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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.

Income Overview
A quick computer screen unearths a cornucopia of high-yielding securities that appear too good to be true. Many are. What you see isn't always what you'll get. Trailing yields tell you the income a security has already paid relative to its current price. They can't tell you if a security will continue to pay the same income. And with a slowing economy and credit crisis impacting firms and municipalities across sectors and regions, investors need to dig into the financials to confirm expected payouts will remain intact. In many cases, they will not. Below are a handful of securities we expect to continue delivering solid income streams in a tough environment.
Overview by Michael BreenPAGEBREAK

Mutual Fund: Eaton Vance Inc. Fund of Boston EVIBX
An experienced team with a proven record of strong credit selection gives this fund an edge. Managers Michael Weilheimer and Tom Huggins like stable franchises with predictable cash flows. So, they are light in energy and commodity plays and overweight in consumer-related issues, especially in the gaming and retail sectors. Neiman Marcus' debt is a top holding-- the managers say that the firm's affluent customer base will be lightly impacted by a tough economic environment, preserving the firm's cash flows. They also own debt from several casino operators such as Waterford and Trump Entertainment that provide high income but are a tad riskier. Rounding off the fund's consumer exposure is such specialty retail plays as Gamestop GME, the leading purveyor of videogame products, and Hit Entertainment, an online retailer. This fund is yielding 8.8%, and we don't anticipate a big drop-off based on management's strong long-term record.

Stock: Southern Company SO
Southern Company's four traditional regulated utility operations provide a strong and steady stream of cash flows that have led to 243 consecutive quarters of stable or increasing dividend payments. While traditional utilities are typically viewed as stable but relatively low-growth businesses, Southern's enviable market position in the growing Southeastern economies of Alabama, Florida, Georgia, and Mississippi presents transparent and material opportunities for investment that we think support projections of 4%-6% growth in both earnings and dividends over the next five years. Moreover, a constructive regulatory environment and favorable rate mechanisms allow Southern to capitalize on these opportunities with timely and generally guaranteed recovery of its investment. With its strong balance sheet, commitment to the pure-play regulated utility model, and steady prospects for growth, Southern provides one of the safest dividends in the market today and currently yields almost 4.5%. It is also worth noting that during the past four recessions, Southern has outperformed the S&P 500 by a wide margin, averaging total returns of almost 31% during those periods, compared with 2.5% for the S&P.

ETF: iShares Dow Jones Select Dividend DVY
This fund sifts the Dow Jones U.S. Total Market Index for about 100 stocks that pay the highest dividends and bolsters quality by omitting those that have made a dividend cut in the past five years or dole out more than 60% of earnings in dividends. The fund's 0.40% expense ratio is inexpensive in absolute terms and relative to most dividend-oriented conventional mutual funds. That low price tag assures that the bulk of the dividend income that the portfolio's holdings throw off ends up in investors' pockets. The fund also scores well from a tax perspective, as it hasn't made a capital gains distribution since its 2003 launch. Using the depth and breadth of our analysts' coverage, we also think this ETF is cheap using a bottoms-up valuation analysis. This ETF is trading near our Consider Buying price, which means that you're getting both income and a substantial bargain all in one fund.PAGEBREAK

International Overview
Quality knows no boundaries, so it shouldn't surprise investors that we prefer firms that have carved out economic moats whether they are domestic or international. Well-founded is the argument for maintaining a healthy exposure to foreign equities under optimal asset allocation strategies, but macroeconomic shifts are often hard to foresee and can cause rapid valuation shifts. Over the long haul, a passive approach of owning a large bucket of geographically diverse firms will suit most investors better than speculating on specific countries. However, by owning firms with sustainable competitive advantages, either through stock selection or by finding the right fund, investors can find superior returns with investment horizons beyond a few cycles.
Overview by Paul Justice

Mutual Fund: Artisan International Value ARTKX
This compact portfolio has plenty of exposure to consumers around the globe. That's a function of management's requirements. Like many, David Samra and Dan O'Keefe favor firms with strong cash flows, high returns on capital, and clean balance sheets. But they only buy those trading at healthy discounts to their estimate of a firm's intrinsic value. Slumping consumer stocks have provided plenty of opportunity in recent years. The fund's top holdings include Signet, a U.K.-based jewelry retailer whose shares have cratered on fears that a recession will decimate demand. But the firm remains profitable and trades at a fraction of the market's valuation. Unicharm is a leading Japanese personal-health product company, with top diaper and feminine hygiene brands. It is also benefitting from regional expansion. A record of strong stock-picking makes us confident that management will hit the mark with its picks.

Stock: Veolia Environment VE
Veolia, based in France, is the second-largest water-treatment and waste-treatment company in the world. Its main business is running water systems for governments in many parts of the world, both developed and emerging. As emerging countries develop, they have an increased desire for clean drinking water, which provides long-term growth for this business. There is an ongoing $1.5 trillion clean water project under way worldwide. The demand for environmental services--water, waste, energy, and transportation--will always exist. In fact, we believe that demand will increase as municipal governments face financial deficits. Thus, they will look to operators like Veolia for business. Case in point: Management recently announced that it would exceed its 2008 10% organic revenue growth target, which helps support our revenue growth assumptions. We believe that the market is overly pessimistic on Veolia's prospects. For example, re-engineering our model to today's market price implies Veolia will earn a 6% midcycle operating margin. Undoubtedly, operating margins will suffer this year, due to both the strengthening euro and sky-high fuel costs. However, we think the 6% margin is a very pessimistic forecast, given that Veolia has delivered average operating margins of 7.5% over the past three years.PAGEBREAK

ETF: BLDRS Emerg. Mark. 50 ADR Idx ADRE
This ETF has placed itself squarely in the large-cap bucket by tracking the 50 most actively traded emerging-markets ADRs. Though size doesn't automatically translate to quality, large-cap firms more often tend to boast key attributes like scale, brand equity, or high barriers to entry. Nearly 75% of the fund is in giant caps. Firms domiciled in Brazil, South Korea, and China are most common, while the telecom, industrial, financial, and energy sectors dominate. Since ADRs are widely available to U.S. investors, this fund has not opened any previously inaccessible doors with its strategy. However, its 0.30% expense ratio when compared with most other funds likely trumps the trading costs that investors would incur if they tried to replicate this portfolio.

Non-Market Correlated Overview
Call them what you will--dynamic or quantitative-active--but when exchange-traded fund providers began rolling out their alpha-seeking factor-based models over three years ago, market-watchers dismissed them as a passing fad with dim prospects. Though some will undoubtedly fail, others finally have been around long enough to post measurable performance records--and some have performed well enough to earn our 5-star ratings. Since some of these sport reasonable fees and are well-defined enough to avoid style drift, perhaps it's no longer absurd to consider these offerings as a way to add diversification without getting battered by hedge fund-like fees.
Overview by Paul Justice

ETF: PowerShares Dynamic Large Cap Value PWV
Though decidedly in the large-cap value space, this compact ETF tracks a quasi-actively managed index that sifts through large, cheap stocks for 50 names with the best upside potential. PowerShares divvies stocks into the growth and value camps based on traits like earnings growth, price/book multiples, and dividend yield. The resulting portfolio sports purer large-cap exposure than the Russell 1000 Value Index. Though Morningstar's bottom-up approach toward valuing stocks is different from the indexes', we are currently coming up with similar results--we think this collective basket of stocks is considerably undervalued. We cover every holding in the fund, so we have a fairly high degree of confidence in this pick. Though the fund reconstitutes quarterly, it has remained tax-efficient and has not distributed capital gains since it launched. Assets are spread relatively uniformly, as the top 10 holdings soak up only 35% of assets and the median position size is roughly 1.5%. While cheap compared with several mutual funds, its expense ratio of 0.63% makes it relatively expensive compared with plain-vanilla ETFs.

Mutual Funds, Michael Breen
ETFs, Paul Justice, CFA
Stocks, Paul Justice, CFA
Separate Accounts, Michael Breen

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