of natural gas goes way down when the price is this low and that usually sets the stage for future supply shortages. The weather, natural disasters and geopolitical crises can cause some unexpected spikes too.

All we know for sure is that natural gas is more abundant than oil, burns cleaner than oil, and is more plentiful in the U.S. than oil. Sure, natural gas could fall further, but you and I both know that history has taught us that the upside potential from here trumps whatever remaining downside risk that we may experience.

Few investment themes in this day and age have such compelling fundamentals. And there are few natural resources more essential to the energy, transportation, food production and security needs of the world than natural gas.

Take another look at the 1-year [spot price] chart above and ask yourself, “Is natural gas on sale right now?” When is the best time to begin accumulating a “green” natural resource that has had an unprecedented correction? Don’t you wish you had loaded up the truck back in November when gold fell to $700 and silver hit $8?

This looks like an opportuntity that comes along just a few times in an investor’s life. It might be considered an ideal “long-term investment” with the potential of a “short-term positive surprise".


Here is an example of either extreme management prudence, or the power of the herd instinct. Shipping company DryShips had a “well-covered” dividend, using a reasonable standard. But management decided to cut the dividend anyway. The stock looks very cheap at its new much lower level, and may well be worth a look. But the original thesis hit an iceberg.

It is no secret that I view dividend paying stocks as a “girl’s best friend” – at least for the time being. With volatility still at record levels and the continued significant potential for event risk in the credit and equity from mismanagement or fraud, it is wise for investors to move back into long equity positions with some caution.

That said, there is any number of dividend paying companies with temptingly low valuations. For the sake of its dividend, I recently recommended DryShips, Inc. (DRYS), a transoceanic carrier of drybulk cargo – think steel, coal and grains. Sales topped the $1.0 billion level in the most recently reported 12 months ending September 2008. Profits have soared in the last two years, making an $0.80 annual dividend possible. At the prevailing stock price that provided a yield of 5.25%.

During a period of global economic decline many investors might balk at investing in a company dependent upon trade. However, we point out, it is trade in consumer goods that get hit first and most deeply by macroeconomic declines. According to First Call, the 2009 consensus estimate for DryShips does indicate a drop in sales to $963 million, on which analysts estimate earnings of $5.62 per share. This represents a dramatic decline from the current year wherein EPS is likely to top $10.00 per share. Even at the lower EPS level, the forward P/E is 2.3 times at the current price level. That projected EPS level would also be sufficient to sustain the $0.80 per share dividend ... or so I thought.

Within weeks after this commentary was first published, DryShips announced suspension of its dividend, as well as cuts in capital spending plans. Management apparently wants “more flexibility” for its cash reserves. DryShips had $329.1 million in cash on its balance sheet. So my logic was that even if earnings are not as analysts predict, the dividend seemed secure for the time being. Clearly management is looking at a longer “winter” for its business than I measured a month ago.

DRYS shares had soared to $116 per share in May 2008, dropping to an amazing $3.54 by late November 2008. At the current price level, DRYS shares have only just begun to recover and still present an enticing value to investors with a Steady-Eddy investment strategy. A full complement of options provides a means to manage downside risk – or a cheap way to play the long-side for the more wary. This was my original advice and I think I will stick with it. Clearly, however, dividend love should not be allowed to build into blind love. Even the seemingly most well fortified balance sheet and cash flow prospects may not ensure that those dividends will continue.


Fund Manager David Einhorn Buying Gold and Miners, Reluctantly

Hedge fund manager David Einhorn throws in the towel on his prejudice against gold ...

Hedge fund manager David Einhorn, who predicted the fall of Lehman Brothers and was generally spot-on in late 2007 and early 2008 regarding undisclosed risks at the large banks, recently initiated a position in gold in his fund, Greenlight Capital. In his January 20, 2009 letter to investors (cited in brief by BusinessWeek and Bloomberg), Einhorn writes:
We never thought we would ever buy gold or gold stocks. ... David’s grandfather Benjamin was a goldbug. ... And it was a lousy investment. Being a patient investor is one thing. Being “wrong” for three decades is quite another.

To everyone’s dismay, we believe that some of Grandpa Ben’s predictions are playing out. Our current chairman of the Federal Reserve, Ben Bernanke, is an “inflationist.” ... The size of the Fed’s balance sheet is exploding and the currency is being debased. ... Our instinct is that gold will do good either way; deflation will lead to further steps to debase the currency, while inflation speaks for itself. We have bought gold, calls on gold, an index of gold mining stocks (GDX) and calls on higher long-term U.S. interest rates.
See more of Greenlight’s current holdings in this recent post from Market Folly.

Platinum Gets Set for a Rebound

We are partial to the idea of commodities as a long-term investment play, and doubt that the 2007-08 runup – as overdone as that was – is the last we will hear from the group. We will continue to feature blurbs on various commodities markets in the Finance Digest.

Commodities futures markets have the reputation of a gambling den with a semi-respectable face. That is true only if, as with any investment/speculation, you use a lot of margin leverage when placing your position bets. If you do that you need to use a trading system in which capital preservation is the major priority. Otherwise the normal rules apply, and knowing some fundamentals of the underlying markets is a good idea. Platinum, for instance ...

Platinum appears to have jumped the starting gun in 2009. As a result, it may end up back at the starting blocks. But by year end, the price of this once high-flying metal could pick up speed again.

“In the second half, we could see an improving car industry,” says Sterling Smith, vice president with Chicago brokerage FuturesOne. The metal is widely used in automobile catalytic converters.

Nearby platinum on the New York Mercantile Exchange hit a record $2,308.80 an ounce last March before tumbling with other commodities, and was additionally pressured by the unwinding auto industry. Platinum bottomed at $761.80 in October; most-active April platinum ended December 31 at $941.50 an ounce and hit $1,011.60 on January 7. The contract settled Friday (1-16) at $953.30 an ounce, down 5.2% for the week as the weak economic fundamentals reasserted themselves. ...

Although industrial demand remained weak, platinum poked above $1,000 again earlier this month due to jewelry-related buying ahead of the Chinese New Year, new jewelry lines in India and investor demand. “But with that said, we see a period of weakness over the first half of the year,” says John Mothersole, senior economist with international consultant IHS Global Insight. “That suggests the bounce in prices we have seen might be a little bit premature.”

The crumpled car sector means there’s still drag on demand, and financially strapped auto producers may be reluctant to build inventory. They might even dump supplies, says Bart Melek, Toronto-based commodities strategist with BMO Capital Markets. The weak economy could also dent jewelry demand in Western nations. This has Melek and Mothersole looking for a global surplus in 2009. Beyond the first half of 2009, the anticipated U.S. stimulus should begin to boost demand, as should efforts in the U.S. and Canada to free up credit for car loans, Melek says.ss New York-based commodities-research firm CPM Group sees prices around $850 to $900 much of the first three quarters, but then averaging $1,050 to $1,060 in the fourth and perhaps $1,300 in 2010, says analyst Rohit Savant. BMO looks for a first-half average of $938, then $975 in the second. More conservatively, Mothersole of IHS forecasts a trough of $800 in the second or third quarter before a recovery, with the average not moving back above $1,200 an ounce until 2011 to 2012. ...

On the supply side, FuturesOne’s Smith cautions, platinum is a small market, vulnerable to disruptions such as strikes or natural disasters. (In South Africa, which provides 75% to 80% of the world’s primary supply, electrical shortages curtailed mining activity last year.) In fact, Mothersole says that prices around $1,000 are already around the marginal operating cost, defined as the average cash operating cost for the upper quartile of mines. He adds that these costs are likely to slowly rise – reinforcing the likelihood of a price rally.