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
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.
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.
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.
I recommend buying credit-default swaps (CDSs) on financial guarantee companies (such as Ambac
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
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.
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
While both LabCorp and industry leader Quest Diagnostics
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.
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.
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.
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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, visit http://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.