GROWTH TRACK
Housing’s Turn
For the first time in five years, there are signs of hope that the protracted downslide in housing prices may be approaching an end.
BY ELLIOTT H. GUE
The US residential property market was at the center of the 2007-09 recession and global credit freeze. The relentless rise in home prices from 2001 through 2006 was inflated by loans extended to borrowers with questionable credit histories and requiring little or no down payment. When the housing bubble finally burst, banks were stuck with a mountain of non-performing mortgage debt and the government was forced to step in with a massive bailout package.
Since the bubble burst, declining home prices coupled with falling demand for home construction have dragged on US economic growth.
There’s more in pain to come for the US housing market and prices will continue to fall in most regions in early 2012. But for the first time in five years, there are some glimmers of hope that the housing market is beginning to heal.
According to the Mortgage Banker’s Association (MBA), more than 10 percent of all mortgages in the US were delinquent as of early 2010–a record high that’s more than double the average delinquency rate from 1980 to 2000 (See “TK”). But in the third quarter of 2011, the delinquency rate dropped below 8 percent for the first time since 2008.
Another important metric is the housing vacancy rate–the total percentage of US homes that are currently vacant and available for sale (See “TK”). One of the housing market’s biggest headwinds is “shadow inventory”–a large number of houses in the foreclosure process that will ultimately be placed on the market. Foreclosed homes are typically sold at a discount to what the same home would fetch in a normal market. A large inventory of cheaper foreclosed homes entering the market depresses the value of real estate across the board.
The good news is that the housing vacancy rate has fallen from nearly 3 percent in 2008 to about 2.4 percent as of late 2011, its lowest level since the height of the housing boom in 2006. This suggests that the overhang of excess housing supply is beginning to fall. The rental market also continues to tighten and properties once destined for sale can now earn a decent return as rental properties.
The US housing market won’t turn around overnight. But the evidence is mounting that housing prices could finally hit bottom over the next 12 to 24 months, a positive sign for the broad economy.
A Good Start
Genetically modified (GM) seed giant Monsanto (NYSE: MON) in early January reported stellar first-quarter results for its 2012 fiscal year. Earnings per share of $0.23 far exceeded Wall Street’s consensus estimate of just $0.16. The company’s $2.44 billion in revenue was driven by strong seed sales in Latin America, and topped consensus expectations for sales of $2.02 billion. Management also raised its forecast for full-year earnings and revenue growth.
Monsanto’s GM seeds are designed to exhibit beneficial characteristics known as traits, examples of which include resistance to common crop pests and popular herbicides. In 2010, the company’s aggressive pricing of GM seeds resulted in lost market share and damaged relationships with major customers. But the company quickly recognized its missteps and appears to have regained lost ground.
 A few broader market trends continue to help Monsanto. First, the prices for key crops including soybeans and corn remain elevated while supplies of some foodstuffs remain tight. That means farmers’ incomes are high and growers have a strong incentive boost their crop yields per acre.
Genetically modified seeds boost yields and these crops are gaining market share in most major markets. In Brazil, 77 percent of the country’s corn acres will be planted with next-generation GM traits in 2012, compared to just 64 percent last year and less than 50 percent in 2010. In neighboring Argentina, 89 percent of the corn mix is double or triple-stacked GM traits–GM seeds with two or three beneficial traits–up from 74 percent the previous year.
Monsanto also has an attractive pipeline of new seed products that are in late-stage development or due for launch. The list includes a new line of mildew resistant cucumbers, drought tolerant cotton and soybeans with more advanced protection against insects. Monsanto’s turnaround continues to impress and I’ve raised my buy target to $85.
According to data released by the Association of American Railroads (AAR), total carloads transported on freight railroads in 2011 increased 2.2 percent year over year and 9.7 percent when compared to 2009.
Traffic volumes shipped by rail also appear to have accelerated at end of 2011. In December total freight rail carloads jumped 7.3 percent from the year-ago period while intermodal volumes jumped 9.4 percent year over year.
Railroads saw particularly strong growth in shipments of petroleum products and metal ores last year. The former is the result of a lack of sufficient pipeline capacity to transport oil out of fast-growing production regions in the US such as the Bakken Shale of North Dakota. That’s forced producers such as Growth Portfolio holding EOG Resources (NYSE: EOG) to transport significant volumes of oil by rail.
Railroad operators such as Growth Portfolio holding Union Pacific (NYSE: UNP) also stand to benefit as older contracts expire and are replaced with new agreements that provide higher rates.
Union Pacific’s stock surged in early 2012 in reaction to stronger-than-expected AAR. But the shares remain undervalued and trade at just 17 times projected 2012 earnings. Buy Union Pacific at a new target of 120.
High-end jewelry retailer Tiffany & Co (NYSE: TIF) reported disappointing fourth-quarter sales growth of 7 percent, about half of what most analysts had forecast. US sales were particularly weak, up a mere 4 percent. More troubling, sales at the company’s flagship store in New York declined 1 percent and management lowered its full-year earnings guidance.   
Sales of Tiffany & Co’s high-end jewelry exceeded expectations in the first three quarters of the year. But US and European sales weakened markedly during the holiday season on restrained consumer spending.
Most US retailers resorted to deep discounts and promotions to drive sales during the 2011 holiday season. Tiffany & Co typically doesn’t offer promotions for its jewelry, which may have driven some customers from its stores. However, it did allow the firm to retain solid profit margins.  
The company’s fourth-quarter performance is disappointing, but there are reasons to believe the softness will be temporary. Spending by higher-income households tends to be affected by swings in the stock market; the rally in the US stocks that began in October may support spending into early 2012. In addition, the recent improvement in the US economic data is a positive for consumer spending across the board.
What’s more, Tiffany’s sales were strong outside the US and Europe, including a 19 percent jump in sales from the Asia-Pacific region. Tiffany continues to rate a buy under 83.





 
INCOME REPORT
Worst to First
BY ROGER S. CONRAD
It may not always be the case. But yesterday’s income laggards are often the next year’s leaders, so long as underlying businesses stay strong.
There are no guarantees, particularly when economic growth remains soft and uncertain. Even in the safety-first Income Portfolio, some of our holdings faltered enough in 2011 to warrant selling off our positions. The underperforming stocks that we kept, however, are solid as ever and set for a much-improved 2012.
Arrow Financial Corp’s (NSDQ: AROW) $5 million stock repurchase and fourth-quarter dividend increase reflect the company’s strength, even as banking rivals remain weak and vulnerable. The same is true for Washington REIT’s (NYSE: WRE) joint venture with Trammell Crow to develop residential property in Alexandria, Va.
Despite the strength of their respective businesses, both stocks posted single-digit losses last year amid fears about the health of the US financial system and real estate market. Unfortunately, these fears are likely to persist in 2012. Washington REIT faces a skeptical Wall Street in 2012–no analysts recommend that investors buy the stock, eight analysts have a hold rating on and two analysts rate the shares a sell. This is in marked contrast to apparent enthusiasm among company insiders–their holdings increased 20.94 percent over the past six months.
But with secure dividends and strong liquidity, income investors can afford to be patient. Arrow Financial Corp is a buy up to 28; Washington REIT rates a buy up to 30.
Eni (IM: ENI, NYSE: E) and Vermilion Energy (TSX: VET, OTC: VEMTF) finished 2011 in the black–a remarkable feat considering volatile energy prices, political upheaval in Libya and declines in the euro and Canadian dollar. More important, both companies’ long-term plans to boost output remain intact.
Vermilion Energy’s CAD375 million capital spending program for 2012 keeps the firm on track to increase production to roughly 50,000 barrels of oil equivalent per day by 2015, up from an estimated 37,000 to 38,000 barrels per day in 2012. Buy Vermilion Energy’s American depositary receipt (ADR) up to USD50. Buy Eni’s ADR up to 45.
Starting in 2013, the Canadian government will require US investors to provide proof of residency to qualify for a dividend withholding rate of 15 percent on Canadian stocks (zero percent for IRAs). Only “registered” shareholders, however, will have to make a filing.

 
FUND FOCUS
Farewell to the Frontier
By Benjamin Shepherd
The Arab Spring has become an Arab Winter. Although popular uprisings have deposed longtime dictators in Egypt and Libya, unrest continues to rattle the region. Protestors have clashed with government forces in Syria and Iran has ratcheted up the tension with the West by threatening to close the Strait of Hormuz to oil tanker traffic.
Guggenheim Frontier Markets (NYSE: FRN) features a 10.3 percent allocation to Egypt, where the euphoria of promised democratic reforms have given way to a tougher reality. The ruling military council has been reluctant to cede power to a democratically elected government. Meanwhile, inflation continues to rise at a breakneck pace.
Although Egypt’s economy is demonstrating signs of resilience in the face of inflation, the country’s equity market is showing signs of strain, despite posting a generally positive performance in the fourth quarter. Stock markets in Lebanon, Qatar and Oman–which collectively account for 8 percent of the fund’s assets–have yet to break into the green.
South American markets–which account for more than 70 percent of the fund’s assets–have started 2012 with a bang. But these markets face an uphill battle overcoming last year’s declines of more than 20 percent. What’s more, these markets remain hamstrung by worries of sputtering growth in emerging markets such as China. Inflation in Argentina has been officially reported at 9.5 percent, though many Argentine economists believe the true rate of inflation is close to 20 percent.
Given these mounting challenges, it’s time to reevaluate our investment case for frontier markets.
EGShares Dow Jones Emerging Markets Consumer Titans (NYSE: ECON) has been highly correlated to Guggenheim Frontier Markets during the past few months. The two funds employ different strategies in regard to the regions and sectors in which they invest. Nevertheless, investors have lumped frontier and emerging markets together as high-risk plays.
There’s little reason to believe that investors will differentiate between emerging markets and frontier markets in the near term. Consequently it’s become difficult to justify holding both Guggenheim Frontier Markets and Dow Jones Emerging Markets Consumer Titans, particularly when the latter carries less exposure to political risk.
Additionally, many of the nations represented in Guggenheim Frontier Markets’ portfolio are essentially resource-driven economies. That makes holding the fund redundant, given the Fund Portfolio’s exposure to commodities via iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE: DJP).
We were too early to invest in frontier markets. Although I hate to lock in a loss of about 10 percent on Guggenheim Frontier Markets, it doesn’t make sense to hold the fund when better opportunities are available.
Sell Guggenheim Frontier Markets. Continue buying EGShares Dow Jones Emerging Markets Consumer Titans and iPath Dow Jones-UBS Commodity Index Total Return ETN.
 
INCOME SPOTLIGHT
Bristol-Myers Squibb (NYSE: BMY) announced on Jan. 9 that it will buy Georgia-based biotech company Inhibitex (NSDQ: INHX) for $2.5 billion. The deal will give the pharmaceutical giant a beachhead in the rapidly growing market for hepatitis C virus (HCV) treatments, once regulatory and shareholder approvals are received later this year.
The $26 per share offer represents a 163 percent premium to Inhibitex’s closing price and is expected to dilute Bristol Myers’ earnings per share (EPS) by $0.04 in 2012, $0.05 in 2013 and a couple more pennies in 2014-15. But far more important, this deal dramatically strengthens the company’s long-term pipeline of products as it faces a “patent cliff.”
The Inhibitex acquisition is the largest of Bristol-Myers Squibb’s 18 acquisitions since 2007 under its “string of pearls” strategy to offset the loss of patent exclusivity on several key drugs. The pharmaceutical industry faces a wave of looming patent expirations. Bloomberg Industries estimates $21 billion in lost sales in 2011 and 2012 as blockbuster drugs go off-patent and competition from generic-drug makers heats up. Consensus forecast calls for “nominal” average industry sales growth, and a 2 percent drop in average EPS.
Bristol-Myers Squibb’s biggest loss will be blood thinner Plavix in May 2012. The good news is that a string of acquisitions have insulated earnings and will maintain the company’s financial strength and dividend–even as the company continues to invest in newer and better drugs for a wide range of ailments. The current pipeline includes full ownership rights to melanoma treatment Yervoy, which Bristol-Myers Squibb added to its portfolio after the 2009 acquisition of Medarex for $2.5 billion. Yervoy alone is expected to add $403.6 million in incremental sales in 2012. Even without the Inhibitex acquisition, Bristol-Myers Squibb’s pipeline should deliver $4.62 billion in additional revenue by 2015.
Inhibitex’s crown jewel is an oral HCV treatment known as INHX-189, which remains in Phase II trials. The World Health Organization estimates that roughly 170 million people are infected with the hepatitis C virus, with 3 million to 4 million cases added annually. At present the HCV market stands at $3 billion, but analysts expect it to grow to $20 billion by 2020. With its financial power funding Inhibitex’ proprietary processes, Bristol-Myers Squibb may capture the lion’s share of this market and extend its lead in the race to dominate the market for future drug treatments.
When we first added Bristol-Myers Squibb to the Income Portfolio in February 2010, investors were skeptical that the “string of pearls” strategy would pay off. The company’s success has handed us a sizeable capital gain in addition to a generous and rising dividend yield–which will rise 3 percent with the February payment. This deal and the dividend boost make Bristol-Myers Squibb a buy up to 34 for new investors.  
 
ARTICLE UPDATE
Captains of Industry
Article in Review: “Manufacturing Profits,” by Benjamin Shepherd, Oct. 13, 2010
BY ARI CHARNEY
Although 2011 began with a promising start for industrial manufacturers, the sector’s growth quickly came under pressure from supply disruptions, rising input costs and slackening demand amid global economic uncertainty. However, industry sentiment rebounded during the fourth quarter. The NAM/IndustryWeek Survey of Manufacturers reported that 72 percent of its members expect sales to increase next year, with estimated average sales growth of 4.4 percent.
This upbeat sentiment mirrors signs of improvement in the US economy during the latter half of the year, which should benefit the three diversified industrial names we profiled in October 2010. Indeed, the Institute for Supply Management’s Purchasing Managers Index (PMI) rose for the third straight month to 53.9 percent after bottoming at 50.6 percent during the third quarter. A reading above 50 signifies growth in manufacturing activity and the latest reading marked the 29th consecutive month of such growth.
Post-It Note progenitor 3M (NYSE: MMM) boasts a far more diversified product line than its best-known contribution to office supplies suggests. Although the company’s industrial and transportation and health care segments accounted for 33.2 percent and 23.2 percent of operating profits, respectively, during the third quarter, its other four segments contributed roughly equal shares to the balance. Additionally, the company continues to be a serial acquirer, with nearly 40 percent of its global sales growth derived from acquisitions. Global sales rose 9.6 percent year over year in the third quarter.
Most of 3M’s operating segments produced mid-to-high single digit organic sales growth during the first nine months of 2011 versus the year-ago period. But sales for the company’s display and graphics segment dropped 7 percent due to weakness in the liquid crystal display television market. Beyond that, 3M’s earnings dropped 1 percent year over year during the third quarter on weakness in the electronics market and softening global demand. Management plans to aggressively rein in costs at its operations in developed economies, while continuing to invest in emerging markets.
3M’s shares are no longer as cheap in terms of valuation as they were at the time of our original article. The company’s stock now trades at 3.5 times book value, a jump from a price-to-book (P/B) value of 2.5 in late 2010. 3M is a buy under 90.
Growth Portfolio holding Honeywell International (NYSE: HON) produced 8 percent organic sales growth during its third quarter versus the year-ago period, with profit margins expanding across all four operating segments. In particular, the company’s aerospace division, which accounted for 31.4 percent of third-quarter revenue, boosted margins by 120 basis points thanks to strong sales of original and aftermarket equipment to the commercial aerospace industry.
For 2012, management expects favorable tailwinds for long-cycle products produced by its aerospace and specialty materials divisions. Buy Honeywell International under 60.
In late October, ITT Corp (NYSE: ITT) split its operations into three publicly traded entities: Its former fluid technology segment, which specializes in water and wastewater treatment systems, now trades as Xylem (NYSE: XYL); its former defense contracting segment now trades as Exelis (NYSE: XLS); and its legacy diversified industrials business continues to trade as ITT.
This series of corporate actions explains an ostensibly alarming plunge in sales and net income in the table below. Instead, management has sought to unlock shareholder value by allowing these otherwise unrelated segments to operate independently, while focusing on manufacturing components for industries ranging from aerospace to energy at the legacy firm.
In the third quarter, the new ITT grew organic sales by 6 percent from the prior year’s period as the result of growth in energy and mining production among emerging markets. Among ITT’s four segments, its industrial process operations accounted for 36.1 percent of revenue, with sales growth of 13 percent from the previous year. ITT Corp is a buy under 27.
 
ON THE MONEY
Energizing the Economy
The boom in onshore oil and gas drilling continues to redound throughout the US economy.

BY PETER STAAS
“Drill, baby, drill!” was the mantra of the Republican faithful during the 2008 presidential election. At the time, the debate centered on whether the US should expand the scope of exploration and development in prospective oil and gas fields offshore the Lower 48. Supporters argued that an uptick in drilling activity would stimulate the economy, pad the government’s coffers from lease sales and reduce the nation’s reliance on foreign oil. Critics countered that such a move would entail undue environmental risk and deepen the nation’s dependence on fossil fuels.
The Macondo oil spill in the deepwater Gulf of Mexico prompted the Obama administration to institute an extended moratorium on offshore drilling. Many operators lost more than a year on their existing leases and US offshore oil production plummeted to 116,000 barrels per day in 2010 from about 312,000 barrels of oil per day in 2007. Meanwhile, the volume of natural gas extracted offshore the US tumbled to about 2.875 billion cubic feet from 3.476 billion cubic feet in 2007.
Expect this weakness in offshore oil and gas output to persist. Although permitting and drilling activity in the deepwater continues to recover slowly, about 300 shallow-water permits expired in 2011 and acreage acquired during the US Interior Dept’s December 2011 lease sale won’t enter production for several years.
Nevertheless, the energy sector has been an important driver of the US economy, largely because of the rapid development of oil and gas reserves trapped in shale and other “tight” reservoir rocks.
Rising production from prolific plays such as the Bakken Shale in North Dakota, the Eagle Ford Shale in south Texas and the Marcellus Shale in Appalachia has more than offset declines in offshore output. In 2009 and 2010, US oil production increased for the first time since the 1980s, and surging output enabled the US to overtake Russia as the world’s leading gas producer in 2010.
Exploration and production companies such as Growth Portfolio holding EOG Resources (NYSE: EOG) are early movers in some of the nation’s most compelling shale oil and gas fields, reaping the rewards of rising production and elevated oil prices. Frenzied drilling activity in these plays has also been a boon for services companies such as Halliburton (NYSE: HAL).  
More important, many of these fields are located in regions that haven’t traditionally produced energy or that lack sufficient takeaway capacity to handle rising volumes of oil, natural gas and natural gas liquids. Demand for new and expanded midstream infrastructure will be met by master limited partnerships such as Income Portfolio holdings Enterprise Products Partners LP (NYSE: EPD) and Spectra Energy Partners LP (NYSE: SEP), enabling these pass-through entities to grow their cash flow and quarterly distributions.
The rapidly changing domestic energy picture also benefits other economic sectors. For one, the shale oil and gas revolution has resulted in an oversupply of natural gas that in recent years has kept the price of this commodity hovering near record lows. Depressed prices for natural gas add up to lower utility bills for many US consumers at a time when households are focused on making every penny count.
Meanwhile, a newfound abundance of ethane has revivified the domestic petrochemical industry, giving chemical manufacturers a dramatic cost advantage over producers in Asia and the Middle East that rely on naphtha and other oil derivatives for feedstock.
Local economies also benefit from the feverish activity in emerging shale oil and gas plays. For example, North Dakota’s economy has boomed in recent years thanks to the Bakken Shale, while labor shortages in the Permian Basin, Eagle Ford Shale and Marcellus Shale should provide plenty of employment opportunities in these regions. Local financial institutions also reap the benefit of increased economic activity. Texas Capital Bancshares (NSDQ: TCBI), for example, which we profiled in the July 28, 2010, Personal Finance, has been one of the few US banks to post organic loan growth in recent years.
Peter Staas is an associate editor of Personal Finance and managing editor of The Energy Strategist.