Picks Of The Pros, Plus How To Avoid Sand Traps (Extended)

The mavens we've assembled the past two years have done quite nicely, thank you. Can this bunch measure up?

For a vivid view of Wall Street's best investment ideas, gather a few industry veterans in a room to hash out their top stock picks. We did just that a year ago. Our list of 28 stocks delivered a 22.6% total return, nearly double the 12.5% 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 23.8%.) The year before, our panel's 28 stocks beat the market by nearly five percentage points.

So, aiming for a hat trick, we assembled another group early in December when the S&P was at 1,191. Richard Bernstein, the chief U.S. strategist at Merrill Lynch & Co. (MER ), a notorious worrywart, recommended stocks that could shelter investors from rising short-term interest rates and slowing earnings growth. Mary Farrell, chief investment strategist at UBS Securities (UBS ) and a 33-year-veteran of the market, went for multinational companies that will benefit from the weaker dollar. Robert W. Smith, portfolio manager of the T. Rowe Price Growth Stock Fund (PRGFX ), which has a 5-star rating by Morningstar.com, sought out cheap, steady-growth stocks. Repeat panelist David J. Williams, portfolio manager of the Excelsior Value and Restructuring Fund at U.S. Trust Corp. (SCH ) whose picks returned 43% this year, was the most upbeat of all. He told of enticing stocks from Brazil that trade in New York. Here are the highlights. Note: This is an extended, online-only version of the roundtable discussion that appears in the Dec. 27, 2004 issue of BusinessWeek.

In 2005, are stocks going up or down?

Farrell: I'm moderately bullish. The S&P should gain 6% or so, to about 1,265. The market is starting out neither cheap nor expensive, so it should track earnings.

Bernstein: Stocks are going up little. My target is 1,205, up about 1%. Plus you'll get a couple of percent from dividends. It could be a rough ride even for that. The Federal Reserve is going to be tightening short-term interest rates at the same time profit growth is slowing down to about half the 18% we've been getting in 2004. That's a coincidence that never ended well under [Fed Chairman Alan] Greenspan. It contributed to the early-1990s recession, the 1998 financial crises, the deflation of the tech bubble, and the last recession.

Smith: The year will be better than that. I see the S&P going up 10%, maybe even 15%, before falling back in 2006. The international economy will be even stronger. That said, you want to be guarded, because picking stocks won't be easy. This is not the time to take a lot of risk.

Williams: It is not going to be so hard. We're in the midst of a great market that is going to do fine in 2005, probably up 13% or so, to 1,350 on the S&P. The economy is growing at 3.5% with low inflation and low interest rates. If the pro-growth Republicans dominating the government can produce, then stock prices could explode. Besides, Rich, the Fed is not changing rates enough to restrict growth. They're just tightening a little to neutral.

What is the best way to pick stocks now?

Farrell: With all of my picks I'm trying to get good growth at a reasonable price. With the S&P running along with 6% trendline earnings growth, you'll be happy with a company producing double-digit earnings gains that you can get for a good price. Nextel (NXTL ) is a pure wireless play with 12% potential growth for the next several years. It's trading for about 16 times earnings. [Farrell spoke before Nextel announced a deal to merge with Sprint.]

Bernstein: Look to stocks with the most dependable earnings. Like other high-quality assets, they have done well when the Fed tightened rates while profit growth decelerated. The market will turn to them more than now, when people love lower-quality assets. Small-cap stocks, cyclical companies, and emerging-market debt will give you a hard time in 2005.

Smith: Rich is right to be careful. You'd be taking too much risk and paying too much for really fast-growing companies, like eBay (EBAY ), Yahoo! (YHOO ), and Starbucks (SBUX ), whose stocks have soared the past two years. We own some of those, but it is scary because they are very, very expensive. You're better with companies consistently growing 15%, which is still about 8% faster than the market. Wal-Mart Stores (WMT ) and Citigroup (C ) are lower-growth, big companies whose stocks haven't moved even though they've doubled their earnings the past five years.

Williams: I am taking more chances. I've been buying Interpublic (IPG ) as a turnaround play. They manage advertising, which is a big deal in this global economy. The company has had problems, so the stock is around $12, down from $60 a few years ago. United Rentals (URI ) used to be $30 a share, and it's $18 now. It's the biggest rental company in the country and has good, proactive management. The Securities & Exchange Commission is looking at their accounting right now, but I don't think it's a big issue. They're business is construction-related and booming.

How should investors play the dollar?

Farrell: It is key to stock selection. The dollar is going to continue to fall, probably to $1.40 against the euro by yearend 2005. The U.S. current account deficit is so big that something has got to give. I like U.S. companies that get 40% of their earnings from outside this country. PepsiCo (PEP ) will get a nice kick from earnings overseas.

Smith: The dollar's downtrend is one reason I like Citigroup. It is one of the best international financial companies. Switzerland-based UBS, which trades here, is another favorite. If assets move out of the U.S. because of the weak dollar, UBS's private banking business will be one place they go. Deere (DE ) will have a pricing advantage with its farm equipment over its Euro-based competitors.

Williams: I think the dollar is going to be fine; kind of status quo, would be my guess. The stock market has been indifferent to the dollar, unlike the media, which seem to be carrying the ball here.

So Dave, what's up with you and foreign stocks? You like two from Brazil.

Williams: They're real companies with real products, and the stocks still trade at low valuations. Embraer's (ERJ ) new airplane is getting rave reviews. Petrobrás (PBR ) is a safe, established international oil company that pays a better dividend [2.9%] than ExxonMobil (XOM ). It sells for just five times earnings. Emerging markets have lower tax rates, and they want free trade.

Smith: Embraer is very interesting. Emerging-markets companies are getting better, and you're going to see that continue.

Farrell: I'm still inclined to play a lot of these countries by buying U.S. companies that sell overseas. It is less risky.

Smith: Returns on capital for Chinese companies have been going down almost every year. It's because their capital spending is on steroids. Returns are better for India's service companies. They're not as capital-intensive as the Chinese manufacturers.

Could oil prices spoil it all?

Farrell: Oil is a wild card. It is hostage to a lot of forces beyond normal supply and demand. But at UBS we're forecasting prices will go down.

Smith: Lower oil prices will help Wal-Mart. Their average customer makes $30,000 a year and has been hurt by high gasoline prices. Those customers have really, really been in a recession for about five years, yet Wal-Mart has been growing earnings 14% annually.

Bernstein: Energy prices will cycle up and down, but the secular trend is higher. We've been bulls on energy stocks for three years, but the shares have gotten more speculative, and we've backed away from refiners and drillers. It is better to hide out with big, reliable guys like ExxonMobil. That said, I still think energy is the No. 1 story for the decade.

Williams: You can still make some money in oils. Everyone hates Calpine Corp. (CPN ), but I own it. The company is making progress with a big financial restructuring. If they just liquidated the company, you'd get $6 a share, and the stock's selling at $3.50.

Consol Energy (CNX ) is a great stock. I recommended it here last year, and I know it's already up 60%-plus this year. But it's not a wild bet. It's trading around $42, but if you liquidated the business you'd probably get $50 a share at current prices for gas and coal.

Bernstein: Some energy stocks pay good dividends, which are critical when stock returns are generally low. Since mid-1998, in fact, dividends have made up virtually all of the 2% annual return from the S&P 500. Ameren (AEE ), a Midwest utility, yields 5.2%. Dominion Resources (D ), a gas-and-electric holding company, yields 4%.

Williams: Utility stocks have done really well already this year.

Bernstein: Yes, but mutual funds haven't bought enough of the stocks. You can still get them without overpaying.

Farrell: Dividends are getting better tax treatment now. And they're growing faster, up from a rate of about 3.8% in the early 1990s to 12% in 2004. We're looking for 18% growth in 2005. Leggett & Platt (LEG ), Stanley Works (SWK ), 3M (MMM ), and Wells Fargo (WFC ) have all grown their dividends about 5% a year the past decade.

Bernstein: A prime reason to own Bank of America (BAC ) is its 3.9% dividend.

Smith: I'm less interested in dividends than in whether companies are generating the free cash flow to pay them, to buy back stock, or to buy good companies. Citigroup and UBS pay good dividends. But I really like that Citi is growing its free cash 10% a year and making good acquisitions.

If you insisted on getting regular dividends, you'd miss Liberty Media (L ), another stock I like. It's trading around $10.75, but it's $13 or $14 stock. It has been growing, and now I think John Malone [the chairman and major shareholder] is going to be in a period of harvest, either by selling assets for cash or interests in other assets.

Aren't financial companies going to get hurt by rising short-term interest rates?

Smith: They are widely disliked on Wall Street. But I look at the growth potential and their attractive stock prices. Their p-e multiples have gone down. Citigroup and State Street (STT ) will continue to rack up double-digit earnings growth the next three years even as rates go up.

Williams: Citigroup doesn't get credit for a lot of good stuff they're doing. They're big in emerging markets, and the stock sells at 11 times earnings. Financials are a good contrarian bet for next year. For good dividends, good growth, and cheap multiples, buy some financials. Morgan Stanley (MWD ) is probably the best investment bank, and the stock sells at just 12 times earnings.

Bernstein: The risk in the financial sector is in subprime lending. That's not Bank of America, which we like. It is well diversified.

Farrell: We think Wells Fargo has good risk management and growth. It hasn't really leveraged its balance sheet.

Williams: Don't forget Wells Fargo's exposure to mortgages and housing.

Is there trouble coming from the housing market?

Bernstein: I think we're in a housing bubble. The inventory of unsold homes has started to go up at the same time that interest rates are starting back up. Mortgage foreclosures, as a percent of total mortgages, have been rising for the last four years. The foreclosures are increasing because we're giving mortgages to more subprime borrowers, and they're having a lot of trouble.

Williams: That's a fairly small part of the market, though.

Bernstein:: It may seem that way, but we'd be hearing more about it if housing being taken back by the banks had to be sold at a loss. With house prices rising, foreclosures might actually be a profit center.

Williams:: Yes, exactly.

Bernstein:: If the housing market slows, that will constrain consumption. The wealth effect from housing on spending is two to three times the wealth effect of the stock market.

Farrell:: House prices have never fallen nationally.

Bernstein:: I think that's a big misconception. The index of existing house prices everybody quotes never goes down because it gets a boost from improvements people make on the property. It doesn't account for the changes that you make to the house or anything like that. It shows the gain on the house without adjusting for the cost of the improvements. If you look just at new home prices, you'll find they go down quite often.

The market's down on pharmaceutical stocks as well as financials. Is it wrong?

Farrell: This is a good chance to buy Pfizer (PFE ). The stock has been weak. They have quite a pipeline of drugs, and that should go a long way toward offsetting patent expirations. I'm looking for a nice return from solid 10% earnings growth and a 2.5% yield.

Bernstein: People are going to start reevaluating the drug companies. They're going to sort out their litigation risk and future cash flows and buy some of them again.

Smith: Maybe, but I can't think of any companies where you know so clearly that a big part of their income is going to disappear. Take Bristol-Myers Squibb (BMY ). Unless it does something dramatic, it is unlikely to have any earnings growth for three years.

Bernstein: The most attractive area in health care is selling hospital supplies. Abbott Laboratories (ABT ) does it. Its shares have been left behind despite new products.

With the country at war, how about defense stocks?

Bernstein: They should be in a diverse portfolio. There was little reinvestment in defense in the 1990s, and then came September 11. The world is unsafe and getting more so. Income disparities around the world are the widest they've ever been. Investors aren't talking about it enough. I like Northrop Grumman (NOC ).

Smith: We looked at the issue when considering Lockheed Martin (LMT ). That has been a good stock, but defense spending is set to drop off around 2006.

Williams: I disagree with your rationale, Rich. And if you're correct about the threat, airplanes and rockets are not what we're going to be using. We'll need mortars and bullets instead. My hope is that the global growth in emerging markets will reduce income disparity and help with terrorist issues.

Bernstein: I'm thinking of war risks beyond terrorism.

Does anyone recommend tech stocks?

Smith: I like Corning (GLW ). They're one of the few makers of good glass for flat-screen TVs. As prices come down, their business will grow 30%-plus for three years and drive earnings. They made a huge mistake with fiber optic in the past. But that business is O.K. now and could make Corning a great stock if phone companies buy a lot more fiber to compete against cable.

Bernstein: I bought one very chickenish tech stock, Affiliated Computer Services (ACS ). It does info-tech services, where the revenues are steadier. The stock is counter-cyclical and cheaper than the rest of tech.

Smith: The basic problem with tech is that there are no products offering great growth. Cell phones have pretty much played out. There's no great new software application. Internet advertising is wonderful, but the stocks are expensive. We played Yahoo and Google (GOOG ). We like eBay. But it is the wrong time to recommend buying them.

Bernstein: The problem investing in tech is that you have overcapacity now, more coming online, and companies burning cash. That's the opposite of energy. Portfolios should have only about 10% in tech, about half as much as the S&P.

Thank you all.

By David Henry

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