Ready to Ride the Updraft?

Michael Farr, who admires the upside potential of Staples, Wendy's, and Pfizer, is keeping a cautiously optimistic eye on earnings

In the words of Michael K. Farr, president of investing firm Farr, Miller & Washington, the stock market "wants to continue higher" -- and with corporate earnings improving, it should be good for growth stocks. From Farr's vantage point, "It feels like this rally is sustainable."

Farr is particularly impressed by the results at General Electric, which he refers to as "a proxy for Corporate America," and which, in its most recent report, delivered double-digit gains in operating profits at 11 of its 13 business units. He also favors financial stocks such as Citigroup and Capital One Financial, and consumer names like Staples and Wendy's.

With his emphasis on earnings and valuations, he is not keen on technology stocks, at least not yet -- although he admits to owning AOL Time Warner, among others. Farr balances some of these expensive tech stocks in his portfolio with financial, capital goods, and retailing stocks. His investing strategy is to seek growth at a reasonable price (GAARP), and he stresses organic earnings growth -- not growth by acquisition or by manipulating the balance sheet.

In an investing chat presented Nov. 21 by BusinessWeek Online on America Online, Farr responded to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A complete transcript is available on AOL at keyword: BW Talk.

Q: Michael, it was a good day on Wall Street -- is the market going to keep going up?


Yes, until it starts going down again. The real answer is that nobody knows. It feels like this rally is sustainable, it feels like it has merit to it. But we have yet to break on a technical basis the extended downtrend that has been prevailing over the last three years. With the economy improving and slightly positive earnings news, it feels as if this market wants to continue higher. It's really anybody's guess as to how long, but my personal guess is that we've seen the lows.

Q: What's your take on the latest economic data? Do you think the Federal Reserve will have to trim rates again?


I think that the latest economic data have been positive. I thought that the last half-point easing by the Federal Reserve was surprising and unnecessary. If the Fed didn't ease in July, August, or September when the economic data were weaker, why did they ease when they were improving? ...I don't think there will be a further easing, and the Fed pretty much said as much when they went to that neutral status.

Q: What do you think of corporate bond funds? And what about corporate bonds generally?


The spreads on corporate bonds vs. Treasuries have widened, but the yields are still very low historically. Most corporate bond funds of investment grade are typically solid. They provide diversification and a decent yield for smaller investors.

By and large, I think people make the mistake of reaching for the better yields that they frequently offer in lieu of a direct investment in a Treasury bill or note or bond. I think one of the great mistakes any bond investor can make is speculating for income.... Don't get greedy on bonds! So if you're adding to the safe part of your portfolio, make sure it's safe... Volatility is not something that's welcome in a bond portfolio.

Q: Michael, you follow both growth and value strategies. Are growth stocks set for a comeback yet?


I think yes. I think that with some beginnings of strength in the economy, we're beginning to see Corporate America see strength in their earnings and give greater guidance. We saw that in the General Electric (GE ) report today. This should be good for growth stocks.

Q: What's your take on GE? Did its report today change your views in any way?


I think that the news out of GE was significant, and was the primary driver in today's market advance. General Electric has 13 subsidiary companies. One of those companies that's rather volatile is Employers Reinsurance Corp... It has been widely expected that GE would take a fourth-quarter charge for this ERC unit of around $2 billion.

GE announced today that the actual charge would be around $1.4 billion. That came as a relief to the markets. GE said in the release that they would continue to explore "strategic options" for ERC, which probably means that they're looking to divest that unit, and Warren Buffett is looking to buy that unit.

Most important in the news today, 11 of the 13 businesses within GE are expected to deliver double-digit operating profit growth. GE is a very large, diversified company that is seen not only as a proxy for Corporate America but for the economy at large. This expectation of increases for the company in general was a very positive sign.... I don't think that GE is a screaming buy right now, but I like it better than I have in a long while. And for the long term, it's just fine.

Q: What are some of your favorite stocks to buy in an upturn? Any new purchases?


I think some stocks that are continuing to see strength in their earnings, whose prices have suffered, represent some good opportunity. Some of the stocks that I continue to like are Staples (SPLS ), PepsiCo, (PEP ), Wendy's (WEN ), Pfizer (PFE ), Waters (WAT ), Citigroup (C ), and Capital One Financial (COF ).

Q: Tech investors seemed to cheer Hewlett-Packard's (HPQ ) earnings report today. Do you believe tech spending will finally pick up?


Yes. The question is not so much a matter of if, but more a matter of when. We're seeing a pickup in business over at Dell (DELL ), and we saw stronger numbers at Hewlett-Packard. I did not see the sort of strength necessary to attract me to Hewlett-Packard -- I continue to avoid the shares. But I think this eventual return of tech spending will eventually happen.

I don't think we can rely on the consumer for more than the consumer has already been spending.... What we need to see is an increase in corporate spending, particularly in the IT budgets, so that Corporate America can begin to generate its own economic stimulus, which has essentially been absent since the pre-Y2K spending boom.

Q: What are your favorite stocks among the pharmaceutical companies? You mentioned Pfizer earlier, what else?


I like Pfizer a lot, and I own it. I own Eli Lilly (LLY ), I own Merck (MRK ), I own Johnson & Johnson (JNJ ). I like Pfizer -- they're the best in the group for two reasons. One, it's selling at 18 times next year's earnings, but the earnings growth is among the highest in the group, at around 14% per year, projected out over the next four to five years.

That puts shares of Pfizer at about a 20% to 25% discount to the average S&P 500 stock. And for a $200 billion company, with this sort of management track record and pipeline, I think that this will prove to be a good opportunity for the long term, and I also like the demographics that support the health-care industry, with so many of the baby boomers turning 65 over the next 10 years.

Q: What is your opinion of Lowe's (LOW )? We've heard it's gaining market share from Home Depot (HD ).


I like Lowe's, and their earnings numbers were impressive. I don't think Lowe's is cheap anymore.... Lowe's is now selling at a premium to Home Depot, and I don't think that's warranted. It's a fine company -- it's dependent on the consumer (who has been very strong), it's dependent on the homebuilding and improvement industry, which has also been very strong.

But one of my warning signs is that when you begin to think that a company is firing on all cylinders, the economy and demographs are supporting it, and everything is going right, the news you expect is for something to go wrong. While it's a good hold, I don't think it represents compelling value at these levels.

Q: What about other retailers like Limited (LTD ) or Wal-Mart (WMT ), are they attractive?


I like Staples -- I think the valuation is good, I like their earnings report, and I think their earnings growth will continue to be strong. The Limited is more of a specialty retailer that I think is selling for a reasonable valuation, similar to the rest of the retail industry. The chart pattern looks as if it's building a base, but is not out of the woods yet.

Wal-Mart is a stock that we refer to as a category-killer. When Wal-Mart decides that they want to be in your business, it might be time to get out of that business.... Wal-Mart is a very well-managed, very fine company that is selling for a very full valuation. By that I mean the Limited is selling for 17.5 times earnings, Staples for 17 times, Home Depot for 16 times earnings, and Wal-Mart for 26 times earnings.

Q: How about the financial sector, Bank of America (BAC ) for example?


I like the financial sector very much. I think that by and large, the group of bank stocks is cheap. The technicals on Bank of America are strong, the stock has done very well since the lows on Oct. 10, and it is up 16 points since then. It is trading at a resistance point on the charts, but I think for the long term it's a great investment. I do not own it across my accounts.

Q: To what extent do you rely on technical analysis in your money management?


Not very much. It helps the timing on purchases and sales, but we base our purchase and sale decisions on the fundamentals. If a stock's in a steep decline, we'll hold off on our buying. If it's on a steep uptrend, we'll hold off on our selling. We're not technical managers. I mention the technicals a lot during these discussions when I'm unfamiliar with a stock.

Q: Given your caution on corporate IT spending, do you see any tech stocks worth grabbing now?


The tech sector as a whole is still expensive. It's still expensive because the prices have not declined as much as the earnings over the past few years... I like Dell, I don't think it's cheap. I like Microsoft (MSFT ), I don't think it's cheap. I like EMC (EMC), I don't think it's cheap. I like Cisco (CSCO ). It's not as outrageous as it has been. But I don't think it is cheap either.

AOL Time Warner (AOL ) isn't cheap, but I own it... I prefer the names that have earnings, that are growing the earnings, that are well-managed, and I look to balance this more expensive part of my portfolio with other areas such as the financial stocks, capital goods, and some of the retailers that we mentioned.

Q: Are two of the world's greatest franchise names -- McDonald's (MCD ) and Disney (DIS ) -- dead in the water?


I think McDonald's is running into two impediments. One is the rule of big numbers, and the other is that it is a very mature company, with very few rabbits left to pull out of that hat. I still own some, but I have been a net seller of the shares and will continue to be. I think Wendy's (WEN ) is a much more attractive alternative, and I own those shares as well.

Disney is a more difficult question, because it's a difficult company to understand. With their movies, entertainment, and theme parks, the entertainment industry is difficult when you throw in the changes, and vulnerable nature of travel, and the focus of some terrorist talk on Disney theme parks.

Investors, I think, are wise to pause. The stock has appreciated significantly since October, when it was trading at around $14 a share, closing today at $19.5, up 5.4%. I think the stock probably will move higher, but at 31 times earnings it's still too expensive for me.

Q: How do you blend value and growth? What weight are you currently giving each strategy?


We are a GAARP manager. We look at stocks with Graham and Dodd value characteristics -- real Warren Buffett stocks with earnings growth. We have to see earnings growth, and we want it to be organic earnings growth. We discount growth by acquisition and by balance-sheet management. When we're convinced that we can buy a stock at or below a market multiple, with growth superior to the market, we feel that those stocks are best to endure the downturns, and enjoy market advances.

Edited by Jack Dierdorff

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