April/May 2009 Picks

Mutual Fund: Longleaf Partners LLPFX
This fund got hammered in 2008. It lost 50.6% as big positions in several stocks--including Dell DELL, Liberty Interactive LINTA, and Cemex CEMEX--cratered. Even so, the fund's long-term record is impeccable. It has returned an average of 9.3% annually since its 1987 inception, and we think that is a truer indication of management's ability than last year's debacle.

The fund has always taken big stakes in firms facing plenty of issues, but it has been right much more often than not over time. We recall the late 1990s when the fund started building what became a 16% stake in struggling Waste Management WMI. The stock languished for years, raising concerns about the judgment of comanagers Mason Hawkins and Staley Cates. But Waste Management eventually more than doubled, and the fund cleaned up. We don't think Hawkins and Cates, who were Morningstar's 2006 Domestic-Stock Managers of the Year, have lost their touch. They say that the portfolio is trading at less than half their estimate of fair value--its lowest level ever.

This bold fund will make mistakes. But we think every miss, such as General Motors GM, will be more than offset by several winners. The fund also carries a big, negative potential capital gains exposure, which should give it flexibility in dodging the taxman when it does rebound. (By Michael Breen) 

Exchange-Traded Fund: BLDRS Developed Markets 100 ADR Index ADRD
Low cost, big dividend yields, and high-quality holdings make this ETF a promising way to invest in the safest international equities.

This ETF tracks the Bank of New York Mellon Developed Markets 100 ADR Index, a market-cap-weighted index tracking 100 of the largest international companies that have shares listed on U.S. exchanges. This keeps the quality of the index holdings high, while keeping the benefits of diversification across both companies and sectors. We like the low expense ratio of 0.30% and the relatively high dividend yield on this ETF's underlying securities. We also slightly prefer the sector allocation of this ETF to rivals based upon the MSCI EAFE index because the fund holds smaller stakes in the vulnerable financials and industrials sectors while boasting larger investments in health care and the beaten-down energy sector. The fund's 20% stake in financials may still seem hefty, but by this point, it has very little exposure to the vulnerable British or Irish banks whose troubles made headlines in January.

As for the rest of the international markets, every stock suffered in the sell-off of 2008, the frogs and princes alike. This has generated some major bargains among the blue-chip companies held by the fund. Between the high quality of its constituent companies and desirable sector allocation, the ETF trades at an attractive discount to our estimated fair value of the underlying holdings. Equity investors who want to get paid while they wait for price appreciation should give this ETF a long look. (By Bradley Kay)PAGEBREAK

Stock: 3M MMM
The bear market has left many great companies trading at multiyear lows, and this wide-moat firm is one of them. We expect near-term head winds to continue, with further drops in revenue and earnings through 2009, but we believe our long-term assumptions continue to hold. The shares appear dirt cheap to us.

Management's expectation that 2009 earnings per share will fall 10% to 15% is in line with our projections. In addition, we think the firm's strategic decisions will benefit the firm over the long run. 3M plans to cut capital expenditures by 30% next year and save $200 million through bonus and vacation adjustments. Furthermore, the firm's health-care segment will likely remain resilient through trying times, offsetting continued weakness in electronics and other consumer-driven businesses.

We think 3M's pristine balance sheet and prudent cost control will preserve the company's wide moat. Based on our assessment of future free cash flows, we think the shares are worth $85 per share--well above the current share price. The stock not only earns a 5-star rating based on its valuation but also earns a Financial Health Grade of A and a Stewardship Grade of B. (By Haywood Kelly)

Separate Account: Keeley Corporate Restructuring Small Cap
Successful execution of a distinct strategy gives this separate account an edge. Manager and firm founder John Keeley specializes in corporate restructurings. He trolls for spin-off plays, firms emerging from bankruptcy, distressed utilities, or firms trading at big discounts to the sum of their underlying assets. The only constants are the presence of strong cash flow and some sort of catalyst to unlock value. Keeley has consistently hit the mark over time, and this strategy has a great long-term record.

Keeley has long found the most firms meeting his criteria among industrials and energy-related firms. These sectors swooned in 2008, so even though Keeley's picks were better than average, the fund got stung. But Keeley's sticking with his infrastructure and energy stocks because he sees ongoing growth and underfollowed stocks in these areas. For example, Walter Industries WLT has been spinning off businesses on favorable terms for a couple of years. It is now a pure play on metallurgical coal but is lightly followed. And top holding Leucadia LUK is a holding company with widely varying interests, including an Australian iron miner, an early-stage biotech firm, and to a 28% stake in subprime auto lender AmeriCredit ACF. But Leucadia has a proven record of successful capital allocation.

This strategy's sector concentrations can leave it out of step with the market at times, but we have confidence Keeley will continue to outperform over the long term. (By Michael Breen) PAGEBREAK

Hindsight: Summer 2007
While our stocks picks have struggled, an ETF comes through.

Fuel Tech FTEK
Our stock picks from the Summer 2007 issue have struggled: Washington Mutual was a complete miss, and Motorola MOT, Thomson TMS, and Fuel Tech FTEK have lost much more than the market. We remain most confident in Fuel Tech, a maker of pollution-control systems. Political uncertainty over environmental regulation and headwinds from the global economic downturn are pressuring revenues and the stock has shed around two thirds of its value since we first recommended it, but we think it remains well positioned for the long haul. Fuel-Tech has carved a niche for itself with its proprietary slag-reduction technology, which allows utilities using coal-fired systems to cost-effectively reduce emissions. We give the firm a narrow moat. Client-retention rates remain high, indicating that despite increasing competition from large rivals Fuel-Tech's offerings remain differentiated. We've ratcheted back our growth projections to reflect a tough environment, but Fuel Tech still trades at a huge discount to our fair value estimate. This tiny firm carries plenty of risk, but its potential upside is enormous. (By Michael Breen) 

Vanguard Dividend Appreciation VIG
This ETF has held up much better than the overall market since we recommended it, and it remains appealing. It tracks the Mergent Dividend Achievers Select Index, a collection of big firms with strong market positions and entrenched competitive advantages. An additional screen from Vanguard means the ETF only buys firms that have increased their dividends in each of the past 10 years and appear capable of maintaining the streak. Most top holdings, including Wal-Mart Stores WMT, Johnson & Johnson JNJ, Procter & Gamble PG, and Abbott Labs ABT, are assigned wide economic moats by Morningstar's equity analysts. Wide-moat stocks have held up comparatively well in the current bear market, and all but one of this ETF's top-25 holdings fared better than the S&P 500 Index in 2008. The ETF has also benefited from cutting loose several struggling firms, including Citigroup C, that appeared unable to maintain their dividends. Despite a good run, this ETF still looks attractive. It trades at a 25% discount to our estimate of its fair value, and its stable of predictable, financially sound firms is a tonic for uncertain times. (By Michael Breen)