4th FWIW (my last cause I want to watch the rest of the game)
June 15, 1998
Investors Move Into a Defensive Crouch
By ANDREW BARY
Vital Signs
For much of last week, the stock market looked like a battered prize fighter
hunched into a defense crouch to protect against repeated blows. The scent
of fear was unmistakable as investors fled into the bond market in search of
safety, driving long-term interest rates on Thursday to their lowest levels since
the late 1960s. The bad news just kept coming all week long, as Japan
announced it was officially in a recession, the dollar soared to an eight-year
high against the yen and stock markets tumbled all across Asia.
In spite of a late-afternoon rally on Friday, the Dow Jones Industrial Average
suffered its third-worst week of the year, dropping 203 points, or 2.2%, to
end the week at 8834. At one point on Friday, the Dow hit a low of 8680,
moving below the low end of the 8800-to-9200 trading range that has
prevailed since late March.
Even the market's winners last week were a defensive lot. Advancing groups
included utility and drug stocks, which are regarded as a safe harbor in times
of trouble. Oil stocks had a rocky week, but they did lead the rally during
Friday's late-day rebound. This can be seen as yet another sign of investors
looking for refuge. Big oil companies have healthy balance sheets and pay rich
dividends, averaging more than 3%. Later in the column, we'll turn to the oil
stocks that look best for picking about now.
With investors seeking the comfort of well-known names, the blue chips in the
Dow and S&P 500 continued to fare better than small- and mid-cap stocks.
Thus, the Russell 2000, an important small-cap index, dropped 13 points to
441 on the week, a decline of nearly 3%. That leaves the Russell more than
10% below its April peak and ahead just 1% so far in 1998. The Dow, by
comparison, is up 11.7% and the S&P 500, 13.2%. On Friday, the Dow and
S&P ended with modest gains as the Russell and the technology-laden
Nasdaq finished lower. Big Board losers beat winners by a margin of 19 to
11.
Many pros figured that after four disappointing years this would finally be the
year that small-cap stocks outperformed their bigger brethren. But the gap
between the big boys and small fry keeps getting wider. Claudia Mott, the
small-cap strategist at Prudential Securities, calculates that by most measures,
including price-to-earnings multiples and price-to-book ratios, the Russell
2000 is cheaper now relative to the S&P than at any time in the past 20
years. The prior low occurred at the market trough in 1990, after a period in
which small stocks got pummeled.
One unusual, and some would say significant, development last week was that
stocks drew little support from the rally in bonds. The 30-year Treasury
gained two points, dropping its yield to 5.66%. Some observers, notably
Barton Biggs, Morgan Stanley's global strategist, see this trend continuing as
stocks and bonds "delink." Biggs is betting that the generation-old "umbilical
cord" between the two markets will break and that bonds will continue to rally
even as stocks continue their slide.
"I postulate that the
principal worries of
investors may be
about to become
fear of recession and
concern that there is
no pricing power --
in fact, deflation,"
Biggs wrote last
week. In a world of
potential deflation,
good news for bonds
will no longer be
good news for
stocks because
deflation will put
corporate earnings
under added
pressure.
Not everyone buys
Biggs' argument,
including his
colleague, Morgan
Stanley's domestic
strategist Byron
Wien, who says
"stocks and bonds
are still linked." Wien
is more upbeat on
the stock market
because the
combination of lower
rates and lower
stock prices has
made stocks more
attractive, based on
his mathematical
model. "When the
Dow was at 9200,
stocks were 20%
overvalued based on
my model. So I
didn't think the
market had much
upside. But now, the
market is less than
10% overvalued."
Wien's model
suggests an
equilibrium level for the S&P 500 of about 1020, 7% below current levels.
Wien says stocks could rally in the next few weeks, but he sees trouble later
this year.
As investors continued to rotate out of economically sensitive stocks, Morgan
Stanley's index of cyclical stocks fell 4.5% last week, while the firm's index of
consumer stocks was off just 1%. In the Dow, Merck was the biggest
percentage gainer, followed by Johnson & Johnson, Wal-Mart, General
Electric and Disney. The biggest losers in the index were Caterpillar,
Minnesota Mining & Manufacturing, General Motors and DuPont, all
industrial companies.
Retailers are a traditionally cyclical group but they've benefited from strong
consumer spending and an investor preference for domestic plays. In fact,
retailers are the top-performing group in the S&P this year, with an advance
of 50%. The new-highs lists on the New York Stock Exchange has been
pretty skimpy lately but it has included a host of retailing issues like
Dayton-Hudson, Wal-Mart, Gap, J.C. Penney and Walgreen. Somewhat
surprisingly, financial stocks are drawing little benefit from lower rates, which
has raised some concern about the sector among investors.
Oil stocks haven't been great investments this year, given the big drop in
crude prices and sharp decline in company earnings.
Yet the stocks could be near a bottom, argues Fred Leuffer, an oil analyst at
Bear Stearns who has been bearish on them in the past year. "I'm not saying
to drop everything and buy the oils, but I do think the risk-reward is looking
better."
Leuffer points out that the integrated oils are on pace to trail the S&P 500 for
the third straight quarter. Historically, they've rarely lagged for four quarters in
a row, suggesting they could be due for outperformance in the third quarter.
He says the high dividend yields in the group should offer solid support for the
stocks. So far in 1998, the integrated oils are up an average of 7%, but
without Exxon, which has risen 12%, the group's gain is only 4%.
Leuffer recently upgraded long-time underperformers Amoco, Atlantic
Richfield, and Unocal to "attractive" from "neutral." (Attractive is a notch
below Bear Stearns' top rating of "buy.") He also has attractive ratings on
Royal Dutch Petroleum and Philips Petroleum.
The oil stocks fell an average of 4% last week as crude plunged over $2 a
barrel to $12.70 amid waning hopes for an agreement among key producers
to cut production. The stocks did rally 1.5% on Friday. This could be bullish
for oil prices because the stocks often lead the commodity.
Amoco was off 1 1/2 to 41 11/16 during the five sessions; Mobil fell 2 1/8 to
76 9/16; Exxon declined 2 1/2 to 69 5/16, and Arco dropped 2 1/4 to 78
13/16. "You basically have to write off this year's earnings and look to 1999,"
Leuffer says. He doubts oil will hit $20 any time soon, but believes that $17
or $18 isn't out of the question by autumn.
Second-quarter profits, to be reported in a month, won't be pretty. Suffering
from weak crude prices, narrower refining margins, lower chemical prices and
soft natural-gas prices, oil-company profits could be down 20% or more from
year-ago levels.
But in a yield-parched market, the oils are a virtual oasis. Amoco and Arco
yield 3.6%, while Chevron, Mobil and Texaco are around 3%. The stocks
are trading at an average of 21 times projected 1998 earnings, a slight
discount to the market.
Amoco has a rock-solid balance sheet and boasts a strong record reserve
replacement in the past two years. "Amoco has the cheapest valuation among
the majors based on projected 1999 cash flow," Leuffer says.
Arco, he argues, "has turned around its production profile," and isn't living off
declining reserves in Alaska's North Slope. Arco's Alaskan production
actually is expected to rise in the next few years, enabling the company's oil
and gas output to grow by 5%. The company also boasts a well-run refining
and marketing operations on the West Coast, Leuffer says.
Titanic is shaping up as the most profitable movie in history, but its
phenomenal success hasn't done a lot for the shares of News Corp., whose
Fox studio may earn $350 million from the blockbuster film.
News Corp.'s American depository shares stand at 25 11/16, down from a
high of almost 30 in late April. The stock did rise 1 13/16 last week, but it
isn't much higher than it was in 1993.
"News Corp. is quite attractive here," says Matthew Harrigan, an analyst at
J.P. Morgan, whose bullish views on News Corp. originally appeared in this
space in September. Harrigan says there's opportunity now because the
weakness in News Corp. appears related to losses in the Australian stock
market, itself a victim of Asia's malaise. As the largest company based in
Australia, News Corp. is hostage to the country's stock market even though
about 60% of its revenues come from the U.S.
Harrigan estimated that News Corp. now trades at about 8.5 times projected
1998 cash flow, versus a multiple of 11-13 for such U.S. media companies as
Time Warner, Disney and Viacom.
"This company has ended a multi-decade acquisition binge," asserts Ed
Petner, president of Lynch & Mayer, a New York money manager. "They've
concluded that they don't need to fill in any more holes in their global media
empire and that they're going to focus on growing cash flow, selling off the
least compelling assets and improving their balance sheet."
News Corp. has long traded at a discount to its media peers because of the
"Rupert" factor. Many investors have viewed Rupert Murdoch, News Corp.'s
chairman and controlling shareholder, as an undisciplined empire builder with
little interest in boosting the company's lagging stock price.
But a new Murdoch may be emerging. Just last week, News Corp. reached a
deal to sell its TV Guide and some other properties to a company controlled
by cable giant Tele-Communications for $2 billion in cash and stock.
Murdoch's only major U.S. acquisition this year has been the purchase of the
Los Angeles Dodgers for a reported $325 million.
"The TV Guide sale could be the start of a multi-step process to highlight the
value in this company," Petner says. "Murdoch is frustrated with the stock
price."
Petner maintains News Corp. is the most attractive global media play and that
the stock could hit 35 or 40 within two years. News Corp.'s market value is
about $23 billion and it has a relatively modest $6 billion in net debt.
News Corp. controls an enviable stable of properties, including the Fox
studio and network, a group of TV stations and one of the largest newspaper
publishing operations in the world.
An even cheaper way to play News Corp. than its regular ADRs are its
nonvoting preference shares, which trade at 22 1/16, a 3 5/8 -point discount
to the voting stock. Many investors see little point in paying up for voting
stock in a company controlled by Murdoch.
Norwest's $31 billion merger deal with Wells Fargo last week managed to
anger shareholders of both companies.
The stocks of both companies declined, despite all the Wall Street talk of
"synergies" and "cross-selling" opportunities, because many investors
concluded the deal didn't make much sense.
The negative reaction shows that the latest trend in banking, so-called mergers
of equals, is proving a tough sell with investors. Other such deals that have
gotten a lukewarm response are BankAmerica's merger with NationsBank
and Banc One's link-up with First Chicago NBD. Wells Fargo holders will
control about 52.5% of the new bank.
"Merge first, strategize later," is how Carol Levinson, editor of the Gimme
Credit newsletter, sums up the transaction. "The lesson appears to be that
anybody can come up with a rationale for merging with anybody else, despite
the absence of a compelling strategy or financial basis for the deal."
Norwest's offer of 10 of its shares was initially valued at about $397, a
relatively modest 9.5% premium above Wells Fargo's closing price prior to
the announcement Monday. But Norwest's stock promptly dropped three
points on the news and ended the week at 35 1/16, down 4 5/8 . Wells
Fargo shares, which peaked at 390 in May on hopes of a merger with U.S.
Bancorp, fell 14 points to 349 3/16.
Norwest and Wells Fargo couldn't be more different institutions.
Minneapolis-based Norwest is a mix of banking, consumer finance and
mortgage lending. Under its well-regarded chief executive, Richard
Kovacevich, it has shunned big acquisitions as dilutive, focused on creating a
"branded" financial-services company, avoided stock buybacks, employed
conservative accounting and maintained a decentralized structure.
San Francisco's Wells Fargo, run by a bunch of financial types led by Chief
Executive Paul Hazen, has pursued big acquisitions, notably its ill-fated
purchase of First Interstate, aggressively repurchased stock, and used such
liberal accounting as goodwill amortization and cash earnings.
"Both groups of shareholders feel betrayed," says one institutional holder of
Wells Fargo. The Wells Fargo investors figured that the bank, being the last
big independent bank left in California, could fetch a premium price of $450 a
share, or about 21 times projected 1999 cash earnings. "If Wells was the only
game left in California, why'd they sell now, at this price, to Norwest?" this
investor wonders. "Why didn't they wait a year? There was no rush to do a
deal."
Norwest holders were displeased because the bank's complexion has
suddenly changed. "Norwest carried a premium multiple because it was
perceived as a fast-growing financial-services company, not just a bank," the
same investor continues.
Investors are dubious whether the new bank can maintain Norwest's
low-teens profit growth rate after the merger. Moreover, there's concern that
Norwest will bungle the job of integrating the two institutions because it has
no experience with such a large deal.
One of the ironies of the deal is that Wells Fargo is Warren Buffett's favorite
bank. Berkshire Hathaway, controlled by Buffett, owns about 7% of Wells
Fargo stock. Buffett liked Wells because he viewed its management as
shrewd businessmen, not ordinary bankers. The Norwest/Wells combination
may prove to be a winner, like many deals involving Buffett-owned
companies, but so far it's getting a poor reception.
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