What Stock Boom, You Ask?
By James K. Glassman
Sunday, March 21, 1999; Page H01
"My clients just don't get it!" a broker friend of mine was grousing the other
day, reflecting the frustration of many of his colleagues.
"They hear about the market being way up, but their stocks aren't. They
want to know what's going on. But the truth is, only a piece of the market
is way up."
He's right. A remarkable study by Salomon Smith Barney Inc. found that,
over the past 12 months, three-quarters of all U.S. stocks were trailing the
Standard & Poor's 500-stock index by at least 15 percentage points. In
other words, if your own portfolio is up just 10 percent in the past year,
you have done better than the vast majority of investors.
Of course, that's little solace for my broker friend, whose clients have
watched America Online Inc. (symbol: AOL) soar in a year from $15.13
to $119.25. The Nasdaq 100 index, which is dominated by large-cap
high-tech companies such as Microsoft Corp. (MSFT), is up an incredible
76 percent in the past 12 months.
The S&P 500, the benchmark for most money managers, is also heavily
weighted toward the large-cap growth stocks that are now so much in
favor. Last year, as a result, it returned twice as much as the average
mutual fund.
This year, the trend is continuing. Wiesenberger, the Rockville-based
research firm, found that, while the S&P had produced positive returns for
the first two months of the year, the average mutual fund was in negative
territory. Only 605 of the 2,374 diversified U.S. equity funds had beaten
the index.
Part of the problem is poor management, but most of the problem is the
divergence that my broker pal was complaining about. High-visibility
stocks--and indexes--are doing great, but the stocks that most people
actually own aren't.
While I sympathize with the brokers, advisers and fund managers, they are
paid well to handle criticism. I worry much more about the clients--the
small investors who are now sorely tempted to "abandon diversification
and target their portfolios toward an ever narrowing slice of the equity
market," as Jeffrey Warantz and John Manley put it in a recent report for
Salomon Smith Barney. "This course of action is imprudent, and clearly
dangerous."
In other words, it's fine to own tasty Internet and telecommunications
stocks, but consume them in moderation. To lead a healthy investing life,
you need a balanced diet.
A portfolio that is loaded with hot stocks from only one or two sectors is a
portfolio that will have wild volatility over the long term--both up and
down. In the meantime, if you're a typical investor, you won't be able to
handle the risk. You will undoubtedly bail out when the going gets
tough--just when you should be buying.
But won't those hot sectors do better than the market as a whole? No one
knows. You might make a lucky guess, but then again, maybe not. The
best stocks to buy for the long term are the best businesses, not the hottest
industries. As Warren Buffett, the most successful investor of our time, has
written, "The market may ignore business success for a while, but
eventually will confirm it."
Buffett's mentor, the late Benjamin Graham, put it this way: "In the short
run, the market is a voting machine, but in the long run it is a weighing
machine."
The votes these days are going to large-caps--or, more precisely, to
mega-caps. Timothy Dalton Jr., chairman of Dalton, Greiner, Hartman,
Maher & Co., a firm specializing in small-caps, points out that the average
price-to-earnings (P/E) ratio of the 50 largest U.S. stocks (by market cap)
is 10 points above the average P/E of the next 1,450 stocks. That spread,
he writes, "has never been higher."
Dalton adds: "There is no question that Microsoft, Intel, Dell, Cisco, Pfizer
and the like are great companies. . . . However, the odds of companies
remaining true growth stocks for more than five years are very low, and
beyond 10 years it seldom happens. Perhaps the current group of
large-cap growth stocks are exceptions. We'll see."
The most stunning statistics come from what Salomon Smith Barney calls
its Laggards Indicator, concocted by the firm to show the percentage of
stocks that have trailed the S&P by a wide margin.
On March 9, the indicator, which was established in 1971, hit an all-time
high. "In simple terms," wrote Warantz and Manley, "although the S&P
rose 21.6 percent over this 12-month period, more than three out of four
stocks in the U.S. common equity universe had a price performance of 3.4
percent or lower."
Eventually, this kind of wild divergence has to end. But what if something
fundamental has changed? One argument in favor of large-caps is that, in a
global economy with lots of capacity, companies that have dominant
market shares also have more power to raise prices--and thus profits.
Another is that strong brands, recognized worldwide, have a big edge.
Also, contrary to what you might think, large companies seem more
flexible than small. They have more products in development, so if one
fails, they can get another to market--wherever the market might be.
But at this point, betting exclusively on mega-caps is taking a big risk. The
smart play, always, is sensible diversification. Warantz and Manley suggest
broadening your portfolio, not by loading up on mid-caps and small-caps,
but by owning large-caps that are out of favor.
They started by asking their computer to find stocks in the S&P 500 with a
market cap greater than $5 billion that were down more than 10 percent
from their 12-month peaks and that were not in one of the four
top-performing sectors (communications equipment and services,
technology, consumer cyclicals, and health care).
Only 34 of the 500 stocks passed those screens. Then they selected only
stocks that were at least 20 percent below their average long-term P/E and
price-to-sales ratios. That left just 10 stocks--from six different sectors.
They were:
* Alcoa Inc. (AA), the aluminum company. With an excellent record for
growth (the dividend payout has doubled in the past five years), the
company's stock trades at a modest P/E of 15--or about half the average
for the S&P--based on projected earnings for this year.
* Haliburton Co. (HAL), a diversified company with interests in energy
services, engineering, maintenance and construction. Hurt by falling oil
prices, the stock has bounced back 27 percent this year, but it's still off
more than one-third from its 1998 high.
* Honeywell Inc. (HON), which manufactures automation systems such as
thermostats and aircraft guidance controls. Earnings, says Bloomberg
News, are increasing at a rate of 13 percent a year, but the P/E is only 15.
The share price is down by about one-fourth since last May.
* PPG Industries Inc. (PPG), which makes glass products used in
construction and automobiles. The stock, with a yield of 3 percent and a
P/E of 11 (despite long-term earnings growth of 10 percent annually), has
tumbled by more than one-third since last May.
* Philip Morris Cos. Inc. (MO), maker of cigarettes (Marlboro), beer
(Miller), coffee (Maxwell House) and dairy products (Kraft). Tobacco, of
course, raises financial, legal and moral questions, and the stock has
plummeted 28 percent since the start of the year. But the company,
growing at 14 percent annually and carrying a dividend yield of 4.6
percent, trades at a P/E (based on year-ahead estimates) of just 12.
* RJR Nabisco Holdings Corp. (RN), another cigarette and consumer
products company. RJR has announced a spinoff of its tobacco business,
and the future is unclear. Still, this may be an interesting buying opportunity.
The stock carries a dividend yield of 6.8 percent, and that payout has been
growing 9 percent annually. The stock, while near its high, trades at a P/E
of just 14.
* Raytheon Co. (RTN/B), maker of electronics, especially for air-defense
missiles and radar systems. The stock has lost 7 percent over the past 12
months and now trades at a P/E (based on 1999 estimated earnings) of
15, even though historic growth has been in double digits.
* Rohm & Haas Co. (ROH), manufacturer of specialty chemicals used in
everything from laundry detergents to cellular phones. The stock pays a
2.2 percent dividend, which, like RJR's, has been growing at a nice clip. It
carries a P/E of 13.
* SLM Holding Corp. (SLM), better known as Sallie Mae, a provider of
financing for students in private schools and universities. Earnings are rising
at 14 percent annually, but the stock's P/E is only 14.
* Schlumberger Ltd. (SLB), provider of services to the oil and gas
industries. A fast grower with a market cap of $33 billion, the firm has
been hurt by the fall in energy prices. Its stock fell by more than half
between May and November, has since bounced back but is still 30
percent below its peak.
Despite all the talk about this market being "overbought," stocks like these
abound: large-cap growth companies that are being ignored by the market.
No, you don't have to be a flaming contrarian to take advantage of today's
unprecedented divergence.
Glassman's e-mail address is jkglassman@aol.com; he welcomes
comments but cannot answer all queries.
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