Health-Care: It's Good to Be Overweight

With interest rates almost certain to rise, pharmaceutical stocks represent a solid defensive play, according to S&P's Sam Stovall

Interest rates are likely to go up soon -- and worries about the economy may do so as well, so investors may be turning defensive, says Sam Stovall, chief investment strategist of Standard & Poor's. And as a result, Stovall reports, S&P has turned from negative to positive on pharmaceutical stocks.

Health care, including the pharmas, is one of the sectors S&P now recommends overweighting in a portfolio, and Stovall says one of S&P's favorites in the area is Pfizer (PFE ), ranked 5-STARS or buy in the S&P STARS list (Stock Appreciation Ranking System).

In March, Stovall also notes, S&P raised its recommended allocation of U.S. stocks from 50% to 55% of a portfolio, based on technical factors. He says S&P expects stocks to gain close to 9% this year and still thinks they offer a better return than bonds or cash.

These were a few of the points Stovall made in an investing chat presented Apr. 20 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Sam Stovall is a registered representative of Standard & Poor's Securities, Inc. He has no affiliation with or ownership interest in any of the shares he will be discussing, yet S&P's other affiliates might provide compensated services to these companies.

Q: Sam, is the market as spooked by interest rates as it seems?

A:

It appears so. The market has been spoiled by being treated to an artificially low interest rate environment over the past couple of years. And because it's not convinced that the U.S. economy could have grown without this stimulus, investors now worry if a soon-to-be-rising interest rate environment may jeopardize this 2.5-year economic expansion. We think not, but I'll tell you more later.

Q: Why don't you seize this occasion to tell us briefly about S&P STARS, Sam?

A:

S&P's Stock Appreciation Ranking System [STARS] incorporates S&P analysts' investment outlooks on more than 1,250 stocks. Dating back to Dec. 31, 1986, through Mar. 31, 2004, those stocks ranked 5 STARS, or buy, have appreciated 16.6% per year on average, vs. 9.3% per year for the S&P 500 and an average annual decline of 0.8% for our 1-STAR (sell) recommendations.

STARS gives our analysts' investment outlook for the coming 12 months, and is primarily based on fundamental analysis, emphasizing GAARP (growth at a reasonable price).

Q: With ImClone (IMCL ) hitting prescandal highs, why isn't Bristol-Myers Squibb (BMY ) heading in the same direction?

A:

We currently have a 2-STARS (avoid) ranking on the BMY shares. The company earned $1.59 per share in 2003, and is expected to post earnings of $1.50 in 2004 and $1.48 in 2005. Unfavorable studies on Pravachol and worsening generic erosion make us cautious on the shares (in addition to the earlier restating of prior periods in order to correct past accounting errors). While we see robust growth for new drugs, we do not expect them to offset more than $1.1 billion in annual generic losses in the coming four years.

Q: And what does S&P think of ImClone, as mentioned?

A:

We have a 4-STARS ranking on the IMCL shares. We see 2004 earnings at 58 cents and estimate 2005 earnings at $1.37. Even though we like the company's prospects, due to our forecast for strong Erbitux sales and an expanding pipeline, we think high expectations are already partially priced into the shares (we downgraded the shares to 4 STARS from 5 STARS in early April). We have a 12-month price target of $67.

Q: And before we let you go on that area, what's your view of pharmaceuticals generally? And any comment on Pfizer (PFE )?

A:

We are positive on the pharmaceutical stocks, which is actually a relatively new position. We had been negative on the pharmaceutical industry, which currently represents 55% of the market weighting of the S&P Health Care Sector Index. Our caution had stemmed from high-profile drugs coming off patent and weak drug pipelines.

However, we currently believe this condition to be turning around. In addition, with the market anticipating a rising interest rate environment in the quarters ahead, we're of the belief that investors will be attracted to the defensive investment characteristics offered by the pharmaceuticals and other health-care industries.

Pfizer is one of our favorite pharmaceutical stocks and carries a 5-STARS ranking.... We reiterated our buy opinion on the PFE shares today after it posted first-quarter earnings that were 1 cent above our estimate. Driven by robust growth in key drugs and new products, plus merger savings of $3.4 billion, we expect PFE to meet its 2004 guidance of $54 billion in revenues and earnings of $2.13. Despite the recent price advance, we still see PFE as undervalued by about 10% relative to the overall market and Big Pharma p-e's.

Q: You have a chance here to give us more 5-STARS buys -- any other stocks you like, Sam?

A:

Yes. There are currently 125 stocks in the S&P 5-STARS list. Of course, some people say, "That's too many for me to invest in -- do you have a more manageable list?" And I say, "Yes, it's our Top 10 list."

Our Top 10 list, through the end of March, was up 2.7% year to date, vs. a 1.3% advance for the S&P 500. It consists of 10 stocks, each ranked 5 STARS, hand-selected by our director of global equity research and his portfolio team.

The members of this Top 10 list include, in no particular order, but I will be listing the company name, ticker, and [Apr. 20] closing price: FMC (FMC, $42), Qualcomm (QCOM, $64), Caremark Rx (CMX, $33), Anheuser-Busch (BUD, $51), Hologic (HOLX, $22), Landstar Systems (LSTR, $44), Affiliated Computer Services (ACS, $54), Flextronics (FLEX, $17), Comcast (CMCSA, $30), Intel (INTC, $26).

Sorry, that's it for the Top 10. We hope the Top 10 stocks will outperform the market this year as they did in 2003, when they gained 35% vs. the market's advance of 26%.

Q: How long can Bed Bath & Beyond (BBBY ) produce 20% earnings growth and 20% sales growth?

A:

We currently rank the BBBY shares 4 STARS (accumulate). The company posted fiscal year '04 (February) earnings of $1.31, and we see earnings rising 21%, to $1.59, in 2005. The company posted February earnings that were above our estimate on sales that were also better than expected, and their operating margin widened 170 basis points.

We think the 2003 acquisition of Christmas Tree Shops should yield buying and distribution synergies in 2004. Planned new store openings are above our prior expectations. With store count just above the halfway mark of its target, we think BBBY could maintain 20% EPS growth over the coming three years.

Q: Sam, what's your opinion on Citigroup (C )? Especially with interest rates going up.

A:

In the six rate-tightening cycles, dating back to 1970 (in which the discount rate rose at least twice), we found that the financial group was the worst-performing sector, falling an average 13% in the six months following the first rate increase, vs. an average 12% decline for industries in the S&P Industrials sector, and an average 11% slump for the industries of the S&P consumer-discretionary sector.

As a result of this guidance offered by history (but we never use history as gospel), combined with regional bank valuations (the largest industry within this sector) that are above their historic norm, we currently have an underweight recommendation on the financials sector.

That said, we don't imply that no stocks are worth buying in the financial sector. In fact, Citigroup and 23 of its peers carry buy rankings by S&P analysts. On Apr. 15, we reiterated our buy opinion on the C shares, as the company posted first-quarter earnings that were better than our expectations. We expect strengthening global economic and capital-market conditions to support revenue growth, and positive operating leverage to boost earnings in the quarters ahead.

Q: What are some of the other buys you still have among the financials?

A:

Buys in the financials include some insurance stocks, such as Allstate (ALL ) and Hartford Financial Services (HIG ), as well as brokerage-related issues such as AmeriTrade Holding (AMTD ), Bear Stearns (BSC ), as well as Provident Financial Group (PFGI ) and Providian Financial (PVN ).

Q: Would you be committing new money to the market at this time? If not, when?

A:

Our [Chief Technical Analyst] Mark Arbeter believes that we're going through a normal testing process following the initial reaction low from late March. What he means by that is that the indexes may experience additional weakness in the coming period, but then we would be positioned to establish new recovery highs during the summer.

S&P continues to believe that stocks offer a more attractive return than do bonds or cash. We have a yearend target of 1215 for the S&P 500-stock index, which represents a 9% advance for the full year and a near-9% gain from the current level.

Q: Sam, what are the latest sector-weighting recommendations from S&P?

A:

S&P's sector-group heads still have a greater proportion of 5-STARS stocks in the consumer-discretionary, health-care, and technology sectors, with an underweight representation in the financials and utilities sectors. Of course, as I mentioned before, that doesn't imply that we have no buy recommendations in either financials or utilities -- simply a lower overall representation.

Q: And how about S&P's current thinking on allocation of assets?

A:

S&P's investment policy committee is currently recommending that an average, balanced-growth investor should have 55% of assets in U.S. equities, 15% in foreign equities, 10% in bonds, and 20% in cash. While we do see the Fed raising the fed funds rate possibly as early as the June meeting, we still believe equities offer a better return opportunity than bonds or cash, since the Fed would merely be taking its foot off the accelerator rather than placing it on the brakes.

In addition, the current spread between the nominal GDP growth rate at 6% and the Fed funds rate at 1% is historically quite wide. A 2% to 3% point spread is more normal. As a result, we think higher rates will merely be a reflection of an improving economy.

Q: Last time I looked, I think the U.S. stock portion was 50% -- it has been raised five points?

A:

Yes. On Mar. 17, S&P's investment-policy committee decided to increase the U.S. exposure to 55% from 50%. This was based on technical factors. We may be a bit early, but we still believe that a near 9% advance in equities through the end of 2004 is likely.

We see earnings for the S&P 500 rising to $63. Applying a p-e multiple of 20 (the average during the past 15 years) implies a yearend target of 1260, vs. the Apr. 20 close of 1118. We feel that a lower target is appropriate due to the expectation of higher rates as the year progresses.

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