The Return of Double-Digit Inflation?

Leeb Capital Management's Stephen Leeb thinks soaring energy prices could make it happen before the decade is over

"It's a near-certain bet" that inflation will be a problem before long because of energy, predicts Stephen Leeb, president of Leeb Capital Management and author of The Oil Factor, a recently published book on the intricate relationship between energy and the financial markets. In fact, says Leeb, "I wouldn't be surprised to see another bout of significant double-digit inflation before the end of the decade."

He sees rising prices for both oil and natural gas, and considers most energy stocks "dramatically undervalued." His stock recommendations include names in most areas of the industry, ranging from U.S. oil giants to drillers and independent producers, plus foreign energy names such as Russia's Lukoil (LUKOY ) and China's PetroChina (PTR ).

Leeb is pessimistic about the impact of recent events in Saudi Arabia on oil production, and this feeling is compounded by the lack of discussion of alternative energies in the U.S., he adds. He takes note of three companies that are active with alternatives, however -- Entergy (ETR ) in nuclear and FPL (FPL ) and General Electric (GE ) in winds.

These were among the points Leeb made in an investing chat presented June 17 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 complete transcript is available from BW Online on AOL, at keyword: BW Talk.

Q: Steve, give us your macro view of the stock market as it bobs and weaves.

A:

I think the market has a bit more upside. But it's very difficult to make a case for significantly higher prices because of the uncertainty regarding oil. On the other hand, given that the Fed has promised only modest interest-rate increases, it would be very surprising, absent a bolt from the blue, to see stocks break down. In other words, short-term, expect more bobbing and weaving -- with a slight upside bias.

Q: A lot of folks are buzzing about inflation right now. Is it getting troublesome?

A:

At the moment, not that troublesome -- but it's a near-certain bet it will become troublesome and, in fact, so troublesome as to become one of the defining characteristics of the economy over the next five to 10 years. Indeed, I wouldn't be surprised to see another bout of significant double-digit inflation before the end of the decade.

Q: Given your view of higher inflation, which stocks should investors avoid?

A:

Basically, avoid autos, avoid airlines. And one of the horrors of an inflationary economy is that those investments that appear to be the safest -- such as long-term bonds and big blue-chip stocks like Wal-Mart (WMT ) -- turn out to be in many cases money-losing catastrophes. At least, this is the unequivocal message of the 1970s -- the last time we suffered from very high inflation.

Q: Is XTO Energy (XTO ) as good as it appears for the future?

A:

I think most energy stocks are dramatically undervalued. They're trading as if energy prices -- both oil and gas -- are going to retreat 20% to 30% from current levels. Whereas every indicator and predictor I look at suggests that any retreat in energy prices will be short-lived and that the long-term trend in both oil and natural gas prices is higher -- possibly dramatically higher. This makes virtually any member of the energy patch a compelling long-term investment -- XTO included.

Q: What's your view of Occidental Petroleum (OXY )?

A:

Not my favorite...though I do expect it to be a relatively strong performer over the long haul. One reason I like large companies like ChevronTexaco (CVX ) and ConocoPhillips (COP ) better is that they are purer plays. OXY's chemical business is actually negatively affected by higher energy prices.

Q: What about oil and gas outside the U.S.? Opinion on large Russian oil and gas companies Lukoil (LUKOY ) and Gazprom (OGZPF )?

A:

I like them. I think they're among a very few oil and gas companies that have the wherewithal to increase production over the next three -- possibly five -- years. A smaller one in the same part of the world which has an even better production profile would be PetroKazakhstan (PKZ ).

Q: What about Suncor Energy (SU ), the Canadian oil-sands company?

A:

I think it's a very interesting investment. But mining oil sands is not a piece of cake, and I say that because many have used oil sands as an argument against the idea that fossil-fuel production is peaking. Suncor, along with Canadian Oil Sands (COSWF ), Encana (ECA ), and PetroCanada (PCZ ), is among the few that will benefit, long-term, from their stake in Canadian oil sands. In other words, oil sands offer significant opportunity -- but only for a select few.

Q: Is China a good investment today -- CNOOC (CEO )?

A:

I think it's a very good investment area. My favorite play in China would be PetroChina (PTR ). This is a high-yielding (over 5%), major oil company. It's 90%-owned by the Chinese government, and its second-largest shareholder is Warren Buffett. I think it's at once a play on the Chinese economy -- which I expect to be strong in the foreseeable future -- and also a play on higher oil prices. But any major Chinese company -- such as the one you suggested -- should also be a pretty good investment.

Q: Are dividend-paying stocks still the best bet today?

A:

I think the right dividend-paying stocks are excellent bets. But by right, I mean companies that not only are paying dividends but also have the wherewithal to increase those dividends faster than inflation.

Two favorite utilities in this regard would be FPL (FPL ) and Entergy (ETR ). Both are plays on alternative energies -- wind in the case of FPL, nuclear in the case of Entergy. Both offer high yields -- but more important, the wherewithal to sharply increase their dividends as energy becomes more and more a problem.

Q: Talk of inflation brings talk of gold. What's your view of Barrick Gold (ABX )?

A:

Basically, I think there should be a spot for gold in virtually all portfolios -- somewhere between 5% and 10%. And Barrick, along with Newmont (NEM ), is a wonderful anchor in your gold portfolio. They're sure beneficiaries of higher gold prices, but admittedly, because of their size, will not be as leveraged to gold as smaller mines such as Glamis (GLG ).

Q: What do you think of pharmaceutical stocks?

A:

In general, I think pharmaceutical stocks are cheap. But this is a very diverse universe. Overall, I think generics such as Ivax (IVX ) have more growth potential than major pharmaceuticals such as Wyeth (WYE ) or Bristol-Myers Squibb (BMY ). This is because generics will increasingly be favored because of cost considerations in the industry.

That said, my favorite generic company is Teva (TEVA ). But again, some large pharmaceuticals do represent compelling values, and in this category I would include Pfizer (PFE ).

Q: Any insight into Unocal's (UCL ) long-term prospects?

A:

I think Unocal is an absolutely fine diversified, medium-size oil and gas company. Whereas I think Conoco has a bit more upside potential, I certainly wouldn't rush out to sell Unocal for any other oil investment. This is a well-run company that will not be left behind as oil and natural-gas prices rise.

Q: Steve, any comment on Apollo Group (APOL ) [in adult education]? It's due to split.

A:

I think this is a great group. And arguably it's one of the fastest-growing industries in the country. Apollo, however, is very expensive, and while I expect it to be a good long-term performer, I'm going to give you another name which is much cheaper, more diversified, and favored by Warren Buffett. And that is Washington Post (WPO ). Their Kaplan education division is now more important than their well-known newspaper. I think this is the best way of playing this very dynamic industry.

Q: What about fallout stocks from the Enron episode -- El Paso (EP ), Dynegy (DYN ), and Reliant Resources (RRI ), in particular.

A:

I think many of these companies, especially the survivors, do have a very bright future, but you still might have to wait a year or two for that future to be realized.

Inevitably, there will be electricity shortages in the U.S., and these shortages will occur regardless of what happens to energy prices. Companies like El Paso will be in the catbird seat when these shortages develop. But again, the wait may be one, two, or even three or four years.

Q: Do you like Apache (APA ) or Anadarko (APC ) because of gas involvement?

A:

Yes to both. And add to that list Devon Energy (DVN ) and, as mentioned earlier, Encana, PetroCanada, and virtually any other independent oil and gas producer. These are in a universe of very undervalued stocks. All of them should sharply outperform the market over the next several years.

Q: Do you have an opinion on the oil-drilling stocks? Schlumberger (SLB )?

A:

I think Schlumberger is one of the premier energy-related investments you can make. As oil becomes harder and harder to find, the need for advanced technology in the oil-service area will become ever greater. That Schlumberger's technology is head-and-shoulders above anyone else's should translate into torrid long-term growth.

Q: Can you give us your top five picks for the near future?

A:

If I could only pick five, I would choose Berkshire Hathaway (BRK ), Devon (DVN ), Apex Silver (SIL ), Electronic Arts (ERTS ), and Schlumberger (SLB ).

Q: Will techs come on strong later in the year?

A:

If we get a pullback in energy prices -- and a short-term pullback in energy prices is possible -- then I suspect investors will become more aggressive and bid up technology stocks. But given my long-term view on energy prices, I wouldn't expect the strength in tech stocks to last very long. Still, there are some tech stocks that have good long-term potential regardless of energy prices. One favorite name would be Intel (INTC ).

Q: What about Pogo Producing (PPP )?

A:

This is a member in good standing of a group that I think has one of the best long-term profiles, and that is independent energy producers. Pogo trades at a very modest multiple, just 11 times current earnings, and only about four times cash flow. That's comparable to other stocks in the group.

I wouldn't be at all surprised to see these stocks trading at double-digit cash-flow multiples within the next two to three years. In other words, Pogo and similar companies have tremendous long-term potential.

Q: One of the recent features in your Complete Investor newsletter was about homeland security. Which stocks do you like here?

A:

Two that I like, though they're not pure plays, would be Tyco (TYC ) and Thermo Electron (TMO ). More controversial, but one with much greater upside potential, would be CACI International (CAI ). Homeland security is definitely a growth industry.

Q: What's your view of the impact of Saudi turmoil and the Iraq war on Mideast oil production, OPEC, and our energy supply?

A:

I'm very worried. For practical purposes, OPEC is no longer. The only country in the world with marginal oil supplies is Saudi Arabia. Any disruption or damage to Saudi oil production could have a devastating effect on the world's economies. Moreover, while I don't want to sound too pessimistic, recent events in Saudi Arabia make it ever less likely that Western companies will be willing to develop their oil resources. And this development is desperately needed.

I feel very strongly that we should be talking and discussing, as a country, alternative energies.... I'm deeply concerned by events in Saudi Arabia, and those concerns are compounded by a lack of intelligent discussion regarding energy in this country.

Q: You're keen on alternative energy -- and mentioned two companies earlier into that. Any others? In the scant time we have left!

A:

Certainly! FPL, Entergy, and the biggest wind producer of all is none other than General Electric (GE ). Although wind is small in GE's corporate pie, if I'm right, it could become a very significant part of GE's long-term growth.

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