business

Going for Both Growth and Value

Investment manager Michael Farr combines the two strategies to find strong names with good prospects. They include GE and Pfizer

Investors still need strong stomachs, but the stock market is a good place to be -- if you pick the right names. That's the word from Michael Farr, president of investment firm Farr, Miller & Washington, who says corporate earnings are key. Farr's strategy in money management is to combine growth and value techniques.

He says it's quite possible to find growth stocks whose price makes them good values. However, he adds, "No matter how strong the earnings growth, it never makes any sense to pay too much for a stock." Some of the names he likes are General Electric (GE ), Pfizer (PFE ), American International Group (AIG ), and Kohl's Stores (KSS ).

Farr believes fears of deflation are "overblown," but he doesn't see inflation as a threat either. He's encouraged by a recent increase in advertising sales, which he sees as a portent of recovery in the economy.

These were among the comments Farr made in an investing chat presented June 5 by BusinessWeek Online on America Online, in responding to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Michael, will the market continue above 9,000 on the Dow and even move higher? Are you a bull?

A: The move above 9,000 has been encouraging.... Part of this move has been supported by the fundamentals. We have seen earnings begin to recover, but part of this move is anticipatory...stock prices now have moved to a level that expect higher earnings in the future. Will it stay above 9,000? Probably not, but...going forward, I think the constant march above 9,000 is here to stay. Longer-term, the key will be earnings growth.

Q: There seems to be debate about whether the Fed will lower interest rates at the end of the month. What do you think?

A:

I think that there are certainly growing expectations, particularly with the European Central Bank rate cut today, that the Fed will go ahead and lower rates.... Personally, I question whether it will happen. But more important, I question whether it's necessary. I think largely it's seen as an insurance policy against deflation, but I don't see any reason to expect deflation to actually materialize.

Q: Michael, do you find stocks that embody both growth and value characteristics? Or do you take parallel tracks?

A:

We look for stocks that embody both. We like to buy stocks that represent good value but have the additional catalyst of earnings growth. No matter how strong the earnings growth, it never makes any sense to pay too much for a stock.

Q: What are your top three picks in this kind of market?

A:

Our list of picks in the past has been quite broad.... I don't like to make three picks with the idea that people would invest in only those three. We keep a broad portfolio of stocks, always. With that in mind, I have three names that I find attractive. The three would be Pfizer (PFE ), General Electric (GE ), and American International Group (AIG ).

Q: Do you see a revival coming for tech stocks?

A:

I think we've already had one, or certainly the beginnings of one. A lot of the tech revival at this point will depend on three things primarily. One is what kind of earnings season will they have in the second quarter. Two, what kind of boost in info-tech spending? And three, what sort of general market momentum will be present to carry the whole list forward. Also, as a note to add, the Nasdaq is up 44.87% since October.

Q: Biotech stocks have had a spectacular run. Is Amgen (AMGN ) still a good buy, and will it meet growth objectives?

A:

It looks as if there's more room left on the upside. The run in those stocks is supported by the potential, the concept, of drugs that are being developed.... But these are largely not yet approved by the FDA and are not yet in a position to produce any revenue for these companies.... Share prices are trading up in anticipation of just one of them being a blockbuster.

Amgen is a great company -- it's the largest of the biotechs -- but I think that most individuals should avoid any single biotech stock, because the risk of concentration is too high. I like the Biotech Holders trust (BBH ), which represents 20 of the largest biotechs and provides diversification more in line with a long-term investor's stability requirements. And even so, it has been fairly volatile.

Q: Do you think concerns over deflation are overblown, and is inflation possibly looming?

A:

I think the concerns over deflation are overblown. I don't think there's any reason to be concerned that inflation might be looming in any way, however. I think the economy is showing positive signs of recovery -- I'm especially encouraged by the 17% increase in ad revenues over the month of May. Advertising is an important precursor for economic recovery or recession. Right now, it's positive.

Q: What's your take on financial stocks?

A:

I like the financial stocks a great deal. I think the pricing is compelling, I like the dividend yields, I like the growth, I like the cost controls, and I like that a lot of the bad news that has been plaguing these stocks is out.

Q: Do you see AOL's settlement with Microsoft (MSFT ) as a significant step toward financial stability [for AOL (AOL )]? And what's your outlook on MSFT?

A:

I think the settlement with Microsoft is significant, and it's certainly a positive for AOL. Nobody has ever prospered a great deal by maintaining long legal battles with the Microsoft team of attorneys.

Does it create financial stability for AOL? I don't think so. AOL is facing a number of hurdles. There are lower-priced alternatives to providing access, and AOL is still trying to reinvent itself in a way that would be attractive to the general public. In the meantime, I think they're undergoing an uphill climb.

My views on Microsoft are more positive. They have protected their franchise well, their strategic alliances work well for them. Their stock is trading at a slight premium to the market, with a superior growth rate to the average Standard & Poor's 500-stock index. If you're going to own tech, it's one of the more conservative core positions in a portfolio. I own it, I like it at these levels, and I'd especially like it on a pullback.

Q: We have a number of questions on retail stocks -- to name a few, Michaels Stores (MIK ), Kohl's (KSS ), Target (TGT ) -- and there are more. But enough for right now.

A:

Some names within retail I like very much, other names I don't like at all, and I have very few about which I feel in between. Target I don't like. The numbers at first glance look attractive, but you're seeing declining sales from Marshall Field and Mervyn's stores. The revenue has in many ways been due to credit cards, but the quality of credit there is declining.

Kohl's I like very much. Kohl's is growing rapidly, it's a well-managed company, they're seeing great growth and opening new stores, they're trading at 20 times next year's estimates, with growth at almost 20%. The stock represents great value -- it's one I own. Michaels Stores I don't follow.

Q: What do you "like very much" in retail besides Kohl's?

A:

Home Depot (HD ), Wal-Mart (WMT ), Staples (SPLS ).

Q: Michael, do you like any Internet-related stocks?

A:

I think the valuations are very high. I think owning those stocks is speculative and entails a great deal of risk. That said, if I had to wade into that pond, I would wade in with Cisco (CSCO ).

Q: What about health care, beyond biotech? And what about Cardinal Health (CAH )?

A:

Health care in general is a broad sector I like very much. Health-care providers are problematic because of the intense regulatory environment and the difficult process of reimbursement that leads to long periods of delay in accounts receivable. It's a tough business that's fraught with peril. Cardinal Health has done reasonably well lately, but it's not the sort of thing I've been able to get comfortable with so far.

Q: Tell me some stocks that have good dividend yields with the expectation of increasing dividends. Can you combine dividend yield with growth and value?

A:

Many of our stocks pay good dividends, but we never buy a stock because of the dividend. We prefer stocks with low dividends or no dividends, because it's an indication that the company has better uses, better leverage to grow that capital and grow the company than return it to shareholders.

But a number of good solid companies have attractive dividends. GE is paying 2.6%, Pfizer around 2%, Merck (MRK ) 2.5%, a number of the banks also -- Citigroup (C ) at 1.9%. No matter what the dividend is, be sure you're buying a stock based on the fundamentals, their business strategy, and their ability to grow.

Q: Are your clients putting more money in the market lately? It seems the volume is picking up, and I've heard that more long-term investors are coming back to the market.

A:

Investors do seem more comfortable with their stock investments. Most of ours are fully invested or have some portion fully invested all the time. We're beginning to see a slow trickle back into the market from the guys on the sidelines, but institutions have not been ready to jump back in yet. The S&P 500 is up 20% since Mar. 10. The first step in any market recovery is a jump, and this is a huge jump.

Q: A quick final question: Should the average investor be confident about getting back into stocks?

A:

The best time to invest in stocks is when you have money that you don't need for a long period of time. If you find yourself in that situation and are able to invest in high-quality stocks, and you do your homework, now is a good time.

Valuations have come down over the past two or three years, and some very fine companies can be bought for reasonable prices that I think will increase at consistent rates over the long term. The volatility is here to stay. Investors need strong stomachs but should be encouraged as the economy continues to recover. Share prices will continue to grow over the next several years.

Edited by Jack Dierdorff

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