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Sleep Like a Baby

Fourteen fundamentally sound picks that the sandman would love.

Morningstar Analysts, 06/17/2008

A host of firms, many in the beleaguered financials sector, have slashed their dividends recently amid housing- and subprime-induced stress. Not that the problems have been confined to stocks alone, as investors in CDOs and various other exotic debt instruments can well attest. The moral to the story is that a big yield does not a safe investment make. Underlying fundamentals matter a great deal, so with that in mind, here's a short list of investments that sport attractive income payouts yet hold up when we scrutinize the fundamental case, whether it emanates from a skilled, proven active manager or a firm whose business is founded on durable competitive advantages.
Overview by Jeffrey Ptak

Separate Account: Cohen & Steers Realty Income
This separate account is a nice contrarian bet, and you get paid while you wait for a turnaround. Real estate securities have been crushed over the past year, and this strategy has taken its lumps, losing 18% in 2007. But, it looks attractive now. Cohen & Steers is a boutique shop with a long track record of successful real-estate investing, emphasizing firms with attractive assets and growth prospects. This separate account now yields 6.2%. And even if that rate drops as beleaguered real-estate firms trim dividends in the current market downturn, this offering will still throw off a ton of income.

Stock: Pfizer PFE
Pfizer's size establishes the largest economy of scale in the pharmaceutical industry. In a business where drug development needs a lot of shots on goal to be successful, Pfizer has the financial resources and the established research power to support the development of more new drugs. Its strength is evidenced by the 150-plus drugs in its pipeline and 15 new drug approvals in the past four years. Recently approved Sutent and Chantix are poised to be the next generation of blockbusters; we estimate that they can each generate well more than $1 billion in annual sales within the next several years. We expect that this will not only help insulate the firm against declining revenues from its cholesterol drug Lipitor, but will augment the firm's prodigious $10 billion in annual cash flow. While a portion of this cash is earmarked for future research and development, management is also committed to returning capital to shareholders. Thus, current investors have a relatively safe dividend yield of 5.3% and are getting paid to wait for Pfizer's growth engine to restart.

Mutual Fund: Vanguard Inflation-Protected Secs VIPSX
There are few uncertainties with this fund. The goal here is to provide inexpensive exposure to the inflation-protected bond market. Some rivals in the inflation-protected bond category have taken steps like holding unhedged non-U.S. bond stakes or asset-backed securities to boost returns. This fund doesn't take such steps. Instead, managers Ken Volpert and John Hollyer stick mainly with TIPS and make small tilts related to TIPS auctions and on spreads between nominal Treasuries and TIPS. It is cheap, has straightfor¬ward exposure, and the best part is that this fund provides investors with some protection against one of the biggest risks they face--that is, purchasing power. This fund is guaranteed to move in sync with inflation and provide returns that are in line with investors' purchasing power needs. It remains one of our favorites for investors looking to guard against inflation.PAGEBREAK

The one part of the growth market that looks more attractively valued than others is large-cap growth. Looking at the Morningstar Large Cap Growth Index, over the past 10 years the average annual return for these growth stocks has been a negative 1.06%. Many of the firms in this index have seen solid earnings growth year in and year out, but their stock prices have declined as the multiple on those earnings contracted. Now, however, our research shows that the downside in some of these stocks is very low and the upside potential very good. Thus, we believe that for investors with a low risk tolerance, some large-cap growth names have the potential to do well while also affording investors a good night's sleep.
Overview by Justin Fuller

Stock: Medtronic MDT
This wide-moat company's vision is to establish a significant presence in chronic diseases, in addition to its stronghold in heart disease. Investments in neurological, diabetes, and spinal products from the middle to late 1990s have paid off in spades, offering new revenue streams and taking some pressure off of its heart products. Revenue from those three product areas inched up from 25% of total sales in fiscal 2000 to 37% in fiscal 2007. Medtronic's diversified medical technology portfolio allows it to better weather glitches in the development or approval process for any particular new device, and we think this provides downside protection to prospective shareholders. And better yet, we've been impressed by the firm's persistent ability to innovate and by how it's often first to market with new products, which should provide significant tail winds for years to come.

ETF: Health Care Select SPDR XLV
There are few better ways to protect one's downside, we think, than investing in firms founded on durable competitive advantages. While businesses like these can certainly fall out of vogue over short periods of time, they tend to generate handsome profits and gobs of cash flow on a consistent basis, creating shareholder value in the process. Some industries boast more of these high-quality businesses than others. For example, you'd be hard-pressed to find a firm standing head-and-shoulders above the pack in commoditized industries like gold mining. By contrast, the health-care business has often been a fertile source of wide-moat firms given the benefits that intellectual property protection confers. Not too surprisingly, this ETF, which costs only 0.23% to own, teems with the stocks of blue-chip health-care giants like Johnson & Johnson JNJ, Pfizer PFE, and Merck MRK. All told, the fund invests nearly two thirds of its assets in wide-moat names.

These businesses, which typically share traits like broad product portfolios and immense R&D war chests, have been steady growth engines over time. Yet, from our standpoint, the market is discounting these business as if they'll experience nominal growth, the most commonly cited concern being thinning drug pipelines and generic encroachment. While we're not expecting these drugmakers to spurt huge revenue gains in the coming years, we think the consensus view is too bearish. Thus, we're seeing bargains galore in this portfolio, which was recently trading at a hefty 14% discount to what we think its holdings are worth in the aggregate.PAGEBREAK

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