Whether it's Peter Lynch loading up on Chrysler in 1982, Wilbur Ross buying steel mills in 2002, or Warren Buffett opening a bond-insurance unit in February, great investors have a habit of rushing in where others fear to tread. And with ugly subprime surprises cropping up everywhere from Bear Stearns (BSC) to American International Group (AIG), there's plenty of fear in the markets right now.
That's prompting investors to head for the exits. So far this year they've pulled $75 billion from mutual funds that invest in U.S. stocks, including $9 billion in just the past two weeks, according to TrimTabs Investment Research.
Financial stocks are leading the torturous ride. Shock over Bear Stearns' rapid decline sent the stocks of many financial companies on double-digit dives. But then a surprise rate cut by the Federal Reserve and news that it would back a Bear Stearns buyout by JPMorgan Chase (JPM) sent most of the stocks rocketing upward. The chaos hasn't let up since.
The volatility is staggering, but for cool-headed investors who have a long horizon, the markets are creating once-in-a-decade bargain opportunities. The key is to search out offerings where stocks aren't just down but have catastrophe priced in. "Smart investors with strong stomachs are looking for real market failures, not just in areas with a few problems," says James Swanson, chief investment strategist at MFS Investment Management in Boston. Swanson sees such blue-moon bargains in municipal and junk bonds. More equity-oriented analysts and fund managers are considering financials, homebuilders, and even certain technology stocks.
Debt issued by companies with less than investment-grade ratings has historically been a risky bet when the economy heads into a recession. But with the subprime-induced panic, the debt market has been driven below levels that even a major economic downtown might cause. Current yields imply that 50% of all junk issuers will default over the next five years, says Swanson of MFS. "Do you really think half of these companies will go bankrupt?" he asks.
The best way to play the junk-bond panic may be to buy shares of closed-end funds that specialize in high-yield debt. While ordinary mutual funds have to trade at their net asset value, closed-end funds trade freely on the stock exchange. A herd of sellers can push an out-of-favor fund's price well below the value of its assets.
And boy, are junk funds out of favor. Take the New America High Income Fund. Credit problems forced it to cut the value of its holdings by more than 30% over the past year and to reduce its dividend. The fund's shares have lost even more: They're down 42% over the past year. A buyer today gets its bond portfolio at a 20% discount, carrying a yield of over 10%. Once the credit crunch eases, the net asset value should recover, and the discount will narrow, too, says Thomas Herzfeld, whose eponymous firm has specialized in closed-end funds for 24 years.
Municipal debt, paying interest that's free from state and federal taxes, typically trades at yields well below the rates on taxable bonds. But the subprime crisis has slammed bond insurers including MBIA (MBI) and Ambac Financial Group (ABK) that back almost 40% of the tax-exempt market. It has led to an incredible sell-off in munis, with yields topping those of taxable bonds, a rare occurrence that has preceded some of the biggest muni market rallies of the past 25 years.
The situation has also created a second anomaly that won't last long: The yields on insured bonds from financially sound issuers are actually higher than those of bonds from the same issuers that don't carry any insurance. "It's just ludicrous," says veteran bond fund manager Daniel Fuss of Loomis Sayles in Boston.
Fuss is even adding munis to his firm's taxable bond mutual funds. Investors can benefit most easily through a muni mutual fund or one of the new crop of low-fee, exchange-traded funds that buy muni bonds.
Bear Stearns may have seemed like a bargain until JPMorgan Chases's offer emerged at a price of less than a quarter of what Bear's Manhattan headquarters building is worth. The piddling $2-a-share price came about because Bear Stearns had borrowed huge sums to buy a witch's brew of assets that may not cover its debts.
So while some courageous souls are dabbling in the shares of banks and brokerage firms, the better bet may be financial stocks with hard assets, says Horacio Valeiras, chief investment officer of Nicholas-Applegate Capital Management in San Diego. He's looking at real estate investment trusts (REITs). Valeiras thinks the best overall play, as it was in the savings and loan crisis, will be buying hard assets at distressed prices. The real estate market has yet to hit bottom, but Valeiras suggests accumulating a position slowly over the next 12 months. Focus on REITs with solid holdings and good balance sheets, he says. For those who prefer to invest through ETFs, Vanguard's $9 billion behemoth, the largest REIT ETF, is trading at about a 5% discount to its fair value, according to analysts at Chicago fund tracker Morningstar.
Another sector that rocketed during the real estate boom only to crater during the current credit crunch is homebuilding. Justin Walters, co-founder of research firm Bespoke Investment Group in Harrison, N.Y., has spent the past few weeks jawboning his clients with a chart comparing the homebuilding stocks to the Nasdaq Internet bubble. A six-year run in the Nasdaq ended in March, 2000, kicking off a 943-day drop of 78%. Likewise, the homebuilders went on a five-year tear that peaked in July, 2005, and then dropped 76% for 859 days before hitting bottom in January. "We like the fact that homebuilders are getting overlooked right now by all the concerns elsewhere," Walters says. Hovnanian Enterprises (HOV) and St. Joe (JOE) are Walters' top picks, but he says investors will do well, with less risk, just buying the SPDR Homebuilders ETF.
If you have no interest in wading into the finance and real estate sector muck, there are promising opportunities in formerly high-flying tech stocks. Only last year, companies including Cisco Systems (CSCO) and Microsoft (MSFT) were on a roll. But mounting fears that the subprime crisis was pushing the economy into a recession put an end to all the happy talk. Now the tech giants are trading at multiples of 15 to 20 times their earnings, which puts them at the low range of their respective five-year average price-earnings ratios.
Many of the companies have little debt and are flush with cash, leaving them well positioned in a time of economic stress. That has investors like Michael Vogelzang, president and chief investment officer at Boston Advisors, looking at the big tech names as well as scoping out medical technology companies such as Thermo Fisher Scientific (TMO). Says Vogelzang: "What's fun for our business right now is that there's a ton of this stuff."
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