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Three bargains for uncertain times
Forecasters worry the market is too expensive. But you can still find stocks that are great values.
April 21, 2005: 10:36 AM EDT
By Michael Sivy, MONEY Magazine

NEW YORK (MONEY Magazine) - For more than a year, stock prices have failed to make much headway despite above-average economic growth, falling unemployment and rising personal incomes. Most forecasters have regarded the market's sideways drift as a chance for stocks to catch a breath before a second phase of the bull market begins.

Wharton finance professor Jeremy Siegel, for one, believes current data should inspire "an upbeat assessment of growth prospects not only in the U.S. but around the world." And he warns that pessimists who bet against growth will soon be sorry.

But in the past few months, a number of highly regarded forecasters have turned cautious, if not mildly bearish.

Investment adviser Steve Leuthold has begun to describe himself as a "nervous bull," worrying that the market may already have had most of its run and that earnings growth will begin to seriously weaken later this year.

Analyst Jim Stack is even more negative, saying that a recession "will become increasingly probable over the next 12 to 18 months." Reason: Resurgent inflation may push up interest rates enough to choke off growth.

Who's right? Are we poised for another big upswing, or is this bull market on its last legs? I don't know -- and you don't know either.

Certainly there are good reasons the bulls are bullish. The economy is in its third year of above-average growth, and there's no sign that increases in real gross domestic product are slowing.

But there are other factors to worry about. Rather than easing, as was widely expected, oil prices have moved higher. The Federal Reserve has already raised interest rates enough to rein in the economy, at least according to historical patterns.

And Fed chairman Alan Greenspan has started talking tough. "Pressures on inflation have picked up in recent months," Greenspan said in late March. And he pointedly noted that "appropriate monetary policy" would be needed to keep inflation under control. That's a euphemism for the kind of interest-rate increases Stack is concerned about. And you can also bite your nails over Iraq, terrorism, the federal deficit and a possible bubble in real estate.

Amid such uncertainty, there are three steps I believe you can take to lower your portfolio's risk while still preserving the chance to earn a superior return.

  • Be value-conscious. Recognize that at this point stock selection is much more important than it is at the start of a bull market, when all the shares that were depressed during the previous slump rebound together. Right now, rather than looking for broad sector bets, you'll be better off going stock by stock, identifying potential bargains that could exceed the overall market's returns.
  • Play some offense too. The economy could surprise on the upside over the next 12 months just as easily as it could disappoint. So pick up a few stocks that thrive late in an economic cycle.
  • Diversify correctly. A portfolio concentrated in stocks that track the current state of the economy -- technology, industrials, retailers and many consumer-products companies, for example -- could take a nasty hit in the event of an upsurge in inflation or a recession. But there are businesses that lead or lag the business cycle, while still others are driven by completely different trends.

Select stocks that truly march to different drummers, and you'll get the maximum benefit. Here are three that look good to me.

Ready for inflation

Part of the challenge in picking stocks today is that many classic defensive choices are vulnerable themselves.

Real estate investment trusts have run up 50 percent over the past two years and will be hurt if higher mortgage rates undercut property values. Oil stocks aren't cheap either, now that the price of crude is at its highest level (adjusted for inflation) in more than a decade.

So if you're going to pass over REITs and oil stocks, what inflation hedges are left? Alcoa (down $0.04 to $28.86, Research), for one. The largest U.S. aluminum producer, Alcoa is one of the few natural resources businesses with a double-digit projected earnings growth rate even at the current level of inflation. Moreover, the company has been systematically trimming costs and redeploying capital to boost its profit margins.

In late March, Alcoa sold a stake in a Norwegian metals company for $870 million. The proceeds will be used for debt repayment and capital investment. The company also plans to shed 2,000 jobs in a restructuring, which will save an estimated $45 million a year.

At $30.36, Alcoa stock pays a 2 percent dividend yield and trades at less than 13 times projected 2006 earnings, a bit under the multiple of the S&P 500.

Playing defense

There's one sector that is completely detached from the economic cycle -- defense. Military spending is driven almost entirely by imminent threats and takes precedence over all discretionary spending.

General Dynamics (up $0.76 to $101.48, Research) looks like an excellent value. Following the Iraq war, orders should be strong for both the company's traditional military hardware, such as tanks and submarines, and its sophisticated information systems and technology.

Earnings growth is projected at a 10 percent annual rate, and the stock yields 1.5 percent. At $104.80, it trades at 13.9 times next year's projected results.

Getting on board

With the growth outlook uncertain, you don't want to load up solely on defensive stocks. It's also a good idea to have a couple of choices in your portfolio that will thrive if the economy gets a second wind.

One place to look for such a stock is among transportation companies, which typically move later in the economic cycle than industrials do. I like Burlington Northern Santa Fe (up $0.81 to $48.32, Research), which is trading at less than 14 times next year's earnings. (In fact, you'll see that the company is replacing Union Pacific in the Sivy 70 list.)

Freight demand was strong in 2004 and should remain so this year. And Burlington, at $55.69 a share, is now the most attractive stock in the group, with annual earnings growth over the next five years projected at 12 percent, compared with 10 percent for Union Pacific, the largest U.S. railroad.

Read editor-at-large Michael Sivy online every Tuesday at E-mail him at  Top of page

Whatever comes next
These stocks can help your portfolio thrive in any economic climate.
Company (Ticker) Price P/E Note
Alcoa (AA) $30.36 12.9 An inflation hedge that's also a growth stock.
Burlington Northern Santa Fe (BNI) $55.69 13.9 A top railroad that should thrive in an upswing.
General Dynamics (GD) $104.80 13.9 A defense play not tied to the economic cycle.
Note: Prices as of March 24. For up-to-date quotes, click company name.
Source: Thomson/Baseline.

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