A Cautious Time for Investors

Analyst and author Peter Cohan explains why he prefers a conservative approach in these days of soaring oil and China's growing power

The future relationship between the U.S. and China will be at least partly determined by the outcome of the attempt by China National Offshore Oil Co. to take over Unocal (UCL ), in the view of Peter S. Cohan, author, analyst, and president of Peter S. Cohan & Associates.

Cohan notes the current interdependence of the two economies, with China a source of cheap labor for the U.S. and also of financing for the record federal deficit. He predicts that the Unocal deal will become a political issue that "will not get past scrutiny in Washington."

On another oil issue -- the high price of crude -- Cohan comments that disappointing profits from FedEx (FDX ) indicate companies can no longer pass high energy prices along to customers. And that, in turn, suggests a slowing economy, as he sees it.

These were a few of the points Cohan made in an investing chat presented June 23 by BusinessWeek Online on America Online. He was responding to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat (AOL subscribers can find a full transcript of the discussion at aol.businessweek.com/chat):

Q: Peter, with oil tipping over $60 per barrel today, how do you think the market will look as we go on?

A:

Well, I wonder if the $60 a barrel is really the thing that did it. A few days ago, it went over $60 a barrel, and the market was fine. I think it was that combined with the disappointing profits of FedEx. Up until now, investors have been thinking that the price of oil has not had an impact on the general economy, but the FedEx news reflects that the high price of oil acts like a tax that decelerates the pace of economic growth.

I've been looking at some other factors in the economy that suggest a slowdown, particularly earlier in the year with the bankruptcy of major auto-parts supplier Collins & Aikman (CKCRQ ). But in general the auto companies, Ford (F ) and General Motors (GM ), announced their revenues and earnings were going to be disappointing because of the decline in demand for SUVs and trucks on account of the high gasoline prices. That had the biggest negative impact on highly leveraged parts suppliers to the automobile companies.

So that has been a problem, and then another problem has been a decline in shipping rates out to China. This had a major impact on shippers -- there's a company called Frontline (FRO ) that has taken a hit on account of declining rates for shipping. These are just some examples of how the high prices of oil and gasoline have slowed down the economy.

Q: Peter, I've also noticed the last few days some steel companies warning about earnings because of lower steel prices. Are the good days for commodities over?

A:

Well, I think these commodities -- I mean steel and shipping, which is related to steel -- have a lot to do with Chinese demand and the Chinese economy. I think what's going on is that China is beginning to do its own steel, and I think another part of the steel equation is the decline in the auto business.

A drop in demand for steel means a drop in demand for coal and iron ore, which go into the steelmaking process, as well as transportation.... On the other hand, a commodity that's obviously doing well is oil. So it's selective.

Q: How are you personally investing? What's the ratio of cash, hard assets, bonds?

A:

My basic philosophy is maybe 40% in money-market funds or cash, 30% in market-index funds, and the balance in individual stocks. My philosophy is that I don't want to have to lose sleep at night worrying about paying my bills.

I'm not confident in the stock market in general -- and haven't been since 2000. I don't believe the stock market is the place to invest huge sums of money. Individual stocks have certainly done well over the last few years, but the market has not. The S&P 500 is down around 13% since early 2001, the Nasdaq down even more.

People have been putting their money into real estate recently (which I think is also a bubble), but in general my philosophy is that I want to have enough in a safe place so I don't have to worry about money, but also take a little risk in individual stocks.

Q: Peter, what do you see as the economic and market impact here of the big Chinese moves -- Lenovo (LNVGF ) with IBM (IBM ) and now attempts at Maytag (MYG ) and Unocal (UCL )? Plus some auto-parts companies in the U.S.

A:

I think it really is a very interesting sign of the tremendous amount of interdependence between our economies. What has happened is that we have a record federal deficit. We're borrowing more, something on the order of $8 trillion.

China is among the biggest buyers of that debt. They're financing our economy. They're financing our indebtedness, so we're heavily dependent on them for that. We're also dependent on them for cheap labor. A lot of Wal-Mart (WMT ) clothing manufacturers (and others) are based there.

China is moving up the value chain into more intellectual-based businesses. The acquisition by Lenovo is based on Chinese ability to manufacture commodities inexpensively in the computer industry. Going after Unocal is part of an effort to obtain oil for their growing economy.

We are very dependent on China, so we can't just blow them off and say, "Hey, you just can't buy our companies" and raise tariffs. We're too dependent on them.

Their effort to acquire Unocal is going to be a political issue. It will highlight our relationship with China and define what it's going to be -- it will determine our stance on how we'll let China have access to oil, and how they could control us. I feel that it will not get past scrutiny in Washington.

Q: I'm buying puts on Google (GOOG ). Pro or con?

A:

Well, I'm glad you're not shorting Google. If you're buying puts, you've got a limit on how much you can lose. I think it might be a good bet, because frankly Google is a classic case of how silly the debates are about company valuation.

I mean, Google is like a mirror. People talk about whether it's overvalued or undervalued, but are really telling you more about themselves than Google.

If they think it's undervalued, they're saying they're major bulls, but if they're saying it's grossly overvalued, they're saying they have a very traditional view of investing -- they don't want to overpay for what future earnings flow may be.

One thing I'm fairly confident in about Google is that ultimately it can't keep growing at the rate it has been growing, at which point the stock will take a hit, just as eBay's (EBAY ) did. So it will reach a limit, but I can't tell you where that is.

I would consider that put a rational bet, but on the other hand I wouldn't be able to tell you if it'll work or not.

Q: When will the U.S. dollar gain some strength?

A:

I think the dollar, if I'm not mistaken, has strengthened around 10% since the bottom.... I don't know why that has happened. Granted, the European economy is growing more slowly than the U.S. economy. However, I think the dollar will strengthen when we tune up our finances, which are really in bad shape. We had a huge federal deficit last year. It looks like it's getting better this year. We raised our debt ceiling to $8 trillion, though. That's not good.

I think that consumer borrowing is very high, and I think that in general a rise in the interest rates will drive mortgage rates and the amount of money the government pays out in interest expense. Those, combined with the high price of oil, will all have a negative impact on the value of the dollar. The dollar will rise in value when we can balance our federal deficit, lower the price of oil, and pay back some of the borrowing we're doing right now. I think that's the answer to the question.

Q: Which stocks have you bought recently?

A:

I have not bought any stocks recently. However, in my investment newsletter, the Cohan Letter (which comes out every month, and in it I pick three stocks), I mention my best-performing stocks.

The best this year has been Whole Foods (WFMI ). It has had a really nice run. Five years ago it was trading at $20 a share, now it's at $116. It has had a pretty steady rise, beyond the problem in the first quarter of 2001, but it has done pretty well. I like the company for the Peter Lynch reasons, mostly since we buy stuff there. They're good quality, with knowledgeable employees.

Another I like a lot, and I did recommend it recently, was Genentech (DNA ). It's the single most highly valued company in the health-care industry.

Our firm did an analysis of eight sectors in the health-care industry, from pharmas to biotech, and looked at performance of stocks and financials. Genentech came out on top out of about 60 companies.

It was the most highly valued in the market in terms of price-to-shares ratio, and that can be a negative, but the company's highly effective at new drug discovery.

In 1997, I wrote a book called The Technology Leaders, in which I analyzed the factors that allow the most profitable tech companies to succeed and found that these companies have special organizational traits.

When I applied these traits to what Genentech does, I was amazed at how many they have. I'm pretty sure they've never heard of me or my book, but their performance is amazingly closely tied to those organization traits that I talked about in The Technology Leaders.

Q: Peter, you also did a book, Finding the Hidden Blue Chips Among the Internet Impostors. Do you like any Net stocks now?

A:

I guess I would say that I like Google as a company. I'm not sure I like it as a stock.... I would say that, in general, there has been a massive shakeout in the Net stocks since I wrote that book.

There are a few real winners in terms of their ability to compete, and I think Google is one of those. Yahoo! (YHOO ) is another. But I would also say that investors are very familiar with these companies -- they're not hidden blue chips anymore... As an investment, I'd say trade cautiously in those stocks.

Q: How about UnitedHealth Group (UNH )?

A:

What a great stock. In the last five years it has gone from $10 to $52. It's growing rapidly, and it's very profitable. It has a $65 billion market cap, the largest of its competitors.

The only thing you could say that would be a negative is that as an investment, investors are aware of this thing. Its p-e is 25, the industry's is 21. It's highly valued. The market recognizes it's a winner. But it's not grossly overvalued. Its operating margin suggests that it's more profitable than its competitors, and it has a quarterly growth of 34%.... I would keep holding on to it and might even buy into it at these levels.

Q: Don't think we've touched on any financial stocks -- what's your long-term opinion of MBNA (KRB )?

A:

This is a stock that has been flat over the last five years -- basically hasn't done much. I think if you compare it to Capital One (COF ), the latter has done better. KRB is up about 25% over the last five years, while Capital One is up around 100%. I think Capital One is actually stronger -- this is a very intensely competitive industry. I think if I had gains in this industry, I'd take them.

What you're going to see is an increase in charge-offs. If interest rates go up, and the economy slows, you're going to see very highly leveraged people filing for bankruptcy. Granted, the Bankruptcy Act will make these less painful for the credit-card companies, but they'll still lose money.... It might not be this year, or even next year, but it still might be a good time to take your gains.

Q: So your advice to investors would be to be very cautious about stocks. Where to look for a good return?

A:

Where to look for return? I have a tendency these days to start off looking for sectors that have done well over the last year. Utilities, housing have done well, so I start out here and try to assess whether the trends are likely to support their continuing to do well, or if they've started to peak out.

For example, I would look at both of those areas (utilities and housing), as well as steel and coal, but I would say that steel and coal may already have had the bulk of their run-up, same for housing. But utilities still have a ways to run. I would look there and try to find the company that looks the most solid in that area.

Edited by Jack Dierdorff

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