Touring Wall Street With The Brainiest Guides In The Business
If you want to sort through the market, put Wall Street veterans in a room and let them hash it out. A year ago, our panel of pros came up with 28 stock picks that produced an average total return of 27.5% this year, beating the 23% return from the Standard & Poor's 500-stock index, according to FactSet Research Systems. (Twenty of those picks presented only in the print edition of BusinessWeek produced an average total return of 30.7%.)
We assembled another panel in early December as the S&P climbed over 1,065. Jeffrey M. Applegate, a strategist with his Jeffrey Applegate & Co., made a case for tech stocks. Joan E. Lappin, president of Gramercy Capital Management Corp. offered eclectic recommendations. Richard E. Cripps, chief market strategist at brokerage firm Legg Mason Wood Walker Inc., urged caution for the second half of 2004. And David J. Williams, manager of the Excelsior Value & Restructuring Fund since 1993, argued for energy and high-dividend stocks. BusinessWeek Associate Editor David Henry was moderator. Note: This an extended, online-only version of the roundtable that appears in the December 29, 2003 issue of BusinessWeek
For stocks in 2004, who among you are the bulls and the bears?
Applegate: I'm bullish. The market is still below fair value. But people should expect returns to be half as much as 2003, only 8% to 10%. A good target for the S&P 500 at yearend is 1,150. That may be conservative because we are in a multiyear period of productivity gains, low interest rates, and earnings growth.
Cripps: I am optimistic for the start of the year. We have momentum that will take us to a peak in the market midyear of about 1,200 on the S&P. We're still getting stimulation of the economy from the Federal Reserve's low rates and from the tax cuts. But toward the fall, as the market looks into 2005, stocks will slip. We'll end the year back where we started.
Lappin: Yes, the market will get help from President Bush stimulating the economy for his reelection. But to make money this year, you'll have to pick your stocks well. You won't be able to depend on a rising tide giving you a 20% lift in the indexes. We're in a long period of ups and downs, very similar to the 1970s.
Williams: There's a wide consensus among Wall Street professionals that 2004 is going to be good. That bothers me. But I have to agree with most of the optimism. It's hard to argue with stellar earnings and sanguine interest rates.
What should investors know to beat the indexes in 2004?
Williams: The market's dynamics will change during the year as it becomes clear that the Fed is raising interest rates, which will weigh on stocks in general. Then stocks that have done well in 2003, such as the recovering techs, will fall out of favor. Undervalued, high-dividend-yield stocks, such as energy stocks, will do better and become the new leaders. Investors have to be aware of this change in momentum and leadership in the market.
Cripps: This change will probably be the most significant investment event of the year. The small- and mid-capitalization stocks that have been leading and getting 70% of the new money going into mutual funds will lag behind. Big-company stocks with dependable businesses, such as General Electric (GE ), will do better.
Applegate: Bull markets typically start with better returns from the lower-quality and smaller stocks that are most sensitive to economic cycles. Then they peter out about six to eight quarters after a market trough. Since we had a trough in mid-March, these stocks can still run into the later part of 2004 before the shift.
Williams: The change will come when the Fed decides it has to salvage the dollar by raising interest rates.
Applegate: I couldn't disagree more. The Fed has never pitted its policy off the currency. What you want to watch for is the peak in earnings growth. As growth gets more scarce, companies that can deliver it in a stable way will see their stocks rise. You will want more stocks that aren't tied to the economic rebound. An example is Health Management Associates (HMA ), a growth-by-acquisition story that operates hospitals in overlooked rural areas. It will benefit as the market shifts to higher-quality, consistent growers in 2004.
Any tips for playing the weak dollar?
Applegate: There are many companies, including many small-cap issues, with significant sales outside the U.S. The currency translation will help their earnings. They include a fair number of industrial and tech companies, so you don't have to go with consumer-staples companies such as Coca-Cola (KO ) to get the lift. Look at Illinois Tool Works (ITW ); 45% of sales are outside the U.S. Tyco (TYC ) [International] is close to 50% of sales, using its pre-restructuring numbers. Cisco (CSCO ) has 50% of sales outside the U.S.
Williams: Toward the end of next year, the dollar may reverse its downtrend. Until then, it is giving a boost to a stock I like, Enel (EN ), the biggest utility in Europe. It trades here with a great dividend yield, almost 7%.
Applegate: I most want international exposure because we're enjoying the best synchronized global recovery since the second half of the 1980s. Japan is finally out of the soup. China, for the first time, is really contributing.
Williams: Sales to China have been behind much of this year's stock performance, especially for the building-materials stocks. So if for some reason China falters, look out.
Dividend stocks have done lousy. Why buy them?
Williams: Investors haven't yet appreciated how important the dividend tax cut is. When they do, it will lift the stocks of the big payers.
Cripps: Absolutely. With diminishing expectations of additional earnings growth, and no cheap area of the market, buying dividend stocks is a logical move and a good defensive move.
Williams: Dividends will be more important in selecting stocks than whether they have big market caps. Small- and mid-cap companies that increase their dividends and buy back more of their stock will outperform. Look at Carolina Group (CG ), a tracking stock of Loews' (LTR ) tobacco businesses. It's got an 8% yield, which alone gives you the investment return Jeff predicts for the year. And the legal environment is improving. When interest rates rise and hurt stocks that depend most on earnings growth, investors will look for dividends.
Lappin: People thought that a year ago, too.
Should investors buy bonds? Applegate: You would be a lot better in stocks. A year from now, I expect prices on 10-year Treasuries to have fallen and the yield to have climbed to around 5.10%, up from today's 4.40%.
Cripps: I agree. The 10-year yield will rise to between 5% and 5.5%.
Williams: As long as it doesn't go above 6%, I don't see rates as a big stumbling block for stocks. For income, I would rather have high-yield dividend stocks than bonds.
Where are the good deals?
Williams: In oil and energy stocks. They haven't really picked up with the market because there's a feeling that oil is going to fall back to $20 or $25 a barrel from today's $31. That's not going to happen. There's new demand from China. These stocks are cheap, and the companies have good cash flows. Devon Energy (DVN ) has a good mix of oil and natural gas. The stock has been around 50. It's worth 60.
Cripps: I like U.S. natural gas for similar reasons. We're going to have lower supply for three years, so companies will have firm pricing. EOG Resources (EOG ) gets three-fourths of its production in gas.
Williams: You can also buy assets at a discount through Consol Energy (CNX ). It has natural gas and coal. The pricing fundamentals for coal are even better than for gas. It's assets are worth $25 to $30 a share, and the stock is at $20. Both Consol and Devon are doing some restructuring.
Lappin: An energy-related stock that could pay off big is Tesco (TESOF ), a Canadian company with a new technology for drilling a well with a casing. It takes about 25% of the cost and time out of drilling. I thought it would take off last year, but the company ran their balance sheet into trouble. They've cleaned it up now. The stock is about $8. It could double.
Applegate: I didn't pick any pure energy stocks. Their earnings growth outlooks are lagging other companies. There are better choices. Take Tyco. It is resolving governance issues and boosting earnings. It is global, diversified, and selling at a 20% discount to its peers.
Another example is Freeport [McMoRan Copper & Gold] (FCX ). Its earnings revisions are going up sharply. The stock is up a lot, but it's still a good play on the whole synchronized global recovery. And, there's Halliburton (HAL ). Estimates have its earnings up 62% in 2004, and its asbestos litigation issues should be resolved.
Cripps: A lot of people don't want to, but this is the time to buy General Electric. Sure, GE is going to have flat earnings in 2004 for the third year. But [CEO] Jeffrey Immelt has transformed that company. As we get into the global recovery, its businesses will pick up. You're going to see double-digit earnings growth, though the stock may be boring early in the year.
Lappin: So why buy GE now?
Cripps: I am looking one year from now. A lot of the stocks moving right now, like Cisco and other techs, you are not going to want in six months.
Williams: I've never liked Cisco. The problem with tech stocks is that they are so cyclical they don't justify their prices. Very few consistently grow earnings 20%. A few years ago, we thought Cisco did, but that was wrong.
Jeff, why do you recommend Cisco? It's up 80% this year.
Applegate: A lot of reasons: global recovery, foreign sales, declining dollar, and outstanding increases in earnings estimates. It's not cheap at 34 times earnings, but it is less expensive than its peers. No question, though, it is cyclical.
Williams: I know people will continue to bid up the stock as long as its earnings momentum continues, but that is going to stop. You don't want to own it.
Lappin: Techs have replaced steel companies as cyclical drivers of our economy.
Williams: True. My father bought me 25 shares of Republic Steel when I was a kid. It went into bankruptcy, and a lot of the techs will, too.
Applegate: Info-tech companies are going to continue to do well as long as labor is more expensive than capital goods. And, a lot of these U.S. companies don't have global competitors.
Lappin: But you've got to be careful which tech stock you pick. Microsoft (MSFT ) has been the biggest dog this year. I like Novell (NOVL ), which uses Linux software. It's the anti-Microsoft.
Applegate: Isn't Novell up 175% over last year?
Lappin: It started around $3.50 and now it's over $9. I've done well in single-digit stocks that had just been hammered.
Williams: Isn't that game over?
Lappin: No. While some stocks have gone up to low double digits, they can go higher. I recommended Nextel (NXTL ) [Communications] last year at 12, on its way from 3 to now 25. I'm recommending Nextel again. Same with Providian [Financial] (PVN ), the consumer-finance company. I liked it at 6 last year, and I still like it at 11. It's in the second year of a three-year rebuilding. The Fed's low rates have helped its borrowers.
Williams: Providian sounds like an acquisition candidate now.
Cripps: With low-priced stocks, you can make -- or lose -- a lot of money. Many stocks under $10 did well this year with the better economy. There's still a lot of speculation in them. I'd play it safe elsewhere.
Joan, why do you still like Nextel?
Lappin: Like a lot of companies, Nextel has improved its creditworthiness, giving it new flexibility and reducing its costs. Analysts' earnings estimates have almost doubled in the past year, and they're still too low.
Williams: I own Nextel, but a lot of the good news is already in the stock. One I like better, and recently bought, is America Movil (AMX ), a Mexican cellular company with the same characteristics: good balance sheet and great growth. They're paying a dividend and buying back stock. And, the stock is cheap.
Lappin: A number of companies are stronger now and make good investments. General Motors (GM ) is another turnaround I like. Their cars are better. Their ads are attracting younger buyers.
Williams: GM is a good investment. Ford [Motor] (F ) is, too. I own Ford convertible securities. The economic rebound will help their balance sheets. Freddie Mac (FRE ) is another recovery. It had a big financial restatement, but no fraud. Beneath the problems, there's a great business financing mortgages. Its value will rise with the total value of residential housing in the U.S., which has grown historically at 9%.
How do you know what Freddie is worth since it's redoing its books?
Williams: You don't. You make ballpark assumptions. The stock should trade like Fannie Mae (FNM ), the biggest mortgage company, selling at a 50% higher multiple of book value. You've got a $75 stock now around $55.
Applegate: Housing values are generally sound. I don't see mortgage rates going up a lot. I like Pulte Homes (PHM ), the builder. It's controversial because it is up about 100%. But it is growing with consolidation in the industry at the expense of mom-and-pop builders. It can deliver consistent 12% earnings growth. The stock is only 8 times 2004 earnings, a 50% discount to the market.
Cripps: Jeff, conditions for builders are so good they can get only worse.
Applegate: Unless we get high inflation that forces the Fed to raise rates a lot, houses will still be affordable.
Williams: One of my largest holdings, Black & Decker (BDK ), goes well with housing and the recovery. It sells consumer tools. It's just 11 times earnings.
Lappin: If the economy keeps perking up, advertising will, too. So I'm recommending Univision (UVN ). In television and radio, it's preeminent reaching Hispanics, the most rapidly growing ethnic demographic group in our country. And, in 2004, they'll get political advertising.
Are there any finance stocks to buy?
Cripps: Bank of America (BAC ). It is a unique franchise that covers the nation. The stock has already been marked down because of what they're paying to buy Fleet. Now they'll integrate that acquisition. The stock yields 4.2% and sells for a low-risk, 11 times earnings.
Williams: Ace Ltd. (ACE ), like many commercial insurance companies, has been overlooked by the market. The fundamentals of that business are great. Premiums are rising substantially, and they're in very attractive, noncommodity, markets. Management is creating value with a public offering of a subsidiary.
What else should investors consider?
Cripps: One of the best-managed telecoms is Alltel (AT ), which traditionally was a wireline carrier in rural markets in the Southeast. They've built a very significant wireless business, now 60% of revenues. Its wireline business is not deteriorating as much as those in urban areas. It pays a good dividend of 3.2% and has one of the best balance sheets.
Lappin: We should discuss biotech. Cephalon (CEPH ) earns money. The stock has been lame in 2003, but earnings are growing 50%. It has a drug, Provigil, for sleep disorders and is working on pain control for cancer patients. The stock is around 48 and could see 70.
Richard, one of your picks, Pepsi Bottling Group (PGB ), has been a dog, too: down 10%.
Cripps: It was too high, but now it's back in line. The company grows 10%. Management wants to buy back stock and pay dividends.
Applegate: But, Richard, where are the 15%-growers that investors want?
Cripps: UnitedHealth Group (UNH ), the health insurer, is one. Over 15 years it has grown earnings at a 29% compounded pace. It will benefit from Medicare reform. Meat processor Smithfield Foods (SFD ) has a record for building shareholder wealth. Its total return the past 28 years is triple the S&P 500's. It's enjoying the demand for high-protein diets. You can buy it for just 16 times earnings for the fiscal year ending in April.
By David Henry