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Quarter-End Insights

Our Take on the Third Quarter

Stocks suffer through as historic market events unfold.

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Economics may be the dismal science, but the third-quarter of 2008 has been one of high economic drama. The ongoing financial crisis that claimed investment bank Bear Stearns in the first quarter of 2008, and that has roiled markets all year, accelerated to force Lehman Brothers into bankruptcy, put mortgage lenders  Fannie Mae (FNM) and  Freddie Mac (FRE) into U.S. government conservatorship ( ), and force distressed insurance behemoth  AIG (AIG) to take an $85 billion cash infusion ( ) from the government. Additionally,  Bank of America (BAC) purchased  Merrill Lynch (MER), including its army of 16,000 retail brokers--click here for more on the deal ( ), while the last two remaining large, independent investment banks,  Morgan Stanley (MS) and  Goldman Sachs (GS), elected effectively to become regulated commercial banks ( ) with the result being that they won't be able to operate with as much leverage as they did previously.

Despite a respite on the announcement that the U.S. government would likely implement a $700 billion bailout package ( ) for nonperforming loans, the financial markets have responded poorly to these momentous events: The Morningstar U.S. Market Index shed 8% for the trailing 13 weeks through Sept. 22, and is off 15% for the year.

Smaller independent investment banks, such as  Greenhill & Co. (GHL), still exist, but it appears to be the end of an era on Wall Street, with the alterations of the current banking landscape rivaled only by the changes that occurred during the Great Depression.

As stocks have pulled back, bonds have rallied. The Morningstar Core Bond Index rose 2.0% for the trailing 13 weeks through Sept. 22, and is up 2.3% for the year. Government bonds, in particular have surged, as investors have sought their safety amid the turbulence. The Morningstar Intermediate U.S. Government Bond Index rose 3.3% for the trailing 13 weeks, and is up nearly 5% for the year. The yield on the 10-year U.S Treasury note fell from more than 4% in July to less than 3.5% in September, as investors were willing to pay more for a government-guaranteed fixed coupon payment.

By contrast, the Merrill Lynch U.S. High Yield Master II Index, an index of lower-credit-quality, higher-yielding ("junk") corporate bonds, dropped 5.6% for the trailing 13 weeks through Sept. 22, and is down more than 5% for the year. The movement from corporate bonds to government bonds means that the so-called "spread" or difference in yields between the low-quality corporates and high-quality government issues is as high as it's been in years, as investors devalue the fixed coupon payments of the shakier corporates and elevate the values of the safer Treasuries.

Investors also fled oil and other commodities for most of the quarter on fears of an economic slowdown. The price of oil eased for most of the quarter, dropping from $145 per barrel to the mid-$90 range. However, it surged again by $25 to $130 in its biggest one-day gain ever and settled at $120 on Sept. 22. Commodities showed their volatility in general as the Dow Jones-AIG Commodity Index tanked from nearly 240 in July to around 170 in early September and closed at nearly 182 on Sept. 22.

Speaking of energy, Warren Buffett sold shares of  PetroChina (PTR) earlier this year, but he continued to show his interest in utilities, with MidAmerican Energy, a subsidiary of  Berkshire Hathaway (BRK.B), purchasing  Constellation Energy (CEG) for $26.50 per share in the third quarter. Constellation is a merchant power generation company that produces electricity by coal and nuclear power and distributes it to the Northeast. Constellation also has a trading book, which makes the firm a large counterparty and has caused it to have collateral problems. Berkshire's deep pockets make this counterparty risk disappear, according to Morningstar equity analyst Paul Justice ( ), who argues Constellation is worth nearly $90 per share with Berkshire eliminating the collateral problems.

Finally, just as we are completing our review, we have learned that Berkshire purchased $5 billion of perpetual preferred stock from Goldman Sachs in a private offering. The stock has a dividend of 10% and is callable at any time with a 10% premium. Berkshire will also receive warrants to buy $5 billion of common stock with a strike price of $115 per share, exercisable at any time for a five-year term. Goldman closed at around $125 per share on Sept. 23. At first blush, this looks like another classic Buffett investment in a stumbling firm that still has a global franchise and a wide moat.

Sectors and Industries
Health care and (surprisingly) financials led all sectors, adding 3.0% and 0.6% respectively for the trailing three months through Sept. 23. Generic drugmakers, such as  Barr Pharmaceuticals (BRL), and biotechnology drugmakers, such as  Imclone (IMCL),  Amgen (AMGN), and  Genentech (DNA), led the charge for health care. Barr gained 59% for the trailing three months, while Imclone, Amgen, and Genentech added 71%, 26%, and 23%, respectively. Imclone and other biotechs have been in play ( ) as big pharma looks to expand pipelines via acquisition. Traditional pharmaceuticals and device makers enjoyed more modest gains, while managed care companies pulled back slightly, and foreign health-care companies generally slumped badly. Many of Morningstar's favorite fund managers have been finding opportunities in pharmaceuticals and managed care, and Morningstar's equity analysis also reveals a slew of undervalued health-care stocks, including  Pfizer (PFE),  Merck (MRK),  Novartis (NVS),  Wellpoint (WLP),  UnitedHealth Group (UNH), and  Zimmer (ZMH).

In financials, healthy regional and super-regional banks emerged as top performers.  BB&T Corp (BBT),  Wells Fargo (WFC), and  PNC Financial Services Group (PNC) added 71%, 42%, and 28%, respectively, for the trailing three months through Sept. 23. Canadian banks, such as  Bank of Montreal (BMO) and  Royal Bank of Canada (RY), also rose more modestly. Only Bank of Montreal trades below Morningstar's fair value estimate currently. Morningstar equity analyst Chris Blumas argues that the bank's core operations remain strong, despite headline-grabbling losses related to trading and credit risk. Competition appears fierce among the top five banks in Canada, but Blumas argues that retail clients are conditioned to pay high service fees, while regulations insulate Canada from foreign competition.

Energy and industrial materials, the recent darlings, were the worst sectors for the third quarter. They shed 21.8% and 19.7%, respectively. Many natural gas-related holdings such as  Chesapeake Energy (CHK) fared the worst, as natural gas prices eased. Chesapeake trades in 5-star territory currently, and Morningstar equity analyst Justin Perucki notes that the firm has embarked on joint ventures with larger firms, which are starved for the opportunities that Chesapeake has in its Haynesville and Fayetteville Shale assets.

Among industries, appliance and furniture makers finished right behind super-regional and regional banks, adding 15% for the trailing three months through Sept. 23. For example, furniture maker and retailer  Ethan Allen (ETH) added 15%. Morningstar equity analyst R.J. Hottovy has the stock under review currently, given the cautionary outlook from other home furnishing retailers and the difficult housing market. Still, Ethan Allen is among the strongest players in this difficult industry, with a strong balance sheet and differentiated business model.

The weakest industries were radio, followed by coal, steel/iron, mining, and engineering/construction, which lost between 84% and 37% for the trailing three-months through Sept. 23. Weakness, of course, attracts our interest because we seek to buy stakes in companies we like as cheaply as possible. Engineering firm  Chicago Bridge and Iron (CBI) lost nearly 49%, and now trades just above analyst Patricia Oey's consider buying price of $21.50 per share. This firm, although lacking a competitive advantage, is well positioned in the near term because of its niche in constructing tanks and facilities for liquefied natural gas (LNG), which is benefiting from capital spending.

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