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Living on the Edge

Thirteen high-risk, high-reward picks that will add a little sizzle to clients' portfolios.

Morningstar Analysts, 08/04/2008

Growth
As companies evolve through their life cycles, there are usually two growth phases that allow investors to make money. The first is the startup phase, where a company's products and services start to gain acceptance and growth accelerates as demand intensifies. Over time, as the company tries to meet this growing demand, its resources are stretched and the company requires more investment to capture its next leg of growth. During this time of reinvestment, most investors typically think that the company is a fallen star, and they punish the stock price. This creates an opportunity for savvy investors--who aren't afraid of a bumpy road--to make money by capturing the company's second phase of growth. This story is typically known as a fallen growth story, and while it can be very fruitful, it can also be a graveyard without the right investing temperament to ride out the wave.
Overview by Justin Fuller

Mutual Fund: FBR Focus FBRVX
Conviction. Manager Chuck Akre has it in spades. Take top holding Penn National Gaming PENN. Akre has owned the operator of wagering facilities since this fund's 1996 inception. It fits his criteria of only owning firms with high and sustainable returns on equity. The firm's shares have increased more than tenfold since Akre bought them, but he hasn't sold. Firms that compound capital at high rates are tough to come by, so Akre does not readily part with them. The portfolio's turnover rate is glacial, and it has a limited number of names. Even now, as Penn National's shares bounce around on fears that a proposed takeover is fizzling, Akre is holding firm. He thinks the takeover will occur, but he'd be happy if it failed, because then he could continue owning a top business. Such patience and foresight are rare in the growth space and can cause the fund to zig while others zag. This fund is pricier than we like, but Akre has easily cleared that hurdle, crushing his rivals and the benchmark over time.

ETF: SPDR S&P Homebuilders XHB
If there's a fine line between daring and masochism, our recommendation of SPDR S&P Homebuilders probably straddles it. The ETF, which owns the stocks of 20 or so U.S.-based housing-related firms, has gotten crushed, suffering a wrenching 43% loss in the year ended May 2008. And the bleeding shows few signs of subsiding. Yet, despite the carnage and uncertain outlook, we see opportunity--many of this fund's holdings are trading at sharp discounts to what we think they're worth. For example, as of late May, roughly half of the 21 portfolio holdings that our analysts cover were at least 30% undervalued; the portfolio was trading at a steep 25% discount to our aggregate fair value estimate, a level that affords the margin of safety we seek. True, we think the climate for homebuilders will remain very challenging in the near term, and we have constructed our forecasts accordingly--we're extremely pessimistic about these firms' revenue growth and earnings per share growth from 2008 to 2012. But the market is discounting a much higher probability of bankruptcy for many of these firms than we think is warranted. But it's not one for the meek.PAGEBREAK

Stock: Coldwater Creek CWTR
Coldwater Creek's growth over the past few years has been driven by its retail expansion efforts. Revenue from this segment has increased at a rampant 50% on average over the past five years, and the growth in retail sales has made up for a decline in revenue from its original catalog business. Coldwater Creek, however, is reconsidering its expansion strategy after merchandising missteps and a weak macroeconomic environment have sent sales and profits into a nose dive. The company slowed expansion to a planned 50 stores in 2008. Coldwater Creek has also pared down its advertising budget by planning to spend less on national ad campaigns and reducing catalog circulation. All these actions may allow the company to fix some of its internal issues and eventually drive future growth, but if weak economic conditions persist, the stock could only be worth somewhere in the midsingle digits. On the other hand, if management can fire up the growth engine and expand by more than 50 stores this year, the stock could be an easy double.

Value
Value investing essentially boils down to getting more in value than what you are paying for in price. Deep-value investing can be classified as buying those securities that could potentially be near bankruptcy and worth nothing, but if they make it through and avoid insolvency, they could be worth multiples of the current stock price. To be sure, this type of investing is not for the faint of heart and is only appropriate for investors who are comfortable with risk and willing to do a lot of work on their investments. What's more, it's sometimes better to buy a basket of these types of securities than only one, as this strategy allows investors to spread their risky bets over a wider range of potential outcomes.
Overview by Justin Fuller

Mutual Fund: Schneider Small Cap Value SCMVX
Just remember: Short-term performance is meaningless. This fund got poleaxed by its financials in 2007, particularly the now-bankrupt American Home Mortgage. The fund lost 17% for the year and lagged nearly all its rivals. It has slid further in 2008 so far, although it's topping most of its small-value rivals. Don't be scared off. Manager Arnie Schneider is a deep-value investor who isn't afraid to buy struggling companies that he thinks can turn things around. He occasionally has his nose for value bitten off, but he has been right much more often than not over time, leading to topnotch long-term returns. This fund recently reopened, and we recommend it. It has almost no correlation with the broader market, making it a nice diversifier.PAGEBREAK

Stock: MBIA MBI
Over the last few years, MBIA has weathered some tough times, but none as difficult as those encountered today. The company has exposure to subprime collateralized debt obligations, and defaults on these risky debt instruments could ultimately call into question MBIA's solvency--or at least immensely dilute existing shareholders if MBIA is forced to raise even more equity capital. MBIA's AAA credit rating, however, was also difficult to obtain; it requires long-demonstrated risk-management prowess and a strong financial position. Its primary product--insured municipal-bond obligations-- has provided real value to customers. Expansion into other structured credit vehicles outside of its main product line further enriched corporate coffers, which produced a virtuous cycle of enviable returns. If the company can return to profitably insuring municipal bonds, its stock price could be worth multiples of what it is trading for today; if the credit market worsens, however, it's still a possibility that shareholders could be left with nothing.

Separate Account: Pzena Large Cap Value
With Citigroup C, Capital One COF, Freddie Mac FRE, Fannie Mae FNM, Pfizer PFE, and Home Depot HD peppering its top-10 holdings, one might wonder if there are any battered stocks that this separate account doesn't own. Rest easy. There's a method to manager Richard Pzena's madness. As Kunal Kapoor highlighted in a Morningstar Conversation, Pzena's a veteran value hound who thinks near-term business deterioration creates the best long-term opportunities. He willingly dives into battered firms as long as he's confident they will still generate strong returns on capital over time. He's found happy hunting among depressed financials, and this strategy now has about half its assets in that sector. Such concentration can cause near-term pain, but Pzena has proved his mettle over the long haul.

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