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Think Small in Stocks Now

Where are the best bets now for investors? In small-caps, according to David J. Braverman, senior investment officer of Standard & Poor's Corp. He says valuations of small-caps are better, and they'll recover faster when the economy and market turn around.

Braverman predicts that interest rate cuts and the tax rebate will eventually produce a recovery in corporate earnings and thus in the market, though the near-term outlook is poor. By yearend he hopes to see the S&P 500-stock index above 1300, but he concedes that the challenge now is to get it above 1200. And he forecasts a 15% uptick in the Nasdaq for the year, assuming tech companies can get rid of the inventories they're now writing off -- and thus depressing earnings.

As for stocks and stock sectors, Braverman recommends consumer cyclicals and basic materials. Names he mentions include P.F. Chang's China Bistro, Electronics Boutique, Home Depot, and SCP Pool. In basic materials, he likes Smurfit-Stone Container.

Braverman's remarks were made in a chat presented July 10 by BusinessWeek Online and Standard & Poor's on America Online. He was replying to questions from the audience and from Jack Dierdorff of BW Online. Edited excerpts from the chat follow. A full transcript is available from BW Online AOL at keyword: BW Talk.

Q: How do you feel about the current market? There was another strong downdraft today.

A: We are getting more optimistic about the longer term, even though the near term does not look very favorable. The problem is that second-quarter earnings are going to be terrible, and investors do not yet believe that we're going to have a substantial turnaround. But we think that eventually earnings will recover as a result of the tax cuts and interest rate cuts that have been put into place.

Q: What are some standouts on the S&P 5-STAR "strong buy" list now?

A: At this point, we would be going to some of the smaller-cap issues, and we would be stressing names in consumer cyclicals and basic materials. Names we like in those categories include: P.F.Chang's China Bistro (PFCB), Electronics Boutique (ELBO), and SCP Pool (POOL). Also, Smurfit-Stone Container (SSCC).

Q: Why do you find small-caps more appealing now than mid- and large-caps?

A: Even after the decline in the stock market, valuations are still better, and as we get an economic recovery, those stocks with better p-e ratios should recover faster. Plus, these stocks tend to be less followed, and do well as a following among analysts develops.

Q: What is your view of ADCT

(ADC Telecommunications)?

A: We are currently neutral on ADC Telecom. Obviously, they have been caught in the downdraft with most of the other telecommunications companies, but...the stock has not yet become attractive enough to us to say "this is now a bargain."

Q: Before we leave telecom, what's your view of AT&T (T), with all the commotion over breakup and now the Comcast (CMCSK) overture?

A: We're currently neutral on AT&T, and we think, though, that we may see more bids for the broadband unit besides Comcast's. Yet we don't think that there's enough there to warrant purchase.

Q: What would you recommend for "safe" and yield stocks?

A: There are stocks such as Philip Morris (MO) that have high yield and strong fundamentals, and some defensive appeal. In Philip Morris' case, we think that the litigation threat is starting to diminish.

Q:Rather than pick individual stocks, I have been buying the QQQs, SPYs, etc. Is this a smart way to invest?

A: I think so. It's a good way for certainly the beginning investor to start out. You get a huge amount of diversification at very low cost. The other alternative is to do what we're doing here, to research some best ideas, and to own a focused portfolio of probably no more than 25 stocks. My personal view is that when you start getting above 25 stocks, you are destined to start getting index-like returns with higher cost. This is why the majority of active mutual funds underperform the S&P 500.

Q: Your opinion of fiber optics -- JDS

(JDS Uniphase), NT

(Nortel Networks), COLT

(COLT Telecom Group), GX

(Global Crossing)?

A: Of the three, we're probably most optimistic on Global Crossing. At this point, we have an avoid recommendation on JDS Uniphase. They're an example of a company whose market has just evaporated. We are currently neutral on Nortel.

Q: What about LU

(Lucent)? Is Elaine [Garzarelli] right about doubling in a year? Or is Lucent dead money?

A: Our view is somewhere between the two extremes. There's the possibility of a cash infusion for Lucent, but we think the company's end markets are going to remain weak for some time, so it's hard to see the stock quickly rebounding.

Q: Do you think EMC

will rebound?

A: Yes, we think so. EMC is still feeling the impact of a worsening global economy, and gross margins are starting to be affected. But EMC is still the leading storage company and is well-positioned for the economic recovery that we expect.

Q: Where do you see the Nasdaq by yearend? And for that matter, the S&P 500?

A: We see a rebound in the Nasdaq, probably to the 2300 range, which is about 15% above current levels, but it will become increasingly difficult to make that target, if Nasdaq companies continue to disappoint. The S&P 500 also should improve, but it will probably be difficult to get much above 1300. Quite frankly, we need to get back above 1200 first.

Q: On the Nasdaq, does your 15% hope imply that tech companies can work off their inventory overhangs?

A: Yes, that's what it's going to take, and I think what's happening is that companies are throwing in the towel on earnings this year and aggressively writing down inventories that may actually get sold by late this year, or early next year. What it will really take is some more optimistic guidance from these companies, combined with some upside surprises on the earnings front.

Q: Any idea where Home Depot (HD) will bottom out?

A: We actually like Home Depot quite a bit here. We think the new management is on the right track, and that we will see growth coming from more installed sales, as opposed to rapid expansion of new stores. The company, we think, is going to get more out of its existing stores.

Q: Here's one about the latest dot-com disaster -- what will happen to Webvan (WBVN)? Will someone pick up the carcass?

A: We don't follow Webvan, but I would expect that we will see the concept reemerge, probably this time from a bricks-and-mortar retailer.

Q: Does S&P give high marks to any Internet stocks these days?

A: Yes. Our current favorite is DoubleClick (DCLK). The addressable market is now $20 billion and should jump to $65 billion in the next five years.

Q: What do you think of Rational Software (RATL) -- short term and long?

A: We have an accumulate recommendation on Rational Software, and it's a sign of the times that the company is only modestly lowering its revenue and EPS forecasts, which makes the company something of a standout in its industry. Helping as well is $1 billion in cash and a substantial share repurchase program.

Q: What about Cardinal Health (CAH)? And what are S&P's favorites in health care?

A: We're currently neutral on Cardinal Health. Our favorites in health care include HealthSouth (HRC), Immunex (IMNX), Oxford Health Plans (OHP), and Rehabcare Group (RHB).

Q: What about the computer hardware group? Companies like Dell (DELL) and Compaq (CPQ)?

A: We're currently neutral on Dell, and on Compaq as well. Given the pricing pressure, we don't see any earnings growth in the personal computer market.... A better story is occurring at IBM (IBM), where they have been largely transformed into a service company with a huge backlog, so we would be buyers of IBM.

Q: How do you feel about the retail sector (6 to 12 months)? Specifically, Dollar Tree (DLTR)?

A: We're currently neutral on Dollar Tree, but retail is an interesting place to be at the moment. Our favorite stocks there include: BJ's Wholesale Club (BJ) and the previously mentioned Home Depot. Another name that we mentioned earlier was Electronics Boutique (ELBO).

Q: Is this a good time to buy oil stocks?

A: We have recently gotten somewhat less bullish on oil stocks. Probably oil prices have seen an interim peak, but we think there will be some opportunities later this year to reenter and buy stocks that have natural-gas exposure. Those stocks include: BJ Services (BJS) and Nabors Industries (NBR). We currently have buys on both of those stocks, but we probably would not make energy more than 6% or 7% of an equity portfolio at this point.

Q: What is your opinion regarding Cendant (CD)?

A: We continue to have a strong buy on Cendant. We think that the Galileo acquisition will provide benefits. We view the company as an attractive free-cash-flow story.

Q: What is your assessment on U.S. Bancorp (USB)? And any favorite financials to mention?

A: We're currently neutral on U.S. Bancorp. But our favorite financials include: Moody's (MCO), FleetBoston (FBF), and Berkshire Hathaway (BRK.B)

Q: Back to the Net, what do you think about eBay (EBAY)?

A: We would accumulate eBay. They have become an enduring brand name on the Internet that manages to post growing profits, which makes it unlike most Internet companies.

Q: Summing up, what are the best places for new money in the market today? With some choice names, if you will.

A: We would be stressing the consumer cyclical names, including AOL

(AOL Time Warner), BKS

(Barnes & Noble), CHTR

(Charter Communications), PLCE

(The Children's Place), LEN

(Lennar), SCHL

(Scholastic), and we would also be looking at basic-materials companies such as PTV

(Pactiv), PX

(Paxair), and SSCC


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