Model Portfolio crossy:CIAF

The equity markets in the U.S. and internationally are experiencing an unusual crisis of confidence. This can be inferred by looking at interest rate differentials between government bonds and inter-bank Euro-Dollar loans, which have been rising since the sub-prime got exposed this summer and a period of spikes in the volatility indices (VIX).

As a result, we are witnessing a flight to quality, with hot money being withdrawn from sector after sector only to be reallocated into reportedly "safe heavens" like government bonds or gold. Emerging growth and small-cap companies were among the first to be dumped by fear-stricken investors, tracked by the dismal performance of the Russel 2000 index versus the DOW or the S&P.

While my marketocracy.com portfolios, including the CIAF fund avoided direct exposure to industries and firms with mortgage related stress (residential REITs, banks / insurance companies and investment banks with major exposure to residential and sub-prime real estate), it wasn't possible to escape indirect fallouts, due to their underlying small-to midcap investment theme. Consequently, the CIAF fund is down approximately 20% from intra-year highs. Despite this short-term setback, the fund will not change its strategic orientation, simply because in neutral or positive market environments, the small-to midcap segment tend to considerably outperform bigger capitalized companies. A look back in time, to the year 2002 shows us an environment equally unfriendly to smaller capitalized companies, that quickly changed once the dark clouds over the market faded away: the small-cap sector was able to mightily outperform the rest of the market in every year thereafter until 2006.

In some respect, I do indeed compare the current crisis of confidence to the Asian Financial crisis of 1998. And just like 10 years ago, central banks around the world are easing monetary policy. The general consensus among economists is that such policy changes record significant impact on economic activity 6-12 months from their implementation. On the current rounds of rate-cutting by the U.S. Federal Reserve, the export oriented portion of corporate America are already benefiting from a devalued dollar - a tendency that is narrowing down the trade gap. What is more, this stimulus might come in time to offset possible U.S. domestic softness from the sub-prime residential mortgage fallout - resulting in a soft landing rather than a recession. Finally, it should be pointed out that world economic activity is still expected to grow 4.5%, despite any setback that the U.S. economy might experience or not.

In this kind of economic context, it appears to pay off to search for opportunities stemming from reduced interest rates and the export boom due to the U.S. dollar's weakness. Specialized semiconductor companies appear interesting as this sector has been neglected for years, with many firms offering both growth and value at the same time (e.g. TQNT, IXYS, SWKS, OVTI etc..) Reduced interest rates could allow capital intensive companies to refinance at more favourable terms - and the telecom sector should benefit from this (eg. GLBC, VSL, LVLT, CCOI).

Computer hardware, networking equipment etc. might be another area of unexpected strength, and some turn-around candidates such as Extreme Networks (EXTR) recently made it to my screens and into my portfolios. Specialized capital equipment is another sector where the expected surge of U.S. exports might leave more than just a trace.

Oil and Gas (particularly Oil) and commodities in general are still areas of strength, judging by quoted commodity prices. However the market-caps of their producers have suffered in lieu with the market. My CIAF (industry analysis), CEOF (energy) and CRMF (raw materials) funds will attempt to identify neglected and undervalued commodity producers and service companies addressing the sector's needs (such as Allies Chalmers Energy - ALY) in order to capture the differential once this observable disparity will clear up.

Financial service stocks could be judged key beneficiaries of rate-cuts. Investment banks and brokerages without material exposure to residential mortgages (e.g. Stifel ... SF, Raymond James .. RJF) look appealing to me.

Finally, even among companies investing in mortgage papers, there are sub-segments that should not be thought to be undergoing the same stress as the residential side and thus may provide opportunities. For example, commercial mortgages for years have enjoyed low delinquency rates and much greater underwriting discipline than the residential segment.

Due diligence into this sub-sector uncovered REITs geared predominantly towards commercial mortgage investments (such as JRT, CRZ, CBF, VRTB, VRTA). As these shares were unloaded onto the market with the rest of the REIT and housing sectors, they are now yielding 12-20%. Consequently I established starter positions here in order to capture a healthy dividend from a group of income securities with limited downside risk. Once the current dark cloud over the market clears, there is also significant potential for capital gains in this group.

Posted by crossy at 07:11 PM | Permalink