Where Growth at a Good Price Lurks

Taylor McGowan of Farr, Miller & Washington says despite the market's run-up, we're still finding stocks to buy

The biggest upside in the stock market today is probably in health care. That's the view of Taylor McGowan, senior analyst and portfolio manager for money-management firm Farr, Miller & Washington. Among the stocks he likes in the sector are Johnson & Johnson (JNJ ), Pfizer (PFE ), and Medtronic (MDT ).

Farr, Miller & Washington, based in Washington, D.C., shops for stocks that offer growth at a reasonable price. Other sectors McGowan favors are consumer, financials, and technology. Despite the high valuations of many tech stocks, he suggests larger, less volatile names such as Microsoft (MSFT ), Dell (DELL ), and IBM (IBM ). On the telecom front, he likes Nokia (NOK ) but cautions against SBC Communications (SBC ) -- a stock his firm recently sold -- and BellSouth (BLS ), partly because he feels that their Cingular joint venture overpaid for AT&T Wireless (AWE ).

McGowan also thinks Bank of America (BAC ) paid too much for FleetBoston Financial (FBF ), but he likes BAC nonetheless because of its price-earnings ratio of 11 and its 4% dividend. He also recommends American International Group (AIG ) among the financials.

These were a few of the points McGowan made in an investing chat presented Feb. 19 by BusinessWeek Online on America Online, in response 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: Taylor, the market keeps having these bobbles in its upward course -- do you expect a major correction?

A:

Well, it is unprecedented that the market has risen so sharply and steadily since March, so we wouldn't be surprised to see a sell-off at some point.

Q: When you speak of a sell-off, how big of a sell-off and when?

A:

Well, I would love to know that. I can't really forecast the timing or how much it would be, but it would probably be healthy for the market to have a sell-off. We try to position our own portfolios to mitigate whatever the market throws at us, so regardless, our long-term clients will do better than the market.

Q: Are you still finding stocks to buy at this point?

A:

Yes, we're still finding stocks to buy. A couple of the sectors we like are health care and consumer staples. We're continuing to find attractive valuations here. In health care, we like some of the pharmas, like Pfizer (PFE ). In the consumer staples, we like PepsiCo (PEP ) and CVS (CVS ). In general, the area in which we're seeing the highest valuations would be in the technology sector and also certain areas of telecom.

Q: Is it getting harder to find values for your strategy of growth at a reasonable price (otherwise known as GARP)?

A:

Well, it's harder than it was, but again, outside of the technology sector, which seems fully priced to us, we're continuing to find attractive valuations. Some of the financial stocks look good. They're giving investors good dividend yield. So we're finding good things to buy.

Q: So technology is not attractive at this point. Are there any stocks that you would look at in tech?

A:

Well, we're still finding some tech stocks attractive. We're favoring the larger, less volatile stocks at this point. We think that Microsoft's (MSFT ) prospects are solid. We've started to buy a little bit of IBM (IBM ). Dell Computer (DELL ) remains one of our favorites. On the telecom side, we think that Nokia (NOK ) represents decent value at these prices as well.

Q: More on telecom: SBC Communications (SBC ) and BellSouth (BLS ) -- future?

A:

We actually recently sold the rest of our SBC [shares]. We don't like the prospects for the U.S. long-distance telecom business. We also don't like the fact that both these companies are probably paying way too much for AT&T Wireless (AWE ) [SBC and BLS are joint-venture partners in Cingular, which is buying AT&T Wireless]. We would recommend staying away from those names at this time.

Q: Any semiconductor stocks you like and follow?

A:

We still own a little bit of Intel (INTC ), which is less expensive than a lot of tech stocks. It restructured wildly during the downturn and is reaping the benefits now. The stock is trading at roughly 25 times 2004 earnings.

Q: I have $125,000 to invest, and I want income-producing stocks. Can you recommend which ones and how much?

A:

We can't really offer advice like that without knowing the person's complete financial history, their goals, and their risk aversion. It's an interesting question, because dividend yields out there are lower than they've historically been.

One thing I would caution, though, is to stay away from stocks with the highest dividend yields, because dividends will be cut eventually. REITs have high dividend yields. We don't actively own any, and we're a little bit nervous about the market, but as a small portion of the portfolio, they offer a good way of diversifying.

A couple of examples of higher-yielding stocks on our list that we're buying: Bank of America (BAC ) is a good name, with a yield of nearly 4%. Citigroup (C ) is another good example. General Electric (GE ) actually has a 2.5% yield, and we're positive on that stock.

Q: How about Johnson & Johnson (JNJ )?

A:

We like Johnson & Johnson at current levels. They have a great track record of growing sales and earnings at double-digit rates. The stock didn't participate in last year's rally. Negative news on their drug-coated stent affected it, but most of that is already priced into the stock at these levels. This is a good opportunity to get into a high-growth health-care stock at probably a market multiple.

Q: Do you like anything in retailing?

A:

The retailers in general had a pretty good run in the last year. One of the stocks that didn't perform last year was Kohl's (KSS ), and we feel that they're attractive today because the valuation has come down dramatically. Their business model, though it has had to be adjusted slightly, is definitely not broken.

Q: What do you really not like?

A:

One name we're not crazy about would be Target (TGT ) -- the Target stores specifically. Our issue would be the company's credit-card operation has become a fairly meaningful percentage of its overall earnings. We also don't like the fact that Target owns two lagging retailers: Mervyn's and Marshall Field.

We also aren't crazy about Coca-Cola (KO ) at these levels. The company has one of the world's greatest brands and a great track record, but we feel the valuation is currently assuming much greater growth than we believe possible in the soft-drink business.

Q: What sectors do you analyze, and which have the biggest upside?

A:

Our portfolios are set up to be diversified, so we never take huge bets on one sector. That said, the ones we're most favorable on for the long term would be: consumer, health care, financials, and technology.

We believe the biggest upside can currently be found in certain areas of health care, especially given that many of these names haven't had the rally that we've seen over the past year.

Q: What do you like specifically in the health-care field? You mentioned Pfizer earlier, also JNJ.

A:

We do like those two. We like pharma stocks in general, though many negatives are out there (generic competition, weak pipelines, etc.). But we feel attractive stocks are out there.

We like Medtronic (MDT ) -- they've had solid earnings (better than 15%) for many years. It's the industry leader in five or six attractive medical-device markets. The valuation is not inexpensive, but more attractive than it has historically been.

Q: I have Sina (SINA ), a Chinese portal. Any thoughts?

A:

We don't follow that company directly, but we're nervous that investor demand for anything related to China has gotten a little carried away. China's growth prospects are obviously very strong, but any disappointments coming out of China would have a huge negative impact on fully priced stocks such as this one.

Q: What are some of the financials you recommend?

A:

We currently like Bank of America, despite the fact that we believe they're paying too much for FleetBoston (FBF ). We believe the stock is attractive at about 11 times earnings, with its 4% dividend yield.

We also still like American International Group (AIG ) -- the stock has had a nice run over the past two months, but historically AIG has traded at a market multiple, and it's still at about a 15% discount to the market. The property-and-casualty insurance business is likely to see softening of pricing at some point. AIG is quite diversified and protected against any softness.

Q: Do you think GE (GE ) has any room on the upside?

A:

We do like GE. We think at current levels it represents a good opportunity. It's a high-class company with high-class management and a good balance sheet. It has an attractive stable of diversified businesses for roughly a market multiple. So, yes, we're positive on GE at this point.

Q: Do you like any Internet stocks?

A:

We like the companies, but we don't like the valuations. Yahoo! (YHOO ) and Amazon (AMZN ), as well as eBay (EBAY ), have all shown that they're going to be long-term survivors. They're great companies, but their prices more than reflect this already. I'd say this is a case where great companies don't necessarily mean great investments.

Q: So as we close, Taylor, what advice would you have for investors at this stage of the market?

A:

My advice would be to remain diversified, make sure you invest for the long term, try to ensure you're buying a high-quality stock or high-quality mutual funds, and remember to stick to your discipline. Don't get distracted by short-term noise in the market.

Edited by Jack Dierdorff

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