Two Ways to Lower Risk in a Rocky Market

07/19/2007 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

James Stack, president of InvesTech Research, finds one steady growth stock and one contrarian fund he thinks will help investors balance out their portfolios.

Walgreen (NYSE: WAG) released a positive third-quarter report [in which] total operating profits advanced 17% and sales rose 12.5% from the prior year. Same-store sales—sales in stores open at least one year—climbed 7.8% during the quarter.

Increasing its geographical footprint, however, is crucial to the company’s growth strategy. Walgreen opened 352 new stores during the first nine months of the fiscal year and plans to open 500 in fiscal 2007. Walgreens is on track to exceed the company’s goal of 7,000 stores in 2010.

The aging population and Medicare Part D prescription coverage has produced an exploding demand. With these industry growth dynamics and Walgreen’s acumen in real estate matters, we believe the company has five to ten years before saturation and deceleration in store growth becomes an issue. Moreover, we have been impressed with the company’s “flexibility” in store design and concept in expensive or high-density metropolitan markets.

The competitive landscape will remain challenging. Walgreen’s stock took a hit last September when Wal-Mart announced that it would sell 30-day prescriptions for nearly 300 generic drugs for $4. [However,] 95% of Walgreen’s pharmacy patients have prescription insurance, and the average co-pay on those prescriptions is only $5.30.

While the stock is not especially cheap, few companies are as well managed and primed to enjoy the demographic tailwinds as Walgreens. From a risk/reward profile, we think the company is an ideal investment choice in this market environment. (The stock closed just below $45 Wednesday—Editor.)

Our decision to purchase the Rydex Inverse S&P 500 Strategy Fund (RYURX) was prompted by risks [of] a correctionless market, increasing bond yields, and inflation pressures one year ago—not in anticipation of reaping large profits in a declining market—but to “neutralize” or hedge against market risk by partially offsetting our long investments.

We continue to hold the bear fund today because the red flags that prompted the original purchase are still intact and, if anything, they have increased. Even the best stocks will fall in a broad market correction, so think of the bear fund as an “insurance policy” to protect investments against the mounting possibility of a bear market or recession in the coming months.

While the bear fund may weigh on performance if the market moves higher, the negative impact is less than one might think. Due to the inherent compounding effect of the bear fund (which inversely mirrors the market on a daily basis), RYURX tends to lose less during a market rally than the S&P 500 gains. The S&P 500 (adjusted for dividends) has gained 23.5% while the Rydex Inverse S&P 500 Strategy Fund has lost only 12.1% [while we held it]. Conversely, the fund should gain more in a bear market than the S&P 500 loses.

This fund serves its purpose well as a low-cost insurance offering an efficient way to offset rising risk in the current market environment. (It closed above $35 Wednesday—Editor.)

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