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05/05/2006 12:00 am EST


James Stack

President, Stack Financial Management

Congratulations to Jim Stack, along with Lisa, Cathy, and the whole InvesTech team on their 24th anniversary, one of the finest newsletters in the industry, noted for its exceptional long-term accuracy, and its prudent approach to overall asset management.

"Looking back over our 24 years, I realize that most of our mistakes have been on the side of excess cautionwhich is our preference, since profit opportunities always come around again. Our only two periods of holding 100% cashin 1987 and the late ’90s turned out to be fortuitous in the aftermath of the subsequent bear markets. Yet according to the Hulbert Financial Digest, we earned the #3 rank in risk-adjusted return over the past 20 years.

"Our technical models suggest this bull market remains intact. Additional profits are possible and even likely, but the market is becoming more selective. The challenge is to try and maintain an ‘all-weather’ portfolio that continues to profit in a late-stage bull market, but offers some resilience if conditions worsen. Our portfolio is currently 68% invested with 13% in international funds, 16% in resource stocks, 17% in value securities, and 22% in growth investments. The remainder of the portfolio (32%) is held in short-term Treasuries or a money market fund.

"We are concerned that systemic risks could create havoc outside the normal economic cycle. The housing bubble is one such systemic risk today. Another systemic risk lies in the derivatives market. These are leveraged investments which have been created to hedge risk by the big market players. The growth in these highly leveraged financial instruments and transactions is truly mind-boggling. Today, the nominal value of global derivatives totals over $271,000,000,000,000. That’s $271-trillion with a capital ‘T’.

"How do we protect our portfolios from this 271 trillion pound Gorilla if it gets unleashed? Watch for a sharp, unexpected move in either the dollar or ten-year Treasury yield—e specially unfavorable changes. We don’t want you to lose sleep worrying about derivatives and systemic risks. But you need to be aware of them, just as we are. With this goal in mind, let’s review the key points in our portfolio strategy, and remember, this is not the time to swing for home runs.

"We suggest maintaining a moderate cash cushion, around 30-35% of one's portfolio. And don’t put all your eggs in one basket, no matter how tempting. This was a common and fatal mistake during the tech bubble of the late 1990s. Maintain a balance between value and conservative growth. Each has its advantages, so it makes sense to include both in one’s portfolio. And emphasize defensive sectors such as healthcare, staples, and energy, which are all non-discretionary in nature. In addition, the industrial sector may offer select opportunities.

"Evaluating the stocks to hold in your portfolio is more important than ever at this stage of the market cycle. The following is an overview of the defensive characteristics we look for in companies in a mature bull market. First, stock valuations should be reasonable. Look for solid revenue and earnings growth over the last five years, which covers much of the 2000-02 bear market as well as the current bull market.

"Paying out steady or increasing dividends is a sign of financial health in a company, and dividends can provide a stable source of income even during bear markets. International sales help offset vulnerability to declining consumer confidence and a potential bear market in the US. All the companies in our portfolio have expanded into international markets. And those with a low debt-to-capital ratio are better situated to survive as interest rates rise and the credit market becomes more hostile.

"Finally, look for unique defensive aspects to a company’s business. For instance, Automatic Data Processing (ADP NYSE) benefits from the float on processing corporate payrolls when interest rates rise. PepsiCo (PEP NYSE) is a leader in food productswith premier consumer brands where sales tend to be resilient even in recessions. BCE Telecom (BCE NYSE) dominates telecom services in Canada where the market is still highly regulated, unlike the US. And the company’s dividend was raised 10% in 2005.

"In addition, Dentsply Int’l Health Care (XRAY NASDAQ) is benefiting from growth in dental care across all socio-economic levels. AFLAC Financial (AFL NYSE) supplemental health and life insurance as well as cancer policies in the US and Japan. In Japan, its major market, prospects are even more attractive than US. Biomet Health Care (BMET NASDAQ), which makes reconstructive products, including knee, hip, and extremity joint replacement systems, has seen 27 consecutive years of earnings growth."

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