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Feb. 5, 2010, 11:22 p.m. EST

Barron's 2010 Roundtable, Part Three -- The New Normal

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By Lauren R. Rublin

YES, IT'S A YEAR -- and maybe a decade -- for belts and suspenders. It began with a bang, as the bull whizzed past Go without even pausing to pick up his $200. Then stocks suddenly stumbled and tumbled, as Wall Street woke up to the economic messes both here and abroad.

The members of the Barron's Roundtable warned it wouldn't be smooth sailing for the market -- or investors -- when these Street seers met Jan. 11 with the editors of your favorite newsweekly. No surprise, their concerns about the economy and the markets, aired in the past two issues of Barron's , underly their investment recommendations for 2010, in particular those of this week's stars: Bill Gross, Meryl Witmer, Fred Hickey and Archie MacAllaster.

Bill, head honcho at Pimco, the bond powerhouse in Newport Beach, Calif., begins the proceedings with a description of what his firm calls "the new normal" -- slower growth in the years ahead than the abnormal growth of the mid-2000s. Accordingly, he emphasizes "stable, conservative income generation" -- and several bonds and exchange-traded funds that offer appropriately juicy yields.

Meryl, a general partner of Eagle Capital Partners in New York, canvasses the earth for intriguing investments, and that includes what's inside it -- namely, salt. This year she shares her upbeat and well-researched views not only of a leading salt producer, but a German biotech outfit and several undervalued insurers.

Fred Hickey is the New Hampshire-based editor of the High-Tech Strategist. Just don't mistake it for bedtime reading, or you'll never fall asleep. Fred says he's sworn off short-selling in a world in which central bankers print money, though that is a decision he may yet regret. Instead, he's buying gold stocks big and small, for the coming "crazy" stage of the gold rally, and a handful of technology companies whose true value inexplicably remains hidden.

Few folks know their way around financial stocks as well as Archie MacAllaster, head of New York's MacAllaster Pitfield Mackay. The Roundtable ends, in print and person, with his astute analysis of several beaten-up banks and insurers, some selling nicely below book value, whose glory days might not be over, no matter the market's current view.

Barron's : Bill, given your concerns about the economy, where would you invest this year?

Gross : Pimco is a "new normal" company. We believe the new normal means slower growth in the years ahead, including the second half of 2010. There are three reasons for this. One is deleveraging -- paying down debt -- a process now under way. No. 2 is re-regulation, which hasn't taken place yet. No. 3 is de-globalization. Various countries around the world will produce slower growth than what we've grown used to, and this leads to lower returns on assets. We are beginning to see evidence of these things in the bond market, where yields on 10-year Treasuries are around 3.5%. The G7 economies [economies of the world's most industrialized nations] could grow 4% to 5% in the first quarter or half of 2010, so the new normal isn't an immediate outlook. It is a longer-term, you-better-be-careful type of outlook.

roundtable three

A year ago Pimco's recommendation, and mine, was to shake hands with the government -- that is, buy what the government was buying. The U.S. and other governments have purchased $1.5 trillion to $2 trillion of assets, which has propelled not just the bond and mortgage markets, but all asset markets higher. In a sense, the global economy has been salvaged, and we are all the better for it, at least in the short run. This morning we talked about the possibility that government stimulus ends. In that case, all investors, not just bond investors, should seek safe-harbor assets and be careful about which government they shake hands with. Money should gravitate away from governments that abused their deficit privileges, such as the United Kingdom and maybe the U.S., to those such as Germany that have much lower deficits. All risk assets have benefited tremendously from the liquidity push. From this point forward, be careful if liquidity is withdrawn in the U.S. and U.K. A bird in the hand -- that is, dividends -- is to be favored relative to the growth rate in the bush. In both fixed income and equity, look to stable, conservative income generation.

Where do you expect to find it?

Gross : Despite my criticism, my picks are U.S.-oriented and speak to generating stable income in two ways. The first is through closed-end funds that, as a class, can benefit by using leverage. They can borrow 35% to 50% of the value of their assets at near-zero percentage rates, and reinvest in their asset class at 5%, 6%, 7%, 8%, even 9%. This isn't a time to leverage up but a time to use mild leverage if you can benefit by being a borrower as opposed to a saver. We like Reaves Utility Income /zigman2/quotes/203557525/composite UTG +0.24% Fund [ticker: UTG]. Utilities are a stable source of income, although they have had ups and downs. Electric utilities currently yield about 5%, plus or minus. I know nothing about Reaves from a management standpoint, only that the closed-end fund has a market value of about $500 million. They did well in the past 12 to 18 months. They weren't forced to liquidate any positions. The fund yields 7.25%, compared with 4.5% to 5% on most electric utilities.

Bill Gross

How does Reaves manage that?

Gross : The extra comes from borrowing at near-zero and investing at 5.5%. And dividends are taxable at only 15%. Is this a perfect investment? Will it let you sleep at night if we have another crisis? No. But it is a decent way to generate income in a slow-growth environment where the premium should be on stability.

What would happen if interest rates rose?

Gross : That's not good. The dividend would become less safe, and maybe vulnerable. We are forecasting that the Federal Reserve keeps interest rates in the 1% range for the next 12 to 24 months. At some point, investors, or even Main Street, may force the Fed to give them something more. Most of the time we view rates from the standpoint of what borrowers and banks need in order to regenerate capital. Rate policy is never determined by the yield Main Street needs on CDs [certificates of deposit] in order to survive. At some point there could be a compromise, but it isn't one the Fed is used to making or even thinking about. Interest rates can't stay at zero forever, but they are going to stay low for a long, long time.

Does Reaves sell at a discount to net asset value?

Gross : It sells close to net asset value. My next pick is Pimco Corporate Opportunity /zigman2/quotes/200556932/composite PTY -0.44% [PTY], a closed-end fund. Don't place an order the day these comments are published. The same goes for Reaves. These are thinly traded issues, and you don't want to overpay if people bid them up. I have recommended Pimco Corporate Opportunity in the past. I have been managing the fund for six months or so, but I've been watching over the nest like a mother hen for a long time. The market cap is $1 billion, and the fund invests primarily in investment-grade corporate bonds. About 20% is in less-than-investment-grade bonds, but this isn't a junk fund. It is a high-yield fund. The typical investment is in shake-hands-with-the-government-type bonds, issued by the likes of AIG [American International Group /zigman2/quotes/203700638/composite AIG +1.06% ], Sallie Mae /zigman2/quotes/205828282/composite SLM +1.32% [SLM] and GMAC. These companies are either mildly government-sponsored or government supported. This closed-end fund has tripled in the past 12 to 15 months. Shares have gone from about 5 to 15. But here's the key: It yields close to 13%. That includes a special dividend. Dividends are determined by the board.

Bill Gross's Picks
Closed-End Funds Ticker 1/8/10 Price/Yield
Reaves Utility Income Fund /zigman2/quotes/203557525/composite UTG UTG $19.14/7.5%
Pimco Corp Opportunity Fund /zigman2/quotes/200556932/composite PTY PTY 14.60/13.0
BONDS
GMAC 8% due 2031 $95/8.5%
AIG 8.25% due 2018 93/9.1
Source: Bloomberg, Pimco

Cohen : What is the yield without the special dividend?

Gros s: The special dividend was 58 cents a share. The regular dividend is $1.38, so the 12-month yield based on that is about 13%. Next, I have two bonds, including one I recommended last year. Some problems in the bond market have to do primarily with the terrible performance of the rating agencies. Not only didn't they downgrade debt in a timely fashion, but having downgraded, they don't upgrade when circumstances change. Take GMAC. It is 54%-owned by the government, which has invested $20 billion in the company. To think the government is going to let GMAC go down the drain when it has 20 billion bucks to lose is sort of a stretch. Yet because GMAC was associated with General Motors, which defaulted, Standard & Poor's downgraded its credit to triple-C. [S&P upgraded GMAC'S debt to B last Wednesday.] Most investors can't invest in triple-C-rated debt.

MERYL WITMER
General partner,
Eagle Capital Partners, New York ARCHIE MacALLASTER
Chairman,
MacAllaster Pitfield MacKay,
New York FRED HICKEY
Editor, The High-Tech Strategist,
Nashua, N.H. SCOTT BLACK
Founder and president,
Delphi Management,
Boston, Mass. FELIX ZULAUF
Owner and president,
Zulauf Asset Management,
Zug, Switzerland BILL GROSS
Founder and co-chief investment
officer, Pimco, Newport Beach,
Calif. MARC FABER
Managing director,
Marc Faber Ltd., Hong Kong ABBY JOSEPH COHEN
Senior investment strategist and president,
Global Markets Institute,
Goldman Sachs, New York OSCAR SCHAFER
Managing partner,
O.S.S. Capital Management,
New York MARIO GABELLI
Chairman,
Gamco Investors,
Rye, New York

Witmer : Such restrictions aren't the rating agencies' fault. They are investors' fault.

Gross : That's true. We like the GMAC 8% due 2031. It was a $5 billion issue. The bonds yield 8.5%. That is a lot for a company that is 54%-owned by the government. What would investors pay for Fannie Mae [FNM] and Freddie Mac [FRE] debt? They are 90%-owned by the government. But the rating agencies never downgraded Fannie or Freddie, for fear the government would run the agencies out of town. Instead they downgraded GMAC and AIG, another bond I'm recommending, which created huge disparities in the market. Fannie and Freddie 10-year paper yields about 4%, whereas GMAC and AIG yield 8.5% to 9%, simply because the rating agencies don't think they are in the same situation. But they are close to the same thing, when you think about.

MacAllaster : Do you like bank preferred?

Gross : I recommended bank preferred stock last year. As a class it was trading for 60 to 70 cents on the dollar. Now many preferreds are trading at par, or 100, but they are still good investments. I have many bank preferreds in my personal portfolio.

My last pick is an AIG issue, the 8.25% due 2018. They yield 8.5% today. AIG has received billions of dollars in government support. The government has invested $45 billion in AIG preferred stock. With that kind of support beneath you , it is a comfortable situation, especially given the yield. The government put billions of dollars more into companies like AIG than it ever put into GM.

There is a difference. Saving General Motors was a popular idea. It kept workers on the job. That's not the case with AIG.

Gross : All I'm saying is the government would lose almost $50 billion if it decides AIG no longer is worth supporting. It is a game of chicken. You either call the government's bluff or you don't.

Faber : Would you buy other AIG bonds?

Gross : Debt of the holding company is the safest. Probably the best value are bonds of AIG's International Lease Finance.

Faber : GMAC also has an 8% of 2018 that seems to yield even more.

Gross : If you are more conservative, go with the 2018.

Thanks, Bill. Meryl, you're on.

Witmer : My first pick is Compass Minerals /zigman2/quotes/201885435/composite CMP -1.31% [CMP], which trades at 72 a share. It has 33 million shares and debt of $500 million. Recently volatile results in potash have obscured the long-term positive trends in its salt and potash operations. Compass owns perhaps the best rock-salt mine in the world, in Ontario, next to Lake Huron. The reserves are huge, and unlike most salt mines, capacity can be increased easily due to the width of the salt seam. Compass expanded this mine from 2.5 million tons in the 1980s to seven million tons, and it is expanding it to nine million tons. Transportation is cheap and easy over the Great Lakes, to the snowbelt states.

Compass also owns mines in Louisiana and the U.K, and evaporation facilities in the U.S. and Canada to produce consumer and industrial salts. These are used in food processing, water softening, chemicals and agriculture. Compass has the leading consumer-salt brand in Canada, Sifto.

Meryl Witmer

Is the salt market growing?

Witmer : Volume usage grows just 1% to 2% a year, and pricing grows about 3% a year. But Compass' revenue has grown 11% a year, and its profit 14%, since 2003. That is because the company has one of the only easily expandable mines, and captures most of the growth in the rock-salt market. The salt industry has consolidated, with just a few players selling a product that is economic to sell only to a limited geographic area.

Compass also produces sulfate of potash, or SOP. It is a specialty fertilizer that typically sells at a premium of $150 to $200 a ton to commodity potash. This potash is used to grow green vegetables, avocados, pecan and citrus trees, potatoes and other specialty crops, which account for 4% of harvested acreage in the U.S. but 40% of crop value. It isn't used on commodity crops such as corn, soybeans and wheat. Compass produces about half its potash at the Great Salt Lake, using solar and wind evaporation. It is expanding its evaporation ponds, and has leases on virtually all the commercially viable SOP production areas of the lake. It also has a nascent document-storage business in the U.K., with virtually unlimited storage capacity in an old salt mine. That could become a very valuable business in its own right.

Tell us about earnings.

Witmer : There is some variability due to the weather and potash pricing. Compass should earn about $5.20 a share for 2009 and $6 this year. The company has earnings power of $8 to $9 in 2011 or 2012. The stock sells for about 72. My earnings estimates reflect capacity additions, normalizing potash volumes and small price increases in salt. Every 10% increase in the price of salt yields $2 more in earnings.

MacAllaster : What is the earnings breakdown between potash and salt?

Witmer : It depends on potash prices, but it is about one-quarter potash and three-quarters salt. Compass should trade at a minimum of 13 times earnings. Our one-year target is 100 a share, or more.

My next pick is a Dutch insurer, Delta Lloyd [DL.The Netherlands]. It trades in Amsterdam at 17 euros [$23.57] a share. It came public in November at €16, with Aviva /zigman2/quotes/210517151/delayed UK:AV +2.84% [AV], the U.K. insurance company, selling 41% of its stake. It still owns the rest. There are 166 million shares. The company caught my attention as a potential investment when, on the roadshow, the CEO said "we will be delivering sustainable value for shareholders through a long-term focus." That means "we will make you money and pay it out in dividends." That's the kind of guy I like.

What sort of insurance does it specialize in?

Witmer : It operates under Delta Lloyd, OHRO and ABM Amro. Life and pension insurance account for 75% of its business. It also has an asset-management arm that manages its own assets and retail mutual funds. Its core markets are the Netherlands and Belgium. It has a strong focus on costs, and capital strength. Ninety percent of core capital is tangible. And Delta Lloyd has great risk management. The company has grown 10% a year in the past decade through organic growth and acquisitions. It has a 30-year exclusive agreement with ABN Amro. In general insurance, it has strong niche positions, and with the Dutch government withdrawing from some income and disability coverage, that opens opportunities in private insurance. Delta Lloyd could earn about 13% over time on tangible book value, or €2.60 a share. It should trade at 10 to 11 times earnings. Our one-year target is €26 to €28 a share.

Genworth MI Canada [MIC.Canada] is another insurance company. It trades on the Toronto Stock Exchange. Genworth Financial /zigman2/quotes/204924015/composite GNW -7.68% [GNW] took it public July 7, as the U.S. company needed capital.

MacAllaster : Genworth Financial used to be owned by General Electric /zigman2/quotes/208495069/composite GE +0.67% [GE].

Witmer : Genworth Canada insures consumer mortgages in Canada, whose residential market is safer than ours. It isn't overbuilt. Lenders have had tougher underwriting standards because they retain most of their mortgages. Proof of the difference can be seen in 90-day delinquency rates. In Canada they are below 0.5 basis points [half a percentage point], and in the U.S. they are over 400 basis points.

The Canadian consumer also is different from the U.S. consumer, and not as comfortable with debt. The mortgage borrower is on the hook for life, and the insurer can garnish his wages in perpetuity. The only way to escape a secured loan is by filing for bankruptcy, and in Canada little in the way of owned assets are retained. Also, given Canada's national health system, there are few medical-related bankruptcies. The competitive dynamic is different, too.

How so?

Witmer : Genworth Canada's main competitor is CMHC, a Crown [government-owned] corporation. Before the financial crisis, Genworth Canada had grown its market share to nearly 50%. Then it lost share, partly because it was owned by a U.S. parent with a low stock price. Even though the companies were separately regulated, lenders were concerned. Plus, the Canadian government guarantees 100% of CMHC's insurance policies but only 90% of Genworth's. As fear of implosion recedes, Genworth Canada is regaining market share. And, there is a chance Ottawa brings its guarantee to 100% for all players in the market. Genworth Canada could earn 2.50 Canadian dollars to C$2.80 a share in 2010, and the stock is C$26. It should trade at 10 to 11 times earnings and earn about C$3 a share in 2011. Our target is C$34 to C$37 a share. The stock yields 3.4% and the dividend may increase soon.

Meryl Witmer's Picks
Company Ticker 1/8/10 Price
Compass Minerals /zigman2/quotes/201885435/composite CMP CMP $73.81
Delta Lloyd DL.Netherlands €17.16
Genworth MI Canada MIC.Canada C$26.00
Stewart Info Svs /zigman2/quotes/209524552/composite STC STC $11.13
Biotest BIO3.Germany €37.51
Source: Bloomberg

Schafer : Mortgage-interest payments aren't deductible in Canada.

Witmer : Good point. Canadians are incentivized to pay down their mortgages, and they do. My next stock is Stewart Information Services /zigman2/quotes/209524552/composite STC -2.11% [STC], which trades around 11. Stewart is one of three major title-insurance companies in the U.S. The others are Fidelity National /zigman2/quotes/207569682/composite FNF -1.66% [FNF] and a soon-to-be-spun-off subsidiary of First American /zigman2/quotes/210452372/composite FAF -1.71% [FAF]. Title-company results have been poor in the past three years due to losses stemming from fraud and poor underwriting in the mortgage-boom years. Before that, underwriting losses averaged around 5% of premiums. It was a nice business. The industry has taken most of the hit with regard to losses bubbling up from the past. More important, the regulatory pendulum is swinging in its favor, and properly so.

How do you mean?

Witmer : Title companies can write business directly or outside agents can write the business, giving title insurers a negotiated percentage of the premium, usually 10% to 30%. Some states have mandated increases in the percentage of premium kept by the title companies. Also, state insurance commissions are putting through rate increases for title insurers because they want the companies to have increased liquidity. They want no chance of another title company going bankrupt, because the states would have to backstop the policies and their own budgets are in deficits.

Stewart also has a hidden asset: tax benefits. The company said it has a $35 million refund from the extension of net-operating-loss carrybacks enacted by the Obama administration. It should have about $75 million in all, worth about $4 a share. Add that to tangible book value of $11.50 a share, and you get a true book value of $15.50. The business should earn 10% to 15% on book and have normalized earnings of $1.50 to $2 a share. At 11 a share it is a real value. Our price target is 15 to 20.

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