A Market Rise in the Low Double Digits

That's the sort of gain S&P's Kenneth Shea expects to see the S&P 500 and Nasdaq chalk up by yearend

The stock market may be showing some softness now, but it should end the year with low double-digit gains in both the Standard & Poor's 500-stock index and the Nasdaq. So says Kenneth Shea, managing director of S&P's Equity Research Services. Information technology is a sector that S&P believes will outperform the 500 this year, Shea says, despite the fact that it has been lagging so far because of profit-taking after last year's big gains. S&P recommends overweighting info tech, he adds, and lists as among S&P's tech buys Microchip Technology (MCHP ), BEA Systems (BEAS ), Flextronics (FLEX ), Vishay Intertechnology (VSH ), and Sybase (SY ).

Shea also notes that S&P is still positive on homebuilders, in the expectation that mortgage rates will remain relatively low, as well as the strength of the sector's big players and the trend toward second homes. S&P choices in this sector include Lennar (LEN ), D.R. Horton (DHI ), Hovnanian (HOV ), Pulte (PHM ), KB Home (KBH ), and Centex (CTX ).

These were among the points Shea made in an investing chat presented Mar. 9 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

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

Q: Ken, what seems to be worrying the market? The lack of job growth, or what?


The stock market seemed to be a little soft over the past couple of weeks, likely owing to a combination of things. First, some profit taking during a relatively quiet period. The job reports may weigh a little bit on investors' psyche. Also, a degree of wait-and-see attitude in light of the so-called preearnings announcement season ready to unfold here for the first quarter.

Q: Does S&P think the upward momentum will resume?


Yes. The S&P investment-policy committee pegs the S&P 500 to close at 1230 at yearend and the Nasdaq composite to close at 2266 at yearend. Both projections would translate to low-double-digit gains for each. S&P expects markets to continue to move higher as a result of continued solid earnings growth, continued investor confidence in the markets, and very low interest rates.

Q: How about the financials, Ken? Outlook for Citigroup (C )?


S&P recommends a market weighting on financials...[stemming] from our neutral stance on the banking industry. Although the industry benefits from low interest rates, overall loan demand remains relatively modest. Our view on Citigroup, though, is very favorable. The shares carry S&P's highest ranking of 5-STARS or buy [in STARS, the Stock Appreciation Ranking System].

We continue to believe that the shares warrant a higher valuation than they currently [have] in the market, in light of its diverse geographic and product mix, high revenue-growth prospects, and consistent, above-average profitability.... Investors should note that Citigroup recently hiked its cash dividend by 50%, to $1.60 per share, which equates to a secure 3%-plus yield.

Q: What about the low end of retailing? What's your opinion of Family Dollar Stores (FDO )?


S&P recommends that investors hold shares of Family Dollar Stores. S&P sees a strong value proposition and an improving product mix continuing to drive sales and earnings growth for this leading retail discount store chain. However, S&P believes that this discount space has become increasingly competitive, and our investment outlook is further tempered by potential delays in new store openings in the second half of fiscal year '04.

Q: Outlook for pharmaceuticals and Pfizer (PFE )?


S&P's investment outlook for pharmaceuticals is neutral. S&P continues to be concerned about the industry's coming patent expirations, relatively slow new-product launches, and the potential for increased government pressures on drug prices.

Near-term, the new Medicare drug bill should have a positive impact on industry profits, with anticipated price discounting outweighed by increased volume. We expect companies that cater to the elderly with drugs for heart conditions, arthritis, and diabetes to benefit the most.

We recommend holding most leading drug stocks and recommend investors accumulate Pfizer. S&P is confident that Pfizer will be successful in generating high-teen earnings-per-share growth over the next few years, aided by a large number of drugs focusing on conditions that affect the elderly. The recent news that Lipitor produced more favorable results than a leading competitor's drug adds to our confidence. Our 12-month target price is $43.

Q: What do you see in technology? It seems the market is a bit ahead of itself when it comes to companies' spending.


S&P still recommends an overweight position in the information-technology sector. Although the sector has underperformed the market, year to date, S&P attributes much of this to profit taking following last year's torrid gains for most of the sector's subindustries.

We still believe, however, that the tech sector will outperform the S&P 500 this year, based on a replacement cycle we project for aging equipment bought in 1999 for Y2K compliance, aided by a general strengthening of the U.S. economy and a low-interest-rate environment conducive to spending on business equipment.

We consider the semiconductor industry to still be an attractive play on a cyclical recovery in technology, and by 2005, we expect chip sales to surpass the $204 billion achieved in the boom year of 2000. Our favorite information-technology stocks include Microchip Technology (MCHP ), BEA Systems (BEAS ), Flextronics (FLEX ), Vishay Intertechnology (VSH ), and Sybase (SY ).

Q: Which are your highest-rated utilities -- and why?


S&P's only buy recommendation among utilities currently is Reliant Resources (RRI ). In light of a number of one-time charges in 2003, significant cost reductions planned for 2004, and the absence of planned construction expenditures for 2005, we believe Reliant Resources has the capacity to post strong free-cash-flow growth through 2005. Our 12-month target price is $10. Among electric utility stocks that S&P favors here as 4-STARS [accumulate] are Dominion Resources (D ), Entergy (ETR ), Exelon (EXC ), and Progress Energy (PGN ).

Q: Outlook for housing stocks?


S&P remains positive on the homebuilding group, as we still expect mortgage rates to remain at low and accommodative levels, and the large public homebuilding companies to continue to gain market share from weaker privately held homebuilders. Sales of new, single-family site-built homes have been at or near record levels since 1998, and S&P sees this continuing for the foreseeable future.

More than a cyclical play, S&P believes the homebuilding industry should continue to benefit from the secular trend toward the purchase of second homes. S&P's favorite homebuilding stocks currently include Lennar (LEN ), D.R. Horton (DHI ), Hovnanian (HOV ), Pulte (PHM ), KB Home (KBH ), and Centex (CTX ).

Q: In a related field, any REITs worth buying now?


S&P is neutral on the real estate investment trust industry, following strong gains in the industry last year. We expect office REITs to experience firming occupancy rates, as we view employment levels as likely to recover. Retail REITs should enjoy rent growth on expected high occupancy rates, due to our projection of further solid retail sales and consumer sentiment. Lodging REITs are seen recovering as travel and tourism shake off terrorism fears and recessionary pressures.

We think, however, residential REITs will continue to be hurt by robust single-family home sales, while health-care REITs face potential tenant bankruptcies. The primary factors to consider in evaluating a REIT security, in our view, are the stock's current dividend yield, its long-term dividend growth rate, and its payout ratio of funds from operations. We currently favor Hospitality Properties Trust (HPT ), with its dividend yield of nearly 7%.

Q: While you're at it, tell us S&P's current thoughts on asset allocation.


S&P currently recommends an asset allocation of 50% U.S. stocks, 15% foreign stocks, 10% bonds, and 25% cash.

Q: On that 15% suggested in foreign stocks, what does S&P recommend? Individual stocks or a mutual fund?


S&P recommends both. And, as the global research director, I'll offer a few individual stocks for the audience to chew on. In Asia, S&P analysts favor stocks in the industrials and materials sectors, including a firm named Hutchison Whampoa, an operator of ports, property, and retail businesses in China.

Our S&P analysts in Europe favor shares in the consumer area, including the shares of Heineken (HEIA.NA ), one of the world's leading brewers. Other ways to invest in equities abroad are through indexes, such as the S&P 1200 Global Index and various mutual funds and exchange-traded funds.

Q: Do you prefer Coca-Cola (KO ) or PepsiCo (PEP )?


S&P recommends that investors buy the shares of PepsiCo, as the company's recent product-mix improvements, growth potential, and continued strong free cash flows make the shares attractive. Our 12-month target price is $58.

Coca-Cola, however, is recommended a notch below, at accumulate, as our expectation for improving volume and earnings trends in coming quarters should allow the company to make niche acquisitions while repurchasing shares at an active pace. Our 12-month target price on KO is $58.

Q: We've had several questions on how S&P sees tech giant Microsoft (MSFT ).


S&P still recommends investors buy the shares of Microsoft, as its recent underperformance leaves the shares trading at a very reasonable multiple to earnings not seen in quite some time.

At its current price of roughly $26, Microsoft trades at a reasonable 22 times its fiscal '04 (June) earnings estimate. The company's substantial cash hoard, stellar balance sheet, and huge free cash flow allow the company virtually unparalleled flexibility to boost future earnings and dividends. We view the shares as very attractive. Our 12-month target price is $35.

Q: Closing time looms -- but does S&P still have its Top 10 Portfolio?


Yes. S&P continues to disseminate its Top 10 Portfolio, which is an actively managed list of S&P's top picks from among its more than 100 5-STAR buy recommendations.

That list is currently comprised of Caremark Rx (CMX ), Qualcomm (QCOM ), Anheuser-Busch (BUD ), Hologic (HOLX ), Landstar Systems (LSTR ), Affiliated Computer Services (ACS ), Flextronics (FLEX ), Comcast (Class A -- CMCSA ), D.R. Horton (DHI ), and Intel (INTC ).

Edited by Jack Dierdorff

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