Tuesday, December 21, 2004

Rising stars and black holes: a few tips for next year


By Stephen Schurr Financial Times
The markets' fate is written in the stars, and FT Wealth has brought together 12 seers to prognosticate and place their bets for 2005.

While members of our panel of money managers, newsletter scribes and strategists do not always agree, a few key themes emerge: rising interest rates loom large, and commodities and dividends look strong.

We have, by design, included a number of prominent bears in our panel. For wealthy investors, capital preservation trumps appreciation, so a little worrying is no bad thing.

Richard Bernstein, Merrill Lynch

Rich Bernstein is not afraid to make bearish calls. Last year, he pegged the S&P 500 to end 2004 at 890, a touch low. But Merrill Lynch's chief US strategist had impeccable timing in November 2003 to call the robust rally in energy stocks - making his clients a bundle of money in the best-performing sector of 2004.

His theme for 2005: get out of the Fed's way. "Alan Greenspan is open about warning people of the negative effects of tightening, and nobody is listening," Mr Bernstein says. "Risk-taking ventures are based on liquidity, and the most important central banker in the world is warning you should not do that."

The strategist recommends hunting for safe, dividend-paying stocks. Does he still like energy? "The long-term story on energy is still very much intact but it got very speculative very quickly."

The best sector bet this year, he says, will be utilities. "It is still the most underweighted sector in mutual funds and still the most shorted sector, in spite of the fact that it has performed so well."

Mr Bernstein offers two of his favourite utility stocks for 2005: Ameren, which sports a 5.1 per cent dividend yield that is secure and growing faster than inflation. The other pick is Dominion Resources, which offers a 3.9 per cent yield and "has a little energy kicker story in that they have an energy trading side".

Susan Byrne, Westwood Holdings

Susan Byrne, chief executive of Dallas investment firm Westwood Holdings, who also manages the Gabelli Westwood Equity fund, expects 2005 will look a lot like 2004. Technology will disappoint but fans of energy and industrials with clean balance sheets and fat dividends should be happy.

"A lot of investors have recently moved out of energy and industrials, thinking, 'I got that cyclical move'," says Ms Byrne. Except this is not a cyclical move. "You have had 50 years of domestic consumption make up the majority of GDP. In the past 18 months, that has not been true. Consumer spending has grown at 7 per cent compounded for 50 years. Now it is 2-4 per cent, which feels like a recession."

Driving the economy are goods, such as steel, defence equipment, tractors and copper, that are in short supply and high demand at home and abroad. Ms Byrne says the shift has not run its course. "When we look at valuations, it looks like the marketplace expects consumption and technology companies will come back, but there is no evidence of that at all."

She remains fond of the energy sector. She likes exploration companies such as Apache, Burlington and Kerr and is particularly fond of dividend payers ExxonMobil and ChevronTexaco. "Both these companies have used the excess cash they generate to pay off debts and pre-paid pension obligations. Now, they will show people what they have got."

Marc Faber, GloomBoomDoom Report

Marc Faber, Hong Kong-based money manager and adviser, is almost as well known by his nickname Dr Doom. A more precise description might be extreme contrarian.

Dr Faber remains saturnine on the long-term US outlook but says the view for 2005 is not clear yet because it depends on policymakers' actions. "If they print money like crazy, inflation will rise. If supply tightens, the dollar will strengthen. And you cannot have a strong economy and a strong dollar."

He is betting on some weakening of the US economy on the consumer side. He also believes the dollar rebound may be greater than many anticipate, even though "in the long term, I am not particularly comfortable with the state of the dollar".

What are the investment implications of this uncertainty? "In the absence of predicting boom or bust, deflation or inflation, you have to be positioned in assets that will do well under both conditions. Either way, you should be overweight Asia."

Dr Faber is especially fond of stocks in Malaysia and Singapore and he singles out BAT Malaysia, the well-run tobacco company. "The stock has more than a 5 per cent yield and the company is not sensitive to exports like much of Malaysia."

Dr Faber has turned bearish on industrial commodities such as oil and copper - "copper is probably a good short for the next six months". He is enthusiastic about agricultural commodities such as wheat, soybeans, coffee, and especially corn.

Larry Feinberg, Oracle Partners Larry Feinberg knows healthcare, having covered it as an analyst for nine years and having spent 16 years running long-short healthcare hedge funds.

Knee-jerk healthcare funds should sit up and take note: "For a long time, the smartest thing for healthcare investors was always to be long. Not any more," Mr Feinberg says. "The dichotomy between winners and losers has never been greater and there will be haves and have-nots in 2005 and 2006."

The key shift, Mr Feinberg says, is the move to consumer-directed healthcare, which will cause higher co-pays and deductibles. With soaring costs coming under pressure from the government and individual healthcare consumers, "healthcare is no longer a blank cheque book".

In Mr Feinberg's view, the haves are the companies that offer "must-have products", while the have-nots are the pharmaceutical companies loaded with "me-too products", for example, the six or seven different cholesterol drugs.

The good news is that the huge investment in biotech looks poised to explode, the bad news that the explosion of new drugs looks to be two or three years off. Mr Feinberg's fund is long "a few pharmaceuticals with must-have drugs, such as Novartis" and Bayer and "short everybody else".

For 2005, Mr Feinberg is extremely bullish on Elan, the Irish biotech company that, with partner Biogen Idec, recently won approval for its Tysabri multiple sclerosis drug. "This is my candidate for the biggest drug of all time," explains Mr Feinberg, saying Tysabri is at least twice as good as any other MS drug.

Fred Hickey, High-Tech Strategist newsletter

Fred Hickey is a successful newsletter writer but if he wanted to he could run a lucrative side business counselling recovering tech-stock addicts. After five minutes talking to him, you may never buy a technology stock again. He sums up his 2005 outlook succinctly: "Anti-dollar, once this little correction finishes. Long gold and silver, short tech."

From Mr Hickey's vantage point, the massive liquidity pumped into the system, the tax cuts and mortgage refinancings have only served to reinflate the market bubble. He believes this bubble popping will be more dangerous than March 2000. "This time," he says, "the economy goes down, the dollar collapses and the Fed has nothing left in its arsenal." When does he expect the reckoning? "It is days, weeks or months, but not years."

Even if one disagrees with his perspective, he makes compelling arguments for his 2005 pick. But first, he has a short-term choice: Google, based in part on the massive number of insider shares set to come on the market between now and February. Meanwhile, there is competition from Microsoft. And the fact that the internet is a rapidly maturing marketplace, estimates put the year-end internet population at 800m.

But his favourite for 2005 is another short-sell recommendation: eBay, whose stock has risen 82 per cent this year and 91 per cent in 2003. The company's growth is slowing: "Domestic auctions are down to 29 per cent last quarter from 40-something just a few quarters ago," Mr Hickey says. "This is not a triple-digit grower, yet it has a triple-digit price/earnings multiple."

Ben Inker, Grantham, Mayo, Van Otterloo

Ben Inker, director of asset allocation for Boston-based Grantham, Mayo, Van Otterloo, "is not expecting a whole lot for next year". Mr Inker's group, renowned for its rigorous research as well as its bearish view of the next few years in stock and bond markets, thinks financial assets around the world are overvalued as we face further monetary and fiscal tightening in the US. "We do not expect a horrific bear market but we also are not expecting a strong positive return from equities."

Grantham, Mayo places quantitative-based asset allocation over stock-picking and Mr Inker has a pick and a pan on that count. "Our favourite asset class is emerging equity, simply because it is cheap relative to everything else." Emerging markets are trading at a decent discount to non-US markets and "a very large discount" to US equities, Mr Inker says. The countries in which Grantham, Mayo are overweight are Korea, Indonesia and Turkey.

His pan turns out to be lower-quality US stocks, which as a short are "our single best investment idea. For 2005-2006 our highest-confidence bet will be that lower-quality stocks [those with low profitability, volatile profits and a lot of debt] will suffer." Eric Hovde, Hovde Capital

Hovde Capital, a Washington, DC-based long-short hedge fund, focuses only on financial stocks and real estate. But that has not hindered its ability to unearth plenty of smart bets for next year, on the long and short side.

Eric Hovde says the portfolio is net short, in part because of the outlook for interest rates and the economy. "I think the market will move up in the first few months of the year because of fund flows, then realisation will set in on rates and that [President] Bush will finally get serious about spending. The economy will weaken, and the market is going to have to adjust."

In this environment, Mr Hovde believes the greatest risk arises from the high-flying community banks and thrifts. He says investors looking for short opportunities "would not go wrong shorting a good percentage of these companies". Community banks and thrifts, he says, "have become the new technology - companies trading beyond any historical norm and yet the future outlook cannot get better".

On the long side, Hovde Capital likes Westcorp, a thrift with $15bn in assets that is "really an auto finance company".

The big risk for lenders to a debt-addled American consumer, of course, is that rising rates will push many borrowers to the breaking point. But Mr Hovde says Westcorp originates higher quality loans and are not trying to chase sub-prime credit.

Bob Howard, Positive Patterns newsletter

The value-oriented Bob Howard, a former Wall Street veteran now based in Missouri, offers a mixed assessment of the market. There is not much that looks cheap in US markets but he believes the commodity stock renaissance has not yet run its course. Still, the leadership may be shifting.

"It is obvious that in the last few years the 'inflation plays' have been a good place to be," Mr Howard notes. But, "we must remember that bull markets rotate. I believe this is the year timber stocks will shine."

Mr Howard says foreign demand for lumber "should show strongly over the next 24 months".

The timber stock with the most upside potential, Mr Howard says, is Rayonier Timberland, a well-managed company that has tremendous earnings leverage if timber prices move higher. With the stock below $50, it has "the potential for a double in the next 12 to 16 months".

John Connor, Third Millennium Russia Fund

John Connor's Third Millennium Russia fund has managed to notch up the best returns of any mutual fund over the past five years, averaging 35.8 per cent a year. While Russia has been uneven this year thanks to the Yukos saga, Mr Connor has managed to return 15 per cent so far because of bets in steel and fertiliser stocks and a lightening up on the oil sector. Looking to 2005, Mr Connor says Russia will remain a rollercoaster ride.

"If we get the Yukos thing behind us, we could have a very good year. If not, the Russian market will go sideways." But big opportunities remain in steel, agriculture and telecoms. He even recently took a position in Yukos. Mr Connor shrugs off the gloomy view that Russia is going to go after companies to nationalise them.

He also calls the fears that commodity prices have peaked "baloney". Indeed, he remains fond of several steel stocks, and high among them is Severstal. This steelmaker pays a 6 per cent dividend and is very well managed - Mr Connor calls chairman Alexey Mordashov "a genius". Bruce Berkowitz, Fairholme Capital Management

Bruce Berkowitz, founder of the $1.25bn-in-assets Fairholme Capital, says his number-one job is to not lose his clients money. "We are constantly thinking, what negative events can happen and how can we avoid them?"

Mr Berkowitz, who also co-manages the stellar Fairholme fund, says his biggest worry is rising interest rates. "Rising interest rates will affect the value of all things. Because of that, our portfolio is well-stocked with cash-rich companies ready to benefit from the inevitable fallout from higher rates."

His favourite is his fund's largest holding, an "out of favour" company called Berkshire Hathaway. Warren Buffett's property-casualty giant is sitting on $40bn in cash and equivalents, including $20bn in foreign currencies, so it benefits from a weak dollar.

While Mr Buffett's age has been an issue for investors, Mr Berkowitz says Berkshire is valued as if "Mr Buffett has already left the building". He pegs the stock's worth at a range between $85,000 and $135,000 a share. It is trading right at the bottom and looks poised to soar.

Mr Berkowitz says his firm has another key job, working out "how to make money after negative events have happened". He has a bet for that scenario in 2005 as well: telecoms services stocks, "the sector that will rise from the ashes".

Telecoms companies such as MCI are "vital to the national interest", he says. "Airplanes do not fly without MCI, the government does not work without MCI and AT&T."

Mark Haefele, Sonic Capital

Mark Haefele is confident the economy is improving and the market can go higher, but the co-manager of a Boston-based long-short hedge fund worries about the amount of leverage added to the system during the past downturn.

"We are watching the 10-year Treasury yield. It will eventually have to rise - depending on how far and how fast, things could get interesting."

Regardless, Mr Haefele sees a great future for steel. "When many people think of steel, they still think of rusting bankrupt mills. But bankruptcies have cut capacity and aided efficiency." Meanwhile, steel prices doubled in 2004 as worldwide demand surged. The skipper disagrees with those who think steel prices are due for a fall and says the robust environment has created many different opportunities in the sector.

Among the steel mills, Mr Haefele likes Bayou Steel, which trades at a low single-digit P/E, and among the processors and manufacturers Olympic Steel, Metals USA and Insteel.

Russell Platt, Dividend Capital Realty Income fund

While a housing bubble may burst in 2005 or 2006, it is of little concern for Russell Platt, long-time real estate investment trust investor and chief investment officer of the Dividend Capital Realty Income fund. Mr Platt thinks conditions are ripe for another decent year for Reits - "8 to 10 per cent returns".

Mr Platt is shying away from the mortgage Reits and remains bearish on the suburban office market, where vacancies remain high. But he believes the hotel real estate market holds promise and he offers an aggressive and a conservative pick.

The aggressive pick is LaSalle Hotel Properties, which owns high-end hotels in big business cities - "cities that show the best occupancy rates". The stock has a P/E of about 15 and earnings are expected to be strong in 2004 and 2005. "It is both a macro-economic and business travel play," and it is boosted by a 3 per cent dividend yield.

Mr Platt's more conservative bet is Kite Realty, a landlord in the retail sector that went public this summer. Kite's strength lies in being a developer as well as a manager - identifying strong locations and bringing in the right tenants. The stock yields 5.1 per cent and, with a P/E of 14, "it is a good deal cheaper than some of the big names that have done well already".

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