Commentary: Educated Investor - Investors facing difficult situation

For the last several years, individuals that had depended on investments for income have suffered as interest rates had reached modern day historic lows. Money markets were paying less than one percent while the 10-year Treasury fell below four percent.

Now these same investors face an even more difficult situation. With employment rising, inflation brewing and the economy recovering, it is just about a slam-dunk that the Federal Reserve will begin to raise interest rates in the near future.

At least in a falling interest rate environment your principal is secure. Not so in a rising interest rate market as you lose principal as rates rise.

In addition if interest rates climb rapidly you could get locked into a fixed interest rate vehicle that would seem antiquated in a relatively short time frame. With rapidly rising inflation, the future for fixed income investors could be even more disturbing than the last several years.

I called on a young man, Charles (Chip) Carlson, CFA, president and portfolio manager for Corbyn Investment Management to get his opinions on the market as well as how an investor might play this market if they are interested in income.

Dave: Chip, what is your take on the U.S. and global economies?

Chip: I believe the strength of the U.S. economy is broadening to the point where corporate America might start increasing its spending on capital investments. Corporations are becoming more confident in the economy whereas in the past they have been fearful that the unfolding recovery in the economy wouldn't hold its ground.

I am surprised how well the markets have digested our geo- political problems especially in the Middle East.

But while the market has been hit by a lot of volatility over the last several weeks, it has given rise to buying opportunities. And since we are never fully invested, we have been buying a few new stocks and bonds recently.

Dave: Are we in the beginning of a bear market?

Chip: Dave, we really don't predict or forecast markets, we are stock and bond pickers. We don't spend time on trying to decide if we are in a bull or bear market.

Coming out of 2003 we realized that valuations were rich and we had a hard time finding stocks to invest in. It was probably a time for a pause. Right now though we don't see tremendous risk. We will probably observe some consolidation during the summer. Then in the fall the market will be guided by the presidential election, the Middle East, strength of the economy and interest rates.

One of the keys to our success has been the fact that we focus on absolute returns and not relative returns.

Dave: In other words you base your returns to the benchmark of zero while most mutual funds and money managers base their performance to one another or some benchmark such as the S&P500. So if a particular manager is down 15 percent but his benchmark dropped 20 percent, the manager feels he has done a relatively good job whereas if you are down any percent you don't feel so good.

Chip: That's right. We want to be on the plus side all the time.

Dave: How would you recommend the individual invest for income in the current investment arena?

Chip: Right now it is tough. As you know, we specialize in busted converts and it is extremely difficult for an individual to single out these opportunities and be able to purchase them on their own.

Dave: I know you use these instruments and you have been able to generate income for your clients. What exactly are busted converts?

Chip: Basically a busted convert is a convertible bond where the underlying common stock has gone down significantly since the bond was issued. Therefore, the ability to convert the bond into stock has become far less important and the bond essentially becomes a fixed income investment.

Dave: What type of income returns are you generating with these issues?

Chip: Currently we're getting a 5 ? percent to 6 percent return, if we simply receive timely interest payments and the bonds mature on schedule. The key is that our duration or expected holding period of the bond is less than two-and-a-half years.

We can add to that return if the bond is redeemed, called or is pushed higher by an upward move in the common stock. Then we might be receiving a total return 2 to 3 percentage points higher.

Dave: I know in addition to investing in busted converts your firm is also known for investing in small to mid-cap value stocks. Any ideas you can share with our readers?

Chip: We have recently finished buying shares in a company called United National Group (UNGL), which is a specialty insurance company. It went public in December 2003 at $17 and now sells for about $16.

With a new management team in place and a book value of about $14 which is cheap to its peers, we expect the company's stock to do well. We are estimating earnings of $1.35 in 2004, rising to $1.80 in 2005.

Dave: Chip I appreciate your time and I know our readers do also. Thank you.

Writers Note: If any one wants to contact Chip Carlson, he may be reached at 410-832-5500. Corbyn Investment Management Inc. has a minimum investment requirement of $250,000. They also offer a mutual fund with initial investments starting at $2,000. The name of the fund is the Greenspring Fund which was established in 1983. Since inception the fund has an annualized return of 11.43 percent.

The last five years the Greenspring Fund had an annual return of 11.69 percent, which is fantastic since three of those five years were horrible for the market. As a matter of fact, Morningstar has awarded them a five-star rating for those five years, which is the highest rating available. Lipper rating gives them a one, which once again is the top rating.

The Greenspring Fund has only suffered three down years since 1983. Not too shabby!

As for my outlook on the market, I still believe it is prudent to keep some powder dry. There is no reason for this market to push upward until we get a better handle on Iraq which will probably determine not only the presidential election, but also have a bearing on inflation and interest rates. So be careful and buy stocks not the market.

David R. Clogg, ChFC is an account executive at Chapin, Davis. He can be reached at 410-435-3200 or visit his Web site at www.theeducatedinvestor.info.

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