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Three Picks for 2006

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January 3, 2006

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Well, the books are closed on the stock market for 2005. Most of the averages were up in the low-to-mid single digits with many sectors (such as energy) turning in impressive performances. However, that is now yesterday's story. As I look to 2006, I believe a combination of the slowing housing market, an income needy baby-boomer generation and high stock valuations will all serve as obstacles to any significant broad stock market gains in the next few years. While Peter Lynch said that he paid no attention to "economic trends", etc. in his stock-picking and predicting recessions is a particularly tricky business, he does have an interesting passage in his book about his first appearance on Louis Rukeseyer's "Wall Street Week" where he describes how he divided Magellan into two categories the aggressive (growth and cyclical) and the conservative and would rotate between them as appropriate. In early 2006, switching from aggressive to conservative definitely seems correct to me given that right now, many conservative stocks are also the most attractive ones available. I think investors who ignore this trend will come to regret it in the years to come. In my opinion, a good defense rather than a good offense is going to be the most important characteristic of investment success in 2006. Here are three "defensive" stocks that I believe are reasonably priced and should give investors reasonable returns in 2006 and beyond. I own all of these stocks.

Carolina Group (CG) (stalwart): This company's stock should probably be called "Lorillard" or "Newport" because it is meant to be tied to the performance of the Lorillard tobacco company which derives over 90% of its revenue from the sale of Newport cigarettes. Actually, the company is a "tracking stock" of Loews Corp, the insurance conglomerate. I am no expert on the "tracking stock" beast but the concept seems to create unique benefits and risks from the parent involvement. Fortunately, Loews' other businesses are healthy and they are committed to paying a nice dividend to the Carolina Group holders. I first became attracted to this company through a highly unscientific survey of cigarette trash in my area. Maybe Newport smokers are just big on littering but discarded Newport packaging seems to be everywhere where I live. It is true that on a market share basis, Newport is one of the few US cigarette brands to gain consistently in market share over the past decade. The stock is also pretty darn cheap. Lorillard has a total enterprise value of about $8.6B (including $1.7B in inter-company debt) and generates EBITDA of about $1.3-$1.4B and free-cash flow in the $750M range. For a company with a great operating history and a stable business, that is about as cheap as you will find. Additionally, a set of recent court rulings has made it harder for potential litigants to win their claims against tobacco manufacturers, which is one of the industry's biggest risks. Loews has been selling down its stake in recent years and perhaps one day will cut Lorillard loose. If this were a freestanding entity, I think it would be an 80-dollar stock. The company pays a 4.2% dividend. Catalyst: Improved litigation environment, potential for independence. Risks: Litigation environment, complicated tracking stock structure, one-product company.

Valero LP (VLI) (slow grower): With 10-year bond yields at 4.4% and major dividend stocks (e.g. REITs) yields shrinking by the day, does a company whose fortunes are tied to one of the largest (by revenue) and most essential companies in America (Valero Energy) and who pays a 6.7% dividend yield sound good? What if I told you that its affiliated company was a major acquirer of other businesses and assets which growth should directly benefit such company and that such company itself has made a significant acquisition of a highly successful company (Kaneb Pipelines) this past year? If that sounds interesting, please call 1-800-BUY-VALEROLP (just kidding) or execute a trade via your nearest broker. While sister company Valero Energy has been the highflying darling of the S&P 500 Index the last two years, Valero LP stock chart looks a lot more like a map of Delaware. That may be unattractive in a bull market but it starts to look a lot better if the market goes sideways or down. The company makes money through volumes shipped through its pipelines and at its associated refineries. With refining capacity being in such short supply, I doubt the company will have to lower its distribution any time in the near future. Of course like many other MLPs, it does pay out almost all of its cash flow and depreciation by way of distribution (currently $3.42/share/year). The MLP structure also serves to tax defer a large portion of the distribution (these stocks are better for a taxable account). Catalyst: Income seeking investors appreciate high distributions and defensive company characteristics; successful integration of Kaneb; Risks: Interest rate sensitive.

Southern Union (SUG) (asset play): Just like us investors, sometimes companies reap the rewards of successful acquisitions years after they are made. I think Southern Unions's acquisitions from the 2002-3 are about to breathe new life into this forgotten company. The first was the acquisition of Panhandle Eastern Pipe Line Company from CMS Energy. Panhandle includes several major pipelines as well as the Lake Charles LNG receiving terminal (one of four such LNG terminals in the US). The Lake Charles LNG facility is slated to complete two major expansions in 2006. The additionally capacity has already been contracted out to BG Group and should provide a nice boost to SUG's earnings. The second acquisition was that of the Transwestern Pipeline, the former crown jewel of the infamous Enron. SUG also recently announced the acquisition of Sid Richardson's natural gas processing and pipeline business, a natural fit with the Transwestern. While the market gave the Sig Rich acquisition a lukewarm reception, I believe it mostly has to do with the perceived lack of expertise in this area and a general cluelessness displayed on the conference call and not on the economics of the acquisition. The LNG terminal and the Sid Richardson businesses give the company some leverage to the price of natural gas. However, basically, these properties are simply highly stable and profitable business and combined with Southern Union's other regulated gas distribution businesses, I believe make this a very low-risk company. The company is led by the colorful George Lindeman, who has been very successful at running the company. Also the CFO just bought about $500K worth of stock and the company introduced a .40 cent/year dividend. With company earnings growing nicely and expected to exceed $1.60 next year, the current stock price presents a low-risk opportunity. I believe this set of high-quality stable businesses is worthy of a multiple closer to 18-20 or a roughly $30 stock price. Catalyst: Increased earnings from acquisitions, high natural gas prices; Risks: lower gas prices, lower equity valuations.

Happy New Year!


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