Investors are becoming more confident that corporate profits are on the road to recovery this year, says Kenneth Shea, vice-president and research director at Standard & Poor's. After five straight quarters of losses, he sees first-quarter earnings for companies on the S&P 500-stock index rising an average of about 7%.
As the economy and earnings show signs of improvement, Shea recommends investors focus on economically sensitive areas of the market such as the information-technology, consumer discretionary, and materials sectors. He says investors should stick with companies with easy-to-understand business models and good track records for generating positive cash flow and increased shareholder value. Some names include Mohawk Industries (MHK), Fortune Brands (FO), Linear Technology (LLTC), and Pactiv (PTV).
Shea made his comments in a chat on Mar. 5 presented by BW Online and Standard & Poor's on America Online, in response to questions from the audience and Karyn McCormack of BW Online. Edited excerpts follow. A complete transcript is available from BW Online on AOL, keyword: BW Talk.
Q: Ken, blue chips took an expected breather today after two days in strong-rally mode. Do you see more confidence building for a rebound in corporate profits this year?
A: Yes, we do. After five consecutive quarterly declines, S&P analysts see a long-awaited year-over-year increase in operating earnings in the first quarter -- up about 7% over prior-year levels. For the year 2002, S&P analysts collectively forecast earnings per share of $53, a sharp 37% increase over 2001 levels.
It should be added, however, that last year was an unusually poor one, in which operating earnings fell 31%. So although 2002 earnings are expected to rise sharply as the economy improves, the actual level is really simply getting back to 1999 levels.
Q: How have your 5-STAR buy picks done recently?
A: S&P STARS [Stock Appreciation Ranking System] has performed very, very well, from both a near- and long-term perspective. Since STARS' inception in 1986, the 5-STAR strong buys have returned more than 18% annually, vs. a 10.7% rise for the S&P 500. From a near-term perspective, S&P 5-STARS have outperformed over the last three years, and are roughly market-performing so far this year.
Q: What do you think of the drug sector, and Andrx (ADRX) in particular?
A: S&P currently has a neutral recommendation on the pharmaceutical industry. Investors are weighing the positives of steady, low-double-digit earnings growth for the industry with the risks associated with major drugs going off of patent protection, a disorganized FDA, and uncertainties with regard to industry pricing. On balance, it's an attractive place for long-term investors. But near-term investors may be disappointed with only market performance.
S&P analyst Herman Saftlas upgraded Andrx shares earlier this week from"hold to accumulate following the company's favorable summary judgment of noninfringement for its generic version of GlaxoSmithKline's (GSK) antidepressant drug. With other expected launches this year and a still-good chance at winning its generic Prilosec case, the company is attractive for above-average gains ahead.
Q: Nokia (NOK) and AOL Time Warner (AOL) -- buy, sell, or hold here?
A: S&P analyst Ari Bensinger recommends investors avoid the shares of Nokia. That's because he believes the company's network operating margins will come under pressure in the near term, reflecting the initial rollout of low-margin 3G products. Moreover, industry competition continues to be intense. With the stock trading at a healthy premium to the market, S&P would avoid the shares.
S&P analyst Scott Kessler recommends investors accumulate the shares of AOL Time Warner, in light of the company's broad and deep entertainment and cable assets and steady cash-flow generation. With the shares down significantly from their high, S&P believes they may mark a good entry point for investors.
Q: What energy stocks do you rank as 5 STARS?
A: S&P currently has 5-STAR rankings on the shares of ExxonMobil (XOM), Nabors Industries (NBR), Weatherford International (WFT), GlobalSantaFe (GSF), and Evergreen Resources (EVG). S&P recommends investors to market-weight the energy sector in light of its current expectations of relatively flat commodity prices near-term.
Q: What does S&P think about Compaq (CPQ) and Hewlett-Packard (HWP)? Will the merger go through?
A: Another S&P analyst continues to recommend holding both Hewlett-Packard and Compaq. With regard to Hewlett-Packard, the company recently said it plans 9% operating margins for the new Hewlett-Compaq merger entity [if it's] completed. S&P views the company's projected $2.5 billion in cost synergies related to the potential merger as achievable, but at an ample valuation, we recommend that you hold both.
Q: Turning to the housing sector, which has been hot recently: What is your opinion on Toll Brothers (TOL)?
A: S&P recommends investors hold the shares of Toll Brothers. With mortgage rates very low, the population again is regarding new homes as an attractive purchase. With Toll Brothers' shares trading at only about eight times S&P's fiscal-year 2002 EPS estimate, the shares are in the low end of a historical range. But since luxury homes are usually the weakest housing area early in the economic cycle, we would not currently add to positions.
Q: What are your current thoughts on Flextronics (FLEX)?
A: S&P continues to recommend a strong buy on the shares of Flextronics. The company recently said it sees fourth-quarter revenues in line with earlier expectations, but earnings at the lower end of expectations.
Nevertheless, the company continues to gain market share in consumer products and expects to generate $500 million of free cash flow in fiscal-year 2003. Despite the stock's near-term weakness, S&P believes Flextronics' shares remain attractive due to its favorable industry position, potential for new program wins, and the shares trading at a discount to both its peers and the overall market on a price-earnings-to-growth basis.
Q: What is S&P's stance on financial stocks? What are the current 5-STAR stocks in the area, and your opinion on Citigroup (C)?
A: S&P currently recommends investors to market-weight the financial sector, as positive news coming out of the insurance and insurance broker industries are offsetting some weakness in the banking and consumer finance areas. S&P currently recommends investors to hold the shares of Citigroup. That's because Citi's premium p-e multiple to others in its peer group is justified due to the company's broad business mix and geographic diversity relative to other banks. The stock remains a good long-term holding.
Some recommended 5-STAR stocks right now include: Commerce Bancorp (CBH), an operator of banks in the Northeast Corridor; [Arthur J.] Gallagher (AJG), a provider of insurance brokerage, risk management, and employee benefits services to a variety of commercial and institutional organization; and MetLife (MET), the large provider of insurance, annuities, and investment products.
Q: Do you have any favorite areas of technology right now? Which tech groups should investors avoid?
A: Favored industries within the info-tech sector include semiconductors and semiconductor equipment and software, which include stocks such as: Fairchild Semiconductor (FCS), LSI Logic (LSI), Linear Technology, and Kulicke & Soffa (KLIC), as well as Siebel Systems (SEBL) and Symantec (SYMC).
On the negative side, we recommend investors avoid the telecom equipment and computer storage industries. Names to avoid here include ADC Telecommunications (ADCT) and Qwest Communications (Q). Also, computer storage companies such as McData (MCDT) and Brocade Communications Systems (BRCD).
Q: What is your opinion on Oracle ORCL
A: S&P still recommends investors to accumulate the shares of Oracle despite the company's negative preearnings announcement yesterday. Company execs stated that its revenue and earnings growth for the fiscal third quarter will be roughly the same as in its second quarter. Its Asian-Pacific business was cited as the main reason of the weakness. While S&P was disappointed with the news, it still believes the reaction was overdone and would recommend investors use this dip as an opportunity to accumulate this market leader.
Q: Retailers have been coming out with earnings, and Gap (GPS) was upgraded today by Merrill Lynch. What is your outlook?
A: S&P continues to recommend avoid on the shares of Gap in the wake of an awful fourth quarter, in which sales fell 11% on a 16% drop in same-store sales. Margins continue to be hurt by lower volume and heavy discounting.
Although the company deserves credit in reducing its inventory levels, we believe its ultimate success will depend on customer acceptance of its new merchandise. With the same-store sales in February below expectations, S&P remains unconvinced Gap has found the right product mix, and consequently cut the company's earnings forecast by $0.15, to $0.35, for the fiscal year ended 2003. S&P believes the shares remain vulnerable to further earnings disappointments.
Q: Ken, do you think the worries about Enron and related accounting problems are waning?
A: Although the hysteria surrounding Enron has certainly waned somewhat, the lasting impact on investors is to be more critical with regard to the way companies report their earnings -- and explain complicated financial transactions to the investing public. Clearly, the Enron debacle was exacerbated by the inability of investors or even the company's auditor to uncover some of the financial shenanigans the company allegedly resorted to to cover up a volatile business model that was widely misunderstood.
As a result of this, investors will have heightened sensitivity to complicated business models, as well as companies that aren't forthcoming in explaining their financial statements to the best of their ability. That will likely weigh on many companies for a while.
Q: Here's one company that had accounting trouble in the past. Is this not a good time to get into Cendant (CD)?
A: S&P currently recommends that investors hold the shares of Cendant. That's because S&P remains mixed on the near-term outlook for travel and hospitality-related businesses. The company did do a good job in putting its financial problems behind it and has restored a great deal of its credibility among its investors. While S&P is favorable on the company over the long haul, near-term uncertainties with regard to travel may dampen price action.
Q: What are your thoughts on tobacco companies like RJ Reynolds RJR
and Philip Morris (MO)?
A: S&P is positive on the tobacco industry near-term. That's given a fairly positive regulatory and legal environment. S&P recommends investors accumulate the shares of Philip Morris but hold RJ Reynolds and UST (UST).
Q: Ken, can you sum up your market outlook for us?
A: S&P believes investors should emphasize the economically sensitive areas of the market -- such as the consumer discretionary, information-technology, and materials sectors -- in light of the strengthening economy and expectation of significantly improved earnings as the year progresses. My recommendation is to stick with companies from these sectors that have easy-to-understand business models and have a good track record of generating positive cash flows and increased shareholder value. Some of those names include Mohawk Industries, Fortune Brands, Linear Technology, and Pactiv.