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Three Big Themes Can Spell Opportunity for Investors

Pat Dorsey, CFA

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. People often ask me what themes we're seeing in the market, since I'm looking at the output of all 90 analysts that we have, covering 1,800 companies.

So I thought I'd talk a little bit about three big themes that are giving us a few investable ideas right now, that might give you some thoughts on new purchases for you portfolio in a market where, frankly, there are a lot fewer attractively priced stocks then there were, say, a year ago.

One is health care, where we've talked a lot in the past about how attractive we think health-care stocks are and the degree to which they're probably pricing in a much worse reform environment then is actually coming to pass.

But there's sort of an interesting under-the-radar thing that is happening in health care that I don't think is being recognized as well, which is that the stimulus bill from last year actually contained a fair amount of funding for life sciences research--the kind of stuff that the National Institutes of Health disperses a lot of money for.

The NIH disperses about $30 billion a year most years for life sciences research to university labs and all kind of places for basic research into the way our bodies work and making new drugs, and that sort of thing.

Interestingly, the stimulus package had $10 billion--$10 billion on top of the usual $30 billion--of incremental funding for life sciences research. This has not been dispersed yet. We think it will probably flow through the system to life sciences research labs in the next few quarters. And who this really benefits is companies that sell the picks and shovels, if you will, to life sciences research labs.

You might think of kind of like DNA sequencing companies like Affymetrix and Illumina. Companies like Agilent, which has about a third of its sales coming from life sciences research. All three of those companies are not terribly attractively priced right now, but worth keeping an eye on in case we get a downdraft in the market.

The one that's cheap, and we think will really benefit from this trend is Thermo Fisher, a company I've talked about in the past, which is a merger of Thermo Scientific and Fisher a couple of years ago, that really sells a lot of basic equipment, both on the consumables side and kind of the big-ticket side into life sciences labs.

And given that life sciences labs have had such tight budgets over the past year, given how rough the economy was last year, we think there's a fair amount of catch-up spending to be done. So this extra $10 billion coming from the NIH could really benefit Thermo Fisher's bottom line. TMO is a name you would look at to take advantage of this extra spending on life sciences research from the stimulus package.

Another theme we're looking at is consumer credit, and the degree to which it's improving. Looking at the master trust data, which is basically data filed by all big credit card lenders, whether they're a standalone like Capital One or inside a large bank like JP Morgan or Bank of America.

Looking at this data, we think the peak in consumer charge-offs and consumer credit is either here now or has just passed. That means basically the earnings power for credit card companies like Capital One and Discover, two big stand-alone companies, should really begin to shine over, say, the next four to six quarters.

You're going to see provisioning come down, and that's really going to see earnings power to shine through. And so we'd take a long, hard look at both Capital One and Discover, both names we think are very, very cheap right now, to take advantage of this probably unrecognized and not-priced-in scenario of declining charge-offs and rising earnings power.

And then finally a third theme to look at it earnings power at big banks, which seems to be under-recognized by the market right now. Investors like to typically anchor on things, they like to sort of have mental models of the ways things will look in the future. And what they often do, of course, is look at history for the way things will look in the future.

The problem is, especially for the big banks, right now history isn't a very good guide, because you had two very anomalous periods in the recent past. You had anomalously good times in 2004, 2005, and 2006, and then you anomalously bad times in 2007 to 2009 in almost all of the big banks.

Plus most all the big banks, all of them pretty much, did big mergers at that point, over the past couple of years. J.P. Morgan bought Washington Mutual, Wells Fargo bought Wachovia, Bank of America bought everybody under the sun. PNC bought National City.

What that means is, it's very hard to get an easy feel for what they're going to look like going forward in terms of their earnings power. And we think many investors are really anchoring on these bad times recently and underestimating their earnings power, frankly.

Right now at Wells Fargo, for example, we're seeing a lot of revenue synergies at Wachovia branches. Wells has always been a master as cross-selling, and we're seeing that now at the Wachovia branches with many more products being sold to existing customers.

It's a fascinating thing. I was out in San Francisco last week talking to some asset managers, and every single time I brought up Wells Fargo, every single person said, "What about Wachovia? Isn't Wachovia and that bad loan book just going to blow up on them? They bought Golden West and, my gosh, that's going to be terrible."

Well, Wells wrote down most of that loan book when they bought them. They bought Wachovia and wrote off a lot of the nastier securities and nastier loans that were on the book. And in fact, they were so pessimistic at the time of that purchase, they've had to write up some of them over the past year.

And so again, you've had this, I think, misguided opinion of the market, that there's this ticking time bomb sitting in Well's balance sheet that frankly we just don't think is there. So Wells is a company we would look at. We think it's probably got $4.50 to $5 of earnings power going forward. On a $30 stock, that looks pretty cheap to us.

J.P. Morgan is not as cheap, but Jamie Dimon has obviously steered it very well through the crisis. Bank of America is a lower-quality institution; forward-looking returns on equity are definitely going to be lower than they have been in the past. But below book value, we think one of the nation's largest banks, with that huge source of low-cost deposit funding is probably going to be an investment that's going to make investors a decent amount of money going forward.

Those are three themes to look at: incremental funding to life sciences companies, declining consumer charge-offs, and the earnings power of big banks, with a few investment ideas in each.

I'm Pat Dorsey, and thanks for watching.