Top Picks From Money Managers

In my last column, Buffettesque Superinvestors, I profiled 12 of my friends, all of whom manage hedge funds that have been beating the market and, in my opinion, will continue to do so because they manage money according to timeless principles of sound investing and have the necessary Traits of Successful Money Managers.

While SEC regulations prevent me from publicly disclosing the names of these managers, one of my readers emailed me a great suggestion: Why not ask them to share their single favorite stock pick? So, that's exactly what I did, and a number of them agreed to participate.

Without further ado, their picks are below, in their own words (in alphabetical order):

American Financial Realty
American Financial Realty
(NYSE: AFR  ) is a real estate company focused solely on buying bank properties from high-credit-quality financial institutions in sale-leaseback transactions. AFR has distinct competitive advantages: (1) its ability to acquire entire portfolios of properties and re-lease or sell any excess space; (2) no old portfolio positions that competitors paid dearly for in the late 1990s; and (3) a clean balance sheet that can be leveraged further.

I expect that the portfolio of properties, which currently generates about $1.00 per share of adjusted funds from operations, could more than double in the next 18 months, and I anticipate further growth over the next several years. I believe shareholders will be amply rewarded for this growth over the next several years, plus there's a 5% dividend to boot.

Aon Corp.
Aon
(NYSE: AOC  ) is engaged in insurance brokerage and consulting, which includes insurance and benefits and human resources outsourcing. The underwriting cycle for companies like Aon has turned for the better, yet the stock trades for about 10x 2004 projected earnings, 1.5x book value, and yields 2.4%.

I like to look at a stock's trough valuations for each of the last 10 years on a price-to-book and return on equity basis to come up with a benchmark price below which to purchase the stock. In Aon's case, the shares are selling for less than my 10-year downside benchmark buy price.

Cash
C-A-S-H. Yes, cash. While cash today generates interest income at an annual rate so insignificant that it's best left unmentioned, it has a redeeming (and often overlooked) quality: it carries negligible risk of large, unexpected losses -- something that I can't say today (at least not with a straight face) about many other kinds of assets (e.g., generously valued stocks).

When interest rates are as low as they are today, it takes only a slight increase in them to wreak havoc with the financial situation of a stretched-out borrower. For example, an increase from, say, 5% to 6% per year increases a borrower's monthly interest payments by a whopping 20%. Well, the United States of America, its government, and its people are all borrowing like there's no tomorrow. Household debt, in particular, is growing at an alarming rate.

What the ultimate consequences of this borrowing binge might be, no one really knows. But the risks and potential instability inherent in the present situation should be evident. Even the most rational, cool-headed person, when indebted to the hilt, will quickly become desperate in the face of even a mild financial setback. And desperate people do desperate things -- like, say, sell assets at any price to repay costlier debt to anxious lenders. A little setback here, a little setback there, and before your know it we could be facing an avalanche of desperate sellers. Having some cash in your portfolio (and an easily manageable level of personal debt) could provide a bit of cushion against it. You might want to think of a cash position as an insurance policy -- it seems unnecessary until you really, really need it.

Credit-default swaps
I recommend buying credit-default swaps (CDSs) on financial guarantee companies (such as Ambac (NYSE: ABK  ) ), as well as PMI (NYSE: PMI  ) , MGIC Investment Corp. (NYSE: MTG  ) , Radian (NYSE: RDN  ) , and XL Capital (NYSE: XL  ) . [Ed. note: Whitney Tilson discussed CDSs in an earlier column.] All of these companies are double or triple A rated financial institutions that have taken on new types of risks (in terms of severity, frequency, and correlation) over the past few years, yet have not priced these risks adequately in my opinion (it's hard to know for sure, as losses won't be known for several years).

Since they do not know their actual cost of doing business (losses), these companies are, I believe, making guesses that are overly optimistic, resulting in terrific (though artificial) reported profits. This behavior is hardly surprising, given that the companies' management teams have large incentives to manage earnings and ignore potential risks that have low frequency but very high severity.

The likelihood of significant future losses, combined with highly leveraged business models and balance sheets, makes these companies good candidates for severe financial distress at some point in the future. The best way to profit from this scenario is to invest a very small part of one's portfolio (perhaps 5% of total capital over the entire life of the contract) in five-year CDSs. If a credit event doesn't occur, one only loses 5%, but if one does, profits could exceed 20 times the original investment.

Del Monte Foods Company
Del Monte
(NYSE: DLM  ) is a high-quality, premium-priced branded food processor. Some 70% of its products are low-growth/high cash flow and 30% are growing more rapidly. It acquired a portfolio of neglected Heinz brands (i.e., Starkist, Kibbles `N Bits, 9 Lives, Pup-Peroni, Nature's Goodness) in December 2002 and is well on its way to improving quality, retail and distribution relationships, and advertising and promotion for all of them. The new Kibbles `N Bits dancing dog commercial has already had a positive impact on sales, and in 2004 Del Monte will be re-introducing 9 Lives' famous feline spokesperson, Morris The Cat.

With estimated cash flow of $175 million for the year ending April 2004 being used to pay down debt, a P/E of 11.9x and 10%+ earnings growth, Del Monte is a high-quality value stock with talented and experienced management.

Doral Financial Corp.
Doral
(NYSE: DRL  ) is the largest mortgage banking company in Puerto Rico, as well as a large and fast-growing commercial bank. The company maintains a very high-quality loan portfolio and has consistently grown 20% per year, driven largely by the substantial increase in construction and mortgage activity in Puerto Rico. Doral's mortgage business in Puerto Rico is driven by a severe, multi-year shortage of affordable housing that is not dependent on interest rates to spur demand. The company has a unique and powerful franchise and a top-tier management team that is driven to excel (they own approximately 20% of the company and have been buyers of the stock).

The company earned $2.72 per share in 2003, and earnings are expected to grow rapidly to $3.50 in 2004 and at least $4.25 for 2005. At around $31 per share, there are few stocks that I can think of with Doral's growth prospects and earnings visibility that are trading at less than 9x '04 numbers and approximately 7x '05 earnings.

Laboratory Corp. of America
LabCorp
(NYSE: LH  ) is the second-largest clinical lab company in the U.S., processing over 300,000 specimens per day for over 200,000 clients worldwide. The industry, which is growing at a fairly high rate due to the availability of more and better diagnostic tests and favorable demographic trends, remains highly fragmented, which provides the opportunity for continued growth for the top players by acquisition.

While both LabCorp and industry leader Quest Diagnostics (NYSE: DGX  ) are well-positioned, LabCorp looks like the better investment for two reasons: The stock is cheaper and LabCorp is aggressively emphasizing higher-value, higher-profit genomics-based testing.

Sales have nearly doubled from $1.6 billion in 1998 to an expected $3 billion in 2003. Meanwhile, operating cash flow has exploded over the same period, growing from $125 million to an expected $550 million or so. With a recent enterprise value of around $6.5 billion, LabCorp trades at about 15 times estimated 2003 free cash flow -- a reasonable price for a business that combines high profitability, stability, and excellent long-term growth prospects. I own both the stock and the January '06 calls, which are very cheap.

Washington Post Co.
I recommend Washington Post Co. (NYSE: WPO  ) , though not as a newspaper or media play. Rather, through Washington Post's ownership of Kaplan, this is one of the more interesting plays that one can make in the burgeoning for-profit education sector. This part of their business spans Kaplan's test preparation business and also includes bricks-and-mortar degree-granting institutions as well as online degrees. This is a business with a large and growing moat, which has the capacity to earn very high returns on a growing pool of capital for many years into the future.

All in all, Washington Post is trading at a modest discount to its intrinsic value, but it is an intrinsic value that is growing at a 15% clip, and is managed by some of the better capital allocators in the world. A dollar invested in 1994 has almost tripled in value. And Washington Post is not hard to value; management truly gives shareholders the information that they need to evaluate the company. They do a great job of helping to educate shareholders.

Conclusion
I think that these are all solid ideas. As a group, however, they are not incredibly cheap, which I think says a great deal about how unattractive the market for equities is today.

If you're interested in stock picking, The Motley Fool has a suite of newsletters offering our best investment ideas every month.

Whitney Tilson is a longtime guest columnist for The Motley Fool. He did not own shares of any of the companies mentioned in this article at press time (the disclosures in the text refer to the specific money managers), though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visithttp://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.


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