Stocks to Weather Summertime Blues

Rates will rise and profit growth will slip, says S&P's Sam Stovall, but some good buys beckon, even in the already-stoked energy sector

Interest rates, oil prices, and corporate earnings -- those are the three factors investors will be watching most closely to determine the market's direction, according to the analysis of Sam Stovall, chief investment strategist for Standard & Poor's.

Stovall's take on those three areas? He expects the Federal Reserve to continue raising interest rates through the end of the year, oil prices to average $50 per barrel, and operating earnings to rise by 8%, year-over-year.He cautions that the profit front could be disappointing, however.

SMALL-CAPS BIG.

  On another front, Stovall reports that small-cap stocks are still doing better than large caps -- with the S&P SmallCap 600 index down 0.6% so far this year, vs. 1.7% for the S&P 500. And he adds that, although growth stocks may be gaining an edge over the value variety, investors keen for dividends should "stick with value, since it offers a 2.2% dividend yield, vs. 1.9% for the S&P 500 as a whole and 1.5% for the S&P growth component."

These were some of the points Stovall made in an investing chat presented June 28 by BusinessWeek and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat (AOL subscribers can find a full transcript at aol.businessweek.com/chat):

(Sam Stovall is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Sam, that was a nice recovery in the stock market today -- do you think it will have legs?

A:

I think that there are three things the market will be focusing on in the weeks ahead. First is the Fed meeting -- that by the end of this week it should give an indication as to whether the Fed is finished or nearly finished raising interest rates (we think it will continue raising rates through the end of the year). [Editor's Note: The Fed indeed raised its benchmark rate by a quarter-point, to 3.25, on June 30.]

Next, investors will be keeping a watchful eye on oil prices. And since oil prices fell more than $2 today, that allowed investors to breathe a sigh of relief, at least in the short term. (We expect oil prices to average $50 per barrel this year.) And, finally, the second-quarter earnings season is getting ready to begin. S&P analysts are looking for an 8% year-over-year increase in operating earnings.

Should investors not be pleasantly surprised with stronger-than-expected earnings and earnings rise by a single-digit rate rather than a double-digit rate as they have over the past 12 quarters, investors might be taken aback, especially if guidance for the third quarter is tepid as a result of uncertainty surrounding economic growth.

Q: Should I sell eBay (EBAY )?

A:

No. S&P has eBay ranked 3-STARS (hold). S&P's 60-plus equity analysts evaluate more than 1,500 domestic equities, giving each a 5-STARS (strong buy), 4-STARS (buy), 3-STARS (hold), 2-STARS (sell), or 1-STARS (strong sell) rating. This 12-month outlook incorporates intrinsic evaluations (primarily a discounted cash-flow model), relative valuations (i.e., the company's p-e vs. other companies in the industry), and a sum-of-the-parts technique where, on the whole, S&P analysts are evaluating the investment prospects for a company in the year ahead.

Q: Could you review S&P's favorite dividend-producing stocks, please?

A:

I am currently logging onto our Web-based service, which allows me to sort on a variety of criteria, one of which happens to be dividend yield. The system is called Advisor Insight. I am going to start by selecting those companies ranked 5-STARS by S&P analysts, then selecting companies with dividend yields of 2% or higher, and I find 17 of the 117 satisfy this selection.

Obviously, most of the higher yielders are in the bank or real estate investment trust [REIT] category. Such companies include US Bancorp (USB ) with a 4% dividend yield; Simon Property Group (SPG ) with a 3.7% yield; Duke Energy (DUK ) at 3.7%; Dow Chemical (DOW ) at 2.8%; and finally Colgate-Palmolive (CL ) with a dividend yield of 2.3%.

Q: What is your opinion of Goldman Sachs (GS )?

A:

Goldman Sachs is currently ranked 5-STARS. The company posted fiscal year 2004 earnings (ended November) of $8.92 [per share]. We estimate earnings at $9.50 for fiscal year 2005. We would use any weakness in the GS shares as an enhanced buying opportunity, given our view of its strong competitive position and highly attractive valuation. Our 12-month price target is $140.

Q: What is your opinion regarding oil stocks for the balance of the year?

A:

We have several oil stocks on our strong buy list -- in particular, such names as Chesapeake Energy (CHK ), GlobalSantaFe (GSF ), Patterson-UTI Energy (PTEN ), and Valero Energy (VLO ). We're positive on these select companies, but our 12-month outlook for the entire sector is neutral.

Our feeling is that, from a global fundamental standpoint, oil should be trading around $50 per barrel. Plus, we anticipate year-over-year earnings growth to decline from a 40% rate in the first quarter to a 4% rate in the fourth quarter. In addition, early indications point to a decline in earnings growth for 2006. So, as a result, the sector carries a market-weight recommendation, even though we believe there are a variety of opportunities available within the sector.

Q: Over into retailing -- what are your thoughts on Bed, Bath & Beyond (BBBY ), Chico's FAS (CHS ), and Staples (SPLS )?

A:

Your lucky number is 4, because that is the number of STARS we have assigned currently to all three companies. Actually, the BBBY shares were downgraded to 4-STARS from 5-STARS on June 23, because of the recent runup in stock prices. Our 12-month discounted-cash-flow-based target price remains $49. Our 12-month target price for Chico's is $38, while our 12-month target price for Staples is $25.

Q: Another financial name -- is JPMorgan Chase (JPM ) a buy?

A:

Yes, it is. It's not a strong buy, but it's a buy. We have it ranked 4-STARS. The company posted earnings of $1.55 last year, and will likely post earnings of $3.10 this year, rising to $3.50 next year. Our price target is $43.

Q: Sam, any thoughts on broad trends, such as growth stocks surpassing value in popularity, and large caps vs. smaller caps?

A:

That's a good question. Usually in this phase of the stock market cycle, large-cap stocks have begun to outperform small-cap issues. Yet small-cap stocks continue to hold their own. Year-to-date through June 24, while the S&P 500 was down 1.7%, the S&P SmallCap 600 was down 0.6%, and the S&P MidCap 400 was up 2%. While p-e's look a little pricey for mid- and small-cap stocks at 18 times 2005 earnings estimates, small-caps and mid-caps appear more attractive than large-caps when viewed from a "p-e to projected five-year growth rate" standpoint.

In addition, of the 117 companies in our 5-STARS list, 68 have market caps of less than $10 billion, 51 have market caps of less than $5 billion, and 10 have market caps of less than $1 billion. As a result, one can see that S&P analysts continue to find investment opportunities in the large-, mid-, and small-cap arenas. Granted, the small-cap outperformance is getting a bit long in the tooth. In the 1960s, small-caps beat large-caps six years running, whereas in the 1970s and 1980s, they beat large-caps 10 years in a row.

From a growth and value standpoint, S&P separates companies along price-to-book-value lines. These indexes are rebalanced every December. And so far this year, the value side is beating the growth side, posting a 1% decline within the S&P 500's value component vs. a 2.4% decline for the S&P growth component.

From a STARS standpoint, S&P analysts are currently leaning a little more toward the growth side of the equation than the value side. This indicates that they believe there is a greater price appreciation potential in the coming 12 months for growth than for value.

If you are a dividend-oriented investor, however, stick with value, since it offers a 2.2% dividend yield vs. 1.9% for the S&P 500 as a whole and 1.5% for the S&P growth component.

Q: And what do you see as the best sectors now? Where does tech stand?

A:

We currently have an underweight recommendation on technology, because we believe that the near term will likely be challenging for the tech sector. More than 50% of tech's revenues come from overseas. And with many economies shutting down during the summer months, combined with the prospects of a strengthening U.S. dollar, we think third-quarter earnings increases could be tough to come by.

Q: What's S&P's general asset-allocation recommendation now?

A:

S&P's investment policy committee currently has a 60%/40% recommended split [between stocks and bonds] for the average (balanced) investor. The 60% recommended equity exposure consists of a suggested 45% holding of domestic equities, with 15% allocated for foreign investments. On the fixed income side, we suggest a 25% exposure to short- to intermediate-term bonds and a 15% holding of cash.

The domestic equity exposure was recently raised, taking 5 percentage points out of international, since we felt that because of the recent weakness in the euro (as a result of the uncertainty surrounding the recent referendum vote), we could see an additional flight to safety here in the U.S.

Q: Has the Chinese bid for Unocal (UCL ) affected oil stocks at all yet? Will it roil that market?

A:

Certainly I think it has caught investors' attention. Many believe that foreign investment here in the U.S. will likely support, if not propel, the stock market through increased M&A activity in the energy sector and other areas. While some foreign purchases of U.S. assets are likely to be approved, I think it will be difficult for a foreign investor to purchase assets of a strategic nature, which oil most certainly is. We don't want to increase our reliance on foreign oil.

Q: How about the giant of retailing -- Wal-Mart (WMT )?

A:

We like the outlook for Wal-Mart and have a 5-STARS ranking on the shares. Fiscal '05 earnings (January) came in at $2.41, which is likely to grow to $2.65 in fiscal '06 and $3.05 in fiscal '07. Our current target price is $59 per share, which would represent a 20% appreciation from current levels.

In general, I think one has to be a bit cautious about retailing expectations in the future in the face of stubbornly high oil prices, as well as the prospects of a slowdown in economic growth over the next few years. Yet, obviously, our analysts believes that Wal-Mart will emerge as a market leader in the coming year.

Q: Does S&P recommend overweighting any market sector now?

A:

S&P recommends overweighting the consumer-staples, health-care, and utilities sectors. S&P recommends underweighting consumer discretionary, financials, technology, and materials. Our outlook is one of caution over the next several months. But we believe that the market could eke out a low-single-digit advance for the full year. High oil prices, slowing economic growth, decelerating corporate earnings advances, and an aging bull market temper our enthusiasm.

Edited by Jack Dierdorff

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