Ramblings of a Portfolio Manager

Dear Investor:

After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?

We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.


Barron's(8/8) Attention, Shoppers. It's Time To Buy

12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.