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Consumer Confidence

Thirteen investment vehicles that offer strong plays on consumer spending.

Morningstar Analysts, 11/03/2008

Growth Overview
Back in the day, consumer stocks were a staple of growth investors. It seemed there was always a new retail or dining concept capturing the public's imagination and attracting flocks of momentum investors. Those days are a fading memory. Traditional value areas like energy and materials have posted big gains over the past five years, catching the fancy of the momentum crowd. Meanwhile, consumer-related stocks have struggled, gaining fans in the value camp but reducing their presence in growth investors' portfolios. Still, a little digging reveals plenty of consumer plays with profiles to cheer the most ardent growth investor.
Overview by Michael Breen

Stock: Apple, Inc. AAPL
Most people associate Apple with the iconic iPod, but the real growth opportunities lie in the company's Macintosh and iPhone businesses. The Macintosh business has averaged 30% annual growth since 2003, and we expect that growth to continue. The advent of the Internet as the means by which people gain access to their information means that users are less tied to desktop operating systems like Microsoft Windows. Moreover, the transition from desktops to notebooks places a premium on design. When you pull out your notebook at the local Starbucks, you want something that looks good, and no other computer maker does industrial design like Apple. The second growth driver, the iPhone, could end up as Apple's biggest business a decade from now. Think about all the mobile devices people carry: cell phone, music player, GPS device, digital camera, and more. One major trend will be the convergence of all that functionality onto one device. The iPhone is Apple's play to own the digital screen that you carry around. Much like Windows came to dominate the PC market, we think one software platform will dominate the converged-device market.

ETF: Vanguard Growth VUG
This fund tracks the MSCI U.S. Prime Market Growth Index, which sifts through the 750 largest U.S. stocks for the fastest-growing companies. MSCI defines growth using an eight-factor model, and it further enhances its quality by employing buffer zones to limit the migration of stocks between the growth and value camps. These traits help limit turnover and make the ETF a better representation of the growth stock universe. Another main attraction of this fund is its paltry expense ratio of 0.11%, making it dirt-cheap on both absolute and relative levels compared with both mutual and exchange-traded funds. If that were not enough, we think its stock holdings are also cheap. Our equity analysts cover 98% of the fund's holdings, which allows us to peg a fair value estimate on the ETF itself. As of this writing, the fund is trading at a decent discount to our Consider Buying price, and the collection of companies held in the fund exhibit healthy competitive advantages over their peers.PAGEBREAK

Separate Account: Baron Small to Mid-Cap Equity
Manager Ron Baron's eponymous firm has built a stellar record focusing on firms with dominant market positions and sustainable growth prospects. He has long eschewed commodity and high-tech firms because the former have low barriers to entry while the latter run the risk of obsolescence. But consumer plays are right in his wheelhouse. Baron's funds and separate accounts typically keep close to one third of their assets in consumer-related fare. Baron has a good track record with gaming, dining, and retail plays. So, it's no surprise that this portfolio has been a big holder of such names as casino operators Wynn Resorts WYNN and Ameristar Casinos ASCA, restaurateurs Panera Bread PNRA, California Pizza Kitchen CPKI, and Cheesecake Factory CAKE, as well as specialty retailers like Dick's Sporting Goods DKS and J. Crew JCG. Baron's strong long-term track record with such consumer stocks makes us confident in this separate account's prospects.

Value Overview
It's not surprising that those who make a habit of buying straw hats in winter are finding attractive stocks in the consumer sectors. A housing crisis, recessionary fears, and the specter of inflation have the once-mighty American consumer reining in spending. In turn, firms are struggling and share prices have cratered. The worst-performers list for the past five years includes many consumer-related industries. In contrast, the top performers are commodity-related. But opportunity is often born of misery. The next five years are unlikely to mirror the past five, and forward-looking investors will find happy hunting among consumer-related plays.
Overview by Michael Breen

Mutual Fund: Oakmark Select OAKLX
This beleaguered fund has more than half of its assets in consumer-related stocks, a big reason it's deep in the red over the past year. Such names as apparel retailer Limited LTD and Liberty Interactive LINTA, the owner of online retailer QVC, have hit potholes. But manager Bill Nygren makes strong cases for both. He says that Limited has shed unprofitable divisions to focus on its two dominant franchises, Victoria's Secret and Bath & Body Works, which should boost returns on capital. Liberty Interactive was spun out of Liberty Media, which Nygren has had a long and fruitful relationship with. The firm continues to generate prodigious free cash flow and has a dominant market position. Nygren recently grabbed electronics retailer Best Buy BBY. He says that it's a top operator that had oversold on macroeconomic concerns. This fund has had its travails, but we think it is well positioned going forward.PAGEBREAK

Stock: Jackson Hewitt JTX
This small-cap value stock has carved out a narrow moat for itself and is trading at bargain-basement prices, in our opinion. The company focuses on a niche of the multibillion-dollar tax-preparation business by focusing primarily on low-income filers. These filers tend to receive refunds and prefer bricks-and- mortar locations, which typically provide faster refunds through piggy-back services such as refund anticipation loans. Though not without risks--two years of declining volume is certainly a cause for concern--we believe that Jackson Hewitt can right the ship. The fallout from its 2007 regulatory issues should pass, and the firm's geographic market penetration is still only 40%. Refund anticipation loans, which can have annual percentage rates above 100%, have been the center of government scrutiny and civil litigation. Regulation was passed in 2007 that put a 36% cap on interest charged to members of the military. Additional regulation like this could reduce the revenue from financial products. Our analysis suggests that the market is currently pricing in customer attrition from 3.4 million this year to 2.7 million by 2012, which seems unlikely to us.

Separate Account: Ariel Mid Cap
Manager John Rogers favors dominant franchises with strong and predictable cash flows. He has often found them among consumer stocks, where this strategy currently keeps about 40% of its assets. Rogers has long avoided energy and materials firms because unpredictable commodity prices are the main driver of those businesses. This combination has provided the worst of both worlds in recent years, and the strategy has lagged badly. But a stock-by-stock review of this portfolio points to a resurgence. For example, Energizer Holdings ENR owns a 40% share of the U.S battery market, a leading razor-blade brand, and Playtex, whose personal-care products are cash cows. Rogers says Energizer is an industry leader that trades at a big discount to its peers and the market. Rogers has been adding to Tiffany TIF and Sotheby's BID lately. He says the former is a luxury jeweler whose clientele is not overly impacted by a dicey economy. The latter's high-end art auctions continue to trend upward on international expansion and demand from the Mideast and Russia. This portfolio is filled with cheap, profitable firms.

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