Dispassionate, Disciplined Investing

It's difficult but the best approach amidst a rocky market and bad corporate news, says Michael Farr of Farr, Miller & Washington

In this down-trending market, investors should be dispassionate in appraising stocks, advises Michael K. Farr, president of investing firm Farr, Miller & Washington. He recommends a disciplined approach to value and believes that if there's organic growth in a company's basic business, share prices will provide a reward in time.

Farr notes the difficulty of maintaining a disciplined approach in the emotional environment that can follow bad news -- such as the recent negative notice in regard to American International Group (AIG ), which is one of his holdings. "We're not rushing to add to the position today," says Farr. Longer term, he still sees value in the investment.

Among the stocks Farr likes are Kohl's (KSS ) and Wendy's (WEN ) in the consumer sector, Pfizer (PFE ) in pharmaceuticals, CVS (CVS ) and Walgreen (WAG ) in drugstore chains, and IBM (IBM ) in tech. He sees IBM as poised to benefit from a revival in corporate spending.

These were some of the points Farr made in an investing chat presented Mar. 31 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a complete transcript at keyword: BW Talk.

Q: Michael, first, as usual, we need your assessment of this every-which-way market.


I'm not sure that the direction has been every which way. It more feels like it has been down. The S&P and Dow are both down for the year to date for the first quarter, though the economy is growing at an above-long-term trend rate, corporate cash flows are high, S&P earnings are expected to grow somewhere around the 8% to 10% range this quarter.

So while the fundamental news is reasonably good, the market seems to be drifting lower on fears of the twin deficits [budget and trade] and the high price of oil, as well as the prospect of rising interest rates.

Q: It seems investors are also following some grim headlines, like the news surrounding American International Group, Biogen Idec (BIIB ), etc. How can investors shake the bad news and focus instead on fundamentals?


There seems to be no end in sight for these unfortunate corporate surprises. The difficult decision that the investor has to make is a disciplined one -- it's made difficult because these news stories often create an emotional response. You get upset at AIG and Hank Greenberg. It's important to stop and see if the current valuation of a stock, post-bad-news, seems strong and is above or below average. It's very difficult to be that disciplined, but it's still important to do the research to assess your position in a stock in a dispassionate manner.

Q: What should investors do if they hold AIG? I note you listed it as one of your top 10 stocks for 2005.


We do own AIG. The first thing that investors need to do is try to assess the situation as best they can, given the information available in the public domain. It's important to realize that maybe all of the bad news is not yet in the public domain.

That said, the balance sheet of this company is exceptionally strong. They have $83 billion in equity. The charges that they may have to take are estimated to be around $2 billion. The stock has always traded at a premium to the financial industry, but no longer. At 11 times '05 estimates, with earnings growth in the double digits (around 12% to 13%), this company, we continue to feel, will provide very good value over the long term.

We're maintaining our position. That said, we're not rushing to add to the position today. Short-term could be dicey, but we're not short-term investors so that doesn't bother me too much.

Q: In this down period, what has your strategy been for the money your firm manages?


Prayer! The strategy really has been to take the advice I've just been offering. Check and recheck our discipline, check our numbers, and be as dispassionate as we can about the really fine companies that we own.

We tend to own companies that have lower-than-average levels of debt, higher-than-average levels of earnings growth,...higher-than-average returns on equity. And as we continue to see organic growth in the basic businesses that we own and invest in, we feel comforted even when the stock prices aren't moving in our direction. As long as those fundamental values are increasing, we're confident that the market share price will recognize those values in time.

Q: Can you update us on some of your favorite holdings? Last time you were here, you said you liked financials and health care.


Well, let's add to that list. I continue to like some of the tech stocks, and in addition, I like some consumer stocks. In the consumer sector, I continue to like Kohl's and Wendy's. Kohl's has really undergone a successful turnaround, with earnings growing around 15% per year, priced [at] 21 times earnings -- that represents a good value.

Wendy's share price has come off its highs as a result of any number of factors, not the least of which is the unfortunate finger incident in California [a customer found a partial human finger in her bowl of chilli], as well as the higher price of beef and the price wars going on in the fast-food chains. Wendy's has very strong management, and they continue to execute their plan very well. We feel there's a good deal of unrecognized value.

All of these stocks are that we will buy in portfolios that we manage. We don't sell research. The things we find we consider valuable for our own portfolios, and you should seek counsel before you include them in your own.

That said, Pfizer continues to provide value in the health-care sector. I think Johnson & Johnson (JNJ ) is still a good value at these levels -- no longer a great value. It has moved up since we last spoke. Among the techs, I like IBM (IBM ) a good deal. It's almost a $150 billion company that's well diversified and broad-based. I think that IBM is very well positioned to benefit from an increase in corporate IT spending.

I like CVS, the drugstore chain, also in the retail space. The demographic trends that support health care very much support CVS. As the baby boomers age and people are living longer, we know that they're going to need more drugs and more health-care items, but most areas of that industry are heavily regulated and facing pressures from the insurers. CVS and the drugstore chains -- Walgreen would also fit in here -- we believe will benefit nicely from those demographic trends outside of that heavily regulated environment. We think that it's a rather defensive way to be involved in those trends that will benefit that sector.

Q: In what would you invest in the brokerage industry? Something like E*Trade (ET )?


I don't follow E*Trade, but I would broaden my investment. I mention Goldman Sachs (GS ) because not only do they have the brokerage revenue but also a strong investment-banking arm, an international scope, etc. They're a well diversified firm -- equity underwriting and debt underwriting, as well as their consulting, provide revenue sources in different currencies that offer a stable investment platform for our clients.

In addition, we like Citigroup (C ) and Bank of America (BAC ). Each has a brokerage division, and again well-diversified business lines and sources of revenue.

Q: Earnings season is coming up. What should investors be on the lookout for in company reports?


One thing to look for is leverage on the balance sheets -- see if those companies that have more leverage are experiencing higher interest rate costs. Hiring is picking up and continuing strong -- these are positive signs for economic growth and in the early stages can translate into higher employment costs, of course.

The one thing to look for in any earnings period is those companies that exceed or miss their forecasts. It's very important for shareholders to stop and pay close attention and find out why those aberrations may occur. They may indicate a tidal change in the companies and should not be ignored by the investor.

Finally, pay attention to those companies that will be commodity-sensitive. Those with high transportation elements in their businesses will move according to oil prices. Any number of companies, though, have faced higher costs for manufacturing supplies as related to other commodities besides oil. It will be interesting to see the extent to which companies will be able to pass these price hikes to consumers or end users.

Q: Michael, are most of your holdings large-cap stocks? Any views on the small- and mid-cap markets?


We're about 85% large-cap, which is more than $5 billion by our definition. The small- and mid-caps have outperformed for the last few years. Even though they may have another year or two of superior performance, it may be that they've had their run. All sectors do, and perhaps they may be ready to revert to the mean.

Regardless of market cap, it's essential to know that the companies you own represent real fundamental value. If you own an index fund, and that particular allocation in your portfolio has become overweighted, it might be a good time to trim and redeploy those resources.

Q: Is there still growth in telecommunications? I have Verizon (VZ ).


We're concerned about Verizon's loss of high-margin landline customers to cable companies who are pushing into the telephone service by offering voice over IP. Of the original Bell operating companies, Verizon is probably the most attractive, but we would not classify this as a growth area. In that industry, or in related areas, we continue to like Nokia (NOK ) and Vodafone (VOD ).

Q: What about Berkshire Hathaway (BRKB )? Could Buffett be tainted by the AIG probe?


I think he already has been. It certainly seems that Mr. Buffett had conversations regarding the transactions in question. While there was an asset transfer, there was not a transfer of risk. The whole purpose of an insurance company's activities is to allay risk. You almost have to conclude that Greenberg and Buffett didn't understand the transaction was a bad one and wouldn't work, or they recognized it would be beneficial to the balance sheet when they did it.

These sorts of transactions, while they may be inappropriate, don't strike me as anything new in the insurance industry. I think different kinds of transactions of this type have been going on for quite a while -- for the express purpose of smoothing earnings, lessening the naturally volatile nature of an insurance company's results.

Q: What do you think of Berkshire Hathaway as an investment amid this controversy?


That's a good question. You know, it's always difficult to calculate and ascribe value to these shares because of the complexity of the many facets of the underlying businesses. Just over 50% of the operating companies are in the insurance business, and other investments include shares in Coca-Cola (KO ), Washington Post (WPO ), Gillette (G ) [being acquired by Procter & Gamble (PG )], and others.

There are certainly less expensive ways to participate in the insurance sector than Berkshire Hathaway, but nobody has gained by betting against Warren Buffett in the last 30 or 40 years -- a strong collection of assets that has been well run. There has long been the question: What's Berkshire worth without Buffett? In spite of his efforts to downplay his importance in the company, nobody has really believed him.

Munger's [Charles T. Munger, Berkshire Hathaway's vice-chairman] even older than Buffett, so perhaps the current unpleasantness will shed some light on the Buffett premium. If we take a page from [Jack] Welch's departure from General Electric (GE ), investors would do well to be patient in finding an entry point for these shares.

Q: Any advice regarding Time Warner (TWX )? I have a small stake.


Time Warner's looking better now than it was this time last year because they've cleared up a lot of the regulatory and FCC investigations. We remain concerned about them, because it's tough to ascribe a value to the AOL unit. It continues to lose subscribers on a quarterly basis, some of which are transferring to Time Warner's cable broadband Internet access -- i.e., Time Warner Cable is cannibalizing AOL. For media/cable, we would prefer Comcast (CMCSA ).

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