Finding the Dow's Sweet Spot

It's small- and mid-cap stocks with growth and value prospects, as Rich Moroney of Dow Theory Forecasts explains in this Q&A

Dow theory is a century-old tool for analyzing the stock market. And Rich Moroney, editor of the newsletter Dow Theory Forecasts, sees the current market in a bearish trend that will be broken only when the industrial and transportation averages break out of their current trading ranges.

Nevertheless, Moroney does suggest some opportunities in stocks today, especially in the small- and mid-caps -- an area with both profit potential and reasonable valuations. Among the names he mentions in that arena are KV Pharmaceutical, specialty-drug company Syncor International, Orthofix, and engineering-software provider ANSYS.

Moroney thinks investors should have 30% to 35% of the equity portion of their portfolios in cash right now. And he is negative on classic Dow names such as Coca-Cola and Procter & Gamble -- on P&G, in fact, he recommends selling and putting money in consumer names Kimberly-Clark or PepsiCo.

These comments came in a chat presented Aug. 9 by BusinessWeek Online on America Online, in response to questions from the audience and BW Online's Karyn McCormack. Edited excerpts from the chat follow. A full transcript is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: What are some of your favorite stocks?


[In specialty drugs, one is] Syncor International (SCOR ), the nation's leading provider of radio pharmaceuticals. Syncor also operates a chain of facilities that provide MRIs and other imaging procedures. In telecom services, we think the long-distance stocks offer considerable value at current prices. Both WorldCom (WCOM ) and Sprint (FON ) represent attractive picks for a value-oriented investor -- looking out at least 12 months, that is.... As Wall Street realizes these companies can still grow sales, I would expect both to rebound. Lastly, in energy, I think you need to be selective. Look for companies that can grow volume while maintaining profit margins. Two we like are Conoco (COC.B ) and Questar (STR ). Both companies have solid volume-growth prospects. And even based on pessimistic expectations for 2002 earnings, both stocks are quite cheap.

Q: What do you think of utility stocks?


The utility area has become a sector where you really have to look at companies on a case-by-case basis. Nearly all the stocks in this sector have been hit in recent months on concerns regarding adverse regulation and falling energy prices....One stock I feel represents a nice rebound play in the group is XCel Energy (XEL ). This company owns a majority stake in NRG Energy (NRG ), one of the nation's leading independent power providers. XCel also operates the nation's fourth-largest utility system, serving the upper Midwest and Rocky Mountain states. The company has a solid balance sheet and a solid dividend yield of nearly 5.7%.

Q: Rich, can you give us your recommended asset allocation right now?


Right now, we're telling investors to keep cash positions of 30% to 35%. That represents the cash position for the part of your portfolio that is normally devoted to equities. For a long-term investor looking out seven years, I think an all-equity asset allocation makes sense during bull markets. But with the primary trend in the bearish camp, such an investor should be holding 30% to 35% cash in our view.

Q: What's your opinion on Coca-Cola (KO )?


I do not like the stock. While I think the company is doing a decent job of accelerating its growth where possible, I don't think the stock represents an attractive value proposition. Coke sells at 34 times trailing earnings. That seems relatively high for a company that has grown at a 5% to 10% rate in recent years. I think there are better stocks available.

Q: Can you give us a 12-month price forecast for Dow component GE ?


I think GE could be under pressure in the near term. The stock is a bellwether holding for the broad market, and I would not be surprised to see some of the large-cap names like General Electric come under some selling pressure. However, GE is a stock I would be looking to buy on pullbacks. On a dip into the mid-30s, GE would be a stock to consider adding to your portfolio.

Q: Since high tech may stay in the dumps for some time, will it be the Dow stocks that pull us out of this slump?


I would expect the Dow to perform better than the S&P 500 if technology remains under pressure. But many of the Dow stocks outside tech have held up relatively well over the last year....In my view, the sweet spot of this stock market is the reasonably valued growth stocks in the small- and mid-cap arena. That's where you can find companies with solid profit outlooks and reasonable valuations. If these smaller stocks continue to lead, I think it will be possible for investors to make money in an environment where the major moving averages are moving sideways.

Q: Can you give us some examples of small stocks that you like now?


I mentioned earlier KV Pharmaceutical (KV.B ) and Syncor. Other small caps I'm particularly high on include Medicis Pharmaceutical (MRX ), which is a leading provider of dermatology drugs. From our sister publication, The Low-Priced Stock Survey, I like Orthofix International (OFIX ), which is a fast-growing provider of bone-reconstruction and fracture-treatment products. In the software area, we like ANSYS (ANSS ), which supplies engineering software. It has an attractive niche and a good record of developing new products.

Q: Mylan Labs (MYL ) is selling pretty cheap as compared to other generic drug stocks. Do you have an opinion on this company?


I like Mylan. The company has been somewhat inconsistent in its ability to deliver on its business plan in years past. However, it appears as though Mylan has gotten its act together. I think the stock is fairly attractive, though I prefer KV Pharmaceutical.

Q: What about Procter & Gamble (PG )? Do you like that stock?


We advise investors to sell Procter & Gamble. While we expect the company to restore some growth, I think the stock already reflects that prospect. PG still seems very expensive, given the company's track record. Rather, I would recommend Kimberly-Clark (KMB ) or PepsiCo (PEP ) in that arena.

Q: What's your opinion about semiconductor stocks -- where do you see them going from here?


On semiconductors, I think the group is likely to remain volatile. I don't think I would be making a big bet in either direction in the chip stocks. To have some exposure through higher-quality names like Intel (INTC ), Atmel (ATML ), and Linear Technology (LLTC ) seems O.K. But I do not think the group is ready to rally substantially yet.

Q: How do you view the energy sector over the next 18 months?


I am relatively bullish on the energy sector. I think many of the better-positioned companies have been hit substantially in recent trading. Stocks such as Chevron (CHV ), Philips Petroleum (P ), and Conoco seem like good values, even if you take a pessimistic view on oil prices. As I mentioned earlier, I think Questar, a combination gas-exploration and utility company, also represents a good buy for investors.

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