Investors Should Study the STARS

S&P's Sam Stovall says the outfit's stock ranking suggests sound picks, which are important in a modest growth year when selectivity is key

"We're in a stock picker's environment where investors need to select shares very carefully." That's how Sam Stovall, chief investment strategist for Standard & Poor's, describes the 2005 investing climate. To aid in the selection, he says, Standard & Poor's has more than 100 names on its 5-STAR or best-buy list under its Stock Appreciation Ranking System (STARS).

S&P also maintains a Top 10 Portfolio of 5-STAR stocks, Stovall reports, currently including Cooper (COO ), MNBA (KRB ), Burlington Northern Santa Fe (BNI ), Ingersoll-Rand (IR ); Amgen (AMGN ), Chattem (CHTT ), Guitar Center (GTRC ), FMC (FMC ), Qualcomm (QCOM ), and Landstar System (LSTR ). These stocks posted a total return of 19.2% in 2004, vs. 10.9% for the Standard & Poor's 500 stock index.

The criteria Stovall suggests for selecting stocks in the new year include good value and a historical record of consistent earnings growth. These were a few of the points he made in an investing chat presented Jan. 4 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at keyword: BW Talk.

(Sam Stovall is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to the Standard & Poor's Securities Web site and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Sam, it doesn't look like such a happy year so far for the market. What happened to the Santa Claus rally? Back to the North Pole?


I guess it's a new year and a new outlook on things, certainly with the Fed indicating inflation is something that needs to be watched a bit more closely than indicated earlier. Yet, obviously, it's too early to get worried about the performance of the market for the full year. Our full-year target is 1,300 for the S&P 500, which indicates that we're looking for a good -- but not a great -- year ahead.

Q: Are your economists worried about inflation? What's the S&P outlook on the economy?


Our outlook on the U.S. economy is one of modest growth. We're looking for a 3.6% increase in real GDP for 2005, with much of that growth coming from the business-spending side of the equation. We believe the consumer will continue to spend almost all that they make. Yet we think inflation will likely remain below 2.5% this year. One reason is that we believe oil prices will gravitate toward $40 per barrel by the end of this year.

Q: Do you think it's a good time for investors to get into equities?


We're not in the short-term timing game. Our outlook is usually based on 12-month projections. Since we see the economy growing by a little more than 3.5% this year and expect corporate earnings to rise by about 10%, and since we believe that bonds won't be the asset of choice in a rising-interest-rate environment, we believe investors will continue to favor equities, but obviously focusing on those companies that offer good value and a consistency in historical earnings growth.

Ways to decide whether stocks have good value and a good historical track record are S&P's STARS (Stock Appreciation Ranking System), which is a fundamentally driven buy, hold, and sell ranking by our more than 70 equity analysts, who cover more than 1,500 stocks, as well as our earnings- and dividend-quality ranks, which offer a grade on the company's ability to grow both earnings and dividends over the past 10 years. (A+ is best, while C is worst.) For STARS, a ranking of 5 is best, while a ranking of 1 is worst.

Q: I want to balance a portfolio -- I see small-caps, mid-caps, international were doing great. Can you advise on the portfolio mix? I'm aggressive and looking for growth.


I cannot offer individually tailored advice. I can simply say that from a broad perspective, our investment policy committee recommends that the average balanced investor have a 45% exposure to domestic equities, a 15% exposure to international equities, a 25% exposure to short-term bonds, and a 15% exposure to cash.

We believe the continued decline in the U.S. dollar makes international investments still attractive. We think that projected growth rates for the mid- and small-cap stocks make many of these still attractive, yet obviously we think that we're in a stock-picker's environment where investors need to select shares very carefully. We currently have more than 100 stocks on our best buy or 5-STAR list, so we obviously think that there are some opportunities out there.

Q: What would be your aggressive growth strategies? Your top three stocks to own?A: Like I said, we don't have different portfolios for different types of investors.... We're primarily a growth-at-the-right-price research operation, and we don't offer individual recommendations. Only a financial adviser who knows your specific investment needs and risk-tolerance capabilities can decide whether you should be aggressively or conservatively positioned.

I can, however, tell you that S&P has a list of stocks from our 5-STAR category that we call our Top 10 Portfolio. These are 10 5-STAR stocks handpicked by our director of global equity research and his team of senior analysts. The Top 10 Portfolio posted a total return of 19.2% in 2004, vs. 10.9% for the S&P 500. The stocks in this list, in no special order, are: Cooper, MNBA, Burlington Northern Santa Fe, Ingersoll-Rand, Amgen, Chattem, Guitar Center, FMC, Qualcomm, and Landstar System.

Q: A follow-up on international. Which Chinese companies are you interested in, if any? Let's settle for ADRs [American depositary receipts] here.


We have only one stock that's an ADR/ADS that carries a 5-STAR ranking. That company is China Mobile Hong Kong (CHL ). On the 4-STAR side, just quickly scanning I find China Petroleum & Chemical (SNP ). Another 4-STAR is Chunghwa Telecom ADS (CHT ).

Q: Your opinion, please, on Juniper Networks (JNPR )?


S&P has a 3-STAR or hold ranking on JNPR shares. The company, which reported earnings of 10 cents per share in 2003, is expected to post earnings of 44 cents in 2004 and 63 cents in 2005. Our analyst believes while demand remains strong for some of Juniper's products, a shift toward higher-speed interfaces will begin to weaken the company's gross margin. Our 12-month price target for these volatile shares remains at $28.

Q: How about the pharmas? Pfizer (PFE ) -- hold, buy, or sell?


Pfizer, along with most of the major pharmaceuticals, is ranked hold. We think that growth in Pfizer's Lipitor and other drugs will help offset the likely significant erosion in Celebrex/Bextra. The company yields 2.8%, and we have a target price of $30. In general, we believe that weak pipelines and litigation overhangs will likely continue to exert pressure on these shares. As a result, we have a neutral investment outlook for the pharmaceutical industry.

Q: Now what about Merck (MRK )?


The MRK shares are also ranked 3-STARS. We see the company posting earnings of $2.62 for 2004, falling to $2.50 in 2005. We upgraded the Merck shares to hold from sell on Dec. 14, citing that despite the potentially significant Vioxx litigation, we believe MRK's strong financials, $14 billion in cash and investments, $6.6 billion in debt, and a projected '05 cash flow of $5 billion to be more than sufficient to fund its $1.52 dividend, which yields 5.2%.

Q: Into a consumer area, thoughts on Chico's FAS (CHS )?


We have a 4-STAR [buy] ranking on Chico's FAS. Fiscal 2004 [ended last January] earnings were $1.14 a share. We expect fiscal year '05 earnings to be $1.56, rising to $2 by fiscal year '06. We remain modestly optimistic on selected high-end retailers, even though some of the specialty apparel retailers saw modest traffic during the most recent holiday season. Chico's was one of the exceptions, and we believe the shares offer above-average price-appreciation potential.

Q: And now to the Net -- how about eBay (EBAY )? Buy, sell, or hold?


We have a 3-STAR ranking on eBay. We see earnings of $1.22 for 2004, rising to $1.59 by the end of 2005. Our neutral stance reflects our valuation concerns, as the eBay shares appear overvalued on both '05 p-e and p-e/projected growth ratios.

Q: United Parcel Service (UPS ) has done well. Is it time to take profits?


The UPS shares still carry a 5-STAR or best-buy ranking. The company is projected to post 2004 earnings of $2.95, rising to $3.40 by the end of 2005. Based on our belief that air freight and logistics demand will remain strong in 2005, we see the potential for p-e expansion of stocks in this industry. Our 12-month target is $107.

Q: What's your take on shorting McDonald's (MCD ) or Tyson Foods (TSN )?


The MCD shares are ranked 4-STARS [buy]. We see the company posting 2004 earnings of $1.91, rising to $1.97 in 2005. At 16 times '05 earnings, we believe the MCD shares are attractively valued, given our view of sales momentum and improving margins.

The TSN shares are ranked 3-STARS [hold]. The company posted fiscal 2004 (ended September) earnings of $1.13. We see fiscal year '05 earnings reaching $1.35. Higher live cattle costs, lower capacity utilization, and decreased international sales continue to hurt the beef segment. However, we believe demand remains strong for pork, and pricing has improved within the chicken and prepared-food segments. Our 12-month price target is $18 for the TSN shares and $33 for the MCD shares.

Q: Our first question on financial stocks -- thoughts on Commerce Bancorp (CBH )?


We have a 5-STAR [best-buy] ranking on the CBH shares. Earnings are likely to come in at $3.24 for 2004, rising to $4 for 2005. Our '05 outlook for 7% to 9% [financial] group earnings growth is based on strong credit quality and improving capital markets. Risks, however, include an uncertain outlook for commercial lending and the yield curve.

Q: How do I see the 5-STAR picks you're talking about?


5-STAR stocks are frequently discussed on BusinessWeek Online and are also made available in our flagship weekly publication, called The Outlook. Investors can subscribe to The Outlook by dialing 1-800-221-5277. They can also check their local library for this and other S&P products.

Edited by Jack Dierdorff

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