We particularly like Berkshire Hathaway and Paychex at this stage

By Xavier Bremner

I recently had a chance to ask Covestor Manager Sherman Lee of Prudent Value his thoughts on the early market action in 2012 as well as his stock picks and trading strategies for the rest of the year.

As 2012 unfolds, what are the biggest surprises to you on the macro front?

There were no real big surprises on the macro front. However, the stimulus from Operation Twist (the Federal Reserve policy to sell $400 billion in short-term Treasuries in exchange for the same amount of longer-term bonds which started in October 2011 and will end in June 2012) has made a difference. That policy, combined with more positive developments coming out of Greece and European leaders over debt, did surprise with improved performance equity prices.

What is your current assessment of stock valuations given the strong start in the equity market?

Given the strong start in the equity market (+8.96% YTD in S&P 500 through Feb. 24), stock valuations are inherently less cheap than they were at the beginning of the year. On a historical basis, averaging last ten years of S&P 500 companies’ earnings and applying the Schiller P/E methodology, the S&P 500 is currently trading at 22.6 P/E, or 37.8% higher than the historical mean of 16.4.

Using this metric, the market seems overpriced. However, given the backdrop of a low interest rate environment for the foreseeable future, the market does not appear as overvalued as this one metric suggests.

What specific sectors and stocks are you active in and why?

Generally, we are well-diversified across various sectors and stocks. With that said, we are particularly active in the financial and technology sectors. In the financial sector we like insurance and holding company giant Berkshire Hathaway (BRK.A) run by the Warren E. Buffett and his partner Charlie T. Munger. The company has a record of outperforming the S&P 500 Index over the long term and to date has outperformed the S&P 500 in every five-year period since inception.

Additionally, the shares are attractively priced as Buffett has recently made a public announcement that Berkshire is prepared buy back its own stock.

In the technology space, we like small and middle market payroll processor, Paychex, Inc. (PAYX) Despite high unemployment during this Great Recession, management was able to stabilize top line revenue and bottom line profits. Any recovery in the job market and/or short-term rates will be a benefit to Paychex. Additionally, we get paid a healthy 4.10% dividend to wait.

What trading strategies aren’t working out as expected for you, and why do you think that is?

With the benefit of 20/20 hindsight, our large overweight position in cash is not working out as expected. In tennis parlance, this was an unforced error because we started acquiring shares in August and September of 2011, but did not follow through in a meaningful way.

How do you see the rest of the year unfolding? What are the key events and variables that shape your outlook?

While we do not generally make market forecasts, the rest of the year should do okay, barring any hiccups from the European debt situation. Also this being a presidential year, coupled with a very accommodative monetary and fiscal policy should provide tailwinds for stocks in general.

Thanks, Sherman.