NEW YORK (MONEY Magazine) -
It's a basic principle of investing that share prices reflect all the information known about a company at any given moment. This efficient market theory, as it's called, is valid up to a point, but it ignores the fact that the stock market periodically goes spinning out of control.
Once or twice a decade, market forces that normally remain in balance begin reinforcing each other instead, creating a sort of chain reaction. When this occurs, a conventional bull market can turn into a wild bubble, like the tech boom of the late 1990s. And a standard recession-induced decline can degenerate into a power dive.
The current downturn is a perfect case in point. This bear market has been unusually severe because it not only reflects the recent recession, it's also reversing all the overvaluation of the late-1990s boom. In addition, concerns about the ballooning federal deficit, fears of terrorism and crooked accounting make the market more unstable. Even so, extreme market trends rarely last longer than two or three years, and normal prices invariably reassert themselves.
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The strategy of buying stocks when they are most out of favor -- straw hats in winter, as the old saying goes -- is known as contrarianism. But because extreme market swings by definition overshoot all the usual valuation benchmarks, there's no telling exactly when the current bear market will hit bottom and begin to rebound. So it makes sense to take a cautious approach to bargain hunting.
The most basic contrarian gambit is to buy the shares of companies with well-known problems. That amounts to betting that the stocks' price declines have been much worse than their problems justify. On that basis, some analysts believe that both the computer storage company EMC (EMC: Research, Estimates), recently below $7 a share, down from a peak of nearly $105, and network-equipment maker JDS Uniphase (JDSU: Research, Estimates), below $3, down from $150, are worthwhile long-term buys.
Preying on fear
A slightly more sophisticated form of contrarian investing involves selecting stocks battered as much by fears of unspecified problems as by known difficulties.
One good example is AOL Time Warner (AOL: Research, Estimates), the parent company of CNN/Money. The company's drastically reduced growth prospects and concerns about its accounting practices justify a price considerably below the $60 level of two years ago. But the stock is now selling around $10, less than the value of the company's assets, because investors worry that AOL may have even more serious problems that they don't know about. Assuming that no catastrophic surprises emerge, the stock price is due for a rebound.
The most popular form of contrarianism today focuses on the sectors that are suffering most, notably big-cap growth stocks. I outlined the case for such stocks in last month's issue. Among the companies I recommended were Citigroup (C: Research, Estimates), $36, Home Depot (HD: Research, Estimates), $29, Microsoft (MSFT: Research, Estimates), $50, and Pfizer (PFE: Research, Estimates), $27, now slated to acquire its competitor Pharmacia.
All these approaches will likely pay off over the long term, but none of them does much to reduce the volatility of your portfolio right now. Since valuations are now depressed for just about every stock group, though, it's possible to be a contrarian even if you stick with only conservative picks.
Here are five.
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Retirement help
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CALIFORNIA WATER SERVICE, the largest water company in the western United States, trades at 17.5 times estimated earnings for 2003 and pays a 4.9 percent yield. Earnings have been depressed for the past two years but are projected to rebound to $1.50 next year. Longer term, profits should grow 4 percent or 5 percent annually. At $24 a share, California Water Service (CWT: Research, Estimates) is only a couple of bucks above its five-year low. Special situations analyst Charles LaLoggia sees the possibility of a takeover bid worth $32 or more from SJW, parent of San Jose Water, which owns 8.7 percent of California Water's stock.
HEINZ stock, now $34.50 a share, is 28 percent off its two-year high. Earnings have been flat for three years, but profits are projected to reach a new high next year and grow at a 7 percent rate thereafter. Heinz (HNZ: Research, Estimates) shares of the ketchup king trade at 13.5 times estimated earnings for the fiscal year ending in April and yield 4.6 percent.
PRUDENTIAL went public late last year at $29 a share. The stock traded as high as $36 but has recently slipped back below $33, or about 13 times next year's projected earnings. Like most other big mutual insurance companies that convert to stock ownership, Prudential (PRU: Research, Estimates) will likely be able to improve its return on equity by trimming costs. In addition, the company could free up several billion dollars -- by selling low-profit businesses, for instance. Some of that cash will be used to repurchase shares, which could help boost earnings at more than 10 percent a year.
SBC COMMUNICATIONS is down by a third from its high late last year, although that's still better than some other stocks in the battered telecom sector. At a recent $27, SBC (SBC: Research, Estimates) trades at a 12 price/earnings (P/E) ratio and pays a 4 percent dividend. The company still earns more than 40 percent of its profits from local telephone service, which provides stability but limits growth to 5 percent or 6 percent a year. When interest revives in Internet access and some of SBC's other high-tech businesses, profit growth should accelerate and the stock's multiple would likely expand from below-average to above-average levels.
TECO ENERGY is the parent of Tampa Electric, which is adding customers at a 2.6 percent annual rate thanks to Florida's continuing boom. The company's unregulated businesses have been growing faster and now account for more than a third of Teco's revenue. In this weak economy, Teco (TE: Research, Estimates) will likely post only minimal earnings gains next year. But the stock's selloff over the past year -- a drop of more than 30 percent -- seems like an overreaction. At less than $21 a share, Teco trades at only a 10 P/E and yields 7 percent.
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