Anatomy of a Bargain: Diamonds Trust

Judging from the valuation of its underlying holdings,  Diamonds Trust (DIA), an exchange-traded fund that tracks the Dow Jones Industrial Average, looks very cheap to us. As of Feb. 7, 2008, the fund was trading at a hefty 17% discount to our estimate of the portfolio's intrinsic worth. That's the cheapest the fund has been since September 2002.

Bargain-Hunting
Where are the bargains? You don't have to squint very hard to spot them in the fund's portfolio: 18 of Diamonds' 30 holdings were trading at least 15% below their intrinsic worth as of Feb. 7, and 13 of those names were at 20% or greater discounts. Only two names-- McDonald's (MCD) and  AT&T (T)--were hovering at, or slightly above, fair value.

All told, 19 of Diamonds' 30 names garner 4- or 5-star ratings from our analysts and none carries fewer than 3 stars.

Diamonds: Good as Gold?
But does that make the fund worth buying? To answer that question, we have to evaluate the portfolio's risk, as the fund's riskiness will determine the discount to fair value we'd demand before recommending it.

So what about Diamonds' risk? Generally speaking, the portfolio has a pleasing risk profile. Many of the Dow's components--which include the likes of  Microsoft (MSFT),  Wal-Mart (WMT),  3M (MMM), and  Citigroup (C)--are among the highest-quality firms that we cover. Most boast competitive advantages of some sort. In fact, our analysts have awarded wide economic moat ratings to 21 of the fund's holdings, which collectively soak up around 72% of assets.

Not coincidentally, there are very few businesses in the portfolio that we'd consider excessively risky. Our analysts consider 13 of the fund's 30 holdings--representing roughly half of the fund's assets--to be below-average risks. And the only two names that pose above-average risk-- Altria (MO) and  General Motors (GM)--account for only 7% of assets. The portfolio is also well-diversified across stocks and industries. For instance, IBM sits alongside  ExxonMobil (XOM) in the portfolio's upper rungs. That diversification has kept a lid on volatility.

Given this, we wouldn't demand a significant margin of safety before recommending Diamonds, as the fund doesn't pose extreme risks. We'd be buyers anytime the fund traded at an 8% or greater discount to our fair value estimate.

In that light, the fund positively gleams, as it was recently trading 17% below what we think it's worth. That affords a margin of safety, and plenty more.

What the Market Is Missing
Still, the question naturally arises: What's the market missing? Why are these names so cheap?

With that in mind, we thought we'd take a deeper dive into the portfolio to examine what's driving the fund's valuation. We canvassed our analysts to get their take on what's creating the disconnect between our assessment of these businesses' intrinsic worth and the value the market is pricing into the shares. We've set forth their capsule summaries below.

You'll hear a few recurring themes: One is that while economic weakness is likely to weigh on some of these firms' results in the near term, that doesn't have a disproportionate impact on our fair value estimates. Why? We think that the best measure of a firm's value is the cash flow it produces over the long haul. Although some market participants view "long" in relative terms (i.e., two quarters from now), our analysts forecast results over many years. This affords us the ability to look beyond near-term murkiness and focus on enduring sources of value creation--such as whether a firm possesses a durable competitive advantage and what benefits it's likely to confer many years hence.

Also, many of these firms do a lot of business abroad. For instance, in 2006, the top eight names--IBM, ExxonMobil,  Boeing (BA), 3M, Altria,  United Technologies (UTX),  Caterpillar (CAT), and  Procter & Gamble (PG)--realized a whopping 62% of their net revenue outside of the United States. The market seems to be discounting these firms' global diversification--and the superior growth that many developing markets are likely to furnish in the future--in its rush to sell.

Here's our analysts' take on some of the Dow's cheapest names.

 IBM (IBM) (6.79% weighting | 0.85 price/fair value)
Analyst Rick Hanna thinks the market is pricing a recession into IBM's shares but not considering the recurring nature of the revenue from the company's software and services units, which comprise approximately 60% of IBM's business. What's more, businesses still appear willing to continue to spend on information technology to grow, reduce costs, and develop new capabilities. That has benefited IBM's services businesses, which have shown strong year-over-year growth, short-term bookings, and total order backlog. In addition, Hanna expects IBM to exploit several pockets of growth within the information technology universe, including storage and a high-end server product line. Finally, Hanna points out that the opportunities in information technology are global, a fact underscored by IBM's European and Asian revenue growth, which has been roughly triple that of its domestic business.

 Boeing (BA) (5.29% weighting | 0.70 price/fair value)
The market continues to focus on the possibility of further production delays of Boeing's game-changing 787 Dreamliner, the first commercial airplane made mostly of lightweight composites. And although analyst Brian Nelson thinks further delays are more likely than not, concerns over penalty payments and cost overruns are severely overblown in his opinion, throwing by the wayside both the stability of Boeing's defense business and the strong demand for its in-production commercial airplane programs. Boeing is also being weighed down by concerns over a potentially deteriorating global economy, which would increase the likelihood of cancellations or deferrals by airplane customers. However, even after factoring in an aggressive cancellation rate, the jet maker would still have about four to five years' worth of deliveries in a backlog that is much more geographically diverse than it has been in years past. Finally, Nelson thinks the market is heavily discounting expectations for double-digit earnings-per-share growth over the next three years and a return to normalized free cash flow, which, when achieved, would imply a double-digit free-cash-flow yield at the current share price.

 3M (MMM) (5.25% weighting | 0.82 price/fair value)
Although 3M's 2007 results reflect a continued slowdown in U.S. sales, the firm's international operations remain strong. Analyst Adam Fleck acknowledges that a potential economic recession could materially weaken much of the firm's consumer-product-driven business. But Fleck notes that many segments--especially the firm's health-care and safety, security, and protection units--enjoy more inelastic domestic demand and account for a much larger piece of the company as a whole. Similarly, Fleck believes 3M's international supply-chain improvement initiatives will continue driving solid growth abroad. Finally, with returns on invested capital north of 20%, Fleck thinks the conglomerate can make bolt-on acquisitions relatively cheaply during a downturn, ensuring further long-term success.

 Johnson & Johnson (JNJ) (4.17% weighting | 0.79 price/fair value)
Analyst Damien Conover believes the market is focusing on Johnson & Johnson's patent expirations within its pharmaceutical business and missing the strength across several of the company's other business segments. Although Conover expects patent losses on antipsychotic Risperdal and neuroscience drug Topamax will slow the company's growth in the near term, he expects Johnson & Johnson's leading position in several other health-care businesses to offset this weakness. In particular, with the purchase of Pfizer's consumer health-care business, Johnson & Johnson is well positioned in the consumer care industry.

 American International Group (AIG) (3.43% weighting | 0.62 price/fair value)
Analyst Matt Nellans contends AIG's stock-price decline largely relates to the panic-selling across the entire mortgage market. True, AIG has invested billions of dollars in mortgage-backed securities and written credit default swaps on securities collateralized by subprime mortgages. However, Nellans believes the market is ignoring the fact that the vast majority of AIG's exposures have plenty of subordination--that is, mortgage defaults must be catastrophic for AIG to incur a permanent capital loss.

 Wal-Mart (WMT) (3.31% weighting | 0.83 price/fair value)
In analyst Joseph Beaulieu's opinion, Wal-Mart currently has two major problems: Its core customer is a bit light in the wallet, and its apparel and housewares businesses suffer from poor merchandising. The first problem isn't permanent, and the second is fixable. Another factor that people tend to overlook is that while Wal-Mart has pledged to rein in new store growth, the company can't turn on a dime given the sheer amount of time it takes to identify sites, obtain the required permits, and build a store. In the interim, while the company generates massive amounts of operating cash flow, much of it will continue to go into new stores. Over time, however, more of this cash will be freed up for other uses, such as addressing the company's aforementioned merchandising problems. Beaulieu thinks that if the company can solve its merchandising problems and slow new store additions to prevent cannibalization at existing stores, earnings, operating cash flow, and free cash flow should improve sharply. He also points out that if we're moving into a period of higher inflation, there isn't any retailer in the world that's in a better position to force suppliers to eat their share (and then some) of those price increases. That's where Wal-Mart's wide moat could really come to the fore.

 American Express (AXP) (3.08% weighting | 0.66 price/fair value)
In the U.S., you can get a credit card from multiple providers, and your bank won't always be your first choice. The large banks are among the largest card issuers, but American Express is putting up a decent fight. Card companies have been in the hot seat lately, as many investors became concerned about their prospects following the mortgage debacle. After all, why would people keep spending money on their credit cards if they cannot afford their mortgages? Although these are legitimate concerns, analyst Michael Kon thinks they are short-lived. Even if the U.S. slips into a recession, the long-term prospects of the card companies aren't as bleak as many expect. Credit quality of card loans is going to deteriorate and growth will slow over the next five years, but Kon points out that we account for all of that in our models and we still think that the card companies trade below the value of the cash flow we expect them to produce in the long run. What's more, AmEx has seen a gradual shift away from travel and entertainment related expenditures (which are more cyclical by nature) toward everyday consumer needs, such as gas and groceries. That spending should, we think, help buffer AmEx somewhat from a consumer-spending slowdown.

 J.P. Morgan Chase & Co. (JPM) (2.99% weighting | 0.72 price/fair value)
Although J.P. Morgan didn't do much wrong in 2007--it posted its best year ever--its stock has been dragged down by association anyway. Analyst Ganesh Rathnam does not expect the bank to emerge from the industrywide downturn unscathed, explaining why he has factored losses into his valuation of the bank's shares. J.P. Morgan chief Jamie Dimon's leadership has been prescient in avoiding the subprime trainwreck. Rathnam believes that Dimon's astute management and foresight will help the bank weather the downturn far more successfully than its peers.

 Alcoa  (2.18% weighting | 0.73 price/fair value)
Alcoa is in the midst of a large-scale reorganization that will focus the company on its core businesses of alumina mining and aluminum smelting. In the process, the company has dumped poor-performing business units at attractive prices. This provides the double whammy of improved profitability going forward as well as a hoard of cash to repurchase shares. In analyst Scott Burns' view, the impact of these moves has created financial statements that can be best described as "muddled" and that mask the firm's improved overall long-term position. On top of this restructuring, the industry also continues to consolidate, benefiting Alcoa by not only helping firm up aluminum prices, but also by making the company a potential target itself.

 Microsoft (MSFT) (1.87% weighting | 0.80 price/fair value)
Microsoft's sheer size has prevented it from exploiting new opportunities fast enough to react to emerging threats (e.g.,  Google (GOOG) is now the dominant search engine). However, the software industry is in perennial change, and advantages can shift. New trends like the software-as-a-service (SaaS) model (in which applications are delivered on demand over the Internet and customers pay for software usage instead of owning it) present a new set of opportunities and challenges. For instance, analyst Toan Tran thinks because it would cost billions to provide SaaS on a large scale, there are tall barriers to entry to that business, and Microsoft, with its huge war chest, could exploit that. Although Tran is pessimistic on Microsoft's hostile bid to acquire Yahoo (and is likely to cut his fair value estimate for Microsoft if the deal is consummated), the shares still look cheap.

 Walt Disney (DIS) (2.11% weighting | 0.79 price/fair value)
In addition to creating great content, Disney has been very successful in exploiting that content through box office and home video sales, television network licensing, sequels, theme park attendance, and merchandising. As content migrates to digital platforms, Disney looks to find new ways to attract and retain customers. To that end, the firm has been very aggressively distributing its content through its own Web site and third parties such as iTunes. The market, however, is preoccupied with Disney's other major media property, ABC. The rise of cable television, the emergence of the Internet, and the proliferation of DVRs is leading to lower ratings for the major networks, including ABC. The ongoing writers' strike is likely to depress earnings as well. However, analyst Larry Witt estimates that ABC represents less than 10% of Disney's operating income and is not a significant driver for his fair value estimate.

 Home Depot (HD) (1.89% weighting | 0.65 price/fair value)
While analyst Brady Lemos thinks the slowing housing market could pressure Home Depot's shares over the next few quarters, he expects the retailer to weather the storm and emerge as a more-dominant force in the home-improvement market. Lemos believes that by updating its stores and adding more full-time sales associates, Home Depot is positioning itself for profitable growth over the long haul. In Lemos' view, Home Depot has one of the widest economic moats in retail thanks to its scale advantages and prime real-estate portfolio. These competitive advantages should help protect the firm in the event of an economic downturn, and reap dividends once the housing market rebounds. The market is currently pricing virtually zero growth into Home Depot over a three-plus-year time horizon, and that view is far too bearish in Lemos' book.

 Citigroup (C) (1.77% weighting | 0.56 price/fair value)
Analyst Ganesh Rathnam believes the market is missing the forest for the trees in its valuation of Citigroup shares. No doubt 2007 was a miserable year for the bank, as its internal controls failed spectacularly. All told, the bank wrote down its subprime securities to about 40 cents on the dollar, raised capital to strengthen its balance sheet, and retrenched its workforce to reduce expenses. Although the losses and capital infusions did destroy economic value, Rathnam believes the market is discounting in much steeper losses than is warranted, presenting a great buying opportunity for investors in the process.

 Pfizer (PFE) (1.50% weighting | 0.73 price/fair value)
Analyst Damien Conover believes the market has placed too much emphasis on the company's weak Phase III pipeline and patent losses on several blockbusters. While he expects Pfizer will likely generate flat to slightly down top-line growth over the next 10 years, Conover believes the company can employ external strategies to grow sales. With more than $22 billion in cash, Pfizer can acquire growth opportunities through acquisitions. Through internal advancement and acquisitions, Pfizer's Phase III pipeline should grow over the next 18 months. This should increase the market's cash-flow projections and boost the firm's stock.

 Intel (INTC) (1.33% weighting | 0.77 price/fair value)
Intel has further cemented its dominant position in the microprocessor market over the past year, at the expense of smaller rival  Advanced Micro Devices (AMD). After several quarters of strong PC demand, there are fears that we will now begin to see a cyclical slowdown in the industry. Nonetheless, analyst Andy Ng believes that the processor market should continue to see decent growth over the longer term, especially from emerging economies around the globe. Ng thinks that Intel's wide moat, combined with recent cost-cutting efforts, will allow the firm to generate impressive profits for years to come.

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