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Cheap is cheap
Despite a strong economic outlook, stocks are correcting -- making this a time for bargain-hunting.
May 11, 2004: 11:41 AM EDT
By Michael Sivy, CNN/Money contributing writer

NEW YORK (CNN/Money) - The economy has averaged nearly 5 percent real growth over the past four quarters.

New jobs are being created at a rapid rate. Federal Reserve chairman Alan Greenspan has declared that there no longer is a risk of deflation. And as the economy gathers momentum, a sustained boom looks increasingly likely.

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So how have investors have responded to all this good news? They're dumping stocks -- even blue chips.

But this slump does not have any deep and sinister significance. It is simply the kind of correction that normally occurs as the first bounceback phase of a recovery ends and a tamer but longer-lasting growth phase begins.

For investors managing a long-term conservative growth portfolio, the strategy is clear: This is a time to be bargain hunting -- to be taking advantage of temporarily depressed prices to scoop up stocks that fill gaps in your investment mix or that seem like exceptional bargains.

Market jitters, rising rates and energy...

Before deciding what to buy specifically, it's helpful to examine the reasons that the correction is occurring. I see two and a half causes.

The first is that stocks get overly depressed during a bear market and then typically snap back powerfully in the first year of a recovery. Sometimes they overshoot during the rebound. When that happens, there often is a small pullback in share prices the first time the economic outlook appears uncertain.

The second reason for the recent correction is the likelihood that the Federal Reserve will raise interest rates within the next few months. Such a hike will erode earnings in industries dependent on low interest rates -- including homebuilders, auto makers and some financial services companies. But from a long-term point of view, higher rates are a good sign, showing that Greenspan thinks the recovery has legs.

The additional partial cause is the likelihood of higher energy costs over the coming decade, which could prompt higher inflation and would also be a drag on growth.

No one can predict how long this correction phase will last, but it's crucial to remember that the only reason it's happening is because the economy is robust. If there were no growth ahead, commodity prices (including energy costs) would be falling, unemployment would be rising and the Fed wouldn't be contemplating higher rates.

Any investor who is looking out three to five years should take advantage of this pullback. In recent columns, I've recommended oil stocks such as ExxonMobil (XOM), ConocoPhillips (COP), Anadarko Petroleum (APC), Apache (APA) and Schlumberger (SLB) because of the outlook for higher energy prices.

I've also recommended high-yield bank stocks, such as Bank of America (BAC) and Washington Mutual (WM) because they have sold off too much in anticipation of higher interest rates.

Since the correction is broad-based, however, you can find lots of cheap stocks in a variety of market sectors. I've screened the Sivy 70 list for stocks with total return potential averaging at least 12 percent annually over the next five years. I've also looked for stocks with attractive yields, price/earnings ratios below 14 and price/cash flow ratios below 9.

Three stocks stand out. They could all suffer over the next quarter or two from whatever sluggishness persists. But they all look like bargains. And cheap is cheap. Here's a quick look.

Johnson Controls (JCI), a leading maker of auto parts reported a 19 percent gain in first-quarter earnings last month. Higher interest rates will doubtless take a toll on auto sales, but Johnson is clearly cheap if you look across the entire cycle. Earnings growth, project to be 16 percent in 2005, should average around 13 percent annually over the next five years. At $51.16, the shares trade at only 12.4 times estimated earnings for 2004 and yield 1.7 percent.

J.P. Morgan Chase (JPM) looks to be the cheapest of the international commercial banking giants. Profit margins may temporarily be squeezed by rising rates, but a large diverse financial services firm can adjust and prosper in a variety of rate environments. Moreover, J.P. Morgan's earnings jumped 38 percent in the first quarter and are expected to grow at around 10 percent annually over the next five years. At $35.41 a share, the stock is trading at 10.8 times estimated 2004 earnings and yields a healthy 3.7 percent.

Union Pacific (UNP) is the cheapest of the three on a cash-flow basis. As the largest U.S. railroad company, Union Pacific's business pretty much tracks overall economic activity. First-quarter results were ahead of analysts' estimates, but were still soft. One problem has been that the railroad doesn't have enough crews to keep up with its freight business. Longer term, however, you'd expect the stock follow the economy. In fact, growth is projected at around 10 percent a year. At $56.69 a share, Union Pacific trades at 13.7 times earnings and pays a 2.1 percent yield.


Michael Sivy is an editor-at-large for MONEY magazine. Beginning May 17, the Sivy on Stocks column and newsletter will be available only to MONEY subscribers. Don't miss out: Continue getting analysis and stock picks twice a week. Plus: Subscribe now and you will also receive access to the Sivy 70 -- our exclusive list of America's Best Stocks -- and coming in June, to Sivy's Guide to Growth. Click here to subscribe to MONEY and to sign-up for the Sivy newletter.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.