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Our Take on the First Quarter

The Fed steps into the storm; stagflation worries persist.

John Coumarianos, 04/01/2008

In the first quarter of 2008, the financial markets struggled with a continuing credit crisis that appears to be the worst since the savings and loan debacle of the early 1990s. Financial stocks continued to falter almost across the board, though J.P. Morgan Chase JPM managed a 7.6% gain for the quarter through March 24 as the government approved its purchase of investment bank Bear Stearns BSC (for what now appears to be $10 per share) in an effort to put Bear's obligations in the hands of a solvent party. The operations of the large investment and commercial banks are intertwined, making the failure of one to meet its obligations a potentially system-crippling event. In the face of the credit contraction, a slower economy, and declining corporate profits, the Morningstar US Market Index was finishing the quarter down 7% to 8%.

Besides encouraging the buyout of Bear Stearns, the Federal Reserve lowered the federal funds rate from 4.25% to 2.25%, lowered the discount rate (the rate at which a limited number of institutions can borrow directly from the Fed) from 4.75% to 2.5%, opened the discount window to investment banks, and reduced the capital holding requirements for Fannie Mae FNM and Freddie Mac FRE. Fed Chairman Ben Bernanke has struggled to provide liquidity in order to encourage borrowing and lending without stimulating inflation. Oil exceeded $100 per barrel during the quarter, and commodities in general surged, magnifying the potentially inflationary results of Bernanke's rate cuts. High oil prices tend to encourage inflation, since they raise the cost of almost every good and service, but they also tend to depress the economy, as they soak up more and more of consumer and business spending. Therefore, observers wonder if Bernanke will be able to avert the dreaded stagflation (simultaneous declining growth and higher prices) of the 1970s.

The Fed's rate cuts had a positive effect on bond prices, and the Morningstar Core Bond Index rose about 3% for the quarter through March 25. (Bonds offer a fixed coupon, for which investors are willing to pay more principal as interest rates decline.) By contrast, high-yield bonds declined as investors sought the safety of lending to the government. The Merrill Lynch High Yield Master II Index dropped nearly 4% for the quarter, and the "spread" (the difference in yield between high-quality and low-quality bonds) has steadily increased, as investors are refusing to risk the same principal they were last year for the comparatively dicier coupon payments of these bonds.

As is often the case, skittish markets brought out the inner bulls of some top investors. First, two of Morningstar analysts' favorite stock funds, Dodge & Cox Stock DODGX and Longleaf Partners LLPFX, reopened to new investments as the managers of these venerable offerings think they see bargains in the market's wreckage. Second, although Berkshire Hathaway BRK.B still sits on roughly $25 billion in cash (accounting for reserves the firm requires to meet its potential policy payouts), the firm's legendary CEO Warren Buffett spent nearly $5 billion to acquire the Pritzker family business called the Marmon Group. He also purchased shares in GlaxoSmithKline GSK and Kraft Foods KFT, both of which Morningstar analysts think are undervalued and trade in 5-star territory. Finally, Morningstar's market valuation graph indicates that the market (consisting of our 2,000-plus stock coverage universe) is 14% undervalued, while wide moat stocks are 17% undervalued. It's been a painful quarter, but we think it's time to be buying stocks.PAGEBREAK

Surveying the Sectors and Industries
Among the sectors, telecommunication stumbled the hardest, dropping more than 12% for the quarter through March 24. Sprint Nextel S dropped a whopping 50% over the same period, as the firm lost customers and suffered declining revenue from existing customers. Nevertheless, analyst Michael Hodel notes that the firm's free cash flow actually increased in 2007 on reduced capital spending. Hodel thinks the firm is well capitalized, and it can make necessary improvements to customer service. Based on his fair value estimate for the firm's shares, the stock is a significant bargain at its current price of about $6.50.

The best sector was consumer services, which was roughly flat for the quarter through March 24. Surprisingly, homebuilders such as Pulte Homes PHM and D.R. Horton DHI were at the top of the sector's charts, posting 47% and 28% gains, respectively. Somewhat less surprisingly, discount retailers Ross Stores ROST and TJX Companies TJX also posted strong gains of 20% apiece, as consumers downshifted to off-price stores. Because of their recent surges, none of these stocks currently trades in 5-star territory.

Among the industries, managed care plunged 30% on the threat of a cyclical downturn and political fears. However, analyst Matthew Coffina thinks UnitedHealth Group UNH is significantly undervalued at its current price of about $35 per share. He cites the firm's network effect as the basis of its moat. UnitedHeatlth connects 70 million U.S. customers to a health-care network that includes 560,000 physicians and 4,800 hospitals nationwide. Customers and providers each seek the firm out for access to the other, giving the firm bargaining power and allowing it to pass cost savings on to customers.

Along with homebuilders, title insurance was at the top of the industry performance charts, surging 22% through March 24. Just as some homebuilders remain in or close to 5-star territory, despite their run-up, title insurer First American FAF also remains a bargain, just below analyst Jim Ryan's $37 per share consider buying price. Ryan notes that First American has overcome rival Fidelity National Financial FNF in market share, though it has lower margins. The firm has successfully restructured a bit, shedding some management fat and trading higher-paid workers for lower-paid employees overseas. Still, Ryan isn't thrilled with First American's plans to spin off its data services business, though he thinks the cyclical title business will retain its narrow moat rating because of the barriers to entry in the form of licensing requirements the government imposes on competitors.

It will be interesting to see whether the builders and other housing-related stocks have turned the corner for good in the immediately upcoming quarters or whether they continue to trade periodically at prices that represent discounts to our analysts' fair value estimates.

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