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Pay Close Attention to Valuations

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello, my name is Nadia Papagiannis, Alternative Investment Strategist at Morningstar. Today, I have with me Brady Lipp, Portfolio Manager of the Quaker Akros Absolute Strategies Fund ticker symbol AARFX. Thank you for being here with us today Brady.

Brady Lipp: It's a real pleasure, Nadia. Thank you for having me.

Papagiannis: Brady, the stock markets have enjoyed a real good run over the last couple of months especially in December and January. Is this a sign to investors that a lot of the worries are over and they should pile back into equities again?

Lipp: Well, I think that its reason to be cautious actually, the incredible run that we've had. But having said that I think the market conditions are still such that there are plenty of good opportunities in the equity markets. It's a time that I think investors can be involved and still feel comfortable, but it's certainly not without risks. And if you are asking me whether or not investors should throw caution to the wind, I am saying definitely not.

Papagiannis: What are some signs then that we might need to take some caution?

Lipp: Well, one of the things that we've kind of taken a look at is you know from an overall investment process perspective. We spend a lot of time kind of developing a risk assessment of the macro environment and certainly the economic news has been favorable over the course of the last several quarters, and it is probably going to continue to remain favorable going forward.

On the other hand, there is significant fiscal concerns that are out in the marketplace right now.The problems for example, that some of the European governments have been well documented and have been talked about quite a bit. There has been a lot of discussions about what's going on from fiscal perspective at the Federal government level here in the U.S. We are bumping up against our $14.3 trillion debt ceiling that's going to have to be dealt with some time here in the first half of the year.

Your state, the State of Illinois, my state, the State of New York are for all practical purposes broke. And you've got a number of states and municipalities are going to have fiscal issues, they're going have to be dealt with. So, for those reasons I think that you need to concerned and…

Papagiannis: But we knew all of this last year, so what's different about now?

Lipp: I think, the thing that's little bit different is stocks are more expensive today than they were a year ago. I think expectations today are a little bit higher than they were a year ago. If you take a look at the sentiment indicators for example, which is something that we do pay some close attention to, you are starting to see many of these types of indicators that are reaching levels that we've seen historically at market tops.

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Papagiannis: Do you have an example?

Lipp: One index that we follow pretty closely is the Daily Sentiment Index, which keeps tabs of the bullishness and the bearishness of non-professional futures traders and that figure recently hit 94%, meaning 94% of these types of traders are bullish and those are kinds of figures that you typically see near market tops.

Investors Intelligence is another group that does surveys of investors and that level has recently hit levels that we saw in late 2007, near the market top. If you take a look at mutual fund investors, mutual fund managers the portfolio managers themselves have a record low level of cash positions right now, again quite similar to the kinds of things that you would typically see at market tops.

Now, these indicators in themselves are not perfect market timing mechanisms by any stretch of the imaginations because these types of indicators can stay at elevated levels for period of time, but all I am saying is, it's reasons that investors still need to be cautious looking forward.

Papagiannis: So, if the indicators, these contrarian indicators are pointing to, we need to dial down our equity risk, where are the opportunities to be made in equities?

Lipp: Well, I really think that, we're going to enter into a period of time, where stock selection is going to once again become a lot more important than it's been over the course of the last couple of years. One of the things that's really been interesting about this market rally that we've had since the bottom in March of '09, is that it's been a rally that's been led by lower quality, higher risk type stocks.

Normally, when you come out of a major market bottom like we had in March of '09, you have this reversion of the mean phenomenon, a rubber band effect if you will, where stocks that had dropped the most during that bear market are the ones that snap back the most, which is definitely intuitive when you think about it.

Now, normally when that type of thing happens, that type of low-quality rally or higher-risk rally relative to say for higher-quality names will generally run for about a year. In this case, we are coming up on the two year anniversary of that cyclical bear market bottom and we're still seeing a lot of these higher risk, lower quality, high beta type stocks being massive outperformers. There's become a real dichotomy now from valuation perspective.

Papagiannis: How are you taking advantage of that in your funds?

Lipp: The way we are taking advantage of it and the way that we think we can make money in 2011 by being involved in the equity market is by buying high-quality blue-chip names that have great balance sheets, in many cases have dividend yields. I am talking about companies like Microsoft, that is just a premier dominant company with a great balance sheet, a 2.6% dividend yield and its selling at 11 times earnings. Company like Intel, which dominates their segment of the marketplace again, selling for roughly 11 times earnings with a 3.2% dividend yield, great balance sheet.

You've got a company in the medical area like Medtronics for example, that we think can grow their earnings at maybe 12% a year over the course of the next three to five years, medical devices are going to be in high demand as baby-boomers age and you have the stock selling for about 12 times earnings and there has been heavy insider buying. They've got maybe 60 new products that are coming on-line over the course of the next several years. We think they have the opportunity to grow and they are selling at reasonable prices.

So, the way we are trying to take advantage of it is we are trying to identify some of these companies that we think offer compelling opportunities with P/E ratios that vary from say 8 to 12 times earnings, but still have reasonable growth rates and we are offsetting that type of position, with short positions in higher beta, higher risk, lower quality type companies and segments of the market.

Papagiannis: What might be an example of that?

Lipp: Well, one example I could use for example is we're long Microsoft which I've just given you the investment thesis for Microsoft. They've been pretty innovative with some of their products. This new Kinect product that you've been reading about in the papers that was such a huge hit during the holiday season is just one example of new products that they are going to be unveiling over the course of the next couple years. They also have the kind of balance sheet that gives them the flexibility of potentially making a strategic investment or to make a special cash dividend payment like they did a few years ago or to continue on with their share buybacks that have been going on.

We've got that offset with a higher priced, higher risk stock like for example which has been a tremendous performer over the course of last couple of years but one that we think is massively overpriced relative to something like Microsoft. I think that's probably the most dramatic example that I could give you of the kinds of strategies that we're trying to employ in this fund.

Papagiannis: You talked about dividends, seeking dividends is that important to investors it is coming out here?

Lipp: It is right now and the reason for it is because we think that investors should have lower return expectations. It wasn't that long ago when everybody was expecting 15% or 16% compounded annualized rates of return, we think going forward that overall returns in the equity markets could be much lower. I'm talking maybe 5% to 7% going forward and if that's the case, a 3% or 4% dividend yield can represent almost half of your total return.

So, dividends are important, there is still tax advantage at least for the next couple of years and one of the other strategies that investors can use with some of these larger cap names is they can also complement the dividend yield by selling call options and collecting premiums on those call options over the course of time if you're very disciplined about doing that month after month. You can actually squeeze another eight to potentially 20% yields from the option premiums to go along with your dividends and to me I think that makes a lot of sense and I'd feel much more comfortable doing that type of strategy than being a bond investor for example right now where yields are very low and I think your capital risk is definitely there with bonds as well.

So, I think it's a great time to be in equities. The point I'm trying to make is that I think investors are going to be rewarded if they pay closer attention to the valuations that they are paying for,  and not to rely on this reversion to the mean action that we've seen in a lot of high momentum, high risk segments of the market.

Papagiannis: So, Brady Lipp here with Quaker Akros Absolute Strategies telling us about his strategy of going long high-quality stocks, going short low-quality stocks but also paying attention to dividends and writing covered cost. Thank you very much Brady.

Lipp: Thank you, Nadia.