Emotion Has No Place in Asset Allocation

In today’s issue, I interview Nathan Slaughter, editor of StreetAuthority’s Half-Priced Stocks. Nathan has developed a long and successful track record over the years by investing in deeply discounted value securities. Nathan uses advanced discounted cash flow techniques, along with a host of fundamental research, to uncover quality stocks that are trading well below their actual intrinsic value. Nathan’s educational background includes NASD Series 6, 7, 63, & 65 certifications, as well as a degree in finance/investment management.   

Nathan, what advice are you giving subscribers/clients to weather the current storm?

Many investors have never experienced a true bear market—particularly one as savage as this. Therefore, I’ve been prefacing recent newsletters with commentary meant to reinforce the fact that deep corrections and cyclical downturns are perfectly healthy and help keep the market from building up excessive valuations. Stocks have been through punishing sell-offs time and again over the years, and in every single case they bounced back stronger than ever. 

However, we’re not in the business of providing empty reassurances. So I’ve also been reminding readers that the specific catalysts triggering each bear market are different, and it can be dangerous to rely on past precedent. In short, stay informed to what’s moving the market, but don’t let panic invade your thinking—emotion has no place in asset allocation.    

Is your focus on safety or profits or both, and why?  

The two aren’t necessarily mutually exclusive, particularly considering how indiscriminate the selling pressure has been. 

Certainly, aggressive investors have their choice of speculative stocks that would be right at home inside a casino. But with the falling tide pulling virtually everybody down together, you’re just as likely to find financially sound companies with excellent earnings visibility in the same bargain bin. 

For example, we’re tracking several utilities and midstream energy partnerships, among others, whose underlying fundamentals are largely unimpaired. And with the shares sliding with the rest of the market, they now offer rich yields and highly attractive risk/reward profiles. 

Because our proprietary fair value modeling pinpoints under-priced companies trading at larger discounts to what they’re really worth, we believe that many stocks offering the widest margins of safety also happen to have the most promising upside potential.

What do you think it will take to inject confidence into the markets?  

Actions always speak louder than words. I think Warren Buffett’s bold (if opportunistic) decision to put billions into the market several weeks ago when tensions were running high helped soothe the market more than any rate cut or other coordinated action taken by the world’s central banks. 

Without a doubt traders are also closely attuned to the credit markets and looking for further indication that the financial rescue package is making an impact and working its way through the system. Many are also pinning their hope on a massive infrastructure-centric stimulus plan from the incoming Obama administration. 

Ultimately, though, everyday investors want to see concrete signs of a market bottom before they can invest with confidence. 

If you are shopping for a new home and find one that has been marked down from $180k to $160k to $150k, you still might be hesitant to act—knowing tomorrow it might be available for $140k. The fact that it just appraised at $200,000 doesn’t really matter. Likewise, compelling valuations haven’t been enough to attract buying interest and stop sharply undervalued stocks from sliding through the floor. But once investors realize that the worst is behind us, prices will rebound and fear will very quickly give way to greed.

Would you have voted for or against the last "rescue" bill, and why? 

Generally speaking, I think that overregulation puts shackles on free enterprise and tends to be counterproductive. In most cases, I’d prefer to see a laissez faire approach where capitalism can govern itself free of the restraints of heavy intervention. 

However, this particular crisis went well beyond the bounds of ordinary business and forced the government into unprecedented action to avert what could have been a global economic derailment. The web of mortgage-backed securities and credit default swaps became so tangled and the risk of counter-party default so great, that the collapse of one or two central players could have brought down the whole interconnected system. 

We got a small taste of that when credit markets froze up and even the most credit-worthy corporate borrowers had trouble accessing the commercial paper market. But it could have been much worse. Money lubricates the system, and when banks turn off the credit spigots and hoard their capital, it doesn’t take long for everything to grind to a halt. So, while nobody is enthusiastic about this bailout legislation, I do think the government acted for the greater good and did its part to avert a cataclysmic financial meltdown. 

What would be your fix for the financial crisis, and is a fix in this sector necessary to boost the markets?

There’s little doubt that the financial system is the backbone of our economy, which is why we’re in this mess to begin with. And considering the financial sector represents the heaviest market-cap weighting in the S&P 500 (about 16%) I don’t think the broader market can move meaningfully forward with this key group still lagging behind. 

Unfortunately, while the diagnosis is simple enough, coming up with a cure is a bit more complex. I think there’s plenty of blame to go around, from overreaching homeowners to lax mortgage lending practices to over-leveraged balance sheets. Hopefully this situation will curb some of the excesses that led us down this path, on both Wall Street and Main Street. 

I think we need to rein in some of the more exotic mortgage loans and adopt stricter lending standards (you can bet many already have). And while additional oversight is needed in some places, I would encourage the government not to lean too far in the other direction, particularly in being heavy-handed with social engineering legislation that makes it difficult for banks to turn away dubious subprime borrowers. 

Finally, spreads between the Libor and U.S. Treasuries are coming down, suggesting banks are finding it safer to lend to other banks. So I believe the credit markets are thawing and we’re already on the road to recovery. But to ensure that future periods of insanity don’t erase hundreds of billions in assets and cripple balance sheets, I think in certain circumstances we need to suspend rigid mark-to-market accounting rules—which only add fuel to the fire. 

What three stocks would you buy today?

Typically, value investors looking for bargains must often settle for troubled turnaround candidates or sluggish companies without any real growth drivers. But the beauty of this downturn is that even the most promising growth stocks have now slipped well into value territory—the best of both worlds. 

I’m concentrating a good deal of my analysis at the moment in the infrastructure sector—an area where both the United States and China will be spending heavily over the next few years. With demand for bridges, water treatment facilities, power transmission lines and other big projects on the rise, Fluor (NYSE:FLR) looks to be a key recipient. For now, the company has a $36 billion backlog of future work orders to keep it busy—and management has already upped its earnings outlook. 

Elsewhere, I expect some of the most unfairly punished companies to emerge as leaders during a recovery—and that includes real estate investment trust (REIT) Weingarten (NYSE:WRI). The company owns over 300 high-volume community shopping centers, most of which are anchored by recession-resistant supermarket chains such as Target. 

I like the firm’s highly diversified base of 5,400 tenants (none of which accounts for more than 2.5% of revenues) and its decision to team up with joint venture partners, which will free up capital and generate a recurring stream of management and leasing fees. Even during this downturn, the company has signed over 300 new leases (or renewals) over the past quarter at rental rates 14% above those from a year ago, while maintaining strong occupancy rates near +95%. 

Weingarten has also hiked its distributions for 23 consecutive years and now offers a generous yield near +12%. And given an ambitious development pipeline filled with promising new projects, shareholders should expect to be showered with cash for years to come.  

Finally, demand for oil may be soft at the moment, but there’s little to suggest this downturn is permanent. But even if it were, exploration and production companies would still spend billions each year to find and develop new offshore discoveries, which means steady business for well-placed companies like Transocean (NYSE:RIG).     

The deepwater drilling specialist locks up most of its rigs under long-term contracts and has already secured a reliable income stream over the next couple years. In fact, over 80% of the firm’s jackup (shallow water) fleet and virtually all of its deepwater and harsh environment rigs are booked solid in 2008, and many are tied up for 2009 and beyond—at day rates approaching $500,000 in some cases. Those fixed contracts will bring in $16 billion in cash flows, rain or shine. 

Though sliding oil prices have battered the stock, they haven’t dampened the firm’s outlook—profits will likely top out above $14 per share this year. But RIG can still be had for around four times trailing cash flows—a tantalizing multiple for a growing industry leader with a stellar return on equity near 40%. With a massive backlog, the best fleet in the industry, and huge new oil discoveries off the coast of Brazil and elsewhere spurring tremendous demand for offshore drilling activity, Transocean should be trading at a premium, not a discount. 

 How does your advisory service help its subscribers/clients get through times like these?  

Half-Priced Stocks is not a timing or swing trading newsletter that attempts to forecast every bend and twist in the market; nor do we seek out momentum plays that soar one day and then fizzle out the next. 

Our goal is to seek out wide-moat companies with sustainable competitive advantages that translate into superior long-term returns on capital. And from there, we only invest in underpriced candidates that are trading at discounts of -25% of greater to their underlying fair value. 

As a result, we steer clear of overheated flash-in-the-pan sensations and point our subscribers toward cash-generating machines that dominate their respective market, those poised to deliver market-beating gains for shareholders over the long-haul. 

Like everyone, some of our holdings have been stung during this downturn—often through no fault of their own. But other selections, such as Diageo (NYSE:DEO), Berkshire Hathaway (NYSE:BRK-B) and Monsanto (NYSE:MON),were all showing sizable gains in our last issue even after this historic pullback. 

As for the others, we worry little about day-to-day price fluctuations, as long as the company is matching the growth assumptions used in our discounted cash flow calculations. Why? Because if a company is performing well, sooner or later the shares always follow. 

Our readers understand that current market conditions have led to irrational prices totally disconnected from value. So we aren’t just looking to "get through" the current pullback—but to cash in on this rare buying opportunity and hit the ground running once the market recovers. 

If you had an investor standing in front of you, what would you say to him/her to ease concerns and raise confidence in the economy and markets?  

First, I would point out that both novice investors and seasoned pros tend to extrapolate based on what’s happening today. When the Dow vaulted past 14,000, many were already looking ahead to 15,000; when crude oil approached $150 per barrel, analysts were busy talking about $200 per barrel. Now that optimism has given way to pessimism, the reverse is also true—things aren’t as bleak as they seem. 

By all means, take steps to protect your assets, but don’t let fear of the unknown prevent you from buying some of the world’s most powerful companies at prices we may never see again. Because this recession, while painful, isn’t likely to persist beyond the next two to three quarters—and GDP growth could snap back smartly from there. 

Plus, most of the forced liquidations from hedge funds and other institutional owners (which exacerbated the sell-off) are now winding down, and stimulus packages around the globe should help expedite a recovery. 

In the meantime, remember that as a shareholder, you’re not renting a ticker symbol—but buying an actual business. Shares of DELL may be down 60% and fluctuating wildly, but patient investors can rest easy knowing that Dell the company is still shipping 140,000 computer systems around the world each day (1 per second) and churning out $2.8 billion in annual free cash flows.