Valuations now look extremely attractive

Author: Mark Holder, Stone Fox Capital

Covestor model: Opportunistic Arbitrage

After a strong 2009 and 2010, 2011 was a year to forget for this portfolio. The market hit highs around the end of April and this model was soaring to new heights at the time. Many of the holdings had valuations nowhere near the 2007/08 peaks or even close to what would normally be considered rich. Regardless, leverage was reduced since some gains were significant. Then, unfortunately, most of the stocks collapsed and even in a few cases approached 2009 lows. With too much leverage left, the model was hit very hard.

The good news is that according to my assessment, valuations started the year as attractive as they were during the financial collapse of 2009.

2012 Outlook

Portfolio Construction

The portfolio remains overweight on the global growth theme. Most of the stocks in this sector trade as if emerging markets are headed towards a recession, instead of continued growth.

The biggest challenge to our investment strategy in 2011 was the major inflation fear in emerging markets like China, India, and Brazil. As 2012 begins, all these countries are reporting lower inflation numbers, which is supportive of monetary easing that has already started in most cases. This removes a significant headwind for the global growth theme going forward.

2011 ended so badly that finding stocks that exceeded expectations for the year is difficult. Liz Claiborne (LIZ) was probably the best performer, as the transformation away from the namesake brand towards kate spade, Juicy Couture, and Lucky Brands was completed. With the announcement of the new Fifth & Pacific (FNP) name and stock symbol, the stock surged to 52 week highs. As kate spade continues reporting strong sales comps, more is expected out of Liz in 2012.

Just about every other stock was uniformly disappointing. Even stocks like Riverbed Technology (RVBD) that met original earnings estimates were hit hard. Of course, I'd be remiss in not mentioning the fraud accusations against Puda Coal (PUDA) that sent the stock to the pink sheets and the bankruptcy of MF Global (MF) that wiped out a small position in the speculative stock.

Our top sectors for 2012 include Emerging Markets, Networking Equipment, Life Insurance, and Oil Services. Though the model doesn't generally focus on a sector lead approach, these sectors provide such great opportunities that the model has found multiple investment options.

Global Markets

As mentioned above, emerging markets were a theme from 2011 that has become even more attractive following dramatic selloffs in stock markets such as China and India. Europe, though, remains the biggest concern. As 2012 began, it appears that the ECB 3 year liquidity program has had an unexpected impact on lowering Spanish and Italian bond yields. This has led to at least a short term reprieve from fears of European contagion. As long as this continues, cheap US stocks can rally. Until the Europeans resolve long term funding issues, the threat will always hang over the market.

As far as individual stocks, the model is more invested in companies benefiting from emerging market growth than firms headquartered in those countries. Look for that to change as the year progresses.

Some top picks include Weatherford International (WFT), which should benefit from increasing oil demand, and Foster Wheeler (FWLT), which should see revenues grow from the need for the construction of more power plants and LNG terminals.

Crane manufacturers Manitowoc (MTW) and Terex (TEX) should see a continued pick up in both domestic and international markets as the need for global construction equipment finally rebounds from the crisis. Alpha Natural Resources (ANR) should benefit from its positioning as the #3 metallurgical coal miner in the world.

ChinaCache (CCIH) is the leading CDN provider in the fast growing China internet market. Look for that market to continue growing and the stock to rebound as investors become more comfortable that not all China stocks are frauds. Look for more direct investments in Brazil and India as the year progresses.

U.S. Market

U.S. stocks enter 2012 extremely cheap in my assessment. If Europe ever retracts from the headlines, this market should rally strong. Economic data was generally strong as 2011 ended, suggesting better times ahead.

The presidential election remains a big concern as the year progresses. I believe Obama losing the presidential race would generally be good for the markets, at least in the short term. Unfortunately though, a good stock market early in the year due to a strong economic rebound could actually place Obama in a position to win the election. This could actually tank the markets in the second half.

U.S. stocks are lead by opportunistic investments in Monster Worldwide (MWW) and SodaStream (SODA). Both stocks were absolutely crushed in 2011, so the model picked them up on the cheap later in the year. These stocks could rally even without a strong economy. SodaStream especially has the chance to expand market share in the home beverage market that should remain robust regardless of the economy.

A couple of oil related stocks should continue to benefit from the expanding unconventional shale plays in the U.S. As the U.S. looks to move closer to energy independence, both oil producer Carizzo Oil & Gas (CRZO) and hydraulic fracturing company C&J Energy Services (CJES) should benefit from high oil prices. Low natural gas prices have held the stocks down, but that might not last long as the U.S. looks to begin exporting LNG in the future.

Look for networking equipment stocks Riverbed Tech and Radware Systems (RDWR) along with storage equipment provider OCZ Tech (OCZ) to benefit from the need for faster corporate networks and cloud computing.

Insurance providers Hartford Financial (HIG) and Lincoln National (LNC) trade below 50% of book value and continue to provide solid earnings that increases book value each quarter. Look for thefinancial sector to break away from group trading as the financially fit such as these two rebound.

Conclusion

At the end of the day, though 2011 was very disappointing, the returns for the first three years of the model were still exceptional - up 103.6% since 1/29/09 inception through the end of 2011.

Investors should understand that this is a high risk/high reward model that will be very volatile at times. Investing after the model has gone through a rough patch could provide better returns to investors than after a good year.

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