What to Hold in Risky Times

Amid the many threats looming over the market, S&P's Kenneth Shea says investors can still find long-term buys

"Investors are still waiting for concrete signs" that earnings are on the way back up and that several other uncertainties are cleared away before they push the stock market robustly higher, says Kenneth Shea, vice-president and director at Standard & Poor's Equity Research & Services.

The process will take time, according to Shea, but he has hope that confidence in accounting and corporate governance can be restored with the help of a more vigilant Securities & Exchange Commission but without massive new government intervention.

For now, he reports, S&P still thinks that buying and holding select stocks for the long term is a sound strategy. He cites such choices as PepsiCo (PEP ), Gannett (GCI ), Sysco (SYY ), St. Jude Medical (STJ ), and Wilmington Trust (WL ). Other S&P buy recommendations include Exxon Mobil, Citigroup, and Qualcomm.

These were among the comments Shea made in a chat presented on June 4 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts from the chat. A full transcript is available from BW Online on AOL at keyword: BW Talk.

Q: I'm getting tired of asking this question, but I'm also getting tired of this market. When do you think it will recover from these sinking spells and get really going again?


I believe that investors are still waiting for concrete signs that corporate earnings are on the mend and that the plethora of uncertainties hanging over the market shows some signs of dissipating. From a technical point of view, the break below 1049 on the S&P 500 suggests a test of the September, 2001, lows of about 9700, according to Mark Arbeter, S&P's chief technical analyst. From a fundamental point of view, the market also seems to be fairly valued at a rich 20 times 2002 earnings estimate of $51 for the S&P 500. So it seems the market is likely to be range-bound in the near term.

Q: Do you think the background public nervousness over terrorism is perhaps exacerbating every bit of bad news?


I believe that the terrorism threat that's overhanging the market is but one risk factor investors are digesting now. Other material risk factors include skepticism over accounting practices and a crisis of confidence in corporate governance and the overall integrity of the markets. Until these issues become resolved in investors' minds, they'll continue to weigh on already rich valuations.

Q: What will it take to resolve those doubts? New questions on accounting and corporate governance seem to be in the news almost every day.


As a result of more intense scrutiny over corporate accounting practices and overall corporate governance by investors and regulators, my hope is that this process will ultimately cause a fundamental change in the way these practices are conducted in the future. I believe that positive strides can be made in these important areas without the need for significant new government oversight. In the long haul, this cleaning-out process, which includes a more vigilant SEC, will be healthy for the equity markets. But this process will take time.

Q: What will it take to restore faith in analysts' research? Can the analyst community ever be trusted again?


The current scrutiny over Wall Street research practices is already bringing about changes in the way many research firms conduct their business. As a result, it has also provided a good window of opportunity for providers of independent research -- which don't face the conflicts of interest of those research firms that share a roof with investment bankers. At S&P, we have been providing unbiased equity research and opinions for many years.

Q: Would you buy GE (GE ) now for the short and long term?


S&P analyst Robert Friedman recommends investors hold the shares of GE. He believes they're fully valued from both an intrinsic point of view, as well as relative to its peers on a p-e basis.

Q: Ken, what's your take on ORCL (Oracle)?


S&P analyst Jon Rudy recommends that investors with long-term time horizons accumulate the shares of the world's largest supplier of information-management software. The company should benefit from its commitment to increasing investments in research and development, and its strategy of selling an integrated suite of applications to compete with "best of breed" vendors to pay off over the long term.

Q: Temp firm Robert Half International (RHI ) -- can it recover its glory days?


S&P currently recommends investors accumulate the shares of the world's largest specialized provider of temporary and permanent personnel in the fields of accounting and finance. The company should benefit from an eventual improvement in job-market conditions and enjoys a highly profitable and cash-generative operation, while carrying very little long-term debt. The shares are a good long-term holding.

Q: Why is Pfizer (PFE ) having such a rocky road lately?


The world's largest prescription-pharmaceuticals company has actually held up better than the shares of most of its closest peers. From a broad view, the major U.S. pharmaceutical industry is being challenged by slowing growth rates amid heightened competition in key therapeutic categories, longer Food & Drug Administration product-review times, and a flood of generic drugs on the market.

In addition, the new-product pipelines appear anemic, with few clear blockbusters on the near-term horizon. Although Pfizer should benefit by virtue of a relatively robust new-drug pipeline relative to its peers, growth prospects still remain less than spectacular, at about 15% over the next few years. The shares already incorporate much of this good news and may see only modest market outperformance over the near term.

Q: Think Qualcomm (QCOM ) will ever make any money?


S&P analyst Ari Bensinger recommends investors buy the shares of this maker of wireless telecom products and services, based on its proprietary code division multiple access, or CDMA, technology. The company boasts a very attractive financial model, with high net-profit margins, no long-term debt, and over $2.5 billion in cash. Future growth prospects look robust. And S&P believes Qualcomm can generate earnings growth in excess of 25% annually over the next few years. The shares are attractive here for long-term investors.

Q: How do you feel about companies using pro forma accounting?


In response to a great deal of frustration by investors regarding the confusing use of so-called pro forma earnings in recent years, S&P announced that it would be incorporating a new measure of earnings reports to help investors better understand the level of earnings that are actually reported by companies.

Dubbed "core earnings," this S&P system will better measure the true earnings power of a company's business by excluding certain nonoperating gains, while including some legitimate expenses that are currently overlooked by some companies. By establishing a better standard with its core earnings framework, S&P believes it will enhance an investor's ability to compare earnings results for a given company and across industries.

Q: Do you see S&P's core-earnings concept being widely picked up?


Yes, I do believe that investors are hungry for such a methodology to emerge, particularly from an independent provider of financial data and analysis like S&P. It should be noted that S&P continues to solicit input from regulatory bodies, as well as the investment community, in polishing and refining this methodology.

Q: How much longer do you expect small caps to outperform large caps?


Over the past five years, the returns for the S&P MidCap 400 index and the S&P 600 SmallCap index have outperformed the returns of the S&P 500 index. Although this trend continues into this year to date, S&P believes that the cycle may be nearing an end soon. The valuation gaps between the smaller-cap indexes and the S&P 500 have narrowed considerably over the last few years -- to the point that the large-cap stocks as represented by the S&P 500 may begin to track the performance of the small caps by the end of this year.

Q: What's in the future for XOM (Exxon Mobil)?


S&P energy analyst Tina Vital recommends investors buy the shares of the world's largest publicly owned integrated oil company. In light of its strong presence in oil exploration as well as refining, it offers a strong balance for those investors who wish to avoid trying to time the oil price cycles. The company generates very sizable levels of free cash flow, with very little long-term debt, and is very well positioned for further growth. Its current moderate valuation level and 2%-plus dividend yield offer compelling total return investment prospects.

Q: What's your opinion on Citigroup (C )?


S&P analyst Stephen Biggar recently upgraded the shares of this major diversified financial services company to a strong buy, due to its attractive valuation and strong position in the most attractive areas within the financial-services industry. The company is a good long-term holding for the unmatched diversity of its revenue stream, both by product set and geography.

Q: Is the strategy of buying and holding for the long term still valid today?


Yes, I do believe that the strategy of buying and holding is a smart strategy for investors in building wealth. I would recommend that investors do their homework to search for those companies that have demonstrated an ability to generate steady increases in earnings with rising levels of free cash flow and profitability. Such companies for the long haul include PepsiCo (PEP ), Gannett (GCI ), Sysco (SYY ), St. Jude Medical (STJ ), and Wilmington Trust (WL ).

Q: Three beaten-down names here -- Lucent (LU ), AT&T (T ), WCOM (WorldCom). Which has the best chance of some upside?


Of the three companies mentioned, the best positioned, according to S&P, are AT&T and Lucent, although both are ranked as market performers over the next 6 to 12 months. S&P continues to recommend that investors avoid the shares of WCOM, however, considering its difficult financial situation and sluggish long-distance market conditions.

Q: Interest rates -- what's the scenario for the rest of the year?


S&P chief economist David Wyss projects modestly rising interest rates through the rest of the year and into the next, reflecting a gradually strengthening economy as well as the possible increase in inflation expectations that go along with that.

Q: Is there any hope for Tyco International (TYC )? I know S&P recommended it for quite a while, though no more.


S&P continues to recommend a hold on Tyco. This follows the latest development of Chairman and CEO L. Dennis Kozlowski leaving the company to attend to some personal tax issues. S&P maintains its opinion that the shares offer somewhat attractive upside potential, based on its analysis that Tyco's assets may be undervalued at the current depressed share levels. It still believes that liquidity remains intact to meet near-term debt maturities.

Edited by Jack Dierdorff

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