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August/September 2009 Picks

Four offerings deemed to be right for right now.

Morningstar Analysts, 08/11/2009

Exchange-Traded Fund: WisdomTree Emerging Markets Small Cap Dividend DGS
Unlike the global giants and exporters that dominate emerging-markets large-cap funds, small-cap companies tend to have much more localized production costs and revenues, giving them greater exposure to their regional economy. As emerging economies continue to develop on the strength of domestic demand, this asset class provides an excellent investment in emerging economies' success. Also, because these smaller companies are not in the global commodities market and have mostly local revenues, they have far less exposure to the dollar than do emerging-markets large caps. Investors seeking exposure to this asset class should consider WisdomTree Emerging Markets Small Cap Dividend DGS.

This ETF sports a strong value tilt. Its holdings have an average P/E ratio around 10 as of May and a price/cash-flow ratio close to 7. The dividend yield on these companies has held steady at 6%, which shows expectations of continued strong earnings in the future. Finally, this fund has a somewhat less-leveraged portfolio than any other international equity class, which should help it survive a credit freeze better than most. Rather than investing heavily in the BRIC countries, this index instead has nearly 45% of its assets in Taiwan and South Africa, with other large stakes in Thailand, Malaysia, Israel, and South Korea. The resultant industry weighting helps avoid the dangers of a slowing global market in commodities and gives the small-cap index much more exposure to local growth. (Paul Justice)

Stock: KLA-Tencor KLAC
KLA-Tencor occupies a sweet spot in the chip equipment industry because of its dominant position in the process diagnostic and control market.

Chipmakers use PDC tools to measure and detect defects during semiconductor production and to identify and correct the problem sources; this lowers costs by reducing the number of faulty chips produced. KLA sits atop the PDC market with 50%-plus share. The firm has steadily gained share in recent years because of its wide economic moat. KLA's vast experience in PDC has allowed the firm to build its leading technical expertise and extensive knowledge base, which are significant competitive advantages. Further, KLA's dominant position gives it an advantage in maintaining its technological edge. The firm has the largest research-and-development budget in the PDC market, and its close working relationships with customers give the firm insight into future PDC needs.

Despite a near-term business slowdown in the cyclical semiconductor equipment industry, KLA's long-term growth prospects look good. Each successive generation of semiconductor fabrication technologies involves smaller circuit sizes, new materials, and more process steps. This all amounts to a greater number of increasingly complex defects, which drives the growing need for ever-more-advanced PDC tools. KLA has a bright future. (Haywood Kelly)

Separate Account: Luther King Management Dedicated Target Equity
Firm founder and lead manager Luther King has generated great long-term risk/reward profiles at his shop's other separate accounts and mutual funds, and you can expect more of the same here. King started his career 40 years ago as a lending officer making commercial loans, and that experience still drives his investing style. Although many of his rivals didn't get balance-sheet religion until after the most recent market debacle, King has always focused on firms with limited debt, strong cash flows, and solid returns on invested capital. The fund's top holdings are heavy in such market-dominating steady-Eddies as Coca-Cola KO and Cisco Systems CSCO. But King isn't a shrinking violet--he has added value over time with tactical bets. In 2008, he trimmed General Electric GE because of uncertainty in its credit arm. He replaced it with electrical-equipment-makers Danaher DHR and Emerson Electric EMR. They face plenty of near-term head winds but have strong balance sheets and continue to grow. He also added Kirby KEX, a leading maker of barges. Its shares got crushed on concerns that declining energy prices would hamper demand, but King says it benefits from long-term contracts with ExxonMobil XOM and Dow Chemical DOW. This is a fine core holding. (Michael Breen)

Mutual Fund: Brandywine BRWIX
There's no sugarcoating it: This aggressive growth fund has stunk lately. It lost 44.5% in 2008 and has followed that up by losing even more so far in 2009--despite a rally in equities. But the immediate past isn't a prologue. The fund has always been prone to extremes, with horrendous stretches followed by big gains. Net result: strong long-term returns. Despite its miserable recent performance, the fund has still returned an average of 9.9% annually since its 1985 inception, handily topping its rivals and the benchmark. The process and staff remain intact, with longtime manager Bill D'Alonzo and his team focusing on firms that are growing their earnings by more than 20% annually and on track to beat Wall Street estimates--standard growth investing. But the team has separated itself from the pack over time via hands-on supply-chain and sales-trend analysis. It can get ugly here at times, but history shows that the best time to buy in is at the tail end of one of the fund's funks. It has loads of tax-loss carryforwards to offset future gains, so the tax man won't be a concern for some time. But this rapid trader is still best used in tax- advantaged accounts. This fund's not for the faint of heart and is too volatile to be a core holding, but it can fill a small role in a portfolio. (Michael Breen)

Hindsight: Winter 2008 a la Carte
The Winter 2008 issue's theme was financials, so it isn't too surprising that our picks have been a mixed bag. Take our stock picks. Financial-services firm Allied Capital ALD has dropped 80% and is in default with its creditors. The firm's survival is uncertain. But title insurer Old Republic International ORI is slowly improving its shabby capital position--its shares have rebounded lately and are up 10% since we recommended them, well above the market. Deutsche Bank DB and Discover Financial Services DFS have soared lately but are still down more than the market since we first recommended them. We're standing by both. Our ETF picks have all lost more than the market but less than their sectors. They're bouncing back of late, and our research says all have plenty of room to run. Our mutual fund picks are a bright spot. Two just barely lagged the pertinent broad market indexes and two greatly outperformed. Not bad considering their emphasis on financials, the worst-performing sector for most of the period since our picks were made. (Michael Breen)

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