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Reading the Street's Conflicting Signals

The market decline may have hit 90% of stocks, but the other 10% have done well, despite recession. That point is made by Peter Cohan, president of Peter S. Cohan & Associates, an investing strategist, venture capitalist, and noted stock-picker.

He cites in particular Apollo Group, an adult-education company; AutoZone, which does well as people hang on to their cars longer; Bed, Bath & Beyond, benefiting from the housing boom; and Thor Industries, which makes recreational vehicles and benefits as baby boomers start to retire.

In general, though, Cohan isn't sure a market recovery is in place and has his doubts about a number of big-name stocks, including Ford Motor, which he says could be having liquidity problems and isn't a stock to go long on. He also says, in reference to the dramatic 32% drop in Sears stock on Oct. 17, that such problems are the result of low (or zero) interest rates and the Bush economic policy.

These were among the highlights of remarks Cohan made in an investing chat presented Oct. 17 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Peter, the obvious first question is whether the market has finally touched bottom and is starting back up. What do you think?

A: I'm always skeptical of anybody who says that they really know what's going on. However, I have an opinion, which is that the market is starting to respond to earnings reports...maybe it means that investors are starting to feel pretty comfortable that the numbers that are reported are real.... For example, today IBM (IBM) and Kodak (EK) reported, Microsoft (MSFT) tonight -- there are a lot of good numbers coming out, which the market responded to positively.

On the other hand, yesterday you had Intel (INTC) coming out with disappointing numbers, and the market dropped 200 points. So it's certainly conflicting signals right now...this could be indicative of a turn, but there are any number of wild cards that could come along and just knock this nascent recovery off its little pedestal.

Q: Are you seeing certain stocks come back more than others? Are there any safe, and also worthwhile, places to be as the market gains some steam?

A: Well, yes, there are some companies that have really profited from this recession. It's interesting that you normally don't think of companies doing well in a recession, and on average 90% of the stocks are down -- but 10% of them are up. One [example] is Apollo Group (APOL), an adult higher education company.... The reason that they're doing so well is that people who get laid off from companies sometimes decide that they can get better jobs afterwards if they get more education.

Q: Were you ever so pessimistic as to think the Dow would fall to about 6,000?

A: Well, it could fall a lot lower, because I think, even after all that it's come down, it's still high on a p-e basis. A lot of the metrics I've read suggest that the Dow is still high in terms of valuation. However, if the earnings start to grow, then that p-e comes down, unless the prices start to go up after the earnings do. I'm seeing these earnings reports coming out, and a lot of them are surprisingly good.... I was thinking that whatever could bring us out of this funk was growth and earnings. So if earnings continue in this manner, maybe it's safe to say that the market isn't so overvalued.

Q: What is your opinion on SUNW

(Sun Microsystems)? How can Java be so dead?

A: That's a very painful situation there. They are the dot in dot-bomb. Today they announced that they were laying off 11% of their workforce (4,400 people). Revenue was less than they expected, falling from $2.9 billion to $2.7 billion. What it boils down to is that they're in a market with excessive amounts of capacity.

The other problem is that there's so much competition in their business. They've been so focused on trying to beat Microsoft that they seem to have lost their focus on customers.... They do have a big hunk of debt, though they have $2.9 billion in cash [as of June, 2002]. But they've lost, in the last year, about $587 million, and they do have $1.4 billion in debt. That's not a huge amount, but any debt when you're losing that much money is bad. Basically, they need to find a new growth engine.

Q: Do you like Ford (F) long, or would you short it or wait? Do you think it will come back?

A: Interesting. About a year ago, I noticed Ford had an incredible amount of debt. They were one of the most highly leveraged companies out there, and it's a real concern. As a matter of fact, they have a debt-to-equity ratio of 16. So for every dollar of equity they have, they have $16 of debt. They have a big financial-services department, which accounts for a lot of that.

The other problem they have is a very weak management team. This guy Ford has a great last name, but I don't think he knows how to manage his business. They have $164 billion in long-term debt. That's just an incredible amount. It makes you a little bit ill to realize how much debt they have. S&P may cut Ford's debt rating as well.

So I think they're in a situation where they're having significant financial-structure issues. They could be having some liquidity problems. It wouldn't actually shock me if they had to file for bankruptcy. If their debt rating does get downgraded, they may be forced to repay some of their debt, and there's no telling if they have the cash to do that.... Shorting a stock is always a little bit scary, but I definitely wouldn't go long on them.

Q: What's happening with biotechnology stocks?

A: In general, the biotech business is an extremely risky place to invest. Usually, what you're doing is you're buying shares in a company that has no product, a limited amount of cash, and little more than promising technology that has a long pipeline to get approved. One bad ruling by the FDA, and you're out of business.

So you have a very limited amount of cash that you're burning through at a fast rate. So when you invest in biotech, you're really just assuming that you could throw the money away. And that's how it would be, with very few exceptions. Biotechs have been around since the late '70s. They were the original dot-coms, where you were buying hope, not products. Not a place for somebody who needs to hold on to their money.

Q: Are there any biotech stocks you like now?

A: You know, actually I thought Amgen (AMGN) was a good one. They look pretty healthy -- a market cap of $64 billion. It's a strong company that has a lot of products, and they just did an acquisition of Immunex Corp., so they're able to fill out a broader portfolio. And for the six months ending in June, their profits were up. If there's any negative, it would be the valuation (at 44). But as far as the company goes, in biotech it's one of the more solid ones.

Q: Was the Sears (S) sell-off overdone today? Down 32%!

A: Yeah, it wiped out $3.85 billion in market cap today. It didn't even come close to meeting drastically reduced third-quarter expectations. It has a lot of credit problems, bad consumer debt. When you think about the situation here with Sears, the situation with Ford and GM -- all the cheap financing that they offer -- that was the Bush economic plan coming home to roost here.

When you give away credit for free, you blow your receivables and you give away debt at very low rates, and you don't care about credit quality. People start to lose their jobs, and you find yourself in a terrible debt problem. That's what the economics here have been over the last few years. Now, if the Sears announcement is one example, they're paying the price, and it will happen more and more. I don't think the sell-off was overdone.

Q: This might be a good time for you to tell us about stocks besides Apollo Group you see as sturdy survivors, Peter.

A: Another one is AutoZone (AZO). In the year ended Aug. 31, sales rose 10%, income rose 145%, and they've been adding new stores. They're really doing well because people are basically keeping their cars longer through recession. They go into these stores and buy replacement parts and accessories to keep their cars longer. So this is another one that's benefiting from recession.

Another is Bed Bath & Beyond (BBBY) -- 30% revenue growth, profit growth 45%, 8% net profit margin. It's a store that sells domestic merchandise and home furnishings. People are focusing on their homes, and of course, they're also buying homes. (The housing market has been booming.)

A third is Thor Industries (THO). This is a company that makes recreational vehicles like the Airstream. This company had revenues go up 41%, and profit was up 69%. The stock is up 149%. This is another one that benefits from the retirement of the baby boomers, a long-term trend that will probably go beyond the recession. They've also been doing a number of acquisitions.

Q: Do you like Intel (INTC)?

A: That was the one that caused the market to drop 200 the other day.... I guess it has been hurting primarily because it's so heavily dependent on the PC. The PC market has been shrinking, and so when you have a company with a p-e of 36, and you're selling primarily to an industry that's shrinking, something has to give.

I also think there's a problem with this guy Barrett [CEO Craig R. Barrett]. Ever since he took over, the company's been doing some pretty disappointing things. Andy Grove was just a better manager. I hate to be completely negative about it -- it has $11 billion in cash. It's still trading well, though. It went up today. But on balance, I would say it has lower to go.

Q: Care to go out on a limb, Peter? Where do you see the S&P 500 at year's end? And what kind of investment strategy would you recommend at this moment in the market?

A: It's trading at 879.20 right now. It was at 1,100 at the beginning of the year. All right, I'll go out on a limb and say that it [the S&P] will make it up to 950 by the end of the year. I guess, in general, I think that it's too early to start throwing money back into the stock market. The bottom at the end of July, followed by the rebound and then crash in September, has given me some pause.

As an investor, my feeling is that if the economy starts to really look strong, then I might feel a little more comfortable putting money back in. It's not a game if you're retiring in 10 years.

Q: Peter, you mentioned Bush's policies earlier. What do you think he should be doing with the economy? Taxes? And what about Iraq?

A: I have no idea what's going on with the military situation in Iraq. There is so much fear out there, and so few facts, that I have no way of evaluating what's going on. But I do feel confident that Bush has a very weak economic team and a total absence of economic policy. For a Harvard Business School graduate, he seems to have very little concept of business or economics.

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