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With some data now emerging that suggest stabilization in the macroeconomic picture, investors are increasingly interested in finding the stocks and sectors that will outperform when a broad recovery from this deep recession finally arrives.

We thought it would be helpful, therefore, to convene a virtual roundtable with four fund managers to discuss (1) how the brighter macro picture impacts their methodology for stock selection, and (2) what specific stocks or ETFs their methods yield as top opportunities at this time. We published part 1 yesterday - here's part 2.

Participants:


Jeffrey Miller, PhD - President and Portfolio Manager at Chicago based New Arc Investments LLC


Sean Hannon, CFA, CFP - President of EPIC Advisors, LLC


Dr. Charles Lieberman - Chief Investment Officer for Advisors Capital Management LLC


David Hartzell - President and CEO of Buffalo, New York-based Cornell Capital Management



Mick Weinstein, Editor in Chief of Seeking Alpha

Part 2: Stock/ETF picks - What specific stocks or ETFs does this method yield as top opportunities for you?

Hartzell: We buy stocks for two reasons: either they have the capacity to grow over a 1/5/10 year cycle, or they pay a hefty dividend.Or, if we are lucky, both! An example of a growth stock we are buying is Medco Health Solutions (NYSE:MHS). Examples of dividend stocks we like are Buckeye Partners (NYSE:BPL), Diamond Offshore (NYSE:DO) and Surburban Propane (NYSE:SPH). All are solid companies, with dividends over 7%.

Weinstein: Dave, what in particular do you like in Medco as a growth stock now?

Hartzell: Although Medco (MHS) had a big run up 2009 (up over 65%) we feel it still has room to grow. Medco benefits by selling both brand name and generic drugs, so it profits no matter what the pharmacy companies decide to sell or the general public decides to buy. Medco is the nation’s largest pharmacy benefit manager, and has expanded worldwide. It has a solid balance sheet w/ cash reserves of about 2B, and continues to repurchase stock.While MHS is at $62 today (2/23) we see rising to $80-90 by 2014.

Weinstein: And why those particular dividend stocks?
Hartzell: All three pay outsized dividends. BPL is at 7.1%, SPH at 7.8% and DO at 8.3%. They all have solid balance sheets and enough top line growth top to make the story interesting. Lastly, all three are involved in finding (DO) moving (BPL) or selling (SPH) energy. It's just a matter of time before oil/natural gas/propane comes back, and when it does all three will push beyond their 2007/2008 pricing levels.
Lieberman: We are finding numerous excellent values in the sectors in which we want a heavier exposure. One example of this is in the cruise business. I wrote an article for Seeking Alpha that was published just last week on the merits for Royal Caribbean (NYSE:RCL). This gives us exposure to a company that is cyclically depressed (despite its sharp rise in 2009), offers plenty of upside, in a sector that should perform very well in a recovering economy, so we think we have many criteria to justify our investment.
Some specifics: the company should have earnings recovery that could yield profits of as much as $5/share in 2012, although something closer to $4 is more realistic. (For details behind the earnings estimate, see the Seeking Alpha story.) The cruise business is still developing, as most people have never taken a cruise, even though it is a very cost effective way to vacation. So, we think of this as a growth business, not yet mature. If we apply a forward market multiple of 15, this could be a $60 stock as we approach 2012, so nearly 2-1/2 times today's price. There are some risks, as mentioned in the Seeking Alpha piece, such a exposure to crude oil prices. If oil prices rise, that cuts into profit margins, although they will have some flexibility to raise prices, at least when economic conditions improve.

We also like the MLPs for income, although we stay away from them in IRA or other tax advantaged accounts because they pay out K-1's instead of 1099s and might expose clients to UBTI. Within this space, we prefer the pure pipelines and tend to stay away from the ones that take commodity risk or the propane companies. So, our picks are EPD, ETP, and KMP, with yields between 7% to 8% that tend to rise over time.

Hannon: As the economy starts to grow, there are two specific stories that will evolve. The first is to focus on those companies that have substantial fixed costs. When demand increases, the large fixed cost component will decrease as a percent of sales and give a tremendous boost to operating margins. Charles’ recommendation of RCL is an excellent example of this.

A company I like is Rock-Tenn (NYSE:RKT). RKT manufactures and sells packaging products. As the economy recovers and consumers start spending, RKT will see an increase in sales. Since it has a large fixed cost component in their operating business, this increase will improve margins and boost profitability. I believe the stock is worth $42 if business remains at current levels, but a strongly expanding economy could push the shares toward $50.

The second area to focus would be companies that benefit from a steep yield curve. With the economy growing and the Fed accommodative, the yield curve will remain very steep. This will be great for banks as growing employment alleviates the pressure from credit losses and a steep yield curve delivers tremendous profits on new business. I expect regional banks to be the main beneficiary and believe the SPDR KBW Regional Banking (NYSEARCA:KRE) ETF offers attractive returns.

Weinstein: Sean, the KRE is equal-weighted, while its peer IAT is market-cap weighted. Why KRE and not IAT - to give greater weight to the smallcaps?

Hannon: I prefer KRE for diversification benefits. With KRE, the largest weighting of any one company is 2.8% so you get a very broad allocation. IAK has 29% of the index in two banks (US Bancorp and PNC) and the top 10 holdings are 61.7% of the index. I view this as overly concentrated and believe IAK offers specific views on some of the larger regional banks while KRE comes closer to giving an allocation to the entire industry.

Lieberman: I agree with Sean that the banking sector will benefit greatly from the steep yield curve. However, smaller banks tend to have a very large fraction of their loan exposure to real estate, either residential or commercial. That's precisely why the FDIC takes over a few banks almost every Friday. Those banks are being closed for suffering too many real estate loan losses. With an ETF, you get exposure to all these kinds of companies, good ones and bad ones. I prefer to do the cherry picking.

One example is Bank of America (NYSE:BAC), which has a great retail franchise with about 10% of all the retail deposits in the country, but also has 25% of the residential mortgage business, plus Merrill Lynch. When the loan chargeoffs stop, which could happen within a year, they will have earnings capacity of at least $3/share, which conservatively implies a stock price of $30, but earnings could be higher and the multiple should also be higher.

Hannon: People do need to watch for the smaller banks, but that is where KRE helps. The ETF is made up of 50 banks with a weighted average market cap of $1.26 billion. Further, no one bank has more than a 2.8% weighting in the index. The regional banks have lagged the money center banks such as BAC and in a recovery environment where increased employment lowers credit losses the regionals will do very well. I also enjoy picking individual stocks, but KRE offers a diversified approach that should appeal to many investors that desire the exposure yet are uncomfortable picking individual stocks.

Miller:
While financial names are not traditional cyclicals, things really are different this time. There was a time when chip stocks were all seen as growth, not cyclical. We soon learned that was wrong. Many financial names are still fragile, and therefore sensitive to economic conditions. Sean and Chuck have a good theme with the focus on fixed costs.

Another way to look at this is to ask the question, What companies have great operating leverage? I wrote a piece on SA last October that suggested using the excellent transcript database to search for that term (or similar ones). The search generated seven names worth checking, but there are plenty more. It was just a starting point for your own research. Find the companies that are lean and mean, prepared to take advantage of an economic rebound. There are often comparative advantages in the same sector. FedEx has more leverage than UPS, for example.

Weinstein: Thank you everyone for participating.

Source: Recovery Investing: Stocks That Are Likely to Outperform From Here