W.I.L. Finance Digest :: May 2009, Part 1

LOOKING AHEAD TO RESTRUCTURED MARKETS

With stocks coming off historic lows, Ron Baron sees lots of interesting investment ideas.

Ron Baron has a growth stock orientation, but when he starts talking about “stocks selling less than their replacement cost” – which he claims is the case for stocks overall – one immediately discerns a value bias as well. His firm ranks in the top 20% of Morningstar’s small-cap growth category over the past 3, 5 and 10 years. He has earned his stripes.

Baron also says of the current investing environment that “this is the most attractive time to be an investor in my lifetime.” This is an opinion which we are not willing to second, given that Baron has been a professional analyst since 1970. At various points during the 1970s stocks were selling at well below replacement cost and at lower earnings multiples than today. Although things seemed grim enough at the time they were nowhere near as grim as now. The debt burden on the system was far lower, and the U.S. government was not philosophically committed to ending free enterprise entirely. Then again, Baron is “so excited” about Obama and Bernanke, so who knows where he comes up with some of his opinions.

When Ron Baron started out as a stock analyst in 1970, he did not specialize in a particular sector, but traveled the U.S. writing about all kinds of companies.

Baron, 65, who founded Baron Capital Group in 1982, still sees investment opportunities across many sectors – including energy, technology, education and gaming. “When you are coming off a historic low [in the stock market], I think everything is interesting,” he says.

The New York firm, which oversees nearly $13 billion, has a growth bent, although Morningstar says Baron hews to a “valuation-conscious strategy.” The Baron Growth Fund [ticker: BGRF], which he runs, ranks in the top 20% of Morningstar’s small-cap growth category based on 3-, 5- and 10-year returns. In the 12 months through [April 30], it was down 32.33%, leaving it 2.51 percentage points behind the Morningstar Small Growth Index. Last week, we caught up with Baron, a former Barron’s Roundtable member, to get his latest perspective.

Barron’s: What is your overall assessment of the stock market?

Baron: We invest for the long term, at a time when everything is focused on trading – whether it is the reflation trade, the carry trade or the gold trade. We look for businesses that are well financed, have a competitive advantage, and are managed by people we like and who are going to allow these businesses to take advantage of their opportunities.

But this is a very challenging time. Our business depends on assets under management. Our revenues are down and, as a result, our profits are less. So we have to make sure we are very careful about how we run our business.

On the other hand, this is the most attractive time to be an investor in my lifetime.

What else makes you so bullish on stocks, which you consider to be the most attractive asset class?

Stocks are cheap. They are down more than 40% from their peak in October of 2007, and that is in line with their profit decline. But stocks are now selling for less than their replacement cost – that is, what it costs to build the businesses or build the buildings. That is very important because until profits go up and prices go up for the services of existing businesses, you are not going to get more competition.

What is the outlook for the financial system?

In 1982, the U.S. had $5.8 trillion of debt, which represented 174% of GDP. In 2008, it was $52.6 trillion, or 369% of GDP.

The debt is out of whack with our economy, and there have to be significant changes. This could have happened last year, it could have happened 5 years ago or 10 years ago – you never knew when it was going to happen. But there has to be a restructuring of the financial system.

So what will things look like?

There will be less leverage. There will be less proprietary trading. There will be fewer [leveraged buyouts], and there will be less derivatives trading. The derivatives that are traded will be on exchanges, so you will not have to rely on counterparties you do not know. And you are going to have to have, in many instances, an insurable interest.

Which is?

It is analogous to life insurance. If you think I am going to die, you cannot go out and buy life insurance on my life. You do not have an insurable interest in my life. That is the way it should be for credit-default swaps.

So that means less profits in the financial sector?

Less profits, but those profits will be given a higher multiple. One of my friends runs a very large investment bank in the U.S. We were at a golf course about two years ago, and he was saying to me, “I am so upset with how my stock is being valued by investors. They are valuing me like I am a hedge fund.” And I said, “You are a hedge fund.” The way his firm was leveraged, it was a hedge fund.

A lot of stocks remain cheap, the recent rally notwithstanding. Is it harder to separate the wheat from the chaff?

The companies that are doing better just stand out more. One of the big themes is that certain companies are the beneficiaries of the competitive problems of others. We look for outstanding people running businesses with initiatives that are able to take advantage of their competitors’ problems.

What is an example of that?

For the most part, we do not invest in banks, but we have a stake in People’s United Financial [PBCT], based in Connecticut. It has become the 11th-largest bank in the country by market capitalization.

It used to be a small regional bank, right?

Yes, it was. But now, because of its access to low-cost deposits and [the fact] that it chose not to invest in risky assets and raised capital exactly at the appropriate time, it has a market cap of about $5.6 billion, and $2.5 billion of excess cash.

They are making a very small return on that extra cash, but it will enable them to make acquisitions. All the loans on its balance sheet were made before 2006. And its loan portfolio is very strong when measured by [the] loan-to-value [ratio]. So even if house prices have fallen 50%, which I do not think they have, they are still in good shape as far as performing assets, thanks to strong underwriting standards.

What is the case for active management, which has taken a hit in the wake of this big downturn in the equity market?

With index funds, you are going to be investing in the most successful businesses at that point in time, and at the top of the market you will be massively overweighted in those companies.

That was oil and gas in the 1970s and 1980s. In the 1990s, it was technology. Earlier this decade, it would have been financial companies, which you would have invested in at exactly the wrong time. When you invest in our funds or other mutual funds that are actively managed, the idea is that you are going to be investing in businesses that a team of analysts and portfolio managers has carefully chosen.

But not every fund is going to outperform its peer group or benchmark. So isn’t there another side to this debate?

Of course there is. But investors have a tool: Morningstar [MORN], which we hold. Morningstar has write-ups of companies and mutual funds. Just as I read opinions on stocks, individual investors can read opinions about their mutual funds.

Have hedge funds and private equity had their day in the sun?

Yes, they have. I have never thought that they should be interesting investments. In fact, they are just simply very leveraged ways to invest in businesses. The government allowed this to happen, and they let the financial industry become too leveraged. They let the financial industry take advantage and do things that put our system in jeopardy. But now I am so excited about our president, Barack Obama, and the head of our Federal Reserve, Ben Bernanke. They realized that there are structural problems in our financial system. President Obama also realized there are structural problems in energy, and his administration is dealing with that right now.

Why do you find that sector attractive?

Energy is a commodity, and we have always contended the price of a commodity ultimately goes to the cost of production, at which point you stop producing it.

Last summer, the price of crude was close to $150, way above the cost of production, and at the same time, the reserves in the ground were enormous, with people rushing to produce and overproduce. Since then, the price has fallen dramatically, to $40 or $50 a barrel. At those prices, it is now at the cost of production. The number of rigs in the U.S. used to find oil and gas has dropped from roughly 1,900 to 900. And there is something called a decline curve. The older a well becomes, the less oil and gas it produces. When you produce from a new shale-oil well, for example, production falls 70% in the first year. On average in America, 20% to 30% per year is the decline we are experiencing in existing wells. So there is falling production in existing wells and fewer new wells, and that should lead to higher energy prices.

What are some areas of energy that interest you as an investor?

There will be opportunities to invest in energy conservation and transmission, which needs upgrading. In France, 80% of power for utilities comes from nuclear; here, it is 20%. We will have to go to 50%. In America, it is 2% in wind, versus 20% in Spain.

So we are going to have to mandate more extensive energy power to America. The government is going to have to say, “OK, utilities, you have to get a certain percentage from nuclear, and you have to get a certain percentage from wind.” One play on this theme is ITC Holdings [ITC], an electricity-transmission company.

Turning to a different sector, another of your long-time holdings is Wynn Resorts. What is to like there?

We invested in Wynn Resorts [WYNN] this time around in 2001, and we bought about 10 or 11 million shares for about $135 million, and we got about $70 or $80 million of dividends back. We sold half of our stock between 100 and 150. But unfortunately for us, we did not sell the other half, which went from 170 in the fall of 2007 down to around 19 recently.

In March, we bought about 1.7 million shares when they were at 19. They are now at 39 and change. We think Wynn has been well-managed financially. At the peak, the company was valued at $10 billion or $11 billion, when it was selling for a high multiple on peak earnings. Now it is selling for a low multiple on trough earnings.

And they have a lot of debt.

But the reason the stock is doing better is because the company did an equity offering, which we participated in, in March, when they issued 9.6 million new common shares. Any company that has raised equity lately, and which had debt that now looks like it has a clear shot of not having difficulty, is considered a survivor, and the stocks have gone up, including Wynn.

What about another holding?

Blue Nile [NILE] is a purveyor of diamonds on the Internet. Instead of going into the mall stores, you can buy directly from Blue Nile without the five or six levels of distribution from the diamond mines.

We have been an investor in the company since it went public in 2004. Of course, in this environment they are not doing as well as they had been, with people deferring purchases or buying smaller items. But they do sell 2% of all the diamond engagement rings in America. One thing that will help them is that a lot of the competitive stores in the mall are going out of business.

Another pick?

I have been investing in DeVry [DV], which provides various education programs, since 1990. The stock has gone from north of 60 in January to around 43 late last week; we have recently been adding to our holdings in DeVry and Strayer Education [STRA]. The state colleges, because of budget constraints, are not offering as much of a program as they did before, so DeVry and Strayer are beneficiaries. Their enrollments are up strongly.

Some closing thoughts?

We do not predict the stock market, but it is clear we are in very challenging times, and that earnings are under pressure. The [Standard & Poor’s] 500 is making about 40% less than it did at the peak. But if you focus on fundamentals, on balance sheets that are strong, and on businesses that are surviving and that have competitive niches, you are going to do fine in the long run, even if you do not in the short term. I would hope that stocks could be back to where they were when they peaked in four or five years – and maybe even sooner if we get lucky. What about lessons learned from this financial upheaval?

One of my very good friends lost his son two years ago in a helicopter accident. His son was the president of their business. The father had been a boxer in South Africa, where he came from, and he became very successful. The father called together his executives to announce the death of his son. When he finished – and I do not really understand how he was able to compartmentalize this – he said, “We have to box on.” I cannot imagine how he does this. But for us, it is very easy to just box on. There are opportunities everywhere to invest at prices that I do not think we are going to see again in a generation.

Thanks, Ron

COMMERCIAL PROPERTY FOLLOWS RESIDENTIAL INTO THE TANK

Separating the winners from the losers.

Even after a 50% bounce up from their March low, the MSCI REIT index is off 65% from its high of early 2007. The value of the underlying properties is allegedly off more like 35% but liberal use of leverage has exacerbated the fall in net equity values. The average debt-to-equity ratio among REITs is 150%. “How many times do real-estate guys have to learn the lesson that leverage can burn you?” asks one real estate analyst below.

A lot of REIT debt is maturing during the next few years, and it may be tough for some to refinance it at a reasonable rate. As with many companies, access to the debt market has become a critical piece of the picture. An REIT may be selling well below its nominal net asset value, but if it is too leveraged and its debt is maturing, the debt buyers in effect will be able to appropriate some of that equity value for themselves. Or the REIT might simply issue a lot of discounted equity, diluting existing unit holders. Thus analysts recommend sticking to financially strong REITs – if you insist on investing in the sector.

So are REITs cheap or not? “REITs are a lot more attractive now than they were at the highs in 2007,” says former REIT bear David Shulman. “But compared with the rest of the stock market, they do not look so cheap.” He notes that most REITs trade at 10-16 times pretax cash flow, while Johnson & Johnson fetches 12 times after-tax earnings and 7 times pretax cash flow. The former multiple is a more valid comparison, as REITs do not pay tax on pre-tax earings the way J&J does. But J&J is a vastly superior business, and is much less leveraged, so why go down the quality spectrum for no gain?

Quality, conservatively-leveraged REITs have the capacity to take advantage of rivals’ misfortunes and buy assets on the cheap if the commericial real estate shake-out continues. And the odds, Barron’s notes, favor exactly that happening.

Americans in the past two years have been closely watching residential real estate, as TV commentators breathlessly relate each downward tick in home prices and upward move in foreclosures. But all the while, another important part of the real-estate market has been quietly cratering, all but ignored by the general press. Since peaking in early 2007, the value of the nation’s commercial property has fallen an estimated 30% to 40%.

You can get a good idea of the pain being suffered by looking at an index of real-estate investment trusts, the publicly traded entities that investors use to play the commercial real-estate sector. The MSCI REIT Index fell 77% from a high of 1233 in February 2007 to the low of 287 hit in March. Since then, it has rebounded 45%, to 420, as investors seek opportunities and the economy seems to be improving.

But the commercial-property sector remains fraught with peril. Some REITs will be strong enough to snap up buildings at bargain prices, while other REITs may go bust or need to raise gobs of new equity to bolster their debt-heavy balance sheets. The commercial real-estate problem has become a focus of federal regulators in recent weeks as they stress-tested the 19 largest U.S. banks to see where losses could pop up if the economy, rather than recovering, worsens.

Why has the value of REITs tumbled an average of 65%, while the value of their properties has slid more like 35%? REITs tend to rely on borrowed money. That boosted profits in the good times, from 2002 to 2007, but has magnified problems ever since.

Optimism about REITs has increased lately, in part because the economy might be bottoming and because $7 billion of common equity has been raised this year by more than a dozen realty companies, including leaders such as Simon Property Group [ticker: SPG], a big mall operator, and Vornado Realty Trust [VNO], a major New York office-building owner. This signals that much of the industry can pare its debt, but sometimes at the cost of significant dilution to existing shareholders.

“The REIT rally has more to do with excitement over the equity sales and the move to stocks than any sudden turn in the fundamentals,” says Alexander Goldfarb, a REIT analyst at Sandler O’Neill. It is expected that industry net operating income, a key financial measure for the realty trusts, will be down in the low-to-mid single digits for 2009 and 2010, thanks to declining rents for office buildings, apartments and shopping malls.

Other major challenges lie ahead. Goldfarb expects what he calls the “re-equitization” of REITs to continue, with potentially tens of billions of dollars of capital left to be raised. There is pressure to build equity because REITs took on excessive debt during the 2005-2007 property boom. The total value of the country’s more than 100 property-owning trusts has shrunk to $160 billion from a high of $400 billion, while debt stands at about $260 billion. The average leverage ratio among REITs is 60%, meaning debt accounts for 60% of their total equity and debt.

In the early 1990s, debt accounted for just a 1/3 of REIT’s balance sheets. Like many executives in other industries during the boom years, some REIT managers thought the good times would linger and that the capital markets would always be welcoming. Rather than sell shares to pay for acquisitions, they piled on what seemed to be cheap debt. Now, they are issuing stock at a fraction of the price they could have gotten two years ago.

“How many times do real-estate guys have to learn the lesson that leverage can burn you?” asks Mike Kirby, director of research at Green Street Advisors in Newport Beach, California. “It happened in 1990 and 1991, and it is happening again now. The industry is going to pay a dear price to re-equitize its balance sheet.”

Kirby adds that REIT executives – many of them aggressive types who turned family businesses into big public companies – must change their mindsets. “Real-estate guys cannot help themselves. Instead of asking, ‘How much debt should I have,’ they ask, ‘How much debt can I get?’” Kirby argues that the trusts need little or no debt.

A good chunk of REITs’ debt is maturing during the next few years. It may be tough to refinance all of it, owing to lower property values and the cost of new borrowing, which is apt to be higher than the 5% to 6% annual rates of the boom years. Traditional lenders such as life insurers want 7.5% to 8% for secured loans. Unsecured debt can cost 9% or more – if it is available.

Investors in the volatile REIT sector should stick with the biggest, best-capitalized outfits, including Simon and Vornado; Taubman Properties [TCO], which runs upscale malls; Boston Properties [BXP], an owner of prime office buildings in New York and Washington; Public Storage [PSA], the top owner of self-storage facilities, and AvalonBay Communities [AVB], a high-end apartment owner.

They all have good balance sheets and can either raise equity to trim debt or do not need to do so. The average REIT dividend yield is about 7%, although some companies, such as Simon and Vornado, are paying most of their dividends in stock, which is of little benefit to investors who own realty-trust shares for reliable cash payouts.

Kirby considers the sector “fairly priced” after the gains since March and says “the one defining feature of REIT performance is that companies with less leverage have dramatically outperformed the ones with high leverage.” He points to the strong standing of Public Storage, which has the industry’s 2nd-highest market value at $11 billion, after Simon’s $13 billion. Public Storage has almost no debt; preferred stock accounts for about 25% of its capitalization. It is REITland’s closest thing to a Berkshire Hathaway.

There are a bunch of REIT funds, including Vanguard REIT Index [VGSIX]. Then there are exchange-traded funds, including iShares DJ U.S. Real Estate [IYR], which yields 7%. Investors also can play preferred shares issued by Public Storage and other realty trusts that yield 8% to 11%. The REIT-preferred market, totaling about $10 billion, is much smaller than the bank-preferred sector, making it better suited to individuals than institutional buyers.

There also are REIT-oriented closed-end funds, including Cohen & Steers REIT & Preferred Income [RNP], which trades near $6, a 15% discount to its net asset value. It yields 15%-plus, thanks in part to leverage. The market also features unsecured corporate debt, issued by REITs such as Simon, Vornado and Equity Residential [EQR], that often yields 9% or more.

Real-estate pros focus on a financial measure called the capitalization, or cap, rate – calculated by dividing annual net operating income by total equity and debt. For REITs, this rate currently averages about 9%. Cap rates hit a low of 5% to 6% in 2007, with some deals, like Tishman Speyer’s $22 billion leveraged buyout that year of high-end apartment REIT Archstone-Smith, done at a 4% cap rate. The cap rate is like a bond yield. The higher it is, the better the return to the investor.

In August 2005, Barron’s warned the REIT market looked rich (“Pop! The Other Real-Estate Bubble”). We were 18 months early. The MSCI REIT index rose another 50% to the 2007 high. But the index is more than 40% below where it was in August 2005.

Anyone who shorted the REIT index at the time of the 2005 Barron’s article would have been stopped out by the time the high hit, showing how tricky trying to call the top of a mania is.

The vicious REIT selloff over the past 1 1/2 years has brought belated vindication to former bear David Shulman, a REIT analyst at Lehman Brothers from 2000 to 2005. After his departure from the investment house, Shulman was mocked by Steve Roth, Vornado’s longtime CEO, for having “a 3-year sell on Vornado with a $43 average target” at a time when the stock was in the 80s. Vornado peaked at $133 in 2007, but plunged as low as $29 in March and now is in the high 40s. It recently sold $741 million of common stock at $43, Shulman’s old price target. Roth has not apologized in print.

“REITs are a lot more attractive now than they were at the highs in 2007,” Shulman said last week from his New Jersey home. “But compared with the rest of the stock market, they do not look so cheap.” He notes that most real-estate investment trusts change hands at 10 to 16 times pretax cash flow, while a quality stock such as Johnson & Johnson, which has a AAA credit rating, fetches 12 times after-tax earnings and seven times pretax cash flow.

In addition, the debt of major REITs often is 8 to eight to 10 times annual cash flow, way above the 3-to-1 ratio most investment-grade companies in other industries strive to maintain.

Shulman, who is now an academic, says one of the big issues for Vornado is the future of Wall Street, because Vornado gets 30% of its operating income from Manhattan office buildings. Prime midtown Manhattan rents, which topped $100 per square foot in 2007 and early 2008, are in the $70 to $75 range now, according to the real-estate advisory firm Newmark Knight Frank. The Midtown vacancy rate hit 14.2% in the first quarter, the highest in 15 years.

In Boston, the John Hancock Tower, one of the city’s premier buildings, was recently sold for $660 million – half of what its former owner, Broadway Partners, paid in 2006. Broadway had hoped to get Manhattan rents in Boston, even though prime space there never has fetched much more than $50 a square foot.

Regional office markets, shopping malls and apartments face trouble, too. What does the continued growth of mass discounters such as Wal-Mart and Target mean for embattled malls, which are suffering from troubles at traditional anchors like Macy’s and Sears Roebuck? In Vornado’s latest annual report, Roth wrote: “In many malls, in many markets, the loss of an anchor now spells a very long-term empty and dead mall wing. Who will replace [bankrupt department-store chain] Mervyn’s etc.? B and C malls will suffer declining sales and difficulty replacing failed tenants and refinancing their loans.” Vornado has minimal mall exposure.

Over all, REIT bears see a slow-motion train wreck as declining rents, which often are locked in for years, pressure profits at the same time that borrowing costs rise and stock sales dilute existing holders.

More heavily leveraged REITs like Kimco Realty [KIM] and ProLogis [PLD] are risky plays whose outlooks hinge on the direction of the economy and the capital markets’ health. Formerly hot office-building owners Brookfield Properties [BPO] and SL Green Realty [SLG] have a lot of debt and are exposed to the weakening Manhattan market. SL Green has a market value of $1 billion and debt of $7 billion, making its shares the equivalent of a call option on the New York office market. The possibility of dilutive common-share offerings is a risk with both SL Green and Brookfield, which owns the lower-Manhattan complex that houses Barron’s editorial offices.

There was 65% dilution when highly leveraged ProLogis, an owner of industrial warehouses, recently had a $1.1 billion equity offering. And shopping-center owner Kimco Realty sold $750 million of stock that diluted existing shareholders by 40%.

Green Street Advisors refers to some REITs as “zombies” because the ratio of their debt to equity was recently at 90%. Debt-laden REITs include CBL & Associates Properties [CBL], Glimcher Realty Trust [GRT], Pennsylvania Real Estate Investment Trust [PEI], Maguire Properties [MPG], Strategic Hotels & Resorts [BEE] and Felcor Lodging Trust [FCH].

The ultimate speculation is General Growth Properties [GGWPQ], a mall owner that filed for bankruptcy recently after failing to restructure part of its $27 billion of debt. General Growth shares, which are trading around 50 cents, amounts to a super-leveraged bet on the health of the commercial-property market and the economy. General Growth has attracted aggressive hedge-fund manager Bill Ackman, who controls about 25% of the company.

“Given GGP’s extremely high leverage, minor changes in cap rates have an enormous impact on net asset value per share,” Green Street wrote recently. At its current cap rate around 9%, General Growth Properties’ equity has no value, but if cap rates fall to 7.5% in an improving economy, the stock could be worth $16 a share, Green Street estimates. In such a scenario, “Pershing Square’s equity investment would be a ‘grand slam’. However, a lot has to go right – in court and in the retail market – for that to happen.”

More conservatively leveraged real-estate investment trusts such as Simon, Taubman, Vornado, Public Storage and AvalonBay are safer bets. They may take advantage of rivals’ misfortune and pick up assets cheaply if a great shake-out in commercial real estate plays out in coming years. And the odds favor just that happening.

MINING MINNESOTA: MAIRS AND POWER’S TALENTED CEO INTERVIEWED

The Mairs and Power Growth is a Minnesota-based mtual fund mixing growth and value investment styles – “large-capitalization blended” by Morningstar’s nomenclature. The fund’s portfolio turnover is less than 4% per year. This sounds like a “Warren Buffett approach,” and it is – the fund managers are “great admirers” of Buffett. Also with shades of Peter Lynch, the portfolio is packed with Minnesota names such as MMM, General Mills, Target and Medtronic. This local bias is favored by tailwinds, as Minnesota public companies are consistent outperformers.

Mairs and Power Growth has been a strong performer since it was started in 1958. Last year, it ranked in the top 4% of all large-capitalization blended funds, which still meant its net asset value plummeted (-28.5%) ... just less than most of its peers. Over the previous 10 and 20 years the fund’s performance was notably greater than that of the standard large cap stock fund benchmark, the S&P 500. For the shorter period this meant the fund’s yearly return was positive rather than negative.

Below is a Barron’s interview summary with fund co-manager William Frels. Clearly someone worthy of one’s attention.

When Wells Fargo stock plunged this year, on concern about the big bank’s financial health and acquisition of Wachovia, William B. Frels, co-manager of the Mairs and Power Growth Fund in St. Paul, Minnesota, began checking with friends and contacts around the Twin Cities to determine just how sickly Wells might be.

Although Wells Fargo (ticker: WFC) is headquartered in San Francisco, it was acquired in 1998 by Minneapolis-based Norwest Bank, whose management kept the Wells name. Thus, it still has significant operations in Minnesota – the home of companies that account for more than half of the holdings in Frels’s fund.

The fund had held the stock (under the Norwest name) off and on since 1960. But Frels began selling shares last autumn, as investors began fretting about Wells Fargo’s mortgage business and the pending Wachovia deal. Those concerns turned into semi-panic this year, driving the stock from about 40 last September to below 8 in March, when the company said it would cut its quarterly dividend from 34 cents to a nickel.

But this spring, when Frels and co-manager Mark L. Henneman began checking with local Wells Fargo branch managers and loan officers, they decided to reverse course on the stock. “We, of course, relied primarily on public disclosures by management to reassure us about the company’s capitalization position,” says Henneman. “But getting up close and personal with people who worked for the bank gave us the confidence we needed at a time to begin rebuilding our position.”

“It’s a core holding for us," adds Frels, who took over as manager of the fund (ticker: MPGFX) in 2004 from iconic stockpicker George Mairs III, whose father had established the asset-management firm in 1931. “We believe the bank is in an excellent position today to expand market share.” Over the next three years, Frels contends, Wells common, recently around 20, can get back to the mid-30s. That estimate is based on his belief that the bank’s earnings will climb back to $3 a share, and that its stock will trade at a multiple of 11 times to 12 times forward earnings. Wells, which made 75 cents a share last year, currently trades around 15 times this year’s expected earnings.

The 69-year-old Frels, a graduate of the University of Wisconsin, joined Mairs and Power in 1992, and has been an investment manager for more than four decades. The $1.4 billion growth fund, holding 44 companies, is packed with Minnesota names like multinational manufacturer 3M (MMM), food giant General Mills (GIS), medical-device makers Medtronic (MDT) and St. Jude Medical (STJ), discount retailer Target (TGT), industrial-filter producer Donaldson (DCI), nuts-and-bolts distributor Fastenal (FAST), paint-sprayer supplier Graco (GGG), and water-cleaning-equipment firm Pentair (PNR). [Ed: Virtually all blue chips or baby blue chips.]

“The Minneapolis-St. Paul area has one of the highest concentrations of large, multinational industrial and financial companies in the U.S.,” Frels observes. “Local surveys claim that Minnesota public companies consistently have outperformed the general stock market, year after year, with the exception of the past two years.”

Last year, the Mairs and Power Growth fund ranked in the top 4% of all large-capitalization blended funds (those mixing growth and value investment styles). It was “only” down 28.5%. Over the 10 and 20 years through December 31, 2008, the fund’s returns outpaced the S&P 500 by 6.9 and 4.3 percentage points per year.

Mairs and Power Growth, rated four stars out of five by Morningstar, has been a strong performer since it was started in 1958. Last year, it ranked in the top 4% of all large-capitalization blended funds (those mixing growth and value investment styles).

That was not much solace for investors, however, since the fund was down 28.5%, even as it beat the Standard & Poor’s 500 by 8.5 percentage points. The fund beat the S&P in 2002 and 2004. But in 2007, ‘06 and ‘05, its 4.9%, 10.2% and 4.4% returns slightly underperformed the broader market.

Over the 10 and 20 years through December 31, 2008, the fund had average returns of 5.48% and 12.73%, outpacing the S&P by about 6.86 and 4.30 percentage points in the respective periods, the company says.

Less than 4% annual turnover.

“We have done well over the years because we focus on companies we know that are well-managed, with strong market share in their industries,” says Frels. “And we tend to stick with them through thick and thin, which is why our turnover [less than 4% annually] – is minuscule. We are investors, not stock traders. We are great fans of Warren Buffett.“

Says Morningstar analyst William Samuel Rocco: “Frels looks for top-quality firms with hearty and sustainable earnings growth, sound balance sheets and excellent returns on equity.” He adds that this sets the fund up for continued strong performance.

At the moment, Frels’ favorite sector is health care, which accounts for about 20% of the fund’s assets, and is represented by Medtronic and St. Jude Medical.

The money manager says Medtronic could grow its earnings by 11% annually over the long term, earn $2.95 a share this year (versus $2.60 in ‘08), and trade at 9 times forward earnings. Currently priced at 30, Frels believes the stock could hit 60 over three years.

St. Jude is benefiting from an aging population’s growing demand for pacemakers, other implantable cardiac devices and heart valves, Frels says.

Adds co-manager Henneman, “St. Jude has proven very adept at successfully delivering effective and safe products to market. The company has been particularly strong in cardiac-rhythm management.”

As for one of his industrial favorites, Fastenal, Frels says that its profits could rise by 10% annually, long-term, boosting its shares, recently around 38.

Frels calls another of his industrial picks, 3M, “a world leader in a lot of niche product areas like dental products, reflective materials, industrial tapes, abrasives and adhesives.” He predicts that its earnings could grow at an annual pace of 10% over the next few years – although profits will slip this year to $4 a share, from $5.17 last year. The stock has been trading in the 50s; his two-year price target is 80.

CLOROX INVESTORS COULD CLEAN UP

Clorox’s stable of iconic brands – along with new additions such as Burt’s Bees and Green Works – will keep the shine on the company’s stock.

Clorox is a true-blue chip, with a stable of leading consumer nondurable brands. Is it cheap at a P/E of 14 and change, and a dividend yield of 3.3%? Not in our book. On the other hand, it is not that expensive either. It sells at a slight premium to Colgate-Palmolive and Proctor & Gamble, which have more international exposure – an exposure that is viewed unfavorably now, but we doubt this bias will last forever.

Housework knows no recession. That is bad news for practitioners, but good news for Clorox, whose shares left competitors in the dust last year. The company’s stock fell about 6%, to 55, though dividend payments cut the loss to a mere 2%. That compares with a total loss of 36% in the Standard & Poor’s 500. Clorox [ticker: CLX] is likely to keep outperforming, as the company’s brands – from its signature bleach products to Kingsford charcoal, Brita water filters and Glad bags – enjoy continued pricing power. Newer additions to its cupboard, including the Burt’s Bees skin-care franchise, snapped up in late 2007, and a line of environmentally friendly Green Works detergents, launched last year, also have performed well, and are ripe for expansion.

The company’s largely domestic focus is another plus. With only 15% of sales outside North America ... Clorox has been hurt less by a rising dollar, which has crimped profits of more global competitors, such as Procter & Gamble [PG]. Not least, Clorox stands to benefit from continued cost cutting and stabilized commodity prices, which could boost margins as sales expand.

“Clorox represents recurring earnings and cash-flow growth,” says Tim Call, a money manager at the Capital Management Corp., a Glen Allen, Virginia, investment-advisory firm. “We expect it to have rising profit margins, and when we look out five years, we have a price target of $118, or a 15% annualized return.”

Friday management raised its earnings forecast to $3.70 to $3.80 a share for the fiscal year ending June 30, versus previous guidance of $3.60 to $3.75. In fiscal 2008, Clorox earned $461 million, or $3.24 a share, on revenue of $5.3 billion. Although sales are expected rise only 4% this year, the company hopes to enhance profitability with up to $120 million in cost savings. It plans to cut about 2% of its global workforce, and could see lower prices for resin and other commodities after three years of increases.

Clorox expects a minimum of 8% earnings growth in the year that ends in June 2010; Friday it issued sales guidance of 1%-2% gains. It also reported March-quarter earnings of $1.08 a share, handily beating Wall Street’s 90-cent estimate, as cost savings and improved productivity offset flat sales. Executives declined to speak with Barron’s, citing the quiet period surrounding reporting season, but Chairman and CEO Donald R. Knauss, 58, boasted in Friday’s earnings release that “we delivered our highest year-over-year quarterly earnings growth in more than three years, and our first year-over-year gross-margin expansion in seven quarters.” The stock fell about 1% on the earnings news, because of the company’s conservative outlook.

Clorox trades for roughly 15 times this year’s profit guidance and 13 times analysts’ 2010 earnings forecast of $4.21 a share. It commands a premium to consumer-products rivals such as Kimberly-Clark [KMB] and P&G, but sports a sizable discount to its own 10-year median price/earnings ratio of 19.2.

Jason Gere, an analyst at RBC Capital Markets, says Clorox is one of three domestic household and personal-care companies about which he has “a higher degree of comfort” concerning their ability to drive stronger earnings in a soft economy. The others are Church & Dwight [CHD] and Alberto-Culver [ACV]. Gere recently initiated coverage of the sector, with a 12-month price target of 61 for Clorox. The company could average gross margins of 42.8% in fiscal 2009, he notes, up from 41.2% in fiscal 2008. Gere projects gross margins of more than 44% in fiscal 2010.

In recent quarters, the brightest spots at Clorox have been Brita, Burt’s Bees and Green Works, which together account for roughly 10% of sales. Green Works sales are “exceeding expectations despite a 10% to 15% price premium to other cleaners,” Gere wrote in a recent report. Green Works is thought to control about 40% of the market for natural home-cleaning products, and he estimates it has about $100 million in annual sales.

Clorox was criticized for paying $925 million for Burt’s Bees, which produces about $150 million in sales, Gere says. But Clorox has leveraged distribution into mass-market channels such as Wal-Mart, and can expand Burt’s overseas.

Clorox’s core businesses have seen some market-share erosion in recent months as strapped consumers turned to cheaper private-label products. In December the company eliminated a 10% price hike on trash bags, the first of more than 40 price increases in the past three years that has not stuck. Friday it slashed Glad bag prices again.

Like many consumer-products concerns, Clorox generates abundant cash. The company is committed to using it to pay down debt – it has $2.1 billion of the long-term variety – and to pay its dividend, now $1.84 a share. Clorox raised its dividend last year, even as profit margins shrank, and Call, of Capital Management, thinks another increase is coming.

Clorox’s stock has benefited as investors have sought refuge in noncyclical shares. As the economy shows signs of improving, some erstwhile bulls may flee for snappier sectors. The company’s true fans, however, applaud its stable of iconic brands and solid balance sheet, and a history of savvy acquisitions. Clorox might even find itself the object of a brawnier company’s affection, though there are no signs of interest on the horizon.

In the meantime, there is housework, and lots of it. And that is hugely bullish for Clorox.

GENERAL MILLS: A CEREAL THRILLER

General Mills, which markets its popular brands in 100 countries, is not getting enough credit for its successful expansion into high-growth markets like China. Indeed, that is what makes this stock so appealing.

General Mills, as with Clorox immediately above, must be considered to be one of the bluest of the blue chips. By most important measures such as return on capital it is among the best run U.S. companies. Around 13 times 2009 estimated earnings is not at all expensive for a company with such a high quality portfolio of businesses.

The main danger, in our eyes, is if its raw material costs, grain and other foodstuff prices, become subject to 1970s-style inflationary pressures – and this is a distinct possibility – General Mills and its packaged food company peers could all go through difficult operating times as they did in the 1970s. Food companies routinely sold at single-digit multiples in that environment.

Now single-digit muliples for blue chips were standard in the value buyers’ fondly-remembered paradise that was the 1970s stock markets, but also beware that those multiples often stemmed from reported corporate earnings being overstated thanks to the inadequacy of standard accounting rules in the face of high inflation. Eventually the FASB required that companies include inflation-adjusted earnings in their footnotes, using replacement costs rather than historical for inventory and fixed assets. This requirement was lifted in the “disinflationary” (i.e., inflation in asset markets but not much in consumer prices) 1980s which followed Paul Volker’s temporary monetary purgatives.

Anyway, nice company. As with any stock purchase, understand the risks.

When General Mills acquired Pillsbury in 2001, the purchase included Wanchai Ferry, a Chinese frozen-dumpling outfit named after the ferry line that connects the island city to mainland China. Wanchai provided the big U.S. food processor with a new means to do what it has become adept at – voyaging into new markets.

Aided by its American owner’s formidable merchandising skills, Wanchai has boomed. Its products are now sold in more than 60 Chinese cities, and in America and Europe as well. General Mills introduced the Wanchai brand to France in 2006 and to the U.S. in 2007 – in the form of dinner kits for meals like sweet-and-sour chicken and other Chinese specialties.

Without being specific, Chris O’Leary, the executive vice president who heads General Mills’ international division, says that Wanchai’s sales have grown by the mid-double digits during the past three years. “We are No. 1 in all the cities we have entered,” he declares.

That is par for General Mills (ticker: GIS). The Minneapolis-based packaged-foods maker holds the top or second spot globally in major prepared-food categories, including dry dinner mixes, refrigerated dough, ready-to-serve soups and cereals and frozen vegetables. Its brands include some of the world’s best-known: Häagen-Dazs, Pillsbury, Green Giant, Old El Paso, Cheerios, Nature Valley, Betty Crocker, Progresso, Cascadian Farm and Yoplait.

Each year, the company introduces 300 to 400 products, mostly extensions of existing lines, many modified for local tastes. In China, for example, it sells Häagen-Dazs “moon cake” ice cream that has the flavor of a favorite Chinese treat. Overall sales in China grew 30% last year and contributed more than $250 million to General Mills’ top line.

With the packaged-food industry expanding by only 3% a year, General Mills , like its rivals, needs to make inroads in big new markets like China and India, to keep its production lines humming. In 2008, according to O’Leary, the company generated about a quarter of its $14.9 billion in sales and 15% to 20% of its $1.2 billion in operating earnings abroad.

In contrast, before 1990, when General Mills created Central Partners Worldwide, a joint venture with Nestlé (NESN), international sales were a small part of the company’s business. Today, General Mills is in 100 countries, and it markets more than 100 consumer brands. “International is a key driver of our future growth,” says Kendall J. Powell, who became CEO in September 2007.

Investors, however, are not giving General Mills much credit for its successful forays outside the U.S...or for much else. At a recent 49, its stock was near a 52-week low and well below its 52-week high of 72, hit last September. But the shares’ pummeling seems unjustified. Demand for Cheerios cereals, Yoplait yogurts, Progresso soups and Betty Crocker cake mixes is rising nicely, and some bulls believe the shares have 25%-to-35% upside over the next 12 to 18 months.

“General Mills remains strong in some of the most attractive categories in food, and its management is first-rate,” says Mark L. Henneman, a portfolio chief with Mairs & Power, a St. Paul, Minnesota asset-management firm [see interview with fund co-manager above] that owns the stock. “I believe the company will be able to generate 8%-9% annual earnings growth consistently in the next few years.”

Last fall, Henneman’s firm had dumped its position in General Mills, in part because it viewed the valuation as too rich. Since January, there has been a general rotation out of defensive sectors like food and consumer staples, as investors perceive what they view as better opportunities in technology, or recovery plays in industrials.

General Mills, which was established in 1928 by the merger of five regional flour millers, did not help its case much either on March 18, when it reported unexpectedly weak earnings for its fiscal 2009 third quarter, ended Feb. 28. The culprits included higher costs and marketing expenses, plus a strong dollar that pushed down the value of profits earned abroad. The stock promptly fell 11% that day, to 47.63, even though management simultaneously raised guidance for the full fiscal year, which ends next month, to $3.87 to $3.89 a share, versus $3.52 in fiscal 2008.

Powell, while acknowledging disappointment, tells Barron’s that the results were distorted by unusual grain-merchandising gains a year earlier, which made quarter-on-quarter comparisons difficult. “The underlying business was actually very much stronger,” he maintains. “We believe very strongly that because our long-term growth story remains essentially intact – and because of the categories we are in and the strength of our brands – that we can deliver EPS growth, year in and year out, that is high single digit.” While most analysts immediately lowered their price targets after the third-quarter numbers came out, few cut their rating on the stock, and some have even raised theirs, arguing that the shares’ drop was temporary and that the company’s business outlook remains favorable.

“Unlike other recent food-stock blowups, General Mills’ earnings miss was caused by weaker-than-expected margins, not sales,” says Bryan D. Spillane, who follows the company for Bank of America Merrill Lynch in New York. “Costs are more fixable than sales,” he says, predicting a 5.4% earnings gain in fiscal 2010. He believes that the stock can hit 52 in 12 months.

Spillane is cheered by the packaged-food producer’s continued gains in market share. Recent data, he says, indicate that General Mills sales were up sharply in food categories that represent more than 60% of its total sales, while advances of 15% and 5% were posted in these categories by Kellogg (K) and Kraft (KFT), respectively.

Bulls on General Mills contend that its stock should fetch a premium to its peers’. Instead, at its recent price-earnings ratio of 12.7 times on expected 2009 profits, its multiple is in line with Campbell Soup’s (CPB) 12.4, Kraft’s 12 and Kellogg’s 12.9.

Analyst Christopher Growe of Stifel Nicolaus argues that the stock is worth $62 – 15.5 times his 2009 earnings estimate of $3.90 a share, That “would be an appropriate premium to the group, given its superior growth characteristics.” he says. An above-average annual dividend yield of 3.4% – $1.72 a share – and management’s fiscal discipline strengthen the bullish case.

“From a fiduciary-responsibility standpoint, General Mills’ management is outstanding,” says James A. Lane, who ran the equity strategy for Tripoint Asset Management until it closed last May. “They have been very vigilant and disciplined about keeping their pension and post-retirement benefits funded at the top of their peer group.” The company has over-funded its pension plan by the equivalent of $2.70 a share. And, Lane adds: “The company is very likely to raise dividends significantly during the next couple of years.” His 12-month price target on the stock: 69.

As of the end of February, General Mills had $937 million in cash and equivalents and $5.8 billion in long-term debt. Controlling costs has become a high priority at the company. One prosaic example: Yoplait containers now are all topped by silver-color lids. Previously, different colors had been used for different varieties. Says Chief Financial Officer Don Mulligan: “We saved $2 million by making that one simple change, $2 million we could then invest back into advertising.”

Currently, General Mills is increasingly focused on health and wellness products and convenience foods. Its line of nutrition-rich Fiber One bars, introduced in 2007, is now a $100 million-plus-a-year business and growing. Progresso’s new light soups have been a big hit among weight-conscious consumers – they are eating away at Campbell’s market share in soups – while reduced-calorie Yoplait Light has become No. 1 in its category.

“Consumers have never been more busy or more health-conscious than they are today,” says Matt Arnold a research analyst with Edward Jones. "“ Mills has really brought a lot of product innovation to the areas that allowed them to take market share from other packaged food companies.”

The company is also gaining market share in grain snacks (Nature Valley), cereals (Cheerios, Fiber One), yogurt (Yoplait) and frozen baked goods (Pillsbury).

With the economy shaky, more people are eating at home. Restaurant traffic, by one estimate, slid 4.3% in 2008 and is expected to fall another 5% this year. “The trend is a good one for General Mills overall because at-home food is our biggest business,” says CEO Powell. It should be good for shareholders, too.

SCHLUMBERGER LOOKS LIKE A POTENTIAL GUSHER

Considered the world’s best oil-service firm, Schlumberger has what it takes to weather the drilling downturn – and prosper in a recovery.

Schlumberger is indisputably the blue chip of the oil services industry. There is no doubt that it is one fine company, with a “strong balance sheet, savvy technology, sound management and a long history of profit growth,” as Barron’s puts it here. Is it worth 19 times earnings? Or 10 times what some analyst is projecting the company will earn at the next oil cycle peak? It does not seem that cheap to us. Schlumberger may be off 60% from last year’s high, but that was an oil-bubble high. Best to not to view that price history as significant.

Having said all that, there is almost no doubt that when oil prices eventually go up again Schlumberger will follow suit. The question is by how much. It involves speculating on how nutty stock speculators will get the next time around.

Investors who have lived through oil-patch busts will tell you that, with oil-service stocks down about 60% from highs, the typical play is to buy the group before signs of an economic recovery become widespread. When demand revives, they will all rise, the thinking goes, so there is no need to pay up for the more expensive shares of, say, Schlumberger, the biggest and arguably the best in the business.

No downturn is exactly the same, however. Oil-service pricing is falling fast in North America, thanks to an overbuilt land-drilling market that may take many years to mend, and to a drop in industrial demand for natural gas. This slump may require special stock-picking skill. Smaller oil-service companies leveraged to the U.S. market – stocks that soared in previous upturns – may have a harder go of it this time.

With international oil-exploration markets likely to fare better, the attractions of Schlumberger [ticker: SLB] – a wide range of product and service offerings and a diverse geographic footprint – are magnified. And if the global economy begins to recover next year or in 2011, as many expect, Schlumberger’s balance-sheet strength, technological leadership, management depth and long history of profit growth will likely give investors the best combination of safety and return.

The Franco-American company, now based in Houston, was founded in 1926 by brothers Marcel and Conrad Schlumberger. It supplies services such as well evaluation and directional drilling, among many others.

Though down big time, crude prices seem to be stabilizing around $40-$50 a barrel, and the sharp deterioration in global economic growth has abated, too. This is typically when savvy investors begin to look at oil-service outfits. Schlumberger stock dropped to 35 in February from a high near 115, before popping up to 50 a share. Even with the rally, the stock sells at a price/earnings valuation significantly below its historical median.

That represents a good opportunity for a patient investor to pick up shares of the world’s best oil-service company at relatively cheap prices ahead of a global recovery. In response to sustained signs of life in the underlying commodity, Schlumberger’s shares could rise 20%-25% in the next 24 months, to 60. And if there were a strong global rebound, the stock could wind up 50% higher four or five years down the road.

As oil prices collapsed to $50 a barrel from last summer’s $145, and natural-gas prices fell to $3 per million British thermal units from $13 per mm BTU, many exploration outfits slashed exploration and production budgets. Revenue at oil-service companies, which help explorers drill holes in the ground or underwater, derive from E&P. In his annual survey of exploration budgets, James Crandell, a veteran oil-service analyst at Barclays Capital, figures E&P spending will drop 12% globally this year.

Things are far worse in North America, where the drilling-rig count is down 54%, to about 950 rigs from nearly 2,000 last September, according to Baker Hughes, an oil-service provider. Even a 50% recovery in rigs would leave capacity far too high, says Dan Rice, a BlackRock Advisors portfolio manager, who cautions investors away from oil-service companies overly exposed to U.S. land drilling.

Andrew Lees, lead manager of the AIM Energy fund [IENAX], concurs, saying “severe margin pressure will continue, especially in the U.S.” He prefers to play an oil-service recovery through “big, diversified” names like Schlumberger, which has a market capitalization of $58 billion. “It is the Exxon of oil-service firms,” says Lees, whose fund bought Schlumberger shares recently.

“Eventually we will get out of this recession, and demand for oil services will increase,” predicts Matt McCormick, a money manager at Bahl & Gaynor, which has added to a long-standing position in Schlumberger. “The company has a strong balance sheet, has never cut its dividend and, despite the tough times, showed good resiliency in the first quarter’s results released April 24,” he adds. It is also a “quasi-tech company dressed up as an oil-service firm,” a big plus in a world where oil discoveries increasingly are in hard-to-get-to places.

In the first quarter, Schlumberger revenue fell to $6 billion from $6.3 billion, while net income dropped to $938 million, or 78 cents a share, from $1.3 billion, or $1.06, in the same quarter of 2008. At quarter’s end, it had cash of $4.4 billion and a net debt position of about $1.5 billion. The ratio of total debt to total capital was a low 26%. In 2008, Schlumberger posted net income of $5.4 billion, or $4.45 a share, on sales of $27.2 billion.

That peak annual number is not likely to be repeated soon. Analysts expect the company to post EPS of $2.57 this year and $2.47 next, for a P/E ratio of 19. In a conference call, CEO Andrew Gould gave a sober picture of 2009, noting the first quarter’s better-than-expected results will be difficult to repeat, and that Schlumberger’s 26% operating margins would weaken further. Drilling “activity continued to weaken around the world ... and the rate of decline in revenues at oil-field services accelerated considerably,” particularly in the U.S., he said.

Schlumberger also said it would reduce head count by about 5,000 beyond the 5,000 it has already cut. Cost reductions will allow the company to stabilize North America margins, said Gould, who does not see a potential cyclical upturn until mid-2010, assuming this is a typical oil-patch bust. Schlumberger declined to speak with Barron’s.

Loomis Sayles analyst Bob Goodof says: “So few big oil projects were OK’d in the last few years [that] looking a few years out, if we get any more oil demand, even 1% ... by 2011-2012 the fundamentals get better” for oil services. The stocks begin to discount that ahead of time, says Goodof, who likes Schlumberger as a “defensive” oil-service play.

s That is why Schlumberger’s shares represent good long-term value even at a P/E of 19 – still well below the median P/E of 23 since 2004. Granted, the stock is up about $15 a share from its lows, but the long-term investor should look at what Schlumberger’s EPS would average over the cycle. Given the $4.45 EPS peak and a typical 50% drop to trough profits, or about $2.25, a through-the-cycle normalized EPS of $3 for Schlumberger seems reasonable, if not conservative. Applying the company’s typical 20-25 P/E gives a share range of $60-$75, though the higher number would likely require a full oil-demand recovery.

Why apply such lofty P/Es to Schlumberger? The company has produced average EPS growth of 40% since 1999, which includes times when oil prices were sharply lower than today’s $50 a barrel. Nor is it all gloom and doom for a company with Schlumberger’s global breadth. The U.S. oil-service market is flat on its back, but Mexico, Brazil and Russia show signs of life; even Iraq may need help soon.

s Says AIM’s Lees: The next peak in Schlumberger’s EPS – whenever that is – could be $5. “It will get more than a 20 P/E. There is ample room for [shares of] a big company like Schlumberger to rise.”

Why should “investors” pay a 20 multiple on peak earnings? It really makes no sense, even if “investors” have done so in the past.

Of course, a bet on Schlumberger is inherently a call on oil prices. But investors can rest relatively easy because of its financial wherewithal. At some point the global economy will revive, and with it Schlumberger’s shares.

MENTOR GRAPHICS: BETTER CHIPS, BIGGER PROFITS

Mentor Graphics, which makes software used to design and test chips, may be surprisingly insulated from the semiconductor slump.

Semiconductor services company Mentor Graphics has fallen from near 20 a couple of years ago to about 6 3/4. The stock is trading at 17 times forward earnings – “hardly expensive” according to Barron’s. Interesting company. Just make sure you really understand the business if you buy.

In investors’ eyes, Oregon-based Mentor Graphics has some big strikes against it.

Mentor [ticker: MENT] makes highly sophisticated software used to design and test chips that go in just about every kind of electronic gadget and appliance.

Not only did it lose money in 3 of last year’s 4 quarters, but it now faces weakness in the global semiconductor industry, its main customer. Mentor is also carrying a large load of debt, which could hurt it if the recession drags on. Finally, of all the places to focus immediate expansion, Mentor’s latest venture is software aimed at the ailing auto industry.

Little wonder the stock has plunged, from a 12-month high of 16 to just under 7 recently. The shares, however, could rebound sharply. The company may prove to be surprisingly insulated from the chip slump, and its fortunes should improve faster than its rivals’ when the economy finally starts to recover.

At the end of May, Mentor is due to report on its first quarter, ended in April. If the company at that time releases upbeat guidance for the rest of this year – a distinct possibility – it may begin to inspire some real confidence among investors.

Over the full 12 months of this current fiscal year, Mentor’s earnings are likely to rise to 36 to 40 cents a share, potentially doubling the 20 cents seen last year. Among other things, that reflects the fact that an unusually large number of the company’s 3-year contracts are up for renewal this year. Because the software is critical to the chip-designing process, many customers will not only renew but increase the size of their contracts; analysts think those rises will average about 10%.

Further growth should come in 2010 and 2011, with an improved economy helping earnings rise to more than 60 cents. Result: The stock could climb 30% over the next 12 months, to about 10.

Mentor’s business is software, specifically some 1,000 diverse applications for designing and testing chips and circuit boards. About a quarter of its total sales are to semiconductor companies, says Walden Rhines, Mentor’s chairman and CEO. Mentor’s single most important product, its Calibre software for verifying that a chip design works, has become the industry standard.

While the semiconductor business has enjoyed a mild recovery this year, thanks to inventory restocking, a full recovery cannot happen until there are improving consumer and industrial orders for electronic goods. That shortfall of orders is seen as a continuing drag on the stock – but it should not be.

While Mentor’s core sales are to semiconductor companies, they are specifically to those firms’ research-and-development divisions, not to operations. Since it typically takes months, even years, to conceptualize, design and test a new chip idea, most chip makers are loath to cut R&D. Most will continue to buy Mentor software to help them create the chips that will power the new electronic goods of a recovering economy in 2010 and 2011.

“Semiconductor revenue could fall 50% in this downturn, but only the very smallest companies will allow their R&D operations to be cut significantly,” says Rich Valera, an analyst with Needham. “Most will make every effort to maintain their core R&D.” He adds: “It is very hard for a chip maker to stop designing and then start up again. They all need new product and they all know that they will continue to need new product.”

Mentor is by no means the only supplier in this field. In fact, it is #3 behind Synopsys [SNPS] and Cadence Design Systems [CDNS]. But Mentor looks much more appealing as an investment. Unlike its rivals, it books sales as soon as the orders come in, meaning its bottom line should improve quickly in an economic recovery. What is more, its stock is cheaper than the two larger competitors’, based on enterprise value – market value plus net debt – to sales (a price/earnings comparison is impossible, since Cadence is posting losses).

The latest venture of Mentor – software to help large auto makers improve vehicle electronics – might seem foolhardy in view of the industry’s woes. But just like chip makers, car makers cannot afford to scrimp on R&D, especially for products designed for hybrid and alternative-fuel vehicles.

Mentor does have one clear negative: long-term borrowings totaling about $220 million, or 31% of its capital, the result of recent acquisitions. But very little of it comes due in the next few years, and the company still has untapped credit lines and holds $96 million of cash.

Right now, Mentor’s stock is trading at 17 times earnings for the year ahead, hardly expensive, given that earnings should double this year and rise a further 50% or so the following year. And if Mentor plays its chips right, it could itself become a takeover target. Cadence made a run at the company last summer and might well try again, once things settle down.

THE CORRECT RECOVERY PARADIGM

It is time for the ghost of Keynes to be exorcized.

The U.S. is apparently hell-bent on implementing a recovery program for which no evidence exists regarding its efficaciousness, and ignoring historic examples of recovery programs which proved to be fully effective in the face of far more trying circumstances than we now face. Too bad our “public servants” are more interested in turning the public into servants than serving the public.

The potential swine flu pandemic has emphasized once again the vulnerability of the global economy to being knocked off an even course by unexpected events, not all of which are as obviously based in past economic policy as the U.S. housing finance disaster. Wars, epidemics, serious terrorist attacks and doubtless in the future ecological crises are all capable of devastating the finely tuned modern economic system. The government panic and misguided activity of the last six months have, however, made on thing abundantly clear: the world urgently needs a better designed paradigm for producing recovery.

Ordinary recessions, a product of a predictable business cycle, do not seem to be much of a problem, and nor do stock market crashes taken by themselves. The last 30 years are full of examples of such events, during which governments either did nothing or confined themselves to moderate monetary and/or fiscal stimulus. In 1987, for example, monetary authorities in both Britain and the United States loosened policy after a stock market crash, preventing it from spreading. Likewise in 2001, both countries loosened monetary policy in face of a stock market crash, though in that case U.S. policymakers kept rates too loose for so long.

The problem is that those remedies, both of which are generally popular with business and the public at large, are only effective when used in moderate doses against moderate, conventionally-caused recessions. In 1987, the stock market crash took prices down to reasonable levels, and policy prior to the boom had not been over-expansionary, so stimulus worked well. Likewise in 2001-03, the U.S. budget was close to balance and so the moderate fiscal stimulus of the early Bush years did its job, particularly as it was accompanied by a modest supply-side effect from the 2001 tax rate cuts and a much larger one from the 2003 partial removal of dividend double taxation.

One need only look at the huge fiscal and monetary stimulus employed in 1990s Japan to realize that fiscal and monetary aspirin can kill the patient if used against a serious disease.

However, loose monetary policy in the U.S. and U.K. in 1970-73 led to much higher inflation without producing much economic recovery. Similarly, Britain’s mid-1970s fiscal stimulus under Harold Wilson produced a sterling crisis but did not cause the economy to recover. Fiscal and monetary stimuli are thus the equivalent of aspirin, effective in small doses against mild illnesses, but ineffectual against major maladies and dangerous if taken in excessive quantities. One need not be a pessimist, as I am, about their efficacy in the current crisis. One need only look at the huge fiscal and monetary stimulus employed in 1990s Japan to realize that fiscal and monetary aspirin can kill the patient if used against a serious disease.

Policymakers therefore need a recipe against serious economic traumas, which prevents these traumas from turning into the Great Depression or Japan’s miserable post-1990 trajectory. It is reasonable to suppose that exogenous shocks to the economic system are more likely in a world of globalization, rapid communication and high population density than in the slow-communications, lower-population less integrated world of the 19th and early 20th century. One way or another, we can confidently expect at least one major economic crisis per generation, generally from a cause that is either non-economic or wholly unexpected beforehand, and we had better learn how to deal with them.

The first point to note in dealing with these serious crises is that the policy aspirins effective against lesser economic ills are positively harmful in these cases. This time round, the Bush “stimulus” of 2008 was not only ineffective, it dangerously increased the government’s borrowing requirements, reducing financial flexibility and increasing the capital starvation caused by the flight to quality in late 2008. Monetary stimulus used after 2001 to counter the effects of the stock market downturn produced the much more dangerous and widespread housing bubble.

The huge additional monetary and fiscal stimuli implemented since September have not yet imposed their costs but may be beginning to do so. The first quarter Gross Domestic Product (GDP) deflator came in contrary to expectations of deflation at a 2.9% rise, while 10-year Treasury bond yields have now broken decisively above 3%. Both inflation and interest rates can be expected to push sharply higher in the months ahead.

History offers plenty of examples of effective responses to major economic crises.

To determine the policy response to a serious economic crisis, it is first necessary to consider what you are attempting to achieve: an economy in rapid recovery, generating large numbers of jobs at good pay rates, with capital formation and entrepreneurship active, inflation low or even negative and government reined in, so that the budget is either in balance or moving rapidly back towards it. The best recoveries from economic catastrophe have all taken this form – you can consider the British 1820s recovery from the Napoleonic Wars and post-war depression, the U.S. 1920s’ recovery from World War I and post-war depression; the U.S. 1945-60 recovery from the Great Depression; the German and Japanese 1950s recoveries from World War II; and many others. Even in the Great Depression itself, Britain, which followed these policies, fared much better than the U.S. and Germany, which did not.

Only the hard money, high savings, balanced-budget approach can be relied upon to recover from a real crisis.

Attempted recoveries from catastrophe that have not taken this form have not worked. The German money printing of 1919-23 led to the Weimar hyperinflation and the impoverishment of the middle class. The British attempt to recover from World War II through Keynesian government spending and economic planning never got off the ground and lagged similar efforts in France and Germany, let alone Japan. Notoriously, Japan’s attempt to achieve prosperity through public sector infrastructure in the 1990s did not work. Russia’s post-Communist attempt in the 1990s to achieve prosperity through dodgy privatization and cheap money failed catastrophically. In each of these cases, other excuses can be made for failure, but the overall picture is clear: Only the hard money, high savings, balanced-budget approach can be relied upon to recover from a real crisis.

These policies have succeeded in the past centuries against wars and major economic collapse, but there is no reason to believe they will not work against other types of catastrophe, such as major epidemics or ecological disaster (which does not include only global warming; economic catastrophe could also result from uncontrollable pollution or a “nuclear winter” period of famine and disruption resulting from volcanic activity). In each case, there would be special factors to be dealt with, such as a catastrophic loss of population, the abandonment of some central economic activity that had caused the pollution problem, or relocation of much of the planet’s agriculture or industry to take account of new conditions. Nevertheless, there is no reason why the same central economic objectives should not hold true, whatever the cause of the initial disaster.

If a high saving, low-inflation, reined-in government environment is the necessary state for economic recovery from disaster, then the correct policies to pursue become obvious.

• Interest rates should be increased to provide adequate returns for savers and rebuild the capital stock.
• Public spending should be reined in sharply, in order to get closer to budget balance without having to increase taxes, which inevitably dampens activity.
• Economic losers should be starved of capital and liquidated, in order to free up resources for the new industries that need to arise.
• Inflation should be treated as a leper because of its erosion of savings, while a moderate amount of deflation should be welcomed, as it will increase the value of capital and thereby produce more and better new businesses.
• Trade should be freed up, in order that new business opportunities appear and Joseph Schumpeter’s “creative destruction” can work its magic.
• Labor laws should be eliminated as far as possible so that wages and employment can reset to market levels, while labor mobility within the domestic economy should be encouraged. (However international labor mobility in a recession depresses living standards in the higher-wage economy, allowing unscrupulous employers to drive wages down to Malthusian levels.)

Against a major economic collapse, only these policies will work. They were employed by Lord Liverpool in 1815-25 Britain, by Andrew Mellon in the U.S in the 1920s, by Dwight Eisenhower and William McChesney Martin in the U.S. after 1951-52 (when the U.S. savings rate was over 10%, far higher than today), by Konrad Adenauer and Ludwig Erhard in Germany from 1948 through 1963, by Shigeru Yoshida and Hayato Ikeda in Japan from 1949 through 1964, and by Neville Chamberlain in 1931-37 Britain.

Maynard Keynes would grind his teeth in thwarted academic fury at the policies proposed. He disliked Chamberlain, disdained Mellon and Liverpool and would have hated the others. Yet they – not he – were true architects of economic recoveries and their policies, not his failed nostrums, should be adopted today.

Which Green Shoots Will Wilt First?

Martin Hutchinson’s “correct recovery paradigm” (above) is not being followed. The apparent “green shoots” of recovery, he posits, are the equivalent of flower buds tempted out during a February warm spell soon to be snuffed out by the return of seasonal cold – cold which will take the form of higher interest rates and very rapid inflation.

Stock markets have shown clear signs of irrational exuberance in recent weeks, on evidence that the U.S. and global economy is exhibiting “green shoots” of impending recovery. While I have said several times that the economy appears to be approaching a near-term bottom, I do not expect recovery to impend any time soon, so I thought it worth examining these “green shoots” to determine which were most likely to wilt first.

Let us start with one that looks pretty robust. Global trade, particularly in the Asian supply chain to the United States, dropped a frightening amount in the first couple of months of 2009. This was very worrying. It appeared possible that we would see a repeat of the Great Depression’s trade madness, when trade declined by 65% in four years. That reduced a lot of the “comparative advantage” efficiencies in the world economy, whereby goods are manufactured in those countries with the best relative costs – thus a repeat of it would have had truly dire implications for global economic prospects, effectively reversing globalization in one bound.

There was however another possibility, which was that U.S. consumption declines caused an inventory backup in the Asian supply chain that, combined with the inevitable difficulties for exporters getting financing, sharply reduced trade for a short period. More recent figures have shown a considerable trade recovery, indicating this to be the most likely explanation. Thus, while trade will not recover completely since the U.S. savings rate has increased and consumption declined, this partial trade recovery is indeed a genuine “green shoot” that will not reverse.

A second “green shoot” that looks likely to persist, although not entirely, is the increased solidity of the U.S. banking system. Back in February, Treasury Secretary Tim Geithner was wailing that the U.S. banking system needed another $1.5 trillion to fix it. Given the relatively robust state of most regional banks, that always looked unlikely, and I said so at the time. Now the “stress tests” have found that a mere $80 billion of new capital, most of it raised freely in the market, will fix the problem. Geithner’s panic in February, which may have been assumed in order to generate support for the bloated and damaging “stimulus plan,” has thus proved wide of the mark.

Having said that, this “green shoot” is by no means assured of growing into a healthy tree. Unemployment figures released Friday showed a continued increase in the unemployment rate more rapid than in past post-war recessions – up by 4.5% in only two years, faster than in 1979-82, when it took 3½ years to rise 5.2%. The Treasury’s “stress test” assumptions were based on data from past recessions. If unemployment continues to rise at a rate with no past parallel since the Great Depression, or continues to rise to a level above the postwar record (10.8% in November/December 1982), then we will be economically “off the map” and it is entirely possible that bank loss rates will rise far above the stress test predictions.

After all, there can be no certainty that the relationship between unemployment and either credit card or mortgage losses is linear. It is possible that there is a “tipping point” as unemployment continues to rise, at which foreclosures or credit card losses increase to such a point that they become self-reinforcing, escalating uncontrollably with only a modest further deterioration in economic conditions.

Treasury bond yields of 10% or more as deficits and inflation provide a howling adverse gale for the T-bond market.

The principal cold gale causing green shoots to wither will probably be the inexorable rise in long-term interest rates. This has already begun; the 10-year Treasury yield is up from its low of 2.07% in December to around 3.3% today. However, the enormous Treasury financing requirement and the increasing visibility of inflationary signals will cause yields to go much higher. In the 1990s, when average inflation was 2.9%, the same level as the recently announced first-quarter GDP deflator, and the federal budget deficit averaged a mere 2.3% of GDP, the 10-year Treasury yield averaged 6.67%. That level may seem very high currently, but in fact is likely to be passed fairly rapidly, on the way to Treasury bond yields of 10% or more as deficits and inflation provide a howling adverse gale for the T-bond market. The rise in interest rates will be prolonged and initially quite slow, but we can probably expect 10-year Treasurys to yield more than 6% a year from now.

Bernanke has enjoyed a period in the public eye, even before his January 2006 ascension as Fed chairman, largely punctuated by self-delusion on an extraordinary scale.

If rising interest rates are the gale causing green shoots to wither, inflation will be the frost causing them to die. Federal Reserve Chairman Ben Bernanke has enjoyed a period in the public eye, even before his January 2006 ascension as Fed chairman, largely punctuated by self-delusion on an extraordinary scale. It began with his discovery of a hitherto undetected dire deflationary threat in 2002, continued with his announcement of the “Great Moderation” in February 2004, just as his lax monetary policy was sending housing policies into orbit, continued with his accusation that evil Asian savers had caused the 2007-08 explosion in commodity prices and has now settled into an indelible conviction that, however “unorthodox” and Weimarite his monetary policies may be, inflation is far less of a danger than deflation.

It will be a race between soaring interest rates and grimly rising inflation to kill the green shoots of recovery and plunge the U.S. economy into renewed downturn. Both factors will reinforce each other as buyers of Treasury bonds, appalled by the price declines in their holdings, will come to realize that inflation as well as soaring interest rates has made long-term Treasurys the ultimate sucker’s bet. Zhou Xiaochuan, governor of the People’s Bank of China, will no doubt be especially withering in his condemnation, discovering a hitherto little-known treatise on sound monetary policy in his copy of the “Thoughts of Mao Zedong.”

The housing market and its corollaries, the housing finance market and the construction market, will recover or wilt further, depending on which – interest rate rises and inflation – proves predominant. Here my crystal ball is a little cloudy. House prices are now around their long-term average in terms of median income, but on the other hand, there is a huge overhang of unsold housing inventory and foreclosures or potential foreclosures which would normally depress prices further.

Nevertheless, very rapid inflation without a concomitant rise in interest rates might cause the housing market to find its feet quickly. Had Bernanke been allowed to wreak his inflationary-producing magic unaccompanied by the deficit-producing efforts of his partner in congressional obfuscation, Geithner, that might have happened. However, in the short term, Geithner’s operations pushing up the federal deficit and interest rates should win out over Bernanke’s attempts to push up inflation by lowering interest rates. In that event, further green shoot wilting and chaos in the housing market is likely, producing knock-on negative effects on construction, mortgage finance and the U.S. banking system.

With higher interest rates, higher inflation, a wobbling housing market and a wobbling banking system, the stock market’s recent exuberance is most unlikely to continue for long. Currently, particularly in the financial sector, the riskiest and most damaged stocks are showing greatest strength, which is always a worrying sign. At some point, investors will note that the old problems have not fully gone away, while new problems have appeared. Then a rapid stock market decline below the March lows will probably occur, although there will be heavy buying at March’s levels by investors who have noticed that in March, stocks at those levels proved to be bargains. This time around, the bargains will be false ones, as further earnings damage is in store through the rising cost of debt in an overleveraged economy.

Consumer spending has shown signs of strength recently, as consumer confidence has risen from its low and retail sales have edged upwards. However, the consumer savings rate, at around 4% to 5% of disposable income, is still too low to balance the U.S. economic system, while consumers’ asset holdings are depleted far below their levels of a couple of years ago. Hence consumer savings will rise further, probably as interest rates firm, which will in turn depress retail sales and consumer-oriented activity generally. The green shoot of consumer confidence will survive only until inflation is seen to have regained a firm grip on the U.S. economy and the stock market has relapsed into its currently natural bearish state.

On the corporate side, the Institute of Supply Management indices for April rebounded somewhat, suggesting that recession is drawing to an end. Inventories also have begun to rebound after their exceptional weakness in the first quarter. Like consumer confidence, the modest impending rebound in production may survive for some months, until it becomes clear that higher interest rates must be factored into all cost calculations and that consumer spending is not about to revert to its robust recent trend. Nevertheless, the U.S. corporate sector will be buoyed by an improving trade position, and will be distinctly stronger than the consumer sector. Capital spending, which has been weak since the tech bubble burst in 2000, is likely to remain so as capital costs rise.

Going forward, with capital spending low and inflation rampant, productivity growth is likely to be exceptionally low, as it was in the 1970s. This will speed the economic transition from a U.S.-dominated world economy to the new domination by east Asia.

The productivity miracle of the late 1990s was always a mirage, caused partly by record levels of capital spending and partly by statistical jiggery-pokery in price index figures. Going forward, with capital spending low and inflation rampant, productivity growth is likely to be exceptionally low, as it was in the 1970s. This will speed the economic transition from a U.S.-dominated world economy to the new domination by east Asia. On the other hand, it might slow the otherwise inevitable decline in U.S. living standards, as labor-saving technologies prove unattractive capital investments while outsourcing falls victim to protectionism, expensive emerging market capital costs and slower trade growth.

Finally, back to unemployment, which on current figures seems sure to exceed 10%, and may well pass 1982’s record of 10.8%. Should it move significantly past previous post-war records into new territory, the effect on consumer costs and bank loan portfolios will be literally un-calculable, as it will have moved beyond the data on which previous regressions have been based. Beyond deficits/interest rates and inflation, this is the third potential adverse “climate” factor that could cause “green shoots” to wither for several years to come. For this reason, unemployment data should be watched closely. If the unemployment rate steams through 10% in the next few months with some apparent momentum behind it, watch out.

Economically, it is currently spring with “green shoots” apparently indicating recovery, burgeoning in the most unexpected places. The economic climate, however, is that of early February rather than mid-April. True recovery is nowhere near imminent, and economic conditions should get considerably worse before it arrives.

SHORT TAKES

Some options tips from Teddy Roosevelt.

Everyone knows about swine flu. Many investors spent last week establishing positions in stocks and options of pharmaceutical and travel companies to profit from the virus’s impact on vaccines, cruise ships and airlines.

But unbeknownst to many, the bloviator virus that normally infects Washington has spread to Wall Street. Two of the key symptoms are palavering and inaction.

Rather than focusing on the merits of individual stocks, bloviators debate whether the stock market’s recent strength is a bear market rally or the real deal, often scaring investors from making risk-adjusted decisions.

Investors would do well to heed President Theodore Roosevelt’s advice offered to one of his Rough Riders struggling with a decision: “Get action; do things; be sane. Don’t fritter away your time.”

Naturally, were TR around today, he would know that options are an antidote to the bloviator virus. Being plugged in, he would also know about the “half-and-half strategy” of Michael Schwartz, Oppenheimer & Co.’s chief options strategist. The strategy uses options to better balance the risk and reward of stock ownership. Here is how the conversation would likely go between TR and the dean of options strategists.

TR: Schwartz! TR here. I am bullish on America, and I want to buy stocks, but I do not want to get scalped if the market turns south. What say you?

Schwartz: Mr. President, my half-and-half strategy may solve your conundrum. Say you want to own 1,000 shares. Instead of buying all at once, buy 500 shares and sell five puts.

TR: Schwartz, I am a hard-charging man; half-and-half sounds like how Mrs. Roosevelt takes her coffee.

Schwartz: Then she must be a natural trader, sir. The half-and-half balances the potential reward of buying stock with the risk of initiating a position when macro-market trends are unusually uncertain.

TR: Don’t talk options voodoo, man. Give me something concrete.

Schwartz: Take Morgan Stanley [ticker: MS]. Oppenheimer rates the stock Outperform and gives it a $42 price target. With the stock at Thursday’s close of $23.54, you buy 500 shares, and sell five July 23 puts for $2.90 each. If the stock advances, you keep the money from selling the puts. If the stock declines, you use the money from selling puts to buy the stock. If the stock is put to you, you will own the total position at an average price of $21.82.

TR: Sounds too good to be true. What is the catch?

Schwartz: One risk is the stock races higher and you miss the gains from the 500 shares you did not buy. Conversely, you could buy the stock and sell the puts, and the stock price plummets and you have a loss below $21.82.

TR: I’m no Prince Hamlet. There is risk in everything.

Schwartz: Then you will appreciate my half-and-half because it helps fence-sitters become position-builders.

ETFs Track Various Bond Indexes

Investors cannot capture the return of indexes but they can buy exchange-traded funds that track just about anything these days, including sectors of the bond market.

For instance, the iShares IBoxx High-Yield Bond ETF [ticker: HYG] returned 13.82% in April, according to Morningstar. For the year to date, however, the junk ETF has returned just 3.86%. Junk rallied even though 10 corporate issuers defaulted last week, including Chrysler’s Chapter 11 bankruptcy filing. That brought April’s default total to 40 and 102 so far in 2009, based on Standard & Poor’s tally.

By contrast, the iShares Barclays 20+ Year Treasury Bond ETF [TLT] lost 6.94% last month, including 3.46% in the week ended Thursday. For the year through April 30, the long Treasury lost 17.12% as the 30-year bond yield shot up past 4% from a shade over 2.5% at year-end.

In the middle of the yield curve, the iShares Barclays 7-10 Year Treasury ETF [IEF] was down 2.74% for April and 1.17% in the week to Thursday as the benchmark 10-year note yield moved decisively above the 3% mark.

That means the 10-year note has more than reversed its half-point plunge on March 18, after the Fed announced its plans to purchase intermediate and longer securities to bring their yields down. While the effort has failed to lower Treasury yields, mortgage rates have responded with conforming fixed-rate loans solidly below 5%. And that, assuredly, was the central bank’s aim.

The long bond ended at 4.09%, up 21 basis points for the week, as the market braced for this week’s auctions. The Treasury will auction $71 billion in three-, 10- and 30-year maturities in its quarterly refunding operation.

In the higher quality corporate sector, the iShares iBoxx $ Investment Grade Corporate Bond ETF [LQD] posted a return of 2.79% for April, almost equal to the intermediate Treasury ETF’s loss. For the year to date, the LQD is still off 3.89%.

The Treasury and the corporate sectors typically trade roughly in tandem, especially for investment-grade credits. But, observes Cliff Noreen, president of Babson Capital Management, a fixed-income manager with over $100 billion in assets under management, the divergent performances of those sectors reflect their relative valuations. Corporate spreads (the yield premium to compensate for credit risk) were so wide and Treasury yields were so low that a snap-back was likely.

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