Where It's Good to Be Overweight

S&P's Kenneth Shea talks about some of the sectors most likely to thrive as the economy continues to gain strength

Investors might want to overweight three areas of the stock market in their portfolios now: Information technology, consumer discretionary, and health care. That's Standard & Poor's current recommendation, according to Kenneth A. Shea, managing director of S&P's Equity Research Services.

Although the valuations of tech stocks may be getting "a little bit stretched," Shea says that S&P's buy ratings in the sector include Microchip Technology (MCHP ), Flextronix (FLEX ), Lam Research (LRCX ), and Intel (INTC ). He notes that the IT group trades at 26 times future earnings, vs. 17 times for the S&P 500 stocks.

Asked about pharmaceutical stocks, Shea says S&P is neutral, partly because of concern over many drugs' loss of patent protection. So S&P's preferences in pharmas are tilted toward generic-drug producers, such as Barr Laboratories (BRL ), Mylan Labs (MYL ), and Abbott Labs (ABT ).

Looking ahead, Shea reports that S&P's investment-policy committee expects the S&P 500 to end 2003 at 1,085 and to climb to 1,190 by the end of next year. These were some of the points Shea made in an investing chat presented Nov. 25 by BusinessWeek Online and Standard & Poor's on America Online, in replying to questions from the audience and from Jack Dierdorff of BW Online. What follows are edited excerpts. A full transcript is available on AOL at keyword: BW Talk.

Neither Ken nor any member of his household has a financial interest in any of the subject companies discussed. Other S&P affiliates may provide services to the companies under discussion.

Q: How does S&P see the market outlook for the rest of the year and into 2004?


S&P's investment-policy committee is bullish on the stock market over the near term, projecting that the S&P 500 Index will end 2003 at 1,085 and 1,190 at the end of 2004.

Q: Before we go to audience questions, why don't you explain the S&P STARS (Stock Appreciation Ranking System) list?


Standard & Poor's analysts cover almost 1,200 stocks in the U.S. with buy, hold, and sell recommendations that adhere to our STARS methodology. Under [this system] a buy recommendation is considered a 5-STAR, accumulate is a 4-STAR, 3 is a hold, 2 is avoid, and a 1-STAR is a sell. The U.S. analysts have been doing this since Jan. 1, 1987, with a great deal of success. Currently, S&P also covers approximately 150 stocks outside the U.S. STARS is intended to provide investors with a relative sense as to the S&P analyst's [view of] a given stock's intermediate price potential.

Q: I have some Cisco stock (CSCO ) -- should I keep it?


S&P recommends that Cisco shares be bought, as we have a 5-STAR recommendation on them. Recent market-share statistics continue to show good momentum for Cisco, and S&P believes that this should translate into continued strong earnings gains ahead. The company has no debt and nearly $3 a share in cash, plus an ability to generate consistent free cash flow. Our 12-month target price for Cisco is $27.

Q: I have Fannie Mae (FNM ), and I'm unhappy hearing the horror stories from Freddie Mac (FRE ). What should I do?


S&P recommends accumulate on Fannie Mae, as we don't view the company as a similar story to the woes at Freddie Mac. Although Fannie Mae also has some political risk, we don't currently believe that there's a near-term threat to Fannie Mae's competitive position. The shares are attractive to us on a valuation basis, [as] the shares [could achieve] $82 in 12 months.

Q: Any input on Harley-Davidson (HDI )?


S&P recommends that investors hold Harley-Davidson shares. Although long-term growth prospects are favorable, given demographic trends and the company's strong brand franchise, we believe that a tough pricing environment for motorcycles may limit near-term upside earnings gains. Our 12-month target price is $54.

Q: After Xerox (XRX ) upgrades today, do you think this could be the rise we shareholders are looking for?


S&P reiterated its hold recommendation on the shares yesterday, following the company's investor conference, in which it outlined its strategy for addressing the expanding color and digital-printing markets. We're encouraged by a buildout of the company's product portfolio, as well as its recent market-share gains.

Xerox is targeting 35% EPS growth in 2004 and 2005, primarily due to an expected pickup in volume. However, given our view of intensifying competitive pressures and with the shares trading at a premium to the S&P 500, we would not add to existing positions. Our 12-month target price is $12.

Q: What about the Nasdaq?


S&P covers many of the companies that trade on the Nasdaq. Most noteworthy are Microsoft (MSFT ), Intel (INTC ), and Dell (DELL ). The Nasdaq composite has performed well this year, largely due to a strong runup in growth stocks in general -- and technology stocks in particular. S&P continues to recommend an overweight portfolio allocation to technology issues, although valuations may be getting a little stretched. For instance, the S&P 500 trades at approximately a 17 times p-e multiple, whereas the information technology sector trades at 26 times next year's earnings. Technology stocks that S&P analysts recommend buying now include Microchip Technology, Flextronix, Lam Research, and Intel.

Q: How do you stand on the near term for integrated oil?


S&P's investment outlook for the international integrated oil and gas stocks is generally positive, on continued high oil and gas prices and a buildout of oil and natural gas inventories. We regard these "super major" oils as defensive investments, based on our view of their conservative accounting practices and steady cash flows, which are diversified internationally and across business lines -- [this,] we believe, mitigates commodity pricing and geopolitical risk. S&P believes U.S. economic growth will pick up in 2004, which should improve energy demand. Some of our favorite stocks in this area are Exxon Mobil (XOM ) and Occidental Petroleum (OXY ).

Q: What's the outlook for the drug industry?


S&P's investment outlook for the U.S. pharmaceutical companies is neutral. The U.S. drug industry generates an estimated $40 billion in sales but is likely to lose a material portion of their patent protections over the next four years. In addition, there has been a significant decline in new drugs approved by the FDA. This adds to the general overall sluggish state of the industry's research and development productivity in recent years. S&P's favorite pharmaceutical companies currently are tilted toward producers of generic drugs, such as Barr Laboratories, Mylan Labs, and Abbott Labs.

Q: Is there any hope left for Lucent (LU )?


S&P recommends investors hold Lucent. Given the company's high level of debt and weak earnings outlook, we believe it will take time for investors to gain confidence that a turnaround is under way. We believe Lucent has sufficient cash to run its business, but sustainable revenue growth is needed in order for a sustained turnaround to emerge. Since we aren't yet confident as to when Lucent will resume meaningful top-line growth and profitability, our 12-month target price is $3.

Q: The homebuilders? Any concern over a hit from rising interest rates there?


S&P remains very bullish on homebuilders. Continued market-share gains by the major public U.S. homebuilders and S&P's economic outlook of continued accommodative mortgage rates should continue to allow homebuilders to thrive in the intermediate term. Strong demographic trends have enabled sales of new single-family site-built homes to be at or near record levels since 1998. Most of the major U.S. homebuilders remain at deep discounts to the overall S&P 500 index, and we thus see continued, strong share gains in many of them. Our favorites include D.R,. Horton (DHI ), Lennar (LEN ), Hovnanian (HOV ), KB Home (KBH ), Centex (CTX ), and Pulte Homes (PHM ).

Q: Washington Mutual (WM ) just got hammered today. Do you still like it?


S&P recommends buying Washington Mutual. Shares may have been down due to the company's agreement to sell its consumer-finance unit to Citigroup (C ). But we believe the decline creates a buying opportunity. S&P believes that Washington Mutual can generate income growth in a variety of interest-rate environments, making it, in our view, one of the most attractive franchises in the savings and loan industry. We believe recent acquisitions, together with a branch-expansion program, have enhanced its geographic reach. Our 12-month target price is $51.

Q: What about telecom stocks? Should I sell SBC (SBC ), Qwest (Q ), Verizon (VZ )?


S&P has a negative outlook on the integrated telecommunications services industry. This sector has been weakened by competitive pricing and sizable fixed costs to run the networks. Thus far this year, results have been helped by wireless and DSL growth. However, wireline revenues remain weak, and access-line countshave been weak amid intense competition. S&P is positive, however, on the wireless telecommunications services industry, as the trend toward mobile use continues to grow. S&P's favored stocks in the telecommunications area include Nextel (NXTL ) and Nextel Partners (NXTP ), as well as AT&T Wireless (AWE )

Q: Ken, can you give us S&P's latest thoughts on asset allocation and on sectors to overweight?


S&P currently recommends investors overweight their stock portfolios in the areas of information technology, consumer discretionary, and health care. We also recommend investors underweight the telecommunications services, utilities, and industrials sectors. The S&P investment policy committee currently recommends investors allocate 65% of their assets toward stocks, 10% toward bonds, and 25% to cash.

Q: Finally, can you share with us S&P's top stock picks?


S&P has a popular actively managed list of their favorite stocks called the S&P Top 10 Portfolio. The current stocks on the list are: Affiliated Computer Services (ACS ), America West Holdings (AWA ), Barr Labs, Lennar, Flextronic, Martek Sciences (MATK ), Comcast (class A -- CMCSA ), D.R. Horton, Corinthian Colleges (COCO ), and Intel.

Before it's here, it's on the Bloomberg Terminal.