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Recalculating the "E" in P-E

The stock market is awaiting an earnings breakthrough, believes David J. Braverman, senior investment officer for Standard & Poor's Equity Investor Services. Until the actual earnings numbers come up to investors' high expectations, stocks are likely to continue alternating between strength and weakness, day to day.

On the earnings front, S&P has just come out with a new rubric for what it calls core earnings in an effort to shed some light on the accounting confusion that recently came to light. Braverman points out that this concept includes employee stock options on the expense side -- and in most cases will result in somewhat lower reported earnings.

These were among the comments Braverman made in a chat presented May 9 by BusinessWeek Online and Standard & Poor's on America Online, in replying to questions from the audience and from Jack Dierdorff of BW Online. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk. Edited excerpts follow:

Q: David, the market has given us real hope two days in a row now. Will it dash those hopes once again?

A: I think that's very possible. I think we're going to continue the pattern of one very strong day followed by some weakness. I think that pattern will continue until it becomes clear that earnings are actually performing in line with some very strong expectations already built into the market.

Q: Meantime, S&P made news by announcing a new way to calculate corporate earnings. That's an important step in evaluating stocks. Can you explain what this is all about?

A: Sure. What we've actually done is describe something that we call core earnings, and it includes employee stock-option expenses and restructuring charges from ongoing operations and pension costs and R&D expense. But it excludes goodwill impairment, gains and losses from asset sales, and pension income. What we're trying to do here is have a standard set of assumptions by which the "e" part of p-e can be calculated.

Q: What's the net effect on earnings as we have known them?

A: Right now, they will be a bit lower, so it adds a little bit to the concern about stock valuations. For example, General Electric (GE) would see its 2001 earnings at $1.11 [per share] instead of the reported $1.41.

Q: Why has the market shown no respect for GE?

A: Probably because growth has started to slow and the investment community has some concern over their use of short-term financing, which boosts earnings in the short run but perhaps puts the company at slightly more risk if liquidity were to dry up. We're currently neutral on GE.

Q: What do you think about WorldCom (WCOM)?

A: We're currently recommending investors avoid the stock, and, in fact, after yesterday's close we deleted WCOM from the S&P 500.... It was replaced by Apollo Group (APOL). US Airways (U) was also removed yesterday and was replaced with BJ Services (BJS).

Q: Would you buy Citigroup (C) now for a one- to three-year investment?

A: The longer the time horizon, the better. With a shorter-term horizon of 6 to 12 months, we're currently neutral on Citigroup. But as time goes on, we would be more positive, given the long-term growth prospects of the franchise.

Q: Where do you see the S&P 500 going this year?

A: We see the S&P 500 perhaps getting a bit past the 1200 mark later this year. We are concerned that there's a great deal of high-earnings expectations embedded in current valuations, so even as earnings get stronger later in the year, it could still be somewhat disappointing to investors. That's part of why our growth expectations are somewhat modest.

Q: What are the prospects for Oracle (ORCL)?

A: We are currently recommending investors accumulate ORCL, even though a challenging information-technology spending environment continues. But ORCL has a return on equity of over 40% and about $5 billion in cash.

Q: A battered name here: Is Lucent (LU) worth investing in for the long term?

A: At this point, I'm not quite sure how long is long. Lucent has disappointed for its entire history. At this point, it looks like things are starting to level off, but we only have a neutral opinion on the shares.

Q: Do you think Washington Mutual (WM) will become the Wal-Mart (WMT) of the savings-and-loan industry?

A: It's starting to look a bit that way, but it will be interesting to see how WM absorbs its acquisition in the New York region. We like the stock and recommend investors accumulate it -- and we see $3.96 EPS for 2002.

Q: As the owner of Compaq stock (CPQ), I'll be receiving about 78 shares of the merged Hewlett-Packard and Compaq (HPQ). Should I add to it at the current price?

A: We would probably stand pat for now. We're now neutral on the stock, and we think the PC market could be somewhat sluggish through the summer. So why not leave it at 78 shares?

Q: Do you believe Johnson & Johnson (JNJ) will be able to maintain its current performance?

A: It looks that way. We see JNJ continuing to outperform both the S&P 500 and the rest of the health-care industry. It's a strong buy.

Q: Two other pharma questions: on Pfizer (PFE) and why it's been languishing, and on Bristol-Myers Squibb (BMY).

A: We would stay the course with both companies, although we would accumulate PFE and hold BMY, which has somewhat worse earnings visibility and a somewhat more questionable pipeline. But neither company is as well-positioned as JNJ.

Q: What is your take on the incestuous relationships between analysts and investment bankers?

A: That's my favorite question so far today, because it gives me the opportunity to boast that S&P has no investment-banking relationships. What you describe is a huge problem that puts into question the credibility of many analysts. And it's a problem that many investment firms and regulators are going to have to wrestle with.

Q: Can you give us a sampling of S&P 5-STAR (strong buy) stocks, perhaps with an emphasis on those that have recently risen to the top?

A: Some names that we like currently include Idec Pharmaceuticals (IDPH). Another name in the news that we have a strong buy on is Sears (S). Others are Quest Diagnostics (DGX), FedEx (FDX), H&R Block (HRB), Kraft Foods (KFT), and Linear Technology (LLTC).

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