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Teen angels
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December 12, 2001: 7:55 p.m. ET
Contrarians can find plenty of stocks that offer above-average long-term returns and P/Es in the teens.
By Michael Sivy
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NEW YORK (CNN/Money) - At this point in the recession, uncertainty about corporate profits is at a maximum -- and lots of stocks are suffering. But for long-term investors, the current market turmoil offers plenty of buying opportunities. If you believe a company's franchise is fundamentally attractive and the price/earnings ratio of its stock is below 20, the odds are that it will perform well over the next decade, even if there are setbacks during the next quarter or two.
That may sound like a wishy-washy approach to investing, but it's based on one of the most important truths about human nature -- people are very bad at gauging what they know and what they don't know. For stocks, that means that investors put too much credence in quarterly earnings projections, overreact to earnings surprises and undervalue long-term earnings potential.
Merck versus P&G
"We are never so happy or so unhappy as we suppose," said the 18th century French writer La Rochefoucauld -- and that goes for stocks as well. As an illustration, consider two stocks -- Merck and Procter & Gamble. I've recommended both this year, and I've been right on P&G and wrong on Merck. But at least I was consistent. I recommended both companies because their long-term earnings potential looked attractive while their share prices appeared undervalued relative to other stocks in the same industry.
Stock analyst recommendations are a lot harder to understand. After Merck announced on Tuesday that 2002 earnings would be flat, its shares fell to a 52-week low -- and a bunch of drug analysts downgraded the stock. By contrast, after P&G announced that earnings for the current quarter would probably beat consensus estimates by two or three cents a share, a number of analysts upgraded the stock. Those upgrades ignore the fact that P&G's share price has already risen more than 40 percent from its April low and is now at a 52-week high of almost $80.
P&G is probably still a good long-term buy. But anyone who likes it here should have liked it $24 lower. The only new information since then is that we now know P&G's turnaround will be underway in 2002 instead of taking until 2003. But did the chance of a delay until 2003 justify passing up the stock when it was only $54? Not in my book.
By the same token, I expect that Merck will have a huge catch-up move sometime in the next few years. There are only a handful of drug giants -- and at any given time, one or two of them is stuck with a lousy product pipeline. Merck, for instance, has three blockbuster drugs going off patent and not a lot to replace them with. But should Merck be so undervalued? Sooner or later, Merck's product pipeline will improve and its stock will be carrying a premium while some other company gets the label of designated loser.
If you look at any group of top-quality stocks, in fact, you won't have much trouble finding companies with above-average long-term growth prospects and P/Es in the teens, based on estimated earnings for the current year. Here are some from the Sivy 100 list:
Companies that are upstream from the troubled airline industry are undervalued from a long-term perspective. It's true that airlines are in a shambles and are canceling orders for new planes, but people aren't going to stop flying. Moreover, as airlines go out of business or merge, the survivors will be able to raise prices. That's bad for consumers looking for cheap flights. But it's good for airline profits -- and ultimately for the businesses that make planes and aircraft components. Boeing, Honeywell and United Technologies all offer long-term growth of more than 13 percent and another point or two of dividend yield. And all three stocks trade at less than 17 times earnings.
There are similar bargains among leading financial stocks. The recession has increased the number of bad loans, which are a drag on earnings. But those problems will abate once the recovery comes and allow top lenders to get back to their core growth rates. MBNA and Washington Mutual both offer growth of at least 13 percent a year, one to three points of dividend yield and P/Es of 17 or less.
Finally, there are individual situations that are attractive. Fortune Brands, for instance, is a collection of top consumer brands -- like Titleist golf balls and Jim Beam bourbon. With a P/E below 17, the stock offers 11 percent core earnings growth and a 2.5 percent yield, all from very stable businesses.
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LONG-TERM BARGAINS
