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The Upside to Low Earnings

It will take good -- and trustworthy -- earnings news to propel the stock market upward with vigor. But in the meantime, some bargains can be had for long-term investors, says David J. Braverman, senior investment officer for Standard & Poor's. Stimulus from lower interest rates and tax cuts will improve corporate earnings, he believes, though some companies have to be more straightforward in their financial statements to regain investor confidence.

For bargain hunters looking long-term, Braverman suggests technology stocks -- specifically, such names as Sun Microsystems, Qualcomm, and LSI Logic. And he reports that S&P currently has strong buy rankings on some stocks, including Amgen, Chico's, DoubleClick, FedEx, H&R Block, Johnson & Johnson, Linear Technology, SCP Pool, St. Jude Medical, and Exxon Mobil.

These were among the comments Braverman made in a chat presented on Feb. 19 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: It was just a few days ago that the market closed above 10,000 on the Dow, and now it's taking gas again. Do you expect accounting worries to keep this sort of thing continuing?

A: Yes, that could be part of the landscape for quite a while, at least until the market has good earnings news to digest. So we could see the market staying weak for a while. But ultimately, the stimulus that's going into the economy from lower interest rates and taxes should improve the corporate earnings picture.

Q: But will investors trust earnings reports any more?

A: I think that after some time, they will. But companies are going to have to be more straightforward in their reporting and in some cases are going to have to deleverage in order to retain investor confidence.

Q: I have dead money in a money market. What bonds would you suggest?

A: Right now, there are two ends of the spectrum that I'd look at. One is the inflation-protected Treasuries (TIPS). Another way of playing this [end of the spectrum] is through Series I savings bonds. At the other end of the spectrum, I'd be looking at some of the high-yield issues. You may see more defaults, but spreads over Treasuries are running over 1,000 basis points.

Q: How can you possibly recommend stocks in this climate?

A: Let me answer the question with a question: Would you prefer a climate in which everything was rising, and we were near the top of the market? Instead, valuations have come down, and the long-term climate may actually be better. So...the climate for long-term gains may actually be pretty good.

Q:Do you like high-yield stocks like Philip Morris (MO) for the short term?

A: We have an accumulate ranking on Philip Morris, we see good price appreciation ahead, and the current 4.5% yield is certainly an added plus.

Q: Three stocks you would buy and hold for the next three years?

A: You get a bonus here -- let me give you a list of 10, which would provide better diversification, and you buy the three that you like the best. Those would be: Amgen (AMGN), Chico's (CHS), DoubleClick (DCLK), FedEx (FDX), H&R Block (HRB), Johnson & Johnson (JNJ), Linear Technology (LLTC), SCP Pool (POOL), St. Jude Medical (STJ), and Exxon Mobil (XOM). All of those are 5-STAR [in S&P's Stock Appreciation Ranking System -- STARS] stocks currently, or strong buy. These stocks all have varying degrees of risk, but as a portfolio, they should provide reasonable diversification over the next year.

Q: This stock was big in the news today -- hold on or sell IBM (IBM) now?

A: We still have a buy ranking on IBM. We still see $4.90 [EPS] for 2002.

Q: Has S&P revised any of its stock rankings significantly since the Enron bubble burst?

A: Well, we're no longer recommending Enron! In fact, Enron had not been a strong buy prior to its downfall. It was at one time, though, an accumulate. To answer your question: We're taking a much closer look at accounting issues, and companies with more aggressive accounting, such as Tyco (TYC), are no longer on our recommended list.

Q: What about Dynegy (DYN) -- a company that for a moment might have been Enron's rescuer.

A: We are recommending accumulate on Dynegy. We see earnings of $2.30 for 2002, vs. the $1.90 reported for 2001.

Q: What do you think of Sanmina-SCI (SANM)? Do you think it's at its low?

A: I don't know if we're at the absolute low. So far, most contract manufacturers have underperformed, but Sanmina-SCI is among the higher-quality issues in this space. Other names we like include Flextronics (FLEX), on which we have a 5-STAR ranking. And Celestica (CLS), which we have an accumulate ranking on. We'd also accumulate Sanmina-SCI.

Q: What do you think of gold stocks?

A: I'm not convinced that we're about to have a huge runup in inflation, so I don't think that gold stocks should be a significant part of a portfolio at the present time.

Q: What should I do with Corning (GLW)?

A: We have a neutral ranking on Corning. And we see a reasonable chance that they'll return to profitability in 2003. The company sees a recovery in telecom spending, but the timing remains uncertain.

Q: With the economic news getting better daily, can the accounting woes be the true drag on the market?

A: Well, they're not the only drag. If valuations were substantially better, I think that people would shrug off the accounting issues. But valuations are still somewhat higher than historical norms, so investors use the accounting issues as a reason -- or perhaps an excuse -- to delay committing more money to the market. In this environment, we'll have to see better earnings before the market takes off again.

Q: Speaking of valuations, do you see some bargains now worth picking up for the longer term?

A: I think that if you were very long-term-oriented, you would start looking again at technology stocks. Some names there that have been beaten down include Sun Microsystems (SUNW), Qualcomm (QCOM), and LSI Logic (LSI).

Q:What do you think of Qwest Communications (Q)?

A: They're another example of a company with an accounting cloud over it. The SEC is investigating transactions with bankrupt Global Crossing (GX). These problems come at a time when Qwest needs to raise more equity capital, so we would steer clear.

Q: I don't want much -- just a stock selling at a 12 or 13 price-earnings with a 5% or 6% yield. Any help?

A: The closest I can find to what you're looking for among our recommended stocks is TXU (TXU). It has a slightly higher p-e and a slightly lower yield, but the growth prospects are a little better. Another name might be Equity Office Properties (EOP). We're neutral on the stock, but it's a reasonable way to achieve a 6.9% yield.

Q: What about consumer stocks -- Wal-Mart (WMT), for one?

A: We would recommend that investors start to overweight some of the economically sensitive areas, and that includes Wal-Mart, which is on a short list of healthy retailers. Their fourth-quarter earnings were up nearly 9% on 5.8% higher same-store sales. The stock is not cheap at 34 times our $1.75 fiscal-year 2003 estimate, but it certainly has a place in most portfolios.

Q: What's wrong with AT&T (T)?

A: Well, we can't get into all of it.... Suffice it to say that they're viewed as lacking a clear growth strategy going forward.

Q: And how about Verizon (VZ)?

A: At the moment, we like them even less. And we would be outright sellers of the shares.

Q: Rare to get a question on an airline stock these days, but what about Southwest Airlines (LUV)?

A: It's an accumulate. Southwest Airlines continues to be the best-positioned airline, and it will continue to expand while much of the industry contracts. The challenge will be to keep the load factor high as the economy starts to improve. But Southwest is the place that most investors should be for exposure to the airline industry.

Q: How do you feel about XCEL Energy (XEL)?

A: We would recommend accumulation. In fact, we have now found the stock that fits the bill for the questioner who was looking for the high-yield, low p-e shares! This stock yields 6.5% and sells for nine times our 2002 EPS estimate of $2.50.

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