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Market Update

Clipper's Stock Model Says Tobacco Is Cheap, but Toys Are Pricey

Fund manager Michael Sandler says he's keeping Fannie, Freddie, and Philip Morris.

Is the stock market overvalued? Michael Sandler thinks so, although he also thinks he knows a stock or two that's undervalued.

Sandler comanages the Clipper Fund (CFIMX), one of the few funds to rigorously follow a value-based strategy in this growth market. He stopped by Morningstar's offices Thursday and talked about some of his top holdings.

Fannie Mae (FNM) and Freddie Mac (FRE), which buy mortgages and then resell them as securities to investors, have both been unjustly punished by the stock market this year because of concerns over rising interest rates, Sandler said.

In past periods of rising interest rates, the firms have performed well. Both stocks are still cheap based on Clipper's valuation model, which attempts to identify stocks that are trading at 70% or less of their true value based on future earnings potential.

Philip Morris (MO), the tobacco giant, has also been beaten up after numerous lawsuits were filed against the company. Sandler said litigation risk will always exist for the company, but investors' skepticism is overblown.

Based on 9% to 13% annual earnings growth, Philip Morris shares should be priced at $60 each, Sandler said. That's 60% higher than the stock's closing price Thursday. Even if you assume the company's U.S. tobacco operations are worth nothing, the stock's worth more than $40 a share, he said.

Clipper's valuation model did eject two toy stocks--Mattel (MAT) and Toys 'R' Us (TOY)--from the fund portfolio in recent months. Like many others on Wall Street, Sandler believes that Mattel overpaid for its recent Learning Company acquisition with undervalued stock and, therefore, diluted shareholder value. He also said the company wasn't doing enough overseas expansion and was missing out on a big growth opportunity.

Sandler said Clipper ran Berkshire Hathaway (BRK.B) through its valuation model, and although the stock has lost about a third of its market value since February, it is not yet cheap enough for his portfolio.

Sandler said he had trouble putting a rosy price tag on Geico, Berkshire's no-frills auto-insurance subsidiary, because of deterioration in its profitability as it aggressively goes after growth in customers. Plus, there's the wild card of how much the stock would drop should something happen to CEO Warren Buffett.

Still, Sandler estimated that Berkshire is fairly valued at its present price of around $55,000 a share.