FINDING BUYS WHEN STOCKS ARE HIGH With the Dow way up there and the economy crawling, investors shouldn't just play the market. They should look for solid businesses that will survive and grow.
By Terence P. Pare REPORTER ASSOCIATES Shelley Neumeier, John Wyatt

(FORTUNE Magazine) – QUITE A FEW investors, remembering how the Dow Jones industrial average leaped 20% in 1991, took to the stock market dance floor this year expecting to boogie. Yet despite falling interest rates and rising corporate profits, the Dow has stepped up a mere 3% since the beginning of the year. That kind of performance is not what you'd call the flatfoot floogee with the floy-floy. Don't expect to kick up your heels in 1993 either. True, we are pegging along into recovery. But economic growth continues to be slow. Fortune, along with others, forecasts growth of just 1.8% for 1992 (see The Outlook). Without a strong economy to propel earnings, stock prices are high. Too darn high, says Jeffrey Diermeier, managing partner at Brinson Partners, an investment advisory firm in Chicago: ''We think that the market is overpriced by 15% to 20%. At best, stocks will be dead in the water for the next two years.'' Pessimism like that may prompt you to follow the droves of investors who are moving into fixed-income investments, especially bond funds. But most stockholders have no reason to liquidate their portfolios, although some may want to cut back on their big winners. The black mood among the pros is far from universal. Measured against future earnings rather than the latest four quarters, stock prices cause less uneasiness. And both bulls and bears agree that equities can still make sense if you choose your companies carefully.

Focus on finding strong businesses, say the pros. Then worry about getting the stocks on the cheap. Even if you overpay for a good business, eventually you will get your money back as the company grows and the market recognizes the fact. But if you buy a bad business and it goes the way of all flesh, so does your investment. Fortunately, plenty of good stuff awaits those willing to shop around. Most investors, thundering into cyclical stocks that were supposed to go through the roof when the recovery took off, ignored scores of good companies selling at acceptable prices, including the 50 listed at the end of this article. The continued sluggishness of the economy, a seemingly unshakable flu contracted in the debt-crazed 1980s, accounts for much of the Wall Street gloom. Compounding the pessimism is the fact that Wall Street has no institutional memory of a slow-growth, low-inflation recovery. The market's behavior itself has added to the confusion. During previous economic recoveries, certain groups of stocks tended to lead the rest of the market. But this time around, says Harold A. Mackinney, chairman of Fleet Investment Advisors in Providence, ''there has been an awful lot of shifting from one group of stocks to another.'' Small wonder, then, that investors large and small are chary. According to Indata, a Connecticut outfit that tracks the performance of some 2,500 institutional portfolios, pension fund managers raised their cash positions from 3.9% of assets last February to about 5.2% in late September. And in a recent survey of its most active customers, discount broker Quick & Reilly found that individual investors felt they should be keeping about 32% of their assets on the sidelines. That caution seems justified, says Melissa Brown, who directs quantitative research at Prudential Securities: ''I just don't see a fundamental case that can be made for stocks.'' Take the ratio of price to book value per share, which compares the market price of a company with its net worth. Over the past 33 years, the price-to- book ratio has averaged 1.95 for Standard & Poor's 400-industrial-stock index. But for the past five quarters, the S&P 400 has been selling for three times book value or more -- pricier by this barometer than at any time since 1926, when reliable statistics begin. When the dividend yield on stocks falls to 3% or less, goes another Wall Street saying, prices are dangerously high. At a recent yield of 3.02% on the S&P 500, stocks are knocking on heaven's door. The worm of doubt that really eats at market watchers taurine and ursine is the price/earnings multiple, recently about 24.4 for the S&P 500. Ten times, from 1946 through September 1991, the market has ended a quarter with the P/E above 20. In eight instances, stock prices tumbled 4.3% to 17.5% over the following 12 months. One exception, the first quarter of 1961, was the beginning of a rampaging bull market that stumbled shortly after John Glenn blasted off in Friendship 7 in 1962. The other exception, the third quarter of 1991, is a story that has yet to play itself out. % The tale could yet have a happy ending. Co-chair Abby Cohen of the investment policy committee at Goldman Sachs, who considers the market 14% to 15% undervalued, sees silver linings. Cohen notes that the P/Es that have everyone so frightened are based on reported earnings pinched over the past four quarters by economic malaise and a wave of corporate write-downs. But look ahead, she says, to the full year 1992. Correct for the distortion of the charge-offs and consider operating earnings per share of the S&P 500, a composite number that reflects the performance trends of companies making up the index. On this basis, Goldman Sachs estimates profits at $25 per share. The P/E drops to 17, about average for a period of moderate inflation. Cohen says that next year the S&P 500 will earn $28 per share on an operating basis, resulting in a P/E comfortably below 17 and leaving room for stocks to move higher. But even Cohen agrees with the pessimists that this is a stock picker's market. Only well-captained ships can successfully navigate this slow economic recovery, she says. Investors will do best to avoid the hot tips in favor of well-run companies with strong financials and admirable track records in good times and bad. MACKINNEY of Fleet, who counts himself among the bulls, thinks that Philip Morris will smoke. The company, selling at 13 times expected 1993 earnings, is thought to be on a 20%-a-year earnings-growth trajectory, vs. a projected 8% for the S&P 500. ''It's probably the cheapest stock on the Big Board,'' says Mackinney, who also expects American International Group to do well. The big insurance company will take some hits from Hurricane Andrew. But the company is superbly managed and, for a price that is just 13 times 1992 earnings, you are getting a company whose profits should ramp up at 15% a year. Parker Hall, president of Lincoln Capital Management, a money management firm based in Chicago, champions tried-and-true growth stocks. So what if the economy comes back modestly, says he. Profits at his companies -- Merck, PepsiCo, and Student Loan Marketing Association, a.k.a. Sallie Mae -- are bouncing up brazenly just the same. According to the most recent consensus of analysts' estimates, compiled by the Institutional Brokers Estimate System, Merck's net income per share should rise 18% in 1992, while earnings at Sallie Mae and PepsiCo should bound ahead more than 15%. Analysts are impressed by PepsiCo's latest moves to expand overseas. Says Hall: ''Hope springs eternal that earnings will surge for cyclical companies. Why bother? The old guys I have just keep plugging along at an average of 15%.'' Unilever N.V., the Netherlands-based half of the Anglo-Dutch consumer goods company, is on Goldman Sachs's buy list. Goldman analyst Jack Salzman thinks that the company will boost earnings by 11% in 1992 and 14% in 1993 as a cost- cutting program starts to pay off. While Unilever functions as a single entity, you can invest in either the British company or the Dutch. Theoretically, the securities for the two outfits should trade at parity. But right now, possibly because of the strength of the guilder relative to the pound, the British variety is trading at a P/E of 15 based on Salzman's estimate of 1992 earnings, while the Dutch trades at a multiple of about 14. Kimberly-Clark is another Goldman pick. The diaper maker's P/E, just 16, is below the market's, but its return on equity is a spanking 20% compared with 14% for the market as a whole.

FOR A DIFFERENT slant, listen to Anthony Spare of Spare Tengler Kaplan & Bischel, a San Francisco investment adviser. Spare, whose name appropriately rhymes with bear, urges investors to stick to cheap stocks of strong companies that pay big dividends. That way, he says, even if prices go down you will still be collecting that check every quarter. But be prepared to sell, says Spare, if a steep price rise leaves the dividend yield too low. Dow Chemical, which is yielding 4.6%, meets Spare's criteria. He believes the company's commodity chemicals and consumer products, like Saran Wrap, and its 70% ownership of Marion Merrell Dow, the pharmaceutical outfit, provide earnings strength through all the turns of the business cycle. Another Spare choice: Bristol-Myers Squibb, which yields 4.3%, sells at a P/E of 16 based on full-year 1992 earnings, and should boost earnings at a 15% clip over the next five years. Diermeier likes some health care stocks. At 17 times the past four quarters' earnings, pillmaker Schering-Plough goes down easy relative to its drug stock peers, which command an average P/E of 20. And analysts' expectations for the company are rising. Hillenbrand Industries, based in Batesville, Indiana, makes hospital beds, high-security locks, and caskets. The P/E, 28 times trailing earnings, is high-powered, but so is the anticipated 15% growth rate in earnings. Here's a company that profits from the human frailties of crime, sickness, and death, all growth businesses. What more could a market bear ask for?

CHART: NOT AVAILABLE CREDIT: SOURCE: GOLDMAN SACHS CAPTION: GROUNDS FOR CONCERN -- AND HOPE The Dow Jones industrials have been hovering not far from the record of 3413 set in June, with multiples to match. But an expected earnings rebound would shore up the market. PRICES ARE HANGING HIGH. . . . . .P/E MULTIPLES LOOK SCARY. . . . . .BUT EARNINGS GROWTH SHOULD HELP

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Watch out when stocks climb far above book value, offer skimpy dividends, and linger at lofty P/Es that often precede sharp corrections. THREE REASONS TO BE CAUTIONS THE MARKET AFTER HIGH P/Es

CHART: NOT AVAILABLE CREDIT: *Estimates from Institutional Brokers Estimate System, except for Citizen Utilities, Glaxo, Unilever, and United HealthCare (Value Line Investment Survey). CAPTION: FIFTY STOCKS TO BUY NOW