Can't Stop the Big Mo

Healthy spending and productivity add up to some good stock buys, says S&P's Kenneth Shea. Plus: His formula for a diversified portfolio

Energy costs are a wild card in the future of the U.S. economy -- but in the view of Standard & Poor's, "even at current elevated levels for oil, real gross domestic product is likely to rise at a 3% or above rate through next year, paced by healthy consumer spending, continued strong equipment investment, and further productivity gains." Those are the words of Kenneth Shea, managing director of Standard & Poor's Equity Research Services.

Looking at the stock market, Shea notes that the worst-performing sector has been telecommunications. However, S&P does give Verizon (VZ ) a buy rating because of its relatively low valuation and attractive dividend.

AT THE PINNACLE.

  And despite worries over banking stocks because of rising interest rates, S&P has a strong buy rating on both Bank of America (BAC ) and Citigroup (C ).

S&P maintains a list of Top 10 stocks -- all strong buys -- as a guide to investors. This portfolio is up 8.4%, vs. 2.9% for the S&P 500 year-to-date through July, says Shea. The current list: Smith International (SII ), International Speedway (ISCA ), Lennar (LEN ), Covance (CV ), St. Jude Medical (STJ ), Burlington Northern (BNI ), MDC Holdings (MDC ), Audible (ADBL ), Ingersoll-Rand (IR ), and Guitar Center (GTRC ).

These were a few highlights of Shea's remarks in an investing chat presented Aug. 16 by BusinessWeek Online and Standard & Poor's on America Online. (BW and S&P are both units of The McGraw-Hill Companies Inc.) Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chats.

(Kenneth Shea is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly related to the specific recommendations or views expressed in this chat.)

Q: Ken, how does the market look to S&P now? Does today's loss in the indexes mean that energy prices are starting to hurt the market?

A:

Let me answer that by saying today's pullback in the equity markets reinforces the volatility that the market has experienced virtually all year. But this is not necessarily indicative of oil's influence on the markets. That said, stocks did tumble shortly after Wal-Mart (WMT ) said higher gasoline prices curb customer spending.

So the wild card remains as to what extent energy costs will dampen economic activity, but our feeling is that even at current elevated levels for oil, real gross domestic product is likely to rise at a 3% or above rate through next year, paced by healthy consumer spending, continued strong equipment investment, and further productivity gains.

Q: Any thoughts on Home Depot (HD )?

A:

Standard & Poor's reiterated its buy (4 STARS) recommendation on the shares of Home Depot following the company's earnings report today, which was a bit higher than expectations. The company's comparable-store sales growth of 4% was a healthy performance, bolstered by the continued good times for housing and related home improvement. S&P remains positive on the home improvement industry.

Q: How about telling us your top picks for the balance of this year?

A:

Standard & Poor's evaluates companies on a five-tiered system called STARS [for Stock Appreciation Ranking System], where 5 is a strong buy recommendation, or those stocks believed by the equity analysts to be best poised for total return gains over the coming 12 months. S&P maintains an active model portfolio of what it believes are its Top 10 stocks [out of the more than 100 stocks rated 5-STAR] for upside potential, dubbed the S&P Top 10 Portfolio.

Those stocks consist of Smith International, International Speedway, Lennar, Covance, St. Jude Medical, Burlington Northern, MDC Holdings, Audible, Ingersoll-Rand, and Guitar Center. The portfolio is up 8.4%, vs. 2.9% for the S&P 500 year-to-date through July.

Q: Why is Verizon's price so low?

A:

On a year-to-date basis, the telecommunications services sector has been the worst-performing of the 10 S&P sectors. S&P analysts have a negative fundamental outlook on the sector and a negative stance on the integrated companies, though the stance on wireless is neutral.

Despite these negatives, Standard & Poor's recommends investors buy (4 STAR) the shares of Verizon, in light of what we believe is an attractive price. Trading at a relatively modest 13 times 2005 estimated earnings and sporting a 5% dividend yield, the shares seem relatively attractive for total-return investors.

Q: What are your thoughts on the financial sector, and specifically Citigroup? And what do you think of Bank of America (BAC )? Buy or sell?

A:

S&P recommends investors market-weight the financial sector, as a flattening yield curve normally portends a challenging earnings environment for banks. We do believe that this potential negative is offset some by relatively attractive valuations.

S&P recommends investors buy (strong buy, 5 STAR) Citigroup, as we believe Citi's wide geographic presence and diverse business mix position it well for sustained growth, even in this challenging environment. The valuation appears attractive at only 11 times estimated 2005 earnings per share and sporting a secure 4% dividend yield.

S&P also maintains a strong buy (5 STAR) recommendation on Bank of America in light of its recent success in integrating numerous acquisitions and its diverse business mix. S&P looks for the company's net interest margin to remain relatively stable ahead.

Q: Is Disney (DIS ) a buy at this time, or will the price of gas hurt the parks?

A:

S&P recommends investors buy (4 STAR) the shares of Disney, as S&P thinks Disney should see double-digit earnings growth through at least fiscal year 2007, based on strong and/or improving business fundamentals at ESPN, ABC, its U.S. theme parks, and worldwide merchandise licensing.

With [Michael] Eisner to step down Sept. 30, we expect CEO-in-waiting [Robert] Iger to remain focused on content creation, digital distribution, and global expansion. S&P analyst Tuna Amobi has a sum-of-the-parts-derived target price of $32.

Q: What about tech stocks? Is Apple (AAPL ) a good buy at this time?

A:

S&P recommends investors hold their shares of Apple. While the success of Apple's iPod has benefited the company's bottom-line results, S&P believes that year-over-year growth rates for the device face more difficult comparisons ahead.

In addition, Apple's larger exposure to the fickle consumer-electronics industry introduces much more variability in quarterly sales. We see Apple, which trades above peers on most relative metrics, as fairly valued, given our view of its strong cash levels and iPod leverage.

Q: Do you like General Electric (GE ) at, say, $33.50?

A:

At current levels, S&P recommends investors hold the shares of GE. S&P anticipates that continued good global economic growth and benefits realized from recent company acquisitions will drive low-double-digit revenue and earnings growth this year. We believe CEO [Jeffrey R.] Immelt's strategy of migration toward businesses that have enduring competitive advantages in growing markets seems to be paying off. Given GE's fairly robust valuation, however, we would recommend investors hold the shares.

Q: Two quite different stocks here: What are your thoughts on Pfizer (PFE ) and Walgreen (WAG )?

A:

S&P recommends investors hold the shares of Pfizer. We expect total revenues in 2005 to decline modestly from last year's level. This performance primarily reflects projected steep declines in the sales of Celebrex and Bextra cox-2 inhibitor treatments for arthritis and pain, as well as reductions in sales of off-patent drugs.

In view of recent dollar strength, we look for a 3% to 4% decline in second-half revenues, but we are keeping our 2005 earnings-per-share estimate of $1.98, given expected benefits from cost-cutting.

S&P recommends investors buy (4-STAR) the shares of Walgreen. Results have benefited recently from improved gross margin trends, derived from generic drug utilization and rollout of in-store digital photo processing. WAG remains on pace to open 365 net new stores in fiscal year 2005.

Q: Ken, what's your view of corporate earnings now?

A:

S&P equity analysts collectively forecast a healthy 14% rise in operating earnings per share over the prior year's level. We also project another 9% year-over-year increase next year. The gain in 2005, if realized, would represent the fourth consecutive year of double-digit operating earnings growth. While that in itself is a positive reflection of the health of corporate profits, the quality of the earnings also remains a positive.

Q: What do you think about 3M (MMM )?

A:

Standard & Poor's recommends investors hold the shares of 3M. S&P expects near-term sales growth to benefit from continued market penetration of the high-growth Asia Pacific and Latin America regions, the development of adjacent market opportunities, and an expanding pipeline of new products, not to mention contributions from acquisitions.

Looking ahead, we think MMM will remain committed to improving the efficiency of its manufacturing operations, including its focus on Six Sigma and global sourcing. S&P's 12-month target price is $80.

Q: If you wanted to invest $25,000 over the next nine months, what would you invest in?

A:

S&P provides a wide variety of index choices, as well as more than 1,600 U.S. stocks to choose from. A diversified portfolio of common stocks, fixed income, and cash is prudent for those long-term investors. As such, S&P believes that an asset allocation mix for intermediate-to-long-term investors of 50% U.S. stocks, 15% foreign stocks, 20% bonds, and 15% cash is prudent in the current investment climate.

The U.S. stock portion should itself be diversified among large, small, and midsize firms, with an emphasis on securities with demonstrated records of earnings and dividend growth and stability.

Q: How would you suggest picking that 15% of foreign stocks?

A:

Standard & Poor's believes that most U.S. investors are best served by having a diversified exposure to foreign stocks as well, with participation in mutual funds with good track records and individual securities that have American depositary receipts (ADRs) in the U.S., which ensure much-needed market liquidity.

Edited by Jack Dierdorff

Before it's here, it's on the Bloomberg Terminal. LEARN MORE