What Would Warren Do?

An upbeat Timothy Vick, author of How to Invest Like Warren Buffett, sees stocks as the best investments in 2006

As the new year approaches, the stock market is likely to do better for investors than other vehicles for their money, predicts Timothy Vick, senior vice-president of Sanibel Captiva Trust and author of How to Invest Like Warren Buffett. He also thinks the health of the U.S. consumer will "make or break" the market in 2006. Toward that end, Vick thinks consumers should rein in their spending somewhat, clean up their balance sheets, and pay down housing debt.

Like Warren Buffett, Vick looks for stocks of "the best companies within the best industries, and hanging on for a long ride" rather than betting on an index (see BW, 12/5/05, "What's in Buffett's Shopping Bag"). Currently, he thinks the best values are in large-cap stocks that have been beaten down and in "very safe" small-cap names. He has a goal of 10% to 15% growth.

One of the problems with small caps now, however, is that many have been bid up in price, Vick adds. Valuations are more favorable in some of the larger stocks, where stock prices have failed to follow up earnings, he notes. He singles out as attractive sectors business services, established consumer-product stocks, some financial-services companies, and medical-services and -supply companies.

This is a sample of the thoughts Vick expressed in an investing chat presented Dec. 8 by BusinessWeek Online, in response to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat.

Tim, what's your current diagnosis -- and prognosis -- for the market?

We think the stock market remains on pretty sound footing, even though we've seen a little bit of weakness in the past week. We believe the market should provide better returns than most asset classes in 2006, and we really have a solid economy that has the ability to shake off consumer weakness and high oil prices.

Right now, it appears as if the recent spike in oil prices wants to play havoc with some of the indexes. We believe that may open up a couple of buying opportunities over the next few weeks. But otherwise, we see some optimistic economic signals that tell us we can make some money next year.

What are the optimistic signs you see in the economy?

Right now, the economy really has all the ingredients for maintaining at least 3% growth -- the level we've seen for the past few years -- as long as the consumer can live within his means and keep his balance sheet in healthy condition.

We're seeing a very good pickup in corporate capital spending. Business inventories still seem to be pretty lean. Productivity growth seems to be improving again. Interest rates are still pretty low by historical standards. Personal incomes are rising, and corporate cash flows and profit margins are near record levels. Under most scenarios, that should equate to a very healthy increase in business values over the next 12 to 18 months.

Where do you think the "buying opportunities" you mention will show up?

Buying opportunities next year will be rather selective. We never buy the entire market, or a proxy for the S&P 500, but try to focus on individual sectors or companies that look like they can extend their sales and earnings growth levels.

We do like, for example, the business-services sector, which should show very healthy growth concurrent with the pickup in corporate investment and capital spending. We also like established consumer-product stocks, some financial-services companies, and medical-services and -supply companies. Overall, we think it will be a stockpicker's market next year, and not a general play on an index.

On the one hand, the economy is still capable of growing at 3% rates, but there will be some sectors within the economy, such as autos and housing, that will show sluggishness and won't be able to duplicate their recent past gains. That's the trick about investing. The economy is the sum total of several hundred industries, sometimes working at cross purposes to each other. We see our task as finding the best companies within the best industries, and hanging on for a long ride.

Tim, can you give us some of your favorite names in the areas just mentioned [business services, consumer products, financial services, medical services and supplies]?

We like a number of small-cap and large-cap companies, although many of our favorite small caps have run up in price to the point where we have stopped buying. For example, we have liked the retailer Chico's FAS (CHS ) for a couple of years now, but it has gotten a little stretched in price.

We are also big fans of Garmin (GRMN ), which makes technology that enhances global positioning systems. We also like Copart (CPRT ), which is an owner of junkyards that insurance companies use for rebuilding automobiles. Other of our small-cap favorites include Commerce Bancorp (CBH ), Whole Foods Market (WFMI ), and Express Scripts (ESRX ). Unfortunately, these stocks have moved beyond buying range, so we're holding on to some pretty strong gains.

Among large caps, we feel the valuation levels support very good returns for someone who can patiently hold three to five years. Particularly, we like Berkshire Hathaway (BRK ), Cisco Systems (CSCO ), First Data (FDC ), Intel (INTC ), Pfizer (PFE ), Wells Fargo (WFC ), and Fifth Third Bancorp (FITB ). The last is a turnaround candidate.

What's your current view of the balance between the small caps, midcaps, and large caps? Which group looks to do best?

We think the best sales and earnings growth is still going to come from the small-cap sector. However, many of those stocks had fabulous rallies starting in 2003. Quite a number of those companies are likely to experience stock price growth that is smaller than its earnings growth. In other words, we will see some p-e [price-earnings] ratio contraction over time.

The large-cap sector, in contrast, seems more interesting to me. Here, we've had a number of established names -- such as Wal-Mart (WMT ), Cisco, Medtronic (MDT ), and Microsoft (MSFT ) -- that have bobbed up and down for several years now, with no growth in share price. In the meantime, their earnings have continued to expand. We've seen incredible p-e ratio contraction out of these companies.

We're striving to find companies that can safely return in the 10% to 15% annual range. It's getting tougher, and investors are going to have to focus, in our opinion, on some of the beaten-down large-cap companies, or the very safe small-cap companies that can continue to show 15% or more sales growth.

How do you think investors can use Buffett's wisdom in their own investments? What are some of the mantras you follow?

The first mantra is patience. You've got to be able to siphon out all the noise that occurs daily, and determine what really is important with each company you own.

The second mantra follows from the first. You must understand that you own a piece of a company, and not a trading slip that gives you the right to flip assets at will. As an investor, you are a part owner in a business whose growth you want to participate in over a long period of time. You should try to understand, as best as possible, how that company functions and earns its money.

The more you understand about the company, the better you can filter out Wall Street's incessant noise, which tends to distract investors and forces them to make too many decisions.

In investing, it all boils down to two crucial decisions: What is a good company, and what is a good price for buying that company? Once you're very confident about the companies you select, you will tend to hold them indefinitely and enjoy the upward ascent of the company's growth.

Buffett has made nearly all his gains identifying the opportunities and patiently holding on until full value is realized. Early in his career, he did that with a lot of turnaround companies and small-cap stocks. Today, he applies that same patience and fundamental diligence to large-cap companies. But the results have been the same. For 55 years, he has managed to get higher returns on the same stocks as everybody else. I find this to be phenomenal, especially since he has no staff and has never relied on the research spit out by Wall Street.

What specifically has Warren done lately that other investors might profitably emulate?

You've got to admire his willingness to sit on the sidelines and hold tremendous amounts of cash while the market seemingly has been providing lots of opportunities. There's nothing wrong with holding cash, as long as you can deploy it with high rates of return.

Buffett has only made about a half-dozen large investments over the last five or six years, but so far they've all been home runs. He has purchased shares in companies like White Mountains Insurance (WTM ), PetroChina (PTR ), and Moody's (MCO ), and more than tripled his money in each of them, over a time in which the market has basically traded flat.

Are you more inclined to invest in tech stocks than Buffett?

Yes, we are. This is because we're of the opinion that the technology industry can exhibit a growth rate far in excess of the U.S. economy over the long haul. We're not tech-averse, but we still want to identify the best of the lot, and choose those types of companies that have some kind of competitive advantage and a sustainable business model that can generate lots of cash.

We think, for example, that companies like eBay (EBAY ) and Affiliated Computer Services (ACS ), as well as Paychex (PAYX ), have very strong growth potential in the future. We already own these stocks in portfolios, and look to pick up more shares occasionally when the prices dip.

Do you make currency bets?

Only when I go to retail stores. I watch the currency markets, especially as they impact interest rates and corporate profits around the world, but I've noticed that most people who bet on currencies end up losing money over time. There has to be a fundamentally compelling reason to buy or sell a certain currency before I would try to predict the equilibrium supply-demand price of any coin.

Buffett, as you know, has made a big bet on foreign currencies, and I think his fundamental reasoning is right on the mark. If Americans do not curb their spending habits, we're very likely to see a gradual decline in the U.S. dollar, relative to many foreign currencies, over the next several years. Near term, anything can happen.

What do you see for financial stocks? And any thoughts on what Ben Bernanke will have in store for us at the Fed?

We don't see Fed policy changing very much. In fact, we believe that [current Federal Reserve Chairman Alan] Greenspan has done most of the dirty work already for Bernanke before he assumes the post. We believe that interest rates are likely to rise a little bit more on the short end, then may start falling back somewhat by the middle of next year. The Federal Reserve will have to be on close watch to make sure they haven't overshot their target on short interest rates.

As for financials, it is a mixed bag right now. The well-diversified companies have shown an ability to weather a flattening yield curve. Other banks, such as Washington Mutual (WM ), correctly predicted this conundrum a year ago, and are slowly rebalancing their assets and liabilities to make them less sensitive to rising interest rates. These banks display quite a bit of long-term appeal if normal financial conditions prevail.

We're a little skeptical, however, of those banks or financial-services companies with huge mortgage exposure. Everything we read about the housing industry tells us that industry is at or beyond its peak and will start slowing. Companies with a lot of exposure to mortgages -- especially those that have offered cut-rate financing to home buyers, interest-only loans, and adjustable-rate mortgages -- are most vulnerable to high appreciation in home prices.

Do you like any Internet companies besides eBay?

I know you're trying to tempt me to recommend Google (GOOG ), but that isn't going to happen.... Seriously, there are a number of technology companies that have a large enough footprint in Internet services that they can be attractive at the right prices.

VeriSign (VRSN ), for example, is a stock we hold in many portfolios. We also are watching Time Warner (TWX ) as a potential turnaround candidate. Certainly, we also own Microsoft and some shares of Dell (DELL ). Cisco is another holding we like quite a bit at current prices.

What are some of the big events to watch in 2006?

I personally think that the health of the U.S. consumer is going to make or break the stock market in 2006. That's the most important thing to watch. Right now, consumers are overspending their incomes for the first time since the Great Depression. On a macroeconomic level, we don't want that to continue. It will be very healthy for this economy if consumers rein in their spending somewhat in 2006, reconstitute their balance sheets, pay down some of their housing debt, and strengthen their balance sheets internally.

If that happens, it may cause some near-term slowdowns in consumer cyclical industries, but the long-term effects will be that consumers will be in a better position to prop up the economy in 2007 and 2008. Right now, it's fair to say that there are several million households living on the edge, who are very vulnerable to a rise in interest rates, increases in gasoline prices, or some hit to their wages and benefits.

Much of that is outside of the individual consumer's control. But if they can rein in their spending and their debt in 2006, the short-term adverse effects it has on certain industries will help prop the economy overall going forward, and lead to much better earnings growth for corporate America.

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