Barrons article - betting on the bull
Still Betting on the Bull
By ANDREW BARY
THE GLOBAL STOCK-MARKET SELLOFF that stunned investors Tuesday looks more like a passing squall than a full-throttle hurricane.
The swift fall fittingly began in China, now the engine of economic growth worldwide, and quickly spread to the U.S., where the major market indexes lost 3% to 4% in a single session. A decline of that magnitude, the worst in four years, understandably inspired fear that the current bull market, which began in October 2002, has come to its untimely end.
Such concerns seem premature, however, because the global economy still looks healthy, equity-market valuations are reasonable in most major markets and the demand for stocks from corporations and private-equity firms remains robust. Barron's ran a bullish cover story last summer, near the market's 2006 bottom ("Time to Buy," July 24, 2006), and we're not throwing in the towel yet.
"It was a long-overdue correction," says Byron Wien, chief investment strategist at Pequot Capital. "The markets had gone 990 trading days without a 3% decline, and people were too complacent."
Before Tuesday, every major stock market in the world -- and nearly all the smaller markets -- were near 52-week highs. Most markets also were near record levels, with the notable exceptions of the Nasdaq Composite and Standard & Poor's 500, a reflection of the absurd valuations they had reached in the tech boom of 2000.
On the full week, the major U.S. indexes had their worst loss since 2003. The Dow plummeted 533 points, or 4.2%, to 12,114; the S&P fell 4.4%, to 1387, and the Nasdaq Composite gave up 5.8%, to 2368.
There was no place to hide last week, save for the U.S. Treasury-bond market, which rallied on expectations of a weakening economy and lower short-term rates. Not so global equity markets, which have become increasingly linked. The S&P 500 has a higher correlation than ever before with major overseas stock markets, including emerging markets, according to Morgan Stanley investment strategist Henry McVey, who speaks of a "Market of One." Even gold, which historically moved inversely to stocks, dropped 5.9% last week to $642 an ounce.
A bullish Wien thinks the S&P 500 could hit 1,600 by year end, a 15% gain. He says U.S. stocks look attractive with the S&P valued at 15 times projected 2007 operating earnings. The Dow Jones Industrial Average trades at 14.4 times estimated "07 profits. Both the Dow and the S&P 500 are in negative territory for the year, with the industrials off 2.8% and the S&P 500 down 2.2%. The so-called earnings yield on both the S&P 500 and the Dow is close to 7%, which compares favorably with the 4.5% yield on 10-year Treasuries. The earnings yield is the inverse of the market's price-earnings ratio.
Companies continue to lift dividends and repurchase record amounts of stock in order to reward shareholders -- and stay out of the sights of private-equity shops on the prowl for new leveraged buyouts.
One notable investor who seems to see opportunity among blue-chips is Warren Buffett. His annual letter to shareholders of Berkshire Hathaway (ticker: BRKA), released last week, made no direct mention of the overall market. But, based on data in his annual report, Buffett was actively buying stocks for Berkshire last year. Berkshire was a net buyer of more than $5 billion of stocks in 2006, building new positions in Johnson & Johnson (JNJ), ConocoPhilips (COP) and U.S. Bancorp (USB). Berkshire has invested about $1 billion in each stock.
HISTORY SUGGESTS THAT STOCKS MAY DO WELL in the next two months. There have been 38 days since 1979 when the S&P 500 has suffered a single-session loss of 3% or more. The average gain in the ensuing 60 days has been 6.9%, with the index rising in 31 of the 38 cases, according to Citigroup research.
Outside the U.S., stock-market valuations still look attractive in Europe despite the past year's rally. The DJ Euro Stoxx 50, made up of the top 50 companies in Europe, trades for 12 times 2007 earnings, while the U.K.'s benchmark FT-SE index commands 11.6 times earnings, according to Bloom-berg. Valuations are higher in Asia.
The selloff probably has excited private-equity firms like Blackstone Group, Bain Capital and Kohlberg Kravis Roberts, which are sitting on record levels of cash. In a recent report, Credit Suisse strategist Andrew Garthwaite estimated there is $250 billion to $280 billion of uninvested private-equity money, which could support $1.3 trillion of leveraged buyouts. With private-equity firms continuing to raise new money, their investment firepower will only grow.
THE CRITICAL INGREDIENT FOR LBOS IS continued access to low-cost financing. That has been available in copious quantities in the past year, and there are no signs that credit is getting much tighter. Just last week, the private-equity firms that plan to buy Univision Communications (UVN), the Spanish-language broadcaster, completed financing for their deal. The final piece, a $1.5 billion junk-bond deal, was sold at 9.75%, about a quarter of a percentage point higher than expected. Yet investors' willingness to finance the deal shows that credit remains plentiful. As a private company, Univision will carry debt of $10 billion. Its annual interest costs may be about equal to its annual cash flow, giving the company little financial breathing room.
THE MAIN RISKS TO THE STOCK MARKET ARE a decelerating economy, diminished earnings growth and potential geopolitical disruptions. The U.S. economy may be set to weaken, hurt by the fallout in the $1 trillion subprime mortgage sector. Fourth-quarter economic growth was revised down to a 2.2% rate from the previously reported 3.5%. More important, 2007 growth may fall from the 3%-plus pace of last year. Merrill Lynch economist David Rosenberg wrote in a client note Friday that he sees 2007 growth of just 2.2%, below the 2.7% consensus estimate. The good news from any economic slowdown likely would be easier monetary policy. Rosenberg sees the key federal-funds rate ending 2007 at 4%, versus the 4.75% now discounted in financial-futures markets. The rate is now at 5.25%.
Where Things Stand Now: Eleven major U.S. stock-market indexes hit record highs in February. Combined with big gains abroad, this led some investors to view equities as overheated…
A FED RATE CUT MAY PROVIDE A NEEDED lift to stocks, particularly financials, which fell more than 4% last week. Investors are worried about the mortgage exposure of both banks and brokerage stocks. Shares of the major securities firms -- Merrill Lynch (MER), Morgan Stanley (MS), Lehman Brothers (LEH), Goldman Sachs (GS) and Bear Stearns (BSC) -- are down more than 10% from their February highs. All these companies pride themselves on their ability to manage risk, so it will be revealing to see how well they've handled the subprime mortgage rout.
Even before the latest mortgage troubles, analysts were reducing their estimates of corporate profit growth. The current quarter looks as though it will be the first since the second three months of 2003 in which S&P operating profits will grow less than 10%.
Earnings are seen rising just 3.9%, and 4.4% in the second quarter, compared with 12.5% in the fourth quarter of 2006. Full-year earnings for 2007 are expected to rise 6.4%, to about $92 for S&P 500 companies, versus 16.4% last year. At the start of "07, analysts estimated that S&P 500 profits would climb 9%. Energy-sector profits may be down this year, reflecting lower oil prices, while financial earnings may rise only 5%, versus 25% in 2006.
…and their worries were further fueled by expectations that growth in operating earnings is slowing for several key stock-market sectors…
Where does value lie? Investors have a choice. They can play the economically sensitive industrial, energy and materials sectors, where many stocks are available for about 10 times earnings. Or they can buy blue-chips for 15 to 20 times profits. Another alternative is financials, now valued at 10 to 15 times estimated 2007 profits.
Tom McManus, the equity strategist at Banc of America Securities, favors "high quality, large-capitalization stocks with diversified, defensive earnings streams." He notes the price-earnings multiple of the market's largest stocks, the top 150 companies in the broad S&P 1,500 index, is much lower than the P/E of the smallest 150 companies.
One place to hunt for value is the top 12 U.S.-listed stocks ranked by market value. Half the top 12 -- ExxonMobil (XOM), Citigroup (C), Bank of America (BAC), Pfizer (PFE) and American International Group (AIG) -- trade for just 12 times earnings or less. The richest stock among the dozen, Procter & Gamble (PG), fetches 19 times earnings.
Citigroup and Bank of America have among the lowest P/Es in the banking sector, carry yields of 4% and have lagged behind their peers in the past year. The heat is on Citi CEO Chuck Prince. If the company continues to disappoint the Street, Prince could be gone, perhaps by year end, and the company could be broken up. Both developments likely would boost the stock.
…However, most large U.S. corporations sport relatively modest valuations -- the biggest companies by stock-market value are shown in the table below -- as do many key markets around the world. Two notable exceptions: China, a young market where the supply of shares hasn't kept up with the demand from buyers, many of them investing novices, and Japan, which historically has had high price-earnings ratios.
AIG arguably has the world's best insurance franchise, including a valuable overseas life-insurance operation and an attractive aircraft-leasing business. A poor performer in recent years, it got a lift Friday from a solid fourth-quarter earnings report, rising 2.13 to 69.54. AIG's P/E based on "07 earnings is below 11. Similarly, it's hard to believe Pfizer, the darling of the drug industry just a few years ago, now trades for 11 times estimates -- the lowest P/E in the group. It carries a bond-like 4.6% dividend yield.
Procter & Gamble got a plug last week from Morgan Stanley analyst Bill Pecoriello, who told clients the stock could rise from the current 63 to 78 in the next year. Pecoriello even had a kind word for Coca-Cola (KO), which has struggled since the 1990s. Coke, at 46, is no higher than it was a decade ago and now trades for about 18 times projected 2007 earnings.
Perhaps the ultimate defensive stock is Buffett's Berkshire Hathaway, which last week reported record annual operating earnings of $9 billion for 2006. The Class A shares, now around $107,000, carry a huge absolute price, but are reasonable, relative to book value and earnings. Berkshire trades for 1.5 times its year-end 2006 book value and 18 times 2006 earnings. Backed by the company's fortress-like balance sheet, Buffett is poised to pounce on investment opportunities should the markets tank.
That's the right strategy in a market rout. But we've got a hunch he won't get the chance to spend down his billions any time soon.
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