"It's Going To Be a Gradual Improvement"

S&P's Research Director Ken Shea sees basic materials, consumer cyclicals, energy, and utilities doing best as the economy gathers strength

It is premature to return to tech stocks in the absence of any sign of a revival in spending on information technology, according to Kenneth Shea, vice-president and director of Standard & Poor's Equity Research & Services. Shea says S&P currently advises overweighting portfolios in four sectors -- basic materials, consumer cyclicals, energy, and utilities -- and continuing to "underweight" tech.

In those sectors, from the S&P buy list he picks names like Smurfit-Stone Container, Barnes & Noble, Exxon Mobil, and Calpine. Shea also reports that S&P has recently added several retailing stocks in the mid- and small-cap areas to the roster of strong buys -- among them Children's Place Retail Stores, Electronics Boutique Holdings, SCP Pool, and United Rentals.

Shea says S&P predicts gradual improvement in the economy later this year, thanks to tax rebates and interest-rate cuts. But he doesn't expect growth in gross domestic product to hit 3% until the second half of next year. Meantime, his forecast for the S&P 500 is that it will rise about 5% this year, to roughly 1350.

These were among his comments in a chat presented June 5 by BusinessWeek Online and Standard & Poor's on America Online. Shea was replying to questions from the chat audience and from BW Online's Jack Dierdorff. Edited excerpts from the chat follow. A full transcript is available on AOL at keyword: BW Talk.

Q: It was a good day for the markets -- has all this swinging between up and down days affected the S&P outlook?


No, not really. Standard & Poor's still looks for roughly $52 in operating earnings [per share] for the S&P 500 this year and relatively stable intermediate and long-term interest rates throughout the rest of the year. Thus, our target for the yearend close for the S&P 500 index is seen at roughly 1350, or up only about 5% from current levels.

Q: Are you still among the optimists looking for a second-half end to the economic slowdown?


Standard & Poor's believes that the second half will benefit from a combination of accommodative monetary easing and the well-publicized tax rebates. That said, though, we don't see GDP growth of 3% or higher until the second half of next year. So, while we see a firming tone to the economy, we think it's going to be a gradual improvement over the next 12 months.

Q: What is your outlook for natural-gas producers over the next 12 months?


Standard & Poor's near-term investment outlook for the natural-gas industry remains positive, despite the group's modest decline since the beginning of the year. Gas utilities' long-term earnings growth will benefit from increased consumption of gas...gas is expected to displace oil, electricity, and coal in traditional markets. We also anticipate increased consolidation within the natural-gas industry. Our current favorites in this industry are Dynegy (DYN ), El Paso Corp. (EPG ), and Kinder Morgan (KMI ).

Q: To stick with energy for a moment, are any names in that broad sector on the S&P buy list 5-STARS [STARS stands for Stock Appreciation Ranking System]?


Yes. S&P recommends "strong buys" on names including oil and gas services stocks such as BJ Services (BJS ), Global Marine (GLM ), Nabors Industries (NBR ), Noble Drilling Corp. (NE ), and Rowan Cos. (RDC ). S&P's industry analyst Tina Vital also strongly recommends purchase of Exxon Mobil (XOM ).

Q: Moving to tech -- Vishay (VSH ) has been trying to go up. What do you think of it for a six-month investment?


Standard & Poor's ranks Vishay Intertechnology as a 4-STAR ("accumulate"). The shares have struggled this year, along with other semiconductor-related stocks. However, the boom in wireless phones offers great opportunities for this company...

Q: We've been talking large-caps so far. So now, which mid-caps or small-caps do you like?


Standard & Poor's has recently upgraded to 5-STARS a few mid- and small-cap companies -- notably many in the retailing industry. Such names include Children's Place Retail Stores (PLCE ), Electronics Boutique Holdings (ELBO ), SCP Pool (POOL ), and United Rentals (URI ). All of these relatively small companies are well positioned to benefit from a gradually improving economy, and all offer excellent growth opportunities.

Q: What do you think of Williams (WMB )?


Standard & Poor's ranks Williams Companies as an "accumulate" (4-STARS). This company operates in three broad categories -- gas pipelines, energy services, and communications. With the recent spin-off of its communications subsidiary, Williams Communications (WCG ), the shares are reflecting the current volatile conditions faced by providers of energy. The shares trade at an attractive valuation, which we believe merits accumulation.

Q: What do you think of AES (AES )?


Standard & Poor's recommends accumulation of AES shares. As the world's largest independent power producer, it stands to be a leading beneficiary of the worldwide trend toward deregulation and privatization of electric utility systems...

Q: Is Nokia (NOK ) a buy, sell, or hold right now?


S&P analyst Ari Bensinger continues to recommend accumulation of Nokia shares as it continues to extend its leading mobile-phone market share...

Q: What do you think of Krispy Kreme stock (KKD )?


Standard & Poor's initiated coverage on Krispy Kreme last Friday as a "sell." After rising more than 700% since its highly successful initial public offering in April, 2000, I believe the risk is high...the stock's excessive valuation -- at more than 90 times my estimated earnings per share for fiscal 2002 (ending in January) -- is unjustified. I expect investor euphoria to wane and profit-taking pressures to ensue after its mid-June 2-for-1 stock split is effected. I love the doughnuts, but would still sell the stock!

Q: Which techs would you keep and which sell?


Standard & Poor's continues to recommend underweighting technology shares, due to the continued pressures on information technology spending. As a consequence, we advise investors to wait for a sign of an uptick in information technology orders before rushing in and making big commitments in this sector...

One area within the technology sector, however, that does have some speculative appeal is in the semiconductor industry. Standard & Poor's industry analyst Thomas Smith believes that there are several semiconductor stocks that are poised for a near-term upturn, including Applied Materials (AMAT ), Linear Technology Corp. (LLTC ), and KLA-Tencor Corp. (KLAC ).

Q: What about Philip Morris (MO )?


S&P analyst Rick Joy continues to recommend "buy" on Philip Morris. The company's dominant market position in tobacco and imminent public offering of a portion of its Kraft Foods powerhouse make these shares appealing. Standard & Poor's believes that the shares are significantly undervalued in light of the company's broad array of market-leading consumer brands, which we believe more than offsets the inherent risk of tobacco regulation and litigation.

Q: How much importance do you give to book value of a stock?


Book value is important in assessing financial stocks, because many of their financial assets are carried on their books at or close to market prices, and book value is therefore a meaningful gauge of value. However, book value is much less important as a valuation tool in most other industries, because the assets carried on the books for most nonfinancial companies are not highly correlated with their true market value. For nonfinancial companies, a better gauge of value is assessing the company's future cash flows that can be generated from its existing base of assets.

Q: Ken, what sectors does S&P suggest overweighting now, and could you give us a quick sample of "buys" in each?


Sure. Standard & Poor's recommends overweighting the basic materials, consumer cyclicals, energy, and utilities sectors. Our favorite stocks in each sector are: Smurfit-Stone Container for basic materials (SSCC ); Barnes & Noble in the consumer cyclical sector (BKS ), Exxon Mobil (XOM ) in the energy sector; and Calpine (CPN ) in the utilities sector.

Edited by Jack Dierdorff

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