Run with the Bulls, but Watch Your Step

Investment manager Michael Farr sees special opportunities in health care and financials, but warns investors that risk will rise with the market

Health care and financials are the two sectors that offer the best gains to investors now, says Michael Farr, president of investment firm Farr, Miller & Washington, because they haven't done as well as others recently. Farr especially likes Pfizer (PFE ), Johnson & Johnson (JNJ ), Bank of America (BAC ), Citigroup (C ), and Travelers Insurance (TAP.A ), among others. He regards the wave of bank consolidations as a sign of management confidence in the economy and the market. As stock prices move higher, Farr urges investors to avoid the mistakes that cost so much in the last three or four years.

These were a few of the points Farr made in an investing chat presented Jan. 15 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

Q: Michael, are you running with the bulls? How strong a market do you see for 2004?

A:

We have been running with the bulls. I don't like the risk of being gored that the analogy might suggest, but certainly the markets are moving higher, and investors have benefited from this over the past 12 months. As the economy expands, corporate profits will, I believe, continue to grow.

Stock prices are up already in anticipation of continued earnings increases. They appear very fully valued. Valuations will become more normal as earnings rise, but as [that happens], stock prices will move even higher. This is the way the dangerous cycle of momentum begins. If you're an individual investor, beware the siren's song. Don't make the mistakes that cost you so much over the past three or four years. Benefit from the lessons you've learned.

Q: Can you comment on the bank consolidation going on? How do you rate J.P. Morgan Chase (JPM ) after its purchase of Bank One (ONE )?

A:

The bank consolidations are significant in two major ways. The first is recognizing that mergers and acquisitions are again occurring, which demonstrates a renewed optimism by corporate management about the economy and the environment.

Two, the mergers that began with Citigroup's (C ) [purchase of] Travelers Insurance have shown that bigger is better and that mergers within the financial-services industry can achieve important economies of scale. The JPM/Bank One merger...seems to make more sense than the Bank of America (BAC )/Fleet merger. Having a national multimarket presence continues to prove beneficial for money-center banks with mortgage and debt exposure in regional markets.

Q: Here's one that's been running up, and a favorite question in the crowd -- what's your take on Lucent (LU )?

A:

I think the company is still fundamentally flawed. I think the stock is moving up on the hope -- and not the promise -- of a turnaround. I think the company has been poorly managed and has been backed into a corner, strategically, from which it will be very difficult to emerge.

There may be a buyer of the remaining operations and assets, but then the value comes in the form of the pieces and parts and not the operating company. And therefore, it's not an investment, it's a speculation.

Q: How do you lean these days on value vs. growth?

A:

My style is the combination of value and growth known as GARP [growth at a reasonable price]. I think we're at an odd point in the markets in that value and growth have rather good prospects. Value outperformed growth during the three years of the bear market. The past 12 months, growth has done better, but not remarkably better. So companies with value characteristics on the balance sheet and superior earnings growth would be most compelling to me.

Q: In general, which industry segments do you believe will be the next to move?

A:

I think the most benefit is to be garnered from those that have not done as well, specifically health-care stocks and the financial and banking stocks. Many of the banks remain inexpensive and carry good dividends.... Some names attractive to us at current prices are General Electric (GE ), Home Depot (HD ), CVS (CVS ), Johnson & Johnson (JNJ ), Pfizer (PFE ), Waters (WAT ), First Data Corp. (FDC ), Microsoft (MSFT ), Nokia (NOK ), Bank of America (BAC ), Citigroup (C ), and Travelers Insurance (TAP.A ).

Q: Which pharmaceuticals do you favor in 2004?

A:

Pfizer, Johnson & Johnson, and Eli Lilly (LLY ), in that order. Pfizer is one of those stocks that hasn't moved very much over the past 12 months. The entire pharmaceutical group has underperformed the broad market. This underperformance has been due to pipeline issues and regulatory issues. These three pharmas I think will leave an investor in very good stead over the next several years. In addition, each is paying about 2% in dividends.

Q: What's your opinion on housing prices and interest rates? Do you think there will be a day of reckoning?

A:

Alan Greenspan suggests that housing markets are disparate and regional. He further suggests that the Federal Reserve expects a rather steady supply of new-home buyers. As interest rates increase, the market will undoubtedly slow. But most indications suggest there is no bubble environment. The lack of mortgage refinancings for banking institutions will probably be replaced by increased earnings on time deposits.

Q: As a retired person, I'm looking at PPL (PPL ) for dividend income -- do you think utilities are a sound investment now?

A:

I don't follow PPL, but in general I think that the dividend income off most utilities is reasonably secure. Stay away from those that are paying the higher dividends because there's always a reason. In general, as energy prices rise, it's difficult for regulated businesses to pass along the increase in costs, and profits suffer. These business are highly leveraged and suffer further in a rising-interest-rate environment. Utility investing isn't without peril, and it should be done very cautiously, especially by investors who can tolerate little risk.

Q: Are you raising cash now? Or buying more of some of the names you listed above?

A:

No. We remain fully invested at all times. While it's always more difficult to find value in a market that's becoming more expensive, we proceed stock by stock -- paring positions as they become too expensive and adding to those that may have declined.... We're buying and selling in almost every market environment. That said, our annual turnover is a very low 25% on average.

Please be careful with your investment decisions. Though I believe the market will go higher, it will become more dangerous as it does.

Edited by Jack Dierdorff

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