Sectors to Tap after the Fed Cut

Fund manager Charles Knudsen III recommends retail, entertainment, health care, and finance -- but says take it easy on technology

Even though there may be more pullbacks in the stock market, it's a good time for investors to get in, according to Charles Knudsen III, manager of the ARK Balanced Portfolio.

He suggests focusing on sectors most likely to benefit from the Federal Reserve's interest-rate cuts, including retailing, entertainment, some health care, and financials. As for technology, Knudsen expects that to be slow in responding and predicts that it may take three to five quarters for demand to pick up. The stocks he likes now include Lowe's, Wal-Mart, AOL Time Warner, Schering-Plough, and J.P. Morgan Chase.

In the near term, he sees small- and mid-cap stocks doing better than their larger-cap brethren, partly because the U.S. economy is ahead of others around the world, and such companies tend to draw more of their revenues from the U.S.

Knudsen made these and many more comments in an investment chat presented on Apr. 19 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Amey Stone. Following are edited excerpts from the chat. A complete transcript of this chat is available from BW Online on AOL, keyword: BW Talk.

Q: Chuck, there have been a lot of smiles among investors in the last few days -- especially Wednesday [Apr. 18]. Do you see the market at or near a bottom?


I think the market for the last couple of weeks has been making a bottom. With the Fed's most recent move, I think we've seen a bottom. That said, we still might see the market pull back. But I think this is a good time for investors to get in on some good prices.

Q: You're the manager of a balanced fund. Do you think that is a good strategy for investors in the current market?


It depends on your overall objective. But I think if you're a nervous investor, then a balanced fund is a good way to move some cash back into the market, because the balanced fund will typically be less risky than an all-equity fund.

Q: What are some stock sectors -- and specific stocks -- you see as especially attractive in price now?


You want to be exposed to sectors that are going to benefit most directly and immediately from the Fed's recent rate cuts. These sectors include retail, entertainment, and some health-care stocks, as well as finance. Technology is a sector that has been roaring back very dramatically. But I think the Fed's actions will have a muted effect on the fundamental issues that face many of the tech-sector stocks.

As for specific stocks, in retail: Lowe's [LOW ], Home Depot [HD ], and Wal-Mart [WMT ]. In entertainment: AOL Time Warner [AOL ] and InterPublic Group [IPG ]. In health care: Schering-Plough [SGP ], Amgen [AMGN ], and Guidant [GDT ]. In finance, I would focus on the money-center banks and brokerage firms such as J.P. Morgan Chase [JPM ], Morgan Stanley [MWD ], and Citigroup [C ].

Q: How do you feel about storage company EMC ?


I think we'll have a pullback in the broad market, and I would certainly expect that to include the tech stocks such as EMC. For most of the tech sector, I'm concerned with the end-market final demand over the next three to five quarters. However, within tech, I think the data-storage companies still have a very strong secular outlook. If your time horizon is longer than 18 months, I would use the pullback to buy EMC.

Q: In your balanced portfolio, how do you mix types of stocks [small- to large-cap] and bonds now?


Two weeks ago, the ARK Balanced fund [ABLDEX ] was 55% stocks and 38% bonds. I decided that the market was close to, if not at, a bottom and moved 7% out of bonds into stocks, so that now the fund is 62% stocks and 31% bonds. The rest is cash. A large portion of the fund is invested in large-cap stocks or companies whose market cap is greater than $20 billion. I still think there are many attractive opportunities in that sector. However, I think that near term, smaller- and medium-cap companies may do better.

Q: Why do you think small-cap and mid-cap stocks may do better near term?


First, I think economic growth in the U.S. will be stronger relative to other global economies. Small- and mid-cap companies tend to have higher percentages of revenues from the U.S. Second, the valuations of many small- and mid-cap stocks relative to their growth potential are more attractive than those of their large-cap brethren. Finally, with the Fed firmly on investors' side, investors should become less risk-averse -- a shift that tends to benefit small- and mid-cap stocks.

Q: Your opinion on XRX [Xerox]?


While I didn't listen to the conference call today, I did see the company's first-quarter earnings release that indicated two important items: First, it appears the company is getting its income statement turned around quicker than expected. Second, the company is improving its balance sheet and net liquidity. The net of these two items is that investors are now beginning to look at Xerox as an ongoing and surviving company with improving fundamentals. If you're willing to take somewhat of a risk, I think it makes some sense to begin to invest in Xerox again.

Q: What is your opinion of the long-term prospects for contract manufacturers like FLEX [Flextronics]?


I mentioned the positive long-term fundamentals for the data-storage companies. I think the long-term prospects for the contract manufacturers are even more positive. Those stocks were the last ones to go down, and they have been the first ones to rally back. I would use any pullbacks in names like FLEX, Jabil Circuit [JBL ], Celestica [CLS ], and SCI Systems [SCI ] to buy.

Q: Where do you see QQQ [Nasdaq 100 index fund] this year?


Keep in mind that the Nasdaq 100 is still heavily skewed toward large-cap tech names such as Oracle [ORCL ], Intel [INTC ], and Cisco [CSCO ]. As I said, I think the fundamentals for these companies will not turn until early next year at the earliest. The risk is that they won't turn until late next year. Therefore, the QQQ may actually underperform the other stock market indexes.

Q: Your opinion on JDS Uniphase [JDSU ]?


The demand outlook for fiber optics and related equipment is murky at best. The valuations are still expensive. The risk is that the numbers still have to come down for companies such as JDSU. The only name that I own in that sector is Ciena [CIEN ] -- and it's a very small position.

Q: What do you think about T 's [AT&T's] near-term prospects?


AT&T is facing a bundle of challenges and issues. I would rather own a pure cable company such as Comcast [CMCSK ], and I would rather own WorldCom [WCOM ] to play a rebound in the telecom sector. I think WorldCom and Comcast together will outperform AT&T alone.

Q: What's your take on troubled Lucent [LU ]?


Where do you begin with Lucent? It's Xerox and AT&T combined. However, although not ignoring the many challenges and hurdles that face this company, it probably will regain at least some of its market presence. I think a year from now, we'll be talking about the Lucent turnaround. Therefore, like with Xerox, if you have an appetite for a higher-risk investment, Lucent would probably be a good buy here.

Q: Do you have hope for any Internet stocks?


I do think we're in the process of seeing the worst in fundamentals for the Net sector. If you want to get exposure to the Net in a well-established, high-quality company, I would buy AOL Time Warner. But I think that for the more risky investor, names such as Amazon [AMZN ] and DoubleClick [DCLK ] may prove to be very attractive investments over the next three years. Risks are still very high, though -- but so might be the potential returns.

Q: Excite@Home [ATHM ], please?


The good news is that I think the rollout of high-speed Net access via cable is going to accelerate as consumers can buy and install the cable modems themselves. The bad news is that ATHM's exclusive agreement with the cable companies is ending over the next 12 to 18 months. It's unclear under what terms they will renegotiate. The cable companies will more than likely not allow Excite@Home the exclusive arrangement it currently enjoys.

Q: What is your opinion of PALM ?


I like the product, but I'm not so sure about the stock. You've got increased competition at a point where demand growth is slowing. That's rarely a good combination.

Q: Chuck, in the bond portion of your ARK portfolio, what type of bonds do you hold?


About half of the bonds are high-grade corporate bonds. The other half are U.S. Treasuries, mortgage-backs, and CMOs. The average duration of the bonds is about in line with the overall bond markets, which is a little less than five years.

Q: What do you think about industrial giant Tyco International [TYC ], and do you think acquiring CIT Group [CIT ] will be good?


I own Tyco, and when I saw the initial announcement that they were buying CIT, I thought it was a bad idea. They were straying outside of their core businesses. However, after looking at it further, it appears they have gotten CIT at a very attractive price, and given Tyco's record of turning around acquired companies, I think it will actually turn out to be a good move. In fact, there are rumors that other companies are sniffing around CIT. GE has been mentioned as one. That to me is a very good endorsement.

Q: Energy and utility sectors were generally down today -- do you see this continuing? What is your opinion of these sectors?


I think the outlook for energy and power are positive. This is due to constraints on capacity in both sectors. For example, the price of gasoline has recently jumped 10 to 30 cents, not because of a jump in the price of oil but because of a lack of refining capacity. This country has underinvested in energy exploration, refining capacity, and power generation for at least a decade. Combining the shortages that I think will occur with a more friendly tone in Washington, there are some attractive opportunities in both sectors.

Edited by Jack Dierdorff

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