Identifying Best-Of-Breed Investments

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OCEAN CITY – In the 1990s, when Michael Hartnett, Co-Head of International Investment Strategy at Banc of America Securities–Merrill Lynch Research, used the phrase “best of breed,” he was referring to Japanese companies that escaped the decade-long bear market in the world’s second-largest economy.

“Japan was facing something similar to what is going on in the U.S. today — a credit-fed boom followed by a deflationary bust,” says Hartnett.

Yet, in sharp contrast to the plight of most Japanese stocks, a basket of 15 top-performing Japanese blue chips rose 330% during that decade, versus a 40% decline for the broader market.

Today “best of breed” applies to the kinds of companies that tend to weather downturns and are more likely to provide long-term opportunity for investors. Such companies have healthy balance sheets, strong management, consistent earnings histories and forecasts with bright future prospects, plenty of cash as a percentage of overall assets, and clear growth strategies.

Now, as investors look for signs of recovery in the global economy and markets, searching for companies with these best-of-breed attributes could help identify stocks that have the potential to rise even if market benchmarks don’t. Although markets may remain volatile, investing in well-positioned companies can potentially enable you to achieve better-than-market results over the long term, according to Hartnett.

Where should an investor look for such companies? One fruitful area might be markets that are primed to outperform. Hartnett is especially optimistic about the prospects for some emerging markets in Asia and Latin America. What makes certain countries in these regions attractive is that they have current account surpluses, they have stronger domestic demand prospects in 2009 and beyond, and their banking sectors are relatively healthy. China currently matches those criteria, so it shouldn’t be surprising that some large-cap Chinese stocks fit the best-of-breed definition, says Hartnett.

Emerging-market banks that avoided the subprime mortgage lending that crippled many U.S. financial institutions could be particularly appealing. “Three years ago, not one of the top 20 banks in the world, ranked by market capitalization, was Chinese,” Hartnett says. “Now the top three are Chinese.”

As far as U.S. investments are concerned, investors may consider globally oriented brand-name companies that export to high-growth countries such as India and Brazil, which have burgeoning consumer markets. “When you wake up one day in the emerging world and recognize you’ve made it to the middle class, you want a Big Mac, a Coca-Cola and a pair of Nike sneakers,” observes Robert Doll, Vice Chairman and Global Chief Investment Officer of Equities at the BlackRock investment firm.

While it makes sense to invest in sectors poised for growth, even hard-hit industries such as U.S. banking and real estate may offer best-of-breed candidates.

“The commercial real estate sector is one of the main beneficiaries of U.S. government intervention, so there are opportunities to invest in REITs [real estate investment trusts], not only on the equity side but also in fixed income,” says Doll

While no investment strategy can guarantee success, screening for best-of-breed stocks offers important historic lessons for choosing equities suited to today’s global downturn, says Hartnett.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)

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