Star Stockpickers Share Their Secrets

Whether the Fed overshoots or the broadband revolution moves into full swing, these pros have a way to play it

Even in the best of times, smart stockpicking has been the way to beat the market. Just look at the results from the panels of experts we've gathered the past three years. Last year's group made 28 picks that delivered a total return of 10.5%, two points better than the S&P 500-stock index, according to FactSet Research Systems. (A shorter list of 20 of those picks presented in the print edition of BusinessWeek produced an average return of 13.4%.) The two earlier groups beat the market with returns of 22.6% and 27.6%.

This year's panelists offer choices for most every appetite. Richard Bernstein, Merrill Lynch & Co.'s (MER ) chief U.S. strategist, recommends stocks that pay hefty dividends. Catherine D. Wood, who manages $15 billion in growth stocks for Alliance Capital Management, aims for big gains from volatile tech stocks. David B. Scott, senior vice-president at Chase Investment Counsel, seeks earnings growth from more cautious plays. David J. Williams, portfolio manager of U.S. Trust Corp.'s Excelsior Value & Restructuring Fund, offers an eclectic mix of mostly beaten-down shares that he thinks are ready to spring back to life. When the group assembled in early December, the S&P 500 was at 1,249. Here are highlights of the discussion. Note: This is an extended, online-only version of the roundtable that appears in the December 26, 2005, issue of BusinessWeek.

Are stocks going up or down in 2006?

Bernstein: Stocks won't do much. Returns are going to be muted -- low single digits, if that. The big reason is capital is so plentiful and has pushed up prices already. We see the S&P in 12 months at 1,225, about where it is now. With dividends, you'll pick up a couple percent. You can do better by picking the right stocks and dividend payers. The risk is that the Federal Reserve hikes rates too high. The Fed has never known exactly when to stop tightening.

Williams: Rich, you said the same thing last year, and you were right. But I'm still much more bullish. I see the massive liquidity, too, but that is good for consumers and for corporations. It will pay for dividends, share buybacks, and takeover premiums. The economy is growing nicely here and overseas. Inflation is low. I see the S&P going up about 100 points to 1,360, about 9%, and that's being conservative.

Scott: It is time to be cautious. The Fed is going to have to continue to raise rates into 2006 and may well overshoot. Inflation is going to put pressure on profits. To pick a number, the S&P will be at 1,180, down about 5%, if not more. I'm looking for defensive stocks from companies that will not suffer if the economy slows, like consumer staples and health care.

Wood: I'm definitely the most optimistic one on this panel. This worry about the Fed overshooting is already priced into the market. Inflation is going to be lower than people anticipate. Energy and other commodity prices are going to come down a lot more because demand worldwide is less than expected and supply is rising quickly. That will lift profits. This is the time to buy earnings growth. That's why I'm overweight in tech and consumer-discretionary stocks, such as some Internet retailers and media companies.

Bernstein: Cathie, I'm skeptical. What you describe would be a great environment for what you would call growth stocks, and what I would call speculation, but I don't think it is going to happen.

Cathie, what are good consumer-stock picks that reflect your optimism?

Wood: Amazon.com (AMZN ) is one. They've had some disappointments, but this is a true growth story and a play on the broadband revolution. With e-commerce taking off, you want to be in a stock like Amazon. The issue is that their earnings have not been going up, but that's because they're investing in the business. It is going to be tremendous as these investments pay off.

Another pick is Audible (ADBL ). They sell subscriptions to consumers for spoken-word audio, such as podcasts and readings from magazines and newspapers. They're moving internationally and into wireless.. The stock is down 50% this year. It could recover all of that and multiples more.

I like XM Satellite Radio (MSR ). Its competitor, Sirius (SIRI ), is getting more attention because it hired Howard Stern. But XM has better technology and 6 million subscribers, twice as many as Sirius. What's interesting about Howard is that he can do anything he wants now, so it is not going to be fun anymore once he's not on public radio.

Williams: XM is my second-largest holding, but I wouldn't put it on my list of best picks. The market has put high expectations in the stock price. What bothers me most is that technology time and again has proved to be a commodity. There's going to be all kinds of competition. Why would an investor pay up for it? That said, I do like satellite broadcaster EchoStar Communications (DISH ). The stock is cheap, around 26, even though its franchise is worth at least 35 a share. The CEO owns half the stock and has a history of creating value.

I'm not a big fan of retailing, but look at TJX Companies (TJX ). It has a great franchise in discount pricing with Marshalls and T.J. Maxx stores. Their earnings have been flat this year, which is highly unusual for them. They've got new management and restructuring opportunities. It is a 30 stock trading around 23.

What do you think of tech stocks?

Wood: Some of them could really take off. We own twice as much tech as is in the S&P. One is Juniper Networks Inc. (JNPR ). The stock is down 15% this year. It is essentially an Internet backbone builder. Broadband has passed 30% household penetration and is accelerating. The Internet bubble held a kernel of truth, just 5 to 10 years too early. Well, we are in year five and we're about to take off with stocks like this.

Scott: I'm leery. Big info-tech stocks are becoming more tied to ups and downs of the economy. They're not consistent. Intel (INTC ), Applied Materials (AMAT ), and Microsoft (MSFT ) are vulnerable to earnings disappointments when things slow. You're better off with companies that use tech to increase productivity, like UnitedHealth Group (UNH ), the HMO, which uses it to contain costs.

Wood: People said the same thing about tech in the mid-'80s, right before Microsoft emerged and PCs took off.

Scott: But for the stocks to move, you need leadership from large-cap issues in the sector. At this moment those are Internet content, search, and advertising companies, which have already run up.

Wood: Juniper could still do just that in the snap of your fingers. It is growing about 35%. It is in a beautiful position with the right technology to enable this broadband revolution, to enable a Google (GOOG ). Another candidate is Silicon Laboratories (SLAB ) which makes special chips that combine analog and digital for telecom and microcontrollers. We think it could earn $1.70 next year and take off. Wall Street's estimate is just $1.25.

Scott: I do see one unusual tech opportunity in Motorola (MOT ). They're big and well-positioned internationally and with new products. The stock is relatively inexpensive at 18 times earnings and potential growth of 20%.

Bernstein: I'm bearish on tech. People are misunderstanding some issues, such as the story about today's corporate cash piles being destined to drive capital spending for tech. There's no historical relationship between the two. And tech bulls are missing that the stronger dollar is going to have a monstrous impact on tech earnings.

Wood: Currency doesn't matter when you're in a tech cycle. And I'm not motivated by customers' cash. What matters is that companies can raise productivity by substituting cheaper capital equipment for labor.

Williams: Tech isn't my thing, but I like Cathie's stocks. Some of her smaller companies are probably going to be acquired for premiums by big tech companies, which are the ones that have this cash we hear about.

David Scott, what are your cautious picks in health care?

Scott: Besides UnitedHealth, I like Teva Pharmaceuticals (TEVA ). It is a global generic-drug maker poised to take advantage of drugs coming off patents. The stock is reasonably priced, and the company is consolidating with Ivax. Amgen (AMGN ) gives you a different play on new drug technology with the comfort of a large-cap company. The stock price is O.K., and people haven't caught on to the new drugs Amgen has coming. I think you've got to look hard for stocks like these that are not overpriced.

Williams: David, speaking of overpriced, why would anyone pay 20 times earnings for UnitedHealth? It's really an insurance company.

Scott: It is one of the very few companies that consistently produces 18% to 22% earnings growth. Yes, it does it by consolidation, but that strategy has a ways to go.

Williams: I think the consolidation story is already far along. It's overpriced.

Wood: There are some tech-oriented early-stage health companies with open-ended opportunities. I like Given Imaging (GIVN ). They have a pill-cam, a tiny camera you swallow instead of going through a colonoscopy. The potential market is huge. The hurdles are changing medical practice and standardizing reimbursement, but those are already in the stock. Affymetrix (AFFX ) is essentially a semiconductor company focused on DNA chip arrays. It is part of the tech-enabled shift from mass medicine to personalized medicine. It could earn anywhere from $1 to $1.40 a share. It has had some growing pains, so the stock is down and one to buy.

Bernstein: There's a totally different opportunity in Merck (MRK ), the big pharmaceutical maker. Everybody hates it because of the litigation risk. That's like the tobacco stocks, which worked well over time. Merck's dividend yield is 5%, which is important in a flat market.

Can investors still make money with energy stocks?

Wood: We've pulled out. They were our biggest portfolio. Oil is about 59, but it could go to the low 30s. We don't want to be in the stocks while that is going on.

Bernstein: We're neutral. Pure speculation has been driving commodity prices the past 18 months. Our forecast is that oil will be 40-something in 12 months.

Williams: If oil goes down, chemical feedstock costs will go down, and Celanese (CE ) will be a winner. It is a bargain at seven times earnings. They've restructured to cut costs. Management is good and has executed well.

Scott: I like Burlington Resources (BR ) because they produce natural gas, which is in tight supply domestically. [After this discussion, Burlington jumped on a takeover bid. Scott offered a similar gas pick instead, XTO Energy (XTO ). Trading at 45, it should go to the mid-50s, he said.] A special situation oil company is Suncor (SU ). They're working through some problems taking oil from tar sands in Canada. They'll probably see double-digit production growth. Profit leverage from tar sands is huge when oil stays above $20 a barrel. The stock could climb 20% in 2006.

Williams: Consol Energy (CNX ) is my only pick that is not beaten down. It's a coal company and locking in prices with long-term contracts. Also, they've got a methane gas business that could be split off. The stock's worth probably 90, so it is still cheap at 63. Coal and gas are relatively safe as energy stocks go.

What are some other safety stocks?

Bernstein: I own Procter & Gamble (PG ). It's not as defensive as a food or supermarket stock. It has some broader appeal in growth potential overseas.

Scott: PepsiCo (PEP ) will do well regardless of the economy, and it is a growth story. Its opportunity is international. Now most of their profits are from North America. They have an edge in noncarbonated beverages, such as water and sports drinks, with Aquafina and Gatorade.

Bernstein: Some people would call Consolidated Edison (CE ) a boring utility, but not me. It yields 5% and has strong cash flow. You could get some price gain, too. BellSouth (BLS ) yields 4%. It is part of the most hated stock group in the entire world, large-cap U.S. telecom. Their earnings are growing with reasonable certainty, just not as much as people thought five years ago.

Williams: Rich, chasing yield is one of the biggest mistakes I made this past year. It is tough for companies that don't have good earnings growth to increase dividends. You've got three big uglies here on your list in BellSouth, Con Ed, and Merck. Many of these are just dying assets, unless they do a huge restructuring.

Bernstein: If I'm right, as the economic cycle starts rolling over, the other stocks that everybody likes will be devoid of growth, and these will start doing pretty well. Still, I brought a pick that's closer to a play on economic growth, Emerson Electric. It is partly technology, with cooling systems for computers. And, with changes in air-conditioning standards around the world, it is sort of a China play. If you want a safer way to play tech, try Xerox (XRX ), a turnaround story.

Williams: Xerox is a good story. I owned it and sold too soon.

Bernstein: Xerox has some new products that may gain market share, and they've got more restructuring to come. When everybody thinks a company is going to strike out, you just need a single to do O.K.

Williams: Singles aren't the way to make money. I don't buy unless I see at least 25% upside.

Bernstein: In a flat market, it is going to be very hard to find those kinds of situations. So I'm choking up on the bat.

Williams: One company where I could get my 25% is Tyco International (TYC ). It is still cheap at 12 times earnings and includes some great businesses, such as their fire systems, connector businesses, and U.S. Surgical. If they decide to split it up, it would probably be worth something like 40, and right now it's trading for 28. Current management is determined to make changes to unlock value.

At Cendant (CD ), which is another amalgamation, management has said the same thing. It doesn't have the same near-term growth in its businesses, which include real estate and travel. Right now, Cendant's parts are worth $25 and the stock's at $18.

Financial stocks make up one-fifth the value of the S&P 500. Are any worth buying?

Williams: Morgan Stanley (MWD ). They'll do well with more mergers and acquisitions. The stock is probably the cheapest of the biggest investment banks, a great name selling at 11 times earnings. They've got a new CEO who is seasoned and knows the business. With the world awash in money, somebody's got to manage it, and Morgan Stanley will be in the forefront.

Bernstein: As a group, the financials are trading at their highest valuation relative to the rest of the market since 1998, so we're underweight. I like one as a turnaround story, American International Group (AIG ). If you X-out the investigation and accounting issues -- and it's probably reasonable to do that -- you've got a very large, high-quality stock with an Asia story that's trading out of favor. Their recent numbers have been fine.

By David Henry

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