Chasing 8 for 2008: What's in, what's out

Looking good:

• Since I added Newcastle Investment Corp (NYSE: NCT) to the list last week I have even more confidence in the company. The stock price has risen about 10% and I think the Fed's reduction in interest rates and its indication that it will be taking action to improve inter-bank lending are positive signs. For the detailed review read Chasing Value: Newcastle's 21.9% yield too good to be true?. I will summarize here by letting you know I did what homework I could and checked out NCT's recent conference call. This company has averaged an 8.8% yield over the last five years. However, today because the stock is now a third of its recent price, the yield has jumped to 21.9%. Newcastle is standing by this dividend. Actually I think it has to because REITS are required to pay out most of their profits and Newcastle has earned 23% over the last fiscal year. The stock is down because the underlying value of the collateral has gone soft in some cases, but mostly it has fallen victim to the generally poor market for various classes of loan packages, be they Alt-A, sub-prime CDOs, or Uncle Joe's handshake. That said, NCT's cash flow seems fine, it only has 10% of its portfolio in residential real estate and of that it claims to have a 60-day delinquency rate of less than 1%. NCT also expects $1 billion in loan repayments over the next year. The PEG ratio is 0.15 and it is trading at a book value of 0.74. On the conference call, management claimed a book value after being marked-to-market of $15-to-$16 a share. This is a strong value proposition. This stock may or may not return to its highs, which I think is unlikely in the coming year. However, NCT just has to keep its doors open to be a success story.
• Raytheon (NYSE: RTN) is a top-shelf defense contractor, and that is the place to be whether we are at war or whether we have to replace everything that was destroyed, damaged, or become obsolete. I think the defense sector will be one of the safe havens for 2008. RTN is a tech stock if you look at all the advanced electronic systems it is developing and selling. This is another touted sector lately. I am not happy that 85% of its revenue comes from the federal government, but this revenue is from different agencies. Beside defense, RTN makes radios, air traffic control systems and radar, and satellite communications systems, so airports and security are customers too. The fundamentals do not display a screaming value, but its growth potential and "recession-proof" business offer value. No presidential candidates will be soft on defense in an election year. The basic metrics are sound, with a PEG ratio of 1.13, a P/B of 2.4 and a P/S of 1.3. The down side does not seem to be a major issue. The P/E and the yield are only average, but like most of my recommendations, it does pay a dividend, and that is important. RTN has the potential to expand airport business as this industry continues to be in the headlines. Airport congestion and security constraints are not going away, they are only getting worse.
• Huaneng Power International, Inc. (ADR) (NYSE: HNP) does pay a sizable dividend and has plenty of room to run. It has come down a lot with the rest of the inflated Chinese stock market, but this one is not threatened by competition and is a good long-term value. The largest potential downside might be costs associated with environmental clean-up. China is addressing these issues but has a long way to go. This is a must own and with all the stories about electric cars and more devices requiring power all the time plus its recently soft price I still favor HNP. It still has a 3.6% yield, and is increasing equity every day. We have all read lately that the Chinese stock market might be ready to bust, but if it does I will probably ride it out long term with this particular stock. It is beyond my imagination how it cannot be a success long term.
• Valero Energy Corporation (NYSE: VLO) was one of my favorites last year, remains one of my favorites now and is a very strong candidate to stay in favor next year. Its margins have been squeezed lately by high crude prices and stable pump prices, but that could change, and the stock may appreciate significantly in 2008. I have no idea what Wall Street is thinking, but it still seems too cheap with a P/E just over 7, a P/S of 0.34 and still no one seems to be building any new refineries, except outside the United States.
• The Dow Chemical Company (NYSE: DOW) has done well this year but not spectacular. It meets my criteria for consideration on all counts and has a lot going for it. In partnership with Corning, it is developing materials for the solar energy industry. It will probably continue to be mentioned in merger and acquisition rumors, and it has historically been an innovator willing to spend on R&D. If oil goes down in price, the primary ingredient in many of DOW's products will create improved margins. A P/E of 10 and a 4% yield, need I say more? Well now there is more, a Kuwaiti Co., Petrochemical Industries Co has invested $9.5 billion in a joint venture - seems like a merger to me.

Looking too pricey with a few outstanding questions:

• Berkshire Hathaway Inc. (NYSE: BRK.B) is a strong candidate. It meets two of the three criteria in a big way. Although it does not pay a dividend, most of its stock holdings do and Warren Buffett has been the gold standard for creating shareholder equity. If 2008 proves to be a shaky year on Wall Street, you will want to own this stock. BRK.A/B has been appreciating but given all the uncertainty in the market I will stick with this solid company. Berkshire is up 35% on the year, see: Chasing Value: Berkshire Hathaway did what it's supposed to do -- go up! I have nothing bad to say about this stock, but it has had a huge run-up to an all-time high and seems like it has been given full credit for all its virtues. A repeat perfomance would be hard to envision, although it is about 6% off its high today, so maybe it will be perfectly situated when the list is finalized.
• Intuitive Surgical, Inc. (NASDAQ: ISRG) is also a strong candidate that I have written about many times. It does not pay a dividend, but this one has beat everybody and everything every year since I bought it, and is likely to do it again. It has hardly penetrated its potential market. It is significantly off its all-time high, and may look like a bargain by December 28. My regular readers know I love this stock but it has gone back up from about $280 to new highs around $357 before simmering down to the $330 neighborhood and by the 28th may not be much of a value unless it drops below $300 or thereabouts.
• Anadarko Petroleum Corporation (NYSE: APC) is one of my favorite stocks. It is in the right business at the right time, and it has substantial proven reserves in North America. I see APC as a perpetual takeover target, but it has been successful as a stand-alone and can remain so. The stock price is about 5% off its 52-week high, but the P/E is still under 7, so I am bewildered as to why some larger fish has not swallowed this one whole just for its North Amercian reserves. Need to take pause after 15% jump in the last week. This too will be strictly a valuation call on stock price at the time.
• Duke Energy Corporation (NYSE: DUK) (NYSE: SE) will remain on the possibility list for now. It pays a handsome dividend and might see some growth next year as investors look for stability. This year it was flat. That might be good enough if the market ends in turmoil next year. Yes, there is room for two power companies on my list, and this one is paying a solid 4% yield. All seems well at Duke but stability and safety might not equal much growth.
• The Home Depot, Inc. (NYSE: HD) was one of my dogs this year (and continues to report poor earnings) but there is value here and this year going forward it is greater than last year. There are a number of latent problems at HD, but at current prices there is also deep value. I still think HD is a buyout candidate now more than ever, but whether the stock recovers in 2008 or deep into 2009 remains a question. It still worthy of consideration because the smallest gains plus the dividend may be more upside then the S&P sees in 2008.
• General Dynamics Corporation (NYSE: GD): The price-to-sales is a low 1.26 and the P/E is average. It makes the Gulfstream aircraft for the wealthy jet-setter and the Abrams tank for the military. How many of those will need parts or replacement in the coming years? See Chasing Value: General Dynamics (GD) looking long and flying high! Another stock I like but I have seen some gains already and the dividend is not competitive, they should share more.
• Anglo American plc (ADR) (NASDAQ: AAUK) is another stock that could end up in M&A discussions. Let's see, it's a global player in diamonds, gold, silver, platinum, coal and more. This is a currency play, a commodities play, a global play, and an inflation hedge - got to love that if you can get it at the right price. Unlike oil prices which may be affected by the weather, new technologies, or alternative sources these commodities will remain in demand. Gold may be used instead of silver, platinum instead of gold but except for locating new supplies the demand for these precious metals and commodities can only grow with the growth of the new economies and the wealth of their citizens. AAUK was one of my better calls during 2007, up about 30%, but I take pause wondering if it will do well based on economic fear driving precious metals up, or whether it will have to rebalance its mining efforts based on less demand for commoditities if there is a slow down.
• Nucor Corporation (NYSE: NUE) is one of the world leaders in the idea of mini-mills. This smallish steel producer prides itself on running a tight ship, pays a dividend, and has a P/E around 10. Once again, it could be a takeover target as the industry continues to consolidate. It is 25% off its high, and is a strong candidate to make the final cut. Still looks like a winner but not as much so given its recent rise. Maybe someone is actually reading my rants? Like AAUK, this one has jumped since I mentioned it, now up 20% in three weeks, but unlike AAUK, it does not sell any precious metals, only commodities.
• Reliance Steel & Aluminum (NYSE: RS) processes and distributes more than 100,000 products made of carbon, alloy, stainless, and specialty steel, as well as aluminum, brass, copper, and titanium. It serves more than 125,000 customers. For reasons that I will explore in future stories, the entire steel industry seems to be on sale and perhaps priced for a recession. Reliance has a P/E of 9.6 and a PEG ratio of 0.71, so unless there is something here that is well concealed, it seems way too low. My opinion has not changed but I wish RS would raise its meager dividend of 0.63%. That might affect my decision if it becomes a close call. The price is back up and the yield is shrinking. The more I learn about this company the more I am convinced it will be a meal for some bigger fish.

The trimmings:

• Northrop Grumman Corporation (NYSE: NOC) sports an even lower P/S of 0.81 and a lower P/E too, of 15.25. It has a higher dividend yield than General Dymanics and a P/B of 1.57, which seems too low. Another defense contractor adding new contracts every week. NOC is a defense systems conglomerate, and like many, has a very complicated corporate structure in many enterprises. Although it is diversified, most of its revenue depends on large government contracts. NOC's debt is higher than General Dynamics and its return on equity and profit margins are half.

Only eight of these stocks will be on the 2008 list, but all of them should be on your watchlist if you are interested in acquiring individual stocks. During 2007, I wrote about many of them in my Chasing Value column and all of them did extremely well. Many actually did better than the ones on the initial 2007 list. In the case of ISRG, it beat just about everything. The final list will be posted in about two weeks.

To find potential opportunities and verify my track record, read Chasing Value or Serious Money.

DISCLOSURE: I currently own shares of BRK.B, ISRG, HNP, DOW, DUK, VLO, GD, APC, and AAUK.

Sheldon Liber is the CEO of a small private investment company and the principal for design and research at an architecture & planning firm.