Stock picking: rosy or rotten

Some bargains look great until you see their wormy core - an earnings growth collapse. But there still are values, says Money Magazine's Paul J. Lim.

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By Paul J. Lim, Money Magazine senior editor

(Money Magazine) -- There are certain times in the market - like during a major sell off - when it's hard for investors to tell if something's a deal or no deal.

Heading into the year, for instance, many on Wall Street argued that stocks were a real bargain. And after the current stock slide, which has pushed the Standard & Poor's 500 index into an official correction and is on the verge of sending the Nasdaq composite index into a bear market, equities look even cheaper than at the start of the year. This is based on the market's most widely used price tag - its price/earnings ratio, which divides a company's share price by its earnings per share.

If you rely on Wall Street's 2008 earnings estimates, the market's P/E stands at 13.2 an appealing 19 percent off its historic price tag since 1945. In fact, based on those same earnings forecasts, you can argue that just about every sector of the stock market is tantalizingly cheap.

But attention, Wall Street shoppers: Low prices don't always reflect a discount. Sometimes prices are slashed because the merchandise is damaged or unwanted, like a grocery marking down bruised produce. The stock market can be considered cheap today only if corporate profits are as good as advertised. And that, unfortunately, appears highly unlikely.

Dreamy forecasts

Though there's clear evidence that the economy is slowing due to troubles in the credit and housing markets - and as talk of a recession grows - Wall Street analysts seem stuck in a fantasy land. They are still forecasting that profits for companies in the S&P 500 index will soar more than 16 percent in 2008, which is double the historic annual rate of corporate earnings growth. "Those numbers are really high, I mean really high," says Jeffrey Kleintop, chief market strategist for LPL Financial.

Wall Street analysts are notoriously bad at forecasting profit trends anyway. At the beginning of last year, they said corporate earnings would grow 8 percent in the third quarter, when in fact they fell nearly 5 percent. And after predicting last fall that fourth quarter earnings would soar nearly 12 percent, analysts now believe S&P profits will plummet a staggering 19 percent, thanks largely to plunging financial sector earnings.

Errors like this are only magnified during a severe slowdown in economic growth or a recession. Earnings don't soar by double digits during these downturns, says Jack Ablin, chief investment officer for Harris Private Bank: "They go negative."

Merrill Lynch started to sound the alarm late last year. After warning investors to expect a drop in earnings this year in December, economists there now think profits could fall as much as 8 percent this year. Just for the sake of argument, let's say Merrill is right. If 2008 profits were to fall 8 percent - a significant downturn - the S&P 500's slowdown-adjusted P/E would rise to 16.7, based on Monday's close of 1325.19. This is higher than the market's average 16.2 P/E since 1945, according to S&P. And instead of a majority of sectors looking cheap, most start to look pricey.

To find the real bargains in this type of market, you have to play it safe. Stick with the most conservative earnings expectations. For instance, we measured the P/E ratios for various sectors based on a hypothetical 8 percent drop in earnings this year.

Next, we compared those figures against the historic relationship between the P/E ratios for sectors and the overall S&P. A lot of sectors that looked cheap are in fact pretty dear. But some bargains can still be found.

Technology stocks are the cheapest

Investors might be wary of tech, given the major losses the sector has suffered so far this year. And even considering this slide, investors might not believe that tech is cheap, given that that the sector's P/E stands at 22.8, after adjusting for a slowdown. But the tech sector has historically traded at a steep premium to the S&P's P/E - 73 percent higher, to be precise. But because they were shunned for most of this decade, tech stocks today are trading at only around a 36-percent premium.

Remember, 55 percent of tech sales are generated overseas. So even if the U.S. economy stalls, as many predict it will, the stronger global economy should protect tech earnings - at least on a relative basis, says LPL's Kleintop.

Though there's value in tech, it's still volatile. The safest way to invest in the sector is through a diversified fund that owns a mix of large-cap tech. The average large-cap growth fund invests 29 percent of its assets in this sector.

A solid choice in this category is T. Rowe Price Blue Chip Growth (TRBCX), which counts Google (GOOG, Fortune 500), Microsoft (MSFT, Fortune 500), Cisco Systems (CSCO, Fortune 500) and Apple (AAPL, Fortune 500) among its top 10 holdings. It can be found in our Money 70 list of recommended funds. If you do want a more concentrated play, go for a low-cost index option: the Technology Select Sector SPDR (XLK), which owns all the S&P 500 tech stocks.

Health-care stocks are reasonably priced

Ernest Ankrim, chief investment strategist for the Russell Investment Group, says that "slowing growth generates interest in areas of the market where growth is stable." Health-care stocks which have been out of favor lately because of the sector's modest earnings growth and the lack of blockbuster new drugs - fit the bill. Recession or not, people will get sick. This explains why in the third quarter health-care profits rose 13 percent while earnings overall sank.

Among health-care sector funds, Vanguard Health Care ETF (VHT) is a low-cost option that diversifies its bets among large pharmaceutical companies, biotechs, medical-equipment makers and health-care services firms. Or invest in a value-minded large-cap fund like Jensen (JENSX), also in the Money 70. It holds more than 20 percent of its assets in a diversified mix of medical companies such as Medtronic (MDT, Fortune 500) and Johnson & Johnson (JNJ, Fortune 500).

Energy and basic-materials stocks also offer value

Both of these sectors have been on a tear in recent years, benefiting from soaring commodity prices and the booming global economy. But because their earnings have grown even faster than their stock prices, many of these companies are still relatively cheap.

Granted, a protracted slowdown in the U.S. could have a ripple effect around the world. "Global growth is not going to continue at the same pace," says Michael Cuggino, manager of the Permanent Portfolio, a fund that invests in stocks, bonds and alternative assets such as commodities. But he quickly adds, "You will see strong growth in the emerging markets for some time."

Indeed, thanks largely to developing countries, global demand for oil is still expected to rise 1.9 percent this year. That bodes well for the large integrated oil companies such as ExxonMobil nd Royal Dutch Shell, which are among the top holdings of T. Rowe Price New Era (PRNEX), another Money 70 fund.

Don't forget Japan

Money has been pouring into stock markets all over the world of late, yet Japanese equities have been all but ignored. No surprise there: While the average emerging markets fund soared more than 26 percent over the past year, Japanese stock funds were down 16 percent. But the silver lining in being overlooked is that Japanese equities, which are usually far pricier than those in the U.S., are now trading more like a final markdown at Filene's Basement.

Historically, the P/E for the MSCI Japan index has been twice that of the S&P. Yet even if you assume that Japanese profits will fall in line with S&P 500 earnings a big if, given that Japanese exporters do as much business with red-hot China and Korea as they do with the U.S. Japanese equities are still trading at a discount.

One way to gain exposure to this market is through a region-specific fund like Vanguard Pacific Stock Index (VPACX), a low-cost option that invests around two-thirds of its assets in Japan. But you can also use a broad international fund, like Vanguard Europe Pacific ETF (VEA), a new entry to the Money 70 this year. A sale on Japan now really is a deal. To top of page

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