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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

Mutual Fund: Primecap Odyssey Aggressive Growth POAGX
This fund was launched in late 2004 as an alternative to Vanguard Capital Opportunity VHCOX, which has been closed to most new investors since early 2004. (The latter fund recently reopened to those who have at least $1 million in other Vanguard funds.) The Primecap team and its low-turnover contrarian growth strategy has put together an outstanding record over the past decade with Capital Opportunity and for more than 20 years with Vanguard Primecap VPMCX. This fund's $375 million asset base (as of late 2007) is a fraction of Capital Opportunity's $10.5 billion. This makes it easier for the managers to own small- and mid-cap stocks, which make up 78% of this fund's portfolio but only 42% of Capital Opportunity's. The small-cap emphasis helped in 2006, but the situation has been reversed as investors have fled from small caps and anything smacking of risk. We're not too worried about this short-term stumble given the managers' track record; this remains an excellent mid-cap option, especially for investors who can't get into its cheaper cousin.

To some portfolio managers, a strong valuation discipline is the pill that helps them sleep at night. By digging into a company's assets, liabilities, and cash flows, value managers try to make money by purchasing securities for less than what they think they're worth and waiting for the market to figure it out. A welcome side effect of such considerations is that stocks with low expectations attached that are undervalued to begin with also have less room to go down. When done right, a well-executed value strategy can offer investors peace of mind.
Overview by Karen Dolan

Mutual Fund: WHG LargeCap Value Instl WHGLX
This fund has a relatively short history, but it's backed by an experienced team and a proven strategy. It's a replica of GAMCO Westwood Equity WESWX, which manager Susan Byrne has run since its 1987 inception. That fund has one of the best track records in the large-cap value category, largely as a result of Byrne's value-orientated contrarian style. This fund should perform better, though, because its fees are currently one third lower than its GAMCO counterpart, leaving more return for shareholders. Byrne's avoidance of the subprime mess and focus on firms with international diversification has helped her amid fears of a slowdown in the United States; her savvy tech moves are also typical of her mix of long-term sector trend analysis and bottom-up research.

Stock: Walgreen WAG
A consistent approach in building larger, free-standing stores on convenient, high-traffic corners since the early 1990s has given Walgreen the best collection of real estate in the drugstore industry and has enabled the firm to prosper. The store statistics bear out the firm's success at finding the best corners. We estimate that a Walgreen store, on average, fills about 275 prescriptions per store per day, compared with fewer than 200 for the average drugstore chain. More productive stores equate to better earnings per store, robust free cash flow, and the highest returns on invested capital of any drugstore chain. And given that prescriptions have constant demand, we expect Walgreen to weather any potential economic weakness quite well.PAGEBREAK

ETF: Diamonds Trust DIA
This old standby, which tracks the Dow Jones Industrial Average, is chock-full of cheap, high-quality stocks. As of early March, the portfolio was trading at an 18% discount to what our analysts think its holdings are worth in the aggregate.

Where are the bargains? Pretty much everywhere you look in the portfolio. For example, not a single one of the Dow's 30 components was trading at a premium to our fair value estimate as of March 3, and two in three names were at least 10% undervalued. Though the Dow is relatively concentrated when compared with more-sprawling large-cap indexes, such as the S&P 500 and Russell 1000, we don't think Diamonds is an especially risky investment. Most of its holdings, such as United Technologies UTX, Merck MRK, and Walt Disney & Co. DIS, are industry bulwarks that are unlikely to be dislodged by competitors anytime soon. All told, the fund invests nearly 75% of assets in the stocks of wide-moat firms. That, coupled with the fund's reasonably wide diversification across industries, should confer stability. No, the fund is hardly loss-proof. But it looks like an awfully tempting value at these levels, even taking that risk into account.

It had become an article of faith in some circles that receding U.S. economic hegemony and the rise of China and other emerging markets had greatly reduced the world's dependence on its largest economy. The theory held that rising domestic consumption and global trade meant a plunge in the United States would have little impact on global equities. And when the U. S. stock market was first tripped up by the subprime-debt debacle, overseas stocks indeed held up. But the U.S. market continued to languish, and markets around the globe sank. In fact, most have shed more than the S&P 500 for the year to date through March 31, 2008. Predicting macroeconomic shifts is tough. That's why we're big fans of individual security selection over top-down market calls. Below are a handful of international securities we think will excel over the long haul regardless of macroeconomic machinations.
Overview by Michael Breen

Stock: Boeing BA
Boeing is truly a global company that along with European rival Airbus supplies the world with commercial jets. Boeing's dominant market position coupled with strong global airline traffic growth, the liberalization of air travel between countries, and replacement demand for more fuel-efficient jets should help it capture a majority of worldwide commercial aircraft demand during the next five years. The ultraefficient new 787 Dreamliner should lead the way. But Boeing is more than just commercial jets, as it has balanced this business with a countercyclical defense unit that benefits from the unique ability to use commercial technology in military applications. And although the defense unit will shrink as a portion of sales in coming years because of commercial unit's growth, the value it provides to smoothing out Boeing's airplane business remains firmly intact, further minimizing the downside to potential shareholders. PAGEBREAK

Separate Account: Manning & Napier Non-U.S. Equity
This lesser-known separate account is a winner. It's run by Manning & Napier, who we profiled in the Fall 2007 issue of the magazine. Like all Manning & Napier offerings, its team manages using an eclectic, bottom-up approach that targets growth, value, and cyclical plays. Top-10 holding Calfrac is an example of the latter. It was recently purchased after tumbling on macroeconomic concerns. But the managers say the Canadian gas-well-services firm is well positioned for the long haul based on secular trends and its own global expansion. This separate account has provided the best of all worlds. It isn't excessively volatile, has held up well in down markets, and has outperformed over time. Its risk/reward profile is among the best in its category. Manning & Napier isn't a household name, but it should be.

Mutual Fund: Causeway International Value Inv CIVVX
This fund reopened to new investors Feb. 1 after being closed for several years, which is a sign that managers are finding ways to put money to work in this challenging environment. That's a good thing. Investors should lose sleep over funds that are taking in assets too quickly and have to invest them in marginal ideas; the opposite is happening here. The managers are uncompromising bargain-hunters who never chase hot stocks or sectors. They often add to names because of weakness and load up on issues in out-of-favor areas, and they focus on large caps from developed markets while doing so. The fund's average market cap normally exceeds the group norm. In addition, the only emerging market in which they look for opportunities is South Korea (which many consider to be a developed market), and they tend to invest limited amounts there.

Non-Market Correlated
In recent years, the quest by investors for securities that aren't correlated with the U.S. market has led to the launch of some complex products. Many of these use a labyrinth of hedging strategies across several global assets classes in their quest for "uncorrelated alpha." Not all succeed and most come with a hefty price tag. It doesn't have to be that hard or expensive. Below are some easy-access ways to add diversification without breaking the bank.
Overview by Michael Breen

Mutual Fund: Janus Contrarian JSVAX
This fund takes risks, but its manager is talented and focused on absolute returns. Veteran manager David Decker doesn't care much for categories or benchmarks. Although the fund currently resides in the large-blend category, it strikes its own pose among its peers. He typically holds more mid-cap stocks than the category norm and has found numerous values outside the United States (at last count, 40% of the fund's assets were parked overseas). Both stakes have been a boon, as both areas have pushed past domestic large-cap stocks in recent years. Decker focuses on firms that are undervalued based on his estimate of future earnings potential with the ability to increase returns on invested capital. In 2006, he significantly increased his position in Owens-Illinois OI, a move that paid off in spades last year as the firm began increasing margins and returns on capital under new management. Takeover news surrounding a handful of holdings--such as Station Casinos STN and Sallie Mae SLM--also boosted returns last year. Decker will still invest in controversy, but an increased focus on clean balance sheets and strong cash-flow generation should help the fund navigate the next market downturn better than the last. In fact, he used the fund's flexible mandate to add index puts to the portfolio in the second half of 2007 on concerns that the U.S. economy would slow.

Separate Account: Davis Real Estate
Like all real-estate products, this separate account has a low correlation with the S&P 500 Index. Managers Andrew Davis and Chandler Spears use an eclectic but cautious approach that focuses on REITs trading at discounts to their estimates of future cash flows. They are contrarians who'll also dabble in other security types when the opportunity arises. For example, they hold the convertible debt of Prologis, which owns industrial distribution sites around the globe. The risk/reward profile was right and the firm fits the duo's theme of firms benefitting from the expanding global supply chain, especially in China. They also recently took a small contrarian bet on bond insurer Ambac ABK. This offering has produced solid returns over time, and Davis is a top steward of investor capital.

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

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