Two Ways to Get Ready for Recovery

02/19/2009 1:00 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Jim Jubak, senior markets editor for MSN Money, finds one bond and one preferred stock in battered sectors he says will lead the market when it bounces back.

We know which stocks will soar when the financial system, the economy and the stock market recover: the best stocks in the most-battered sectors. So, when this turn comes, and for the year after, you'll want to own the best stocks in the battered home-building, financial and energy sectors.

Preferred stocks and corporate bonds with high dividends are your best bets right now for riding out a tough market. We [also] know what we want to avoid: companies with crushing debt loads, operating losses that aren't likely to end soon and very limited access now to the capital markets.

D.R. Horton (NYSE: DHI) showed operating cash flow of $818 million in the quarter that ended December 31st. The company finished that period with $1.9 billion in cash. Gross margins have started to rise again, climbing to 15.5% in the quarter from 10.9% in the previous period. The company still has $3.4 billion of debt on its books, but it is in compliance with the covenants on [its bank] loans.

[Yet] the company's August 2011 senior debt, issued with a coupon yield of 7.875%, has declined to 95.5 cents on the dollar and now pays a yield of 9.948%.

After looking at the company's financials, I think it has the strength to survive. And I like the potential reward for holding this bond until then: income of 9.948% annually and capital appreciation of about 4.7% if the bond's price climbs from 95.5 cents on the dollar back to par (100 cents on the dollar).

I [also] bought preferred shares of W.R. Berkley (WRB-A) in December and January because I think this very conservative insurer is a survivor. The preferred shares were trading 23% below their high of May 6, 2008.

On February 9th, Berkley reported what were, on the surface, stinky numbers for the company's fourth quarter. Net operating earnings, excluding one-time items, came in 16 cents a share worse than Wall Street had expected. Revenue dropped 23% from the fourth quarter of 2007.

But those results aren't nearly as smelly as they look; in fact, they're downright super. A realized loss of $108 million on invested assets of $12.5 billion in this market is evidence of very solid risk management. The fall in revenue is actually great news, too, because it shows that when premiums are low, the insurer is cutting back its underwriting. That's because the company is focused on writing only profitable policies.

The best news on profitability, however, came when it told Wall Street that it anticipates "substantial" underwriting profitability in 2009 and that prices will improve by the end of year.

At a closing price of $18.68 on February 11th, investors were buying the preferred shares about 25% below their 52-week high of $24.87. My target price [is] $22 a share by December 2009. With a current yield of 8.85%, that would push the potential total return from these shares to about 25%.

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