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Stock Strategist

Second Quarter in Stocks: Buyout Binge Boosts Bulls

But interest rate worries also build.

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Stocks continued their rally from the end of the first quarter into April and May. The markets appear to be sputtering in June, but unlike in late February, another tumble in Chinese stocks at the end of May caused barely a ripple on U.S. exchanges. Moreover, the problems of subprime loans, a continuing housing slowdown, and high energy prices haven't spooked the rest of the economy, which is still solid, though slowing. The Morningstar U.S. Market Index was up 5.2% for the trailing 13 weeks through June 22, and is up 7.6% for the year.

Contributing to the subprime and housing issues were sagging bond prices and higher yields, leading to higher mortgage rates. (Bonds offer a fixed coupon, so their yield--the coupon divided by the price of the bond--rises as bond prices fall.) The Lehman Brothers U.S. Aggregate Bond Index shed 1.62% (nearly all its year-to-date gains) for the quarter through June 21. The bond sell-off pushed the yield on the 10-year U.S. Treasury note to 5.2%, up significantly from the 4.6% range in early March. Investors anticipated that Federal Reserve Chairman Ben Bernanke would hold the line on interest rates as he balances the pressures to lower them in response to a softening economy against the pressures to raise them due to inflation, including higher energy prices. As a side note, Bernanke's still-influential predecessor, Alan Greenspan, moved his employment address from Washington, D.C., to Newport Beach, Calif., taking a consulting post with bond manager PIMCO.

Although bond prices faltered and yields went up, the "cheap money" cited by commentators as the reason for the boom in corporate buyouts (and perhaps an underlying buttress for the strong stock market) appeared as abundant as ever. Interest in real estate investment trusts (REITs) remained high as a consortium led by private entity Tishman Speyer and  Lehman Brothers (LEH) purchased high-end apartment landlord  Archstone-Smith (ASN) for about $22 billion. Other merger and acquisition activity included private equity firm Cerberus buying Chrysler,  Microsoft (MSFT) buying  aQuantive (AQNT), and  Wachovia (WB) buying  AG Edwards (AGE).

Buyout firm Blackstone (BX) also capitalized on investors' appetite for access to deals--and satisfied its own desire for a permanent, flexible funding source, according to Morningstar analyst Jeff Ptak--by going public, prompting Congress to examine tax regulations governing publicly traded partnerships.

The doings of other notable investors or financiers included Chicago real estate mogul Sam Zell buying  Tribune (TRB) (owner of the Chicago Tribune and other media outlets),  News Corp.'s (NWS) Rupert Murdoch making a high bid for Wall Street Journal publisher  Dow Jones (DJ), Carl Icahn failing to gain a seat on  Motorola's (MOT) board, and Warren Buffett's  Berkshire Hathaway (BRK.B) buying gold jewelry manufacturers Bel-Oro International and Aurafin. Both Motorola and Berkshire currently trade in 5-star territory.

Surveying the Sectors and Industries
Energy led all sectors, surging 18.6% for the trailing 13 weeks through June 22. Coal companies  Yanzhou Coal Mining (YZC) and  Fording Canadian Coal Trust (FDG) rose 60% and 46%, respectively, as global demand for energy continues to increase. Morningstar analysts Michael Tian and Kish Patel think both stocks are trading above their fair values, however. Oil drillers and service providers such as  Baker Hughes (BHI),  Transocean (RIG), and  Smith International (SII) also rose 34%, 33%, and 25%, respectively. Baker Hughes and Smith have managed to build narrow moats in a competitive business, but all three trade above our analysts' fair value estimates.

Consumer services was the worst sector, posting a meager 0.35% gain for the trailing 13 weeks through June 22 and a 4% gain for the year. However, this poor performance means that the sector is now offering up some tasty stocks at attractive prices. Food and coffee purveyors  Whole Foods (WFMI) and  Starbucks (SBUX) are in 5-star territory as a result of their 15% and 19% respective declines over the trailing three months. The stocks trade at 27 times and 34 times earnings, respectively, but Morningstar analysts Mitch Corwin and John Owens anticipate strong growth and returns on invested capital for both firms, including significant overseas expansion for Starbucks, and view them as solid long-term holdings at their current prices.

Aluminum and coal were the best industries, with 38% and 26% gains, respectively, for the trailing three months through June 22. Aluminum maker  Alcoa (AA) jumped 17.6% as the market reacted well to its bid for rival  Alcan (AL). Morningstar analyst Scott Burns thinks  the merger makes sense, since aluminum is a commodity business and increased scale can improve a company's cost position. Burns values Alcoa at $40 per share, where it currently trades.

Homebuilders and REITs (real estate investment trusts) were the worst-performing industries, dropping 11% and 10%, respectively, for the trailing 13 weeks through June 22. Among the homebuilders,  Lennar (LEN),  Pulte (PHM), and  Meritage (MTH) trade in 5-star territory. Morningstar analyst Eric Landry thinks Meritage will be one of the winners when the industry begins its next upswing, since it's carrying a bit under one year's worth of land at current production rates and controls about five years' worth of land valued at around $2 billion, with only $200 million worth of options.

Among REITs, office landlords  Brandywine (BDN) and  Mack-Cali (CLI) are in 5-star territory. Morningstar analyst Arthur Oduma anticipates Brandywine will be able to raise rents as more than 50% of its leases come up for renewal in the next five years. Mack-Cali is also enjoying revenue increases and solid occupancy rates, and Oduma likes the suburban firm's strategy to concentrate in the Northeast, including a recent foray into Manhattan.

Morningstar Newsletter Portfolios

The Tortoise Portfolio
The Tortoise Portfolio in Morningstar StockInvestor is a collection of our favorite large, lower-risk companies with economic moats. Both for the year and for the quarter through June 20, the portfolio is up 5.6%. This performance trails the 7.6% year-to-date return and 6.9% quarterly return of the S&P 500 Index.

Editor Paul Larson has added  Bank of America (BAC) to the portfolio. Larson is impressed with the bank's sprawling retail operations, which give it a huge deposit base. Additionally, the bank is the premier credit card, small-business, and home-equity lender in the country. Finally, investment banking and wealth-management (the bank's biggest growth driver) round out the firm's diversified product lineup.

The Hare Portfolio
The Hare Portfolio rose 7.1% for the quarter and is up 9.5% for the year through June 20. The S&P 500, by contrast, added 6.9% for the quarter and is up 7.6% for the year. The Hare Portfolio's outperformance versus the index suggests a recovery in growth stocks, since the portfolio chooses somewhat smaller and faster-growing names than the Tortoise Portfolio.

Top holding CarMax (KMX), which soaks up a whopping 16% of the portfolio's assets, added about 5% for the quarter through June 20. Also, the portfolio's fourth-biggest holding,  MasterCard (MA), surged 54% for the quarter. Morningstar analyst Michael Kon just raised his fair value estimate on the stock to $167 per share from $133, meaning the stock is roughly fairly valued at current prices. While the shares are not cheap enough to buy today, Larson says he does not believe there is an urgent need to hit the "sell" button at this time. Businesses with durable competitive advantages or "wide moats" (like MasterCard) can be difficult to replace with another wide-moat firm at a good price.

Morningstar DividendInvestor
The Builder and Harvest portfolios lagged, posting 1.9% and 2.8% gains for the quarter through June 20. However, the Harvest Portfolio is up 8.2% for the year versus 7.6% for the S&P 500 Index. The Builder Portfolio is heavy with banks such as Bank of America and  US Bancorp  (USB), which have sputtered as investors wait for a clear indication on interest rates and as stocks with larger dividends sold off. In any case, Morningstar analysts are bullish on both banks, which trade in 5-star territory.

The Harvest Portfolio got a boost from energy-related names. Editor Josh Peters continued the energy theme recently by picking up shares of  Crosstex Energy LP (XTEX) for the Harvest Portfolio. Crosstex Energy LP offers more yield, though less growth potential, than its general partner  Crosstex Energy Inc. (XTXI). Peters realized that the limited partnership units would be suitable for the Harvest Portfolio after studying and purchasing the general partner for the Builder Portfolio.

Morningstar GrowthInvestor
Growth stocks appear to be awakening from their multiyear doldrums, and editor Toan Tran has guided the Growth Portfolio to a 7.7% return for the quarter and a 10.4% return for the year through June 19. Machine tool and industrial equipment supplier  MSC Industrial Direct (MSM) rose about 10% for the quarter and is up more than 30% for the year. The narrow-moat stock still trades in 4-star territory, about 13% below analyst Matthew Warren's $60 fair value estimate. MSC is not without competition and has higher inventory carrying costs than its peers, but Warren thinks it is the low-cost provider in its business and has room to grow as consolidation occurs.

Tran is sitting on some $30,000 in cash. We'll have to wait and see whether he uses some of it to purchase shares of  Starbucks (SBUX).

John Coumarianos has a position in the following securities mentioned above: USB, KMX, MSFT, BRK.B. Find out about Morningstar’s editorial policies.