(Too bad you can't get the pretty pictures that go with this- <ggg>)
Cover Story, Part 2
Cover Story, Part 1
Abby Joseph Cohen
Barron's: The markets are "all shook up," to quote Elvis, since
the Nasdaq hit the skids in early April. Has there been a sea
change among investors, Abby, or is it just a momentary mood
swing?
Cohen: There's been a real change in "attitude," as New
Yorkers refer to it. What we saw in January-and it reached a
climax in the middle of Marchwas exuberance and enthusiasm
carried to very interesting levels. In the third week of March we
adjusted our recommended portfolio, lowering our equity
allocation to 65% from a prior 70%. We consider 65% a
"normal" weighting. Secondly, we concluded technology was
getting more than enough respect, and that the tech and telecom
portion of the portfolio should be underweight relative to the
S&P 500. Technology by itself had quadrupled as a percentage
of the S&P 500, and it wasn't going to quadruple again.
Q: What's next for tech and telecom stocks?
A: Fundamentally, the technology sector is in very good shape.
U.S. companies are still at the leading edge, and we expect to see
enormous penetration into non-U.S. markets. There's a great
deal of good news coming from these companies in terms of
both products and earnings. From a stock standpoint, however,
it's a very mixed bag. There is going to be significant
consolidation within the industry. We're not negative on
technology, not at all. It's still 35% of our model portfolio. But in
the case of many poorer-quality companies, investors had put
too much emphasis on share-price momentum, rather than
earnings momentum and cash-flow generation.
Q: Which stocks will lead the market in this year's second half?
A: Our view is controversial: financial services. Financial stocks
have been pummeled in recent months for a variety of reasons,
chiefly concerns about higher interest rates. These concerns are
largely reflected in the stocks, many of which now trade at very
low price/earnings multiples. Also, there has been renewed focus
on bad lending practices after one regional bank [Wachovia]
recently issued an earnings warning. On average, though,
lendingquality standards have gotten tougher since the autumn of
1998. We also view recent delinquencies and defaults in the
corporate bond market largely as company-specific, not
economy-related events.
Q: Financial services is a
broad category. Which stocks
do you like most?
A:Citigroup and Wells Fargo
are among our favorites. Both
are well managed and have
good long-term growth
prospects. Both also have very
good market share. Citigroup is
one of the largest
financialservices companies in
the U.S., and it's multinational
in scope. The company has become increasingly effective in
crossselling its multiple product lines to a large client base. As a
result, the company has a diverse earnings stream, and results
have been terrific. Return on equity exceeds 20%. Earnings are
growing at a long-term rate of 15%. Yet Citi is trading at a
discount to the market because its group is out of favor. At a
current price of about 64 it sells for 18 times this year's
estimated earnings of $3.60 a share, and 16-17 times next year's
estimate of $3.85.
Q: What's to like about Wells Fargo?
A: Much like Citigroup, the new Wells is the product of an
effective merger. The old Wells Fargo was a leader in online
banking, ATMs and other forms of high-tech distribution. When
you couple that with the full-service nature of Norwest, you
have a superregional with a commanding market share. The
company's got a 16%-17% ROE, and long-term earnings are
growing by 15%, as with Citi. This year Wells will earn around
$2.56, and next year we're expecting $2.90. Also, the bank has a
joint venture with HSBC, which gives it greater reach.
Q: To what degree are investors' rate
fears justified?
A: We think the Federal Reserve will raise rates one more time if
the situation warrants. Most economists agree that we're going to
know a lot more about the state of the economy toward the end
of the summer. If I were a member of the Fed I would certainly
want to wait until I had more data and could pull together the
pieces of the jigsaw puzzle. And if our 2000 earnings forecast is
correct-namely, that there is a notable deceleration in earnings
growth under way-the Fed might decide it doesn't have very
much more to do this summer.
Q: How about one more pick, Abby?
A: Merck, which I mentioned in January, previously was a
well-loved stock that now is plagued by a variety of issues,
including patent expirations and concerns about the changing
health-care landscape. While we recognize some products will be
coming off patent, we also see a lot of strength in some newer
products, such as Fosamax, for osteoporosis; Cozaar, for high
blood pressure, and Singulair, for asthma. Merck continues to
have one of the strongest research programs in the
pharmaceuticals business, which attests to the fact that these are
very innovative and creative people. The company will earn
about $2.80 a share this year, and $3.10 in 2001. Most people
would view Merck and Citigroup as high-quality companies,
although their P/Es are not particularly stellar right now. In an
environment in which the economy is doing okay, but isn't going
gangbusters, these are the kinds of companies you want to look
at.
Q: Thanks a bunch.
Barton Biggs
Barron's: Barton, you were right as rain in January about the
trouble awaiting tech stocks. Is it over?
Biggs: Not entirely. The momentum became so excessive that
the bubble burst in the really speculative parts of Techland,
particularly in the dot.coms. A lot of the damage is permanent.
Of course, out of all this there will be 10 great dot.com
companies that will prove wonderful long-term investments. But
thousands were created and most are going to fail. As for the
rest of Nasdaq, the really good Internet infrastructure and
wireless-telecom stocks got nicked. But they didn't get taken
apart. There still is a very significant institutional bubble in those
areas.
Q: How much longer can it endure?
A: We're going to see the pricking of that bubble later this year,
but just when is impossible to forecast. The Ciscos, the Nokias,
the Nortels are absolutely marvelous companies. But at 80-120
times earnings, their multiples are too marvelous.
Q: How will the rest of the year play out for the U.S. stock
market and economy?
A: The good inflation news we had three weeks ago, and the
indications of a weakening economy that triggered the market's
latest surge, are false signals. By late summer there will be more
signs that inflation is beginning to accelerate, particularly in
wages. Also, the economy, though it has slowed, still will be
growing at a 3%-4% real rate, and that's too fast. So the Fed will
have to take more action and possibly raise rates by another 100
basis points [one percentage point]. The stock market has
discounted a soft landing. It may be that we get one, but we
don't have it yet.
Q: Does the rest of the world
look better from an investment
standpoint?
A: Europe is a couple of years
behind us in the economic
cycle. That means the
European economy is
accelerating from a low base,
rather than decelerating the
way ours is. Also, there are real
signs that the euro is starting to
appreciate against the dollar. So
the European markets are going to have the currency wind at
their back.
At the same time, I continue to feel good about Japan. It's had
its ups and downs, but the Japanese economy looks reasonably
healthy, and earnings have been very strong. In the first quarter
they were up 40% on average. Corporate restructuring and
rationalization continues. Meanwhile, Japanese tech stocks have
been hit much harder than tech stocks elsewhere in the world. If
I were going to buy tech I would buy it in Japan.
Q: When the day of reckoning comes for the blue-chip techs
you mentioned, however, won't Japan's technology stocks get
hammered anew?
A: Sure, a big selloff here will affect Japanese tech stocks, but I
don't know when it's going to happen. Until then, I would expect
Japanese techs, particularly in the wireless and telecom areas, to
outperform Nasdaq.
Q: Have you any specific stock recommendations?
A: The single most attractive group right now is energy. Exxon
Mobil, Royal Dutch and BP Amoco are very good plays for big
money. In the U.S., natural-gas stocks such as Apache,
Anadarko and Burlington Resources also look good.
Q: So you're betting that crude prices will stay high?
A: Oil prices are going to stay where they are, around $30 a
barrel. But the oil stocks have discounted $20 crude. The
earnings surprises are going to be on the upside. The price of
natural gas is going up a lot more. We have a real gas shortage in
this country, so these companies are looking at really big
earnings gains.
Q: Your longstanding REIT recommendation has finally turned
out very well. What's the outlook for REITs now?
A: The stocks still look good, but not as good as they did six
months ago. REITs and utilities remain a haven of value in the
U.S. market, however.
Q: Is value investing, in general, on the cusp of a comeback,
particularly now that so many prominent value investors have
thrown in the towel?
A: Absolutely. I think we're just in the beginning stages of what
will be a major rotation to value from growth in terms of market
leadership. The shift has already begun. That's what the decline
in the Nasdaq and the rise in the Dow are all about.
Q: Care to mention any European or Japanese picks?
A: European drug companies such as Novartis and Roche still
look pretty attractive. We also like some European
financial-services companies such as AXA, the French insurer,
and cyclicals such as UPM-Kymmene, the Finnish paper
company. In Japan I liked Nomura six months ago, and I still
like it. In general, financialservices companies around the world
are going to be good investments.
Q: Thank you, Barton.
Meryl Buchanan
Barron's: You must be enjoying this market, Meryl.
Buchanan: The markets overall are flat to down this year, but
there are many high-quality names out there. I'm talking about
very, very good business franchises trading at very, very low
price/earnings multiples-the sort of P/Es I saw back in 1985 and
'86. It seems a lot of money exited the market when the Nasdaq
corrected, and that created additional opportunity in value
stocks. In the past month or two, though, several stocks we own
have moved up quite a bit.
Q: You're not complaining, are you?
A: No. In other parts of the market I think there's been a big
shakeout. A lot of people have gone back to look for jobs after
unsuccessful attempts at day-trading. Alan Greenspan did what
he wanted to do: pop the Nasdaq bubble and get rid of some of
the wealth effect.
Q: In that case, can the Fed take a breather?
A: Don't ask me, ask Abby. I just look at stocks. I've got three
to talk about, starting with MetLife, the largest life-insurance
company in the U.S., with a 9.3% market share. The stock
came public in early April at 14 1/4 , at the very bottom of the
insurance market. It now trades near 20. MetLife is still very
cheap. It's a very, very good company on its way to becoming a
great company.
Q: Why is that?
A: Approximately half its
business is individual life
insurance. The other half is
institutional. It's the premier
provider of life, dental and
disability insurance to large
U.S. corporations. This is the
business that really attracted us.
It is not aggressively bid out
because it's so expensive for
companies to switch insurance
providers. There are also tremendous barriers to entry.
Q: What do Met's earnings look like?
A: Earnings are growing by 15%-20% a year. Met could earn $2
a share this year and $2.75 in 2002. Book value is around $19.
Having been de-mutualized, the company is transforming its
culture and its financial objectives. It's cutting head count,
redeploying excess capital and implementing incentive
compensation. The management team, led by Robert
Benmosche, is very smart, and its game plan is to achieve an
AIG-like multiple of 20-30 times earnings. If management really
executes, Met could be a $75-$100 stock in five years. Another
money manager told me MetLife reminds him of American
Express back when Harvey Golub took over, and I agree.
Q: What's your second pick?
A: It's a mid-cap -- Edwards LifeSciences. The symbol is EW
and there are 58 million shares outstanding. The stock's trading
around 18 1/2 . Edwards was spun out of Baxter International in
March. Its products and services treat late-stage cardiovascular
disease. Tissue heart valves and valve-repair products account
for 35% of sales but generate 50%-80% of profits. There are
two types of heart valves -- mechanical and tissue, and each has
advantages and disadvantages. Mechanical valves last forever
but require the patient to maintain a lifelong regimen of
hard-toregulate blood-thinning medications. Tissue valves, which
are made of the lining of a cow's heart, begin to fail after 17 or
20 years but the lifestyle advantages are considerable.
Q: Does Edwards dominate the market?
A: The Carpentier-Edwards is the most widely prescribed tissue
heart valve. Sales are growing by 10% a year, and there are
natural drivers to growth. People are living longer and are
healthier in their old age, making them likelier candidates for
open-heart surgery. Also, as the valve's durability record grows,
it becomes appropriate for younger patients. Heart valves can go
in two positions in the heart. The Carpentier-Edwards is
approved for the aortic position, which accounts for about 60%
of all valve replacements. This year the valve should be
approved for the mitral position, which could generate an
upswing in the company's growth curve. Edwards also expects
to get approval from the FDA for a stentless valve, which would
be Edwards' first ever offered in the U.S.
Q: What will Edwards earn this year?
A: The company has $900 million in sales, and will earn about
86 cents a share. But cash earnings are $1.66, reflecting a lot of
goodwill amortization, most of which stems from Baxter's 1985
acquisition of American Hospital Supply. Next year reported
earnings will be about $1.03, and cash EPS about $1.83. If
Edwards trades at 15 times 2001 cash earnings, it will be a $27
stock by yearend.
Q: What's your third recommendation?
A: Furniture Brands International, which is trading at 15 1/2 .
There are 50 million shares outstanding, and $500 million of
debt. Revenues are about $2.2 billion, and we expect the
company to earn $2.30-$2.40 a share this year. The stock is
trading at less than seven times estimated earnings. The
opportunity lies in the misperception that the furniture industry is
highly cyclical. In fact, when you look at wholesale furniture
sales over the past 30 years, there were just three modest
downturns-in '75, '82 and '91. We haven't priced into our
numbers the potential gains from a deal the company has struck
with Home Depot, which is using Furniture Brands' Thomasville
brand in top-of-the-line kitchen cabinets. The company will
collect royalty payments from Home Depot, but won't have to
tie up its own assets in inventory or manufacturing equipment.
Q: Sounds good. Thanks, Meryl.
Scott Black
Barron's: How's the market been treating you, Scott?
Black: We're up by double digits. That said, industrial stocks
continue to languish, despite the occasional rally. Look at a
company like Georgia-Pacific. It sells for $26 a share, the
company's going to earn $5.25-$5.50, and it's got a P/E multiple
of less than six. Nobody cares. I've got a whole list of companies
-- little ones like Esterline, bigger ones like ITT Industries -- with
single-digit P/Es and good, sustainable earnings. We don't own
them because nobody cares.
Q: Why so glum when you're doing so well? Somebody cares,
besides you.
A: I'll say this: The S&P 500 is trading at 23.5 times next year's
expected earnings of $62.50, which isn't bad. Using an
old-fashioned dividend-valuation model, the implicit rate of
return in the market right now is a little over 10%. The
expectations built into the S&P are starting to reflect more
realistic rates of return.
Q: Now, doesn't that make you feel better? Let's talk stocks.
A: My first pick is parochial. It's BTU International, out on
Route 128 in North Billerica, Massachusetts. The shares are
trading around 12, and there are 7.28 million fully diluted shares
outstanding. The company's market value is only $86 million,
but that doesn't matter to Delphi. We buy value wherever we
can find it. BTU is the leader in thermal processing systems. It
dominates the market for soldering on printed circuit boards.
Last year, a turnaround year, the company had revenues of
$70.5 million. It earned $2.8 million, or 41 cents a share, up
from 22 cents in '98. Return on equity was a little over 11%, and
BTU generated $3 million of free cash. Like many Delphi
companies, it has no net debt. This year we project revenues of
$88 million, up 25%, while earnings will rise to 74 cents a share.
Next year we see $106 million in revenues, and $1.01 in
earnings.
Q: What's powering this
growth?
A: BTU supplies the contract
manufacturers. As more and
more of the assembly and
layering of circuit boards gets
outsourced, demand for
equipment spills over to
companies like this. Essentially
BTU is in the right space at the
right time.
My second stock is a
medium-sized retailer, Ross Stores. The company, which is
based in Newark, California, is doing extremely well, but the
stock has been annihilated.
Q: You mean it's in the right space at the wrong time.
A: Last year the company generated $89 million in free cash and
earned a 33.4% return on equity. It posted $1.70 a share, or
roughly $150 million, net after-tax, on $2.5 billion in sales. Ross
is a regional off-price chain that had 378 stores at the beginning
of this year. Operations in four states -- California, Texas,
Florida and Arizona -- account for 75% of sales. Historically the
company has grown its square footage by 8%-9% a year. This
year it will add 30 stores, and next year 35-40. A new store is
break-even on a cash-flow basis within 18 months.
Q: How has Ross survived in an industry littered with corpses?
A: The key is smart buyers and a good markdown policy. They
don't stand on ceremony if merchandise doesn't move. They just
lower the price. Over the past five years revenues have
compounded by just under 15% annually, and net after-tax
earnings have jumped about 37% annually. And the company
keeps buying back shares. This fiscal year they'll earn $2.07 a
share, and in the year ending January 2002 we're looking for
$2.38. A company earning 30% on book that generates over
$100 million a year in free cash flow and has absolutely no debt
ought to be worth more than six or seven times earnings. It's
ludicrous.
Q: Can you give us another name?
A: Comcast has also been killed. It's trading at 36, down from
57. As a result of several recent and pending deals, there are
roughly a billion fully diluted shares outstanding. Comcast not
only offers cable distribution but it has tons of programming
assets and a big stock portfolio.
First let's review the balance sheet. As of March 31, it included
$751 million in cash and equivalents and about $12 billion in
marked-to-market investments. These encompass stakes in
Excite@Home and SprintPCS and a put to AT&T, as well as
investments in several cable channels, a sports arena, the
Philadephia Flyers and the 76ers. Although Comcast has $10.8
billion in long-term debt, net debt essentially is zero. On the
operating side we're looking for $2.63 billion in EBITDA in
2001. The stock is selling for roughly 12 times next year's
EBITDA, and we think it's pretty cheap.
Q: Thanks, Scott.
Felix Zulauf
Barron's: What's the good word from Zug?
Zulauf: I see a slowdown coming in the U.S. and in Europe.
Europe has been very robust for the past two years, and we
might hit 4% growth at the peak. But the leading economic
indicators for virtually all European countries have turned down.
The rise in oil and gas prices is biting into consumers' pockets
and retail sales recently have been sluggish. What we're really
seeing is a global slowdown that's probably most pronounced in
the U.S.
Q: Are you also negative on Japan?
A: The Japanese recovery has consisted of some capital
spending by the corporate sector, some government spending
and an inventory swing. The consumer is not participating.
There could be a positive swing to all of this in coming months,
because the monetary framework might become a bit more
friendly, allowing markets to rally. But the rallies will be very
selective and difficult to play-more of a trading affair. This could
be good for bonds, too, but I'm not looking for a big decline in
long yields. Ten-year Treasuries could move within a range of
6.25%-5.25%, or something like that.
Q: How do you invest in this environment?
A: The frustrating thing, and we have learned it the hard way, is
that finding good companies with solid earnings growth at
reasonable prices has not worked. The professional
money-management industry is growing so quickly that
everybody is benchmarking more. Therefore it does not pay to
be original or creative. It pays to follow the weightings in the
indexes and buy the companies that are doing well.
Q: That was last year's story.
A: I do not believe there will be
many sustainable moves in the
second half of this year. I |
