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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

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 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

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.

Income matters. This old saw is no less true for being so often repeated. When global markets were steadily ascending, it was easy to focus exclusively on capital appreciation. But a dollop of economic and market uncertainty has more investors discovering the reassurance that a steady stream of income brings. It's simple: It takes cash to consistently pay dividends, and you can't fake cash. High-yielding securities not only provide steady income, they also attest to an entity's financial health. Below are several securities we are confident will maintain their solid income streams.
Overview by Michael Breen

Mutual Fund: T. Rowe Price Tax-Free High-Yield PRFHX
This fund's measured approach works. Manager Jim Murphy and his team don't recklessly chase yield by making big bets on risky sectors or issue. Rather, they do detailed bottom-up analysis and build a mix of securities with attractive risk/reward profiles. In 2007, for example, Murphy mostly steered clear of airline and real-estate-related issues because he didn't think they paid adequate compensation for their risk levels. Going light in these troubled areas helped the fund hold up better than rivals in 2007's tough market. Still, the fund's 5.2% yield is higher than the typical fund in its category. This prudent high-yield muni fund would be a nice complement to a portfolio. We've long considered it steady rather than spectacular, which is a good thing.PAGEBREAK

Stock: Allied Capital ALD
One of the largest feathers in Allied Capital's hat is that it has maintained or increased its regular dividend for more than 40 years. The total return Allied has generated for shareholders has averaged 12.4% annually from 1996 to 2007, compared with only 8.1% for the S&P 500 during this time. The stock is yielding almost 14%. While this yield is attractive, it also points to some risks to investing in the company. Because Allied pays out the majority of its earnings, it depends on the capital markets to finance growth. Moreover, to finance dividend growth, the new equity must be issued at a premium to book value. Historically, gaining access to capital has not been a problem, but recently, Allied's stock price has swooned, reducing the premium to book value at which the firm is able to issue new equity. If these tight capital-markets conditions persist, Allied could be worth much less, but should the firm return to some form of historical normalcy, the total return on an investment in Allied could easily exceed its already-lofty dividend yield.

Once upon a time, not too long ago, the practice of merely investing in foreign stocks might have been considered risky. Now, investors fret about having too small a foreign stake. Oh, how the times have changed. Yet, while investors' comfort with investing abroad and sophistication in building portfolios has clearly grown, it's not as if there's any shortage of high-quality, if slightly aggressive, foreign-investing options to consider. We've teed up a few below, ranging from a Chinese chipmaker and a globe-trotting international small-cap manager to an equally intrepid team that turns foreign benchmark-hugging on its head.
Overview by Jeffrey Ptak

Mutual Fund: Oakmark International Small Cap OAKEX
This fine fund would be a great addition to a portfolio. It's been successfully run since its 1995 inception by David Herro, Morningstar's 2006 International-Stock Manager of the Year. Herro has made a career of getting off the beaten path. He runs a concentrated portfolio focused on undervalued small caps, while the typical foreign fund spreads its bets across hundreds of pricier global behemoths. Herro dives into battered areas and makes occasional forays into emerging markets. He takes his lumps from time to time, but his intrepid style has prevailed over time. This fund has returned an average of 13% annually since inception, crushing the MSCI EAFE Index.

Stock: Vimicro VIMC
China-based Vimicro International designs semiconductors providing multimedia functions that are used in consumer electronics and mobile phones. The bulk of its revenue is from webcam chips in PCs and laptops, a market that Vimicro now leads. The firm's success translated into rapid growth for the company between 2001 and 2006, with sales increasing from $2 million to $127 million over that period. In an effort to diversify its business, Vimicro has steadily expanded into the mobile-phone multimedia market over the past several years. Challenges remain in its bread-and-butter webcam-chip business. But should demand take off for some of the company's newer products, the stock could be a big hit. If none of its new products catch fire, on the other hand, Vimicro could slowly burn the rest of its cash--the firm is trading for less than cash on the balance sheet--and the stock could be worthless to owners.PAGEBREAK

Separate Account: Thornburg International ADR
This isn't your standard foreign large-blend offering. For sure, this separate account owns plenty of well-known mega-cap names. But manager Wendy Trevisani and her team apply several tweaks that set their strategy apart. Trevisani earned her stripes working as part of Bill Fries' team at Thornburg International Value, a top mutual fund. This separate account shares much with that fund. For one, the portfolio is fairly concentrated. At just 45 holdings, it holds about one fifth the names that its typical peer does. And the fund's country and stock allocations share little with the benchmark index. For example, the portfolio's 15% stake in telecom stocks is nearly three times the MSCI EAFE Index's. Going its own way has paid off, and we expect similar long-term success here. The separate account certainly isn't a wild child, but it's quirky enough to add some diversification to a portfolio.

Non-Market Correlated
It's not necessary to reinvent the wheel when diversifying your portfolio. Sure, a number of specialty products have launched in recent years that do a fine job at diversification. But some of these are more sophisticated than many investors need, and most are pricey. And remember, a low correlation between the securities in your portfolio isn't a victory in and of itself. If a security goes its own way solely because it has steadily lost money or lagged while the major indexes and the rest of the portfolio have compounded nicely over time, that doesn't help anyone make money. Here are a few straightforward securities from traditional categories that can add spice to your portfolio while still generating solid long-term returns.
Overview by Michael Breen

Mutual Fund: Julius Baer Global High Income BJBHX
An experienced manager and flexible mandate give this fund an edge. Although domestic junk bonds correlate with the U.S. economy, this fund can spread its bets around. Veteran manager Greg Hopper buys low-rated corporate debt from the United States and abroad. He mixes in local-currency and dollar-denominated sovereign debt and the occasional emerging-markets issue or busted convertible. The result is a nicely balanced portfolio that has performed well while providing diversification. The portfolio has no correlation with the broad bond market as represented by the Lehman Brothers Aggregate Index. Lower costs would be nice, but the fund's 1% expense ratio is below its category's average.

ETF: iPath Dow Jones-AIG Commodity DJP
We have misgivings about the price of this exchange-traded note, which we think ought to levy a lower expense ratio in order to compensate investors for the credit risk they court. (An ETN is a debt instrument issued by a bank, Barclays Bank in this case.) But there's no other U.S.-listed ETF that tracks the Dow Jones-AIG Commodity Index, the benchmark that we think does the best job of balancing risk and reward by affording investors exposure to a wide variety of commodities, from lean hogs to crude oil. What's more, unlike some other commodities baskets, the energy subsector doesn't dominate the Dow Jones-AIG index, which caps subsector weightings at 34% of assets. Of course, commodities have been on a tear in recent years, making a correction--spurred by curtailed demand or other factors--a possibility well worth considering. Further, even a diversified commodities vehicle like this can be volatile at times; the ETN's standard deviation has been roughly 1.5 times that of the S&P 500. But commodities are useful diversifiers, making this ETN a worthwhile candidate for investors willing to court the bumps along the way.

Mutual Funds, Separate Accounts: Michael Breen
ETFs: Jeffrey Ptak, CPA, CFA
Stocks: Justin Fuller, CFA

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