Stocks: The Watchword For The New Year Is Quality

With interest rates rising and earnings growth slowing, solid, cash-rich companies don't seem quite so dull

If you were looking for excitement in 2004, you wouldn't have found much in the stock market. Truth is, the Presidential debates ("I own a timber company? That's news to me.") and the sports steroid scandal were much more riveting. True, some pockets percolated -- like energy and industrials such as steel. And some techs like Google, Apple Computer, and eBay became market darlings. But overall, sky-high oil prices, turmoil in Iraq, rising interest rates, and a weak dollar kept stocks down and out most of the year. The big thrills came after the Nov. 2 election, when stocks staged a Red Sox-like comeback. They've managed to hold on to most of those gains, and the Standard & Poor's 500-stock index will probably end the year up 8%.

The not-so-great news is that stocks are apt to be lackluster the first half of 2005. The strategists we polled for our "Fearless Forecast" think next year the S&P will return single-digit gains -- around 8% again. The Federal Reserve is expected to keep hiking rates. Given the U.S. trade and budget deficits, the dollar isn't likely to rebound. Oil prices may stay high, especially now that OPEC is cutting output. And profit growth will probably start to decline next year. As a result, most Wall Street strategists see few catalysts that could drive stocks up in the next few months. Says Thomas McManus, U.S. equity strategist at Banc of America Securities (BAC ): "We expect smaller gains in 2005 and believe investors are overlooking significant risks such as inflation." He recommends a 55% allocation to stocks. A year ago, he was at 70%.

So how to play the market? A good strategy is to continue to migrate into quality stocks -- companies that have consistent earnings growth and strong balance sheets with low debt and healthy cash flow. If they're trading at a discount to their peers, all the better. Quality stocks are even more important as earnings growth slows. Corporate profits rose 19% this year, but in 2005 they're expected to be up only around 11%. With interest rates on the rise, solid, cash-rich companies are likely to outperform cash-poor ones. Weaker companies need fresh capital to stay in business, but higher rates make capital more pricey, putting a damper on their earnings.

Although stocks aren't overvalued, they're not cheap. The S&P is trading around 17 times expected earnings over the next 12 months. That's more than the average 15 over the last half-century. Still, many quality stocks -- especially utilities and consumer staples -- are trading at lower price-earnings ratios than the market. Investors have bid up low-quality small-caps and fast-growing tech stocks -- while largely ignoring safer, sounder stocks. Richard Bernstein, chief U.S. strategist at Merrill Lynch & Co. (MER ) and one of our roundtable panelists advises investors to search for companies with the steadiest growth rates -- around 10% to 15% a year, rather than highfliers with often unsustainable 25% to 30%.


To find such companies, look beyond smaller-caps and mega-caps, which are richly valued, and focus on mid- to large-cap stocks. Small-caps, which have outperformed large-caps over the past four years, may start to run out of steam in 2005. They tend to outperform in the early stages of an economic upturn, when they get an easy oomph from increased liquidity. But now that the recovery is maturing, the "I" word (inflation) is heard, and growth is slower. So strong companies matter more than ever. Our "Fearless Forecast" strategists like the energy sector best, followed by technology, industrial cyclicals, and health care.

Companies that raise their dividends are often good picks. They usually have strong cash flow and solid earnings. What's more, dividend-paying stocks outperform nonpayers over the long term. And companies with the highest dividends tend to outperform others. According to a study by Glenmede Trust Co., since 1985 stocks with the highest yields have posted an annual return of 15.1%, compared with 10.8% for those with the lowest. Besides, with President George W. Bush setting the agenda for the next four years, the favorable tax treatment of dividends will continue. Henry McVey, U.S. equities strategist at Morgan Stanley (MWD ), says the bank thinks that "capital-gains and dividend relief are likely to become permanent features of the tax code."

More companies will be paying dividends and staging stock buybacks as they build up record levels of cash on their balance sheets. Witness General Electric Co.'s (GE ) Dec. 10 announcement that it will buy back $15 billion worth of stock and raise its dividend by 10%. GE's stock rose 2% that day alone.

With returns likely to be lackluster on Wall Street, it may be wise to travel abroad for quality. Our Fearless Forecasters are already packing. Their consensus asset allocation for international stocks jumps to 18% from 14% last year. The weak dollar -- down 18% on a trade-weighted basis over the past three years -- will continue to be a boon to many foreign companies, especially in countries like China where the currency tracks the dollar.

Emerging markets may be a good play. Raymond A. Mills, manager of T. Rowe Price Group Inc.'s (TROW ) International Growth & Income Fund looks for countries that benefit from growth in China and India. He likes Australia, Hong Kong, Singapore, and South Korea. Brazil and Russia are also heating up. To get a piece of the action consider emerging-market and country-specific mutual funds or exchange-traded funds.

Beyond that, selected niche plays could be good bets. For instance, Internet advertising is getting bigger by the nanosecond. Some alternative-energy companies are also poised to radiate. And betting on bank mergers could put a jingle in your piggy bank.

But for core holdings, look to quality stocks. According to a November study by the National Association of Investment Clubs, 40% of investors think it's a good time to move into less risky investments. That's up from 34% percent in January, 2004. At BusinessWeek, we've been talking about investing in quality stocks for the past year. Are investors listening? We certainly hope so.

By Marcia Vickers

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