Built to Last
The economy is strong, but perils abound. We find TEN STURDY STOCKS to see you through a tricky year.
(FORTUNE Magazine) – The once-dark mood on Wall Street has brightened considerably. And, no, we're not just talking about the investment bankers dreaming up ways to spend their seven-figure bonuses. With oil prices falling, corporate earnings still growing, and consumer confidence on the mend, the stock market has awakened from its ten-month slumber. The Standard & Poor's 500 returned 5% between November and early December, while the Nasdaq perked up 7%.
Notably, it's not just one industry propelling the stock indexes higher. The big gainers range all the way from Georgia-Pacific to Yahoo, from Nordstrom to Countrywide. And the investment world's best and brightest say that's just the beginning. In a recent letter to investors, Legg Mason fund manager Bill Miller ticked off the positives: "The economy is strong, balance sheets are as liquid as they have ever been, profit margins and return on equity are hovering near all-time highs, earnings are growing double-digit, companies are buying back stock in record amounts, mergers and acquisitions are happening at nice premiums to prevailing prices." To Miller, the conclusion is obvious: "I think the market is going up."
Even the hurricane season from hell doesn't seem to have knocked the economy off stride. Gross domestic product shrugged off Katrina, Rita, and Wilma to grow at a consensus-thumping 4.3% clip in the third quarter. Consumer spending rose 4.2%, while business spending on equipment and software rose at a brisk 10.8% pace. Corporate earnings, meanwhile, are increasing 11% annually, which in turn has reduced the price/ earnings ratio of the S&P to its lowest levels since 1996. Says Yale University finance professor Roger Ibbotson (profiled on page 64): "The main reason to be optimistic is that P/E levels have dropped." ***
Yet there are plenty of reasons to be pessimistic as well. The economic landscape includes an energy shock, a cooling housing market, rising inflation, and Federal Reserve rate hikes. All of these are classic warning signs or symptoms of an economic slowdown--something to keep in mind as you're deciding where to invest in 2006. Rising interest rates, for example, are a big drag on consumer spending. Higher rates mean heftier credit card bills and far fewer opportunities for the cash-out mortgage refinancings that have been putting nearly $60 billion a quarter into the hands of consumers. "That's 2% of GDP, and it goes a long way toward explaining how the consumer has managed to keep things together in the face of punishing energy prices," says Merrill Lynch chief economist David Rosenberg. Just as ominous as the overall rise in interest rates is the relationship between long- and short-term bond yields. We're now on the cusp of something known as an inverted yield curve--a phenomenon that occurs when short-term rates (now 4.3% on one-year Treasury bills) exceed long-term ones (4.5% for ten-year Treasuries). Inverted yield curves predict recessions with frightening accuracy. According to a New York Federal Reserve study, every time the U.S. has had a period of inverted yield curves, recession followed within a year. The danger signals are so unmistakable that J.P. Morgan Chase market strategist Abhijit Chakrabortti believes Wall Street's bulls are in denial. "I'm thinking of calling my year-end report 'Eyes Wide Shut,' " he says.
Confused? Given the mixed signals, that's understandable. It's also why the stocks we're recommending for 2006 don't depend on a rousing economy or a rising-tide stock market. After reviewing the latest research and interviewing dozens of analysts and money managers, we trained our sights on ten moderate-P/E stocks positioned to benefit from secular, not cyclical, trends such as rising commodity prices (Phelps Dodge) or favorable changes in the law (Berkshire Hathaway). If tech stocks take off, our picks may not keep pace. But in a rocky market, they should provide a margin of safety. And speaking of safety, on page 38 we offer two reliable fixed-income funds.
Elsewhere in our 2006 Investor's Guide, on page 50 we spotlight seven mutual funds that have beaten their category averages by the widest margins since 1990. On page 114 we look at six red-hot stocks in Europe (yes, Europe). Our housing outlook starts on page 76 and includes forecasts for 100 U.S. real estate markets. Other features include profiles of Securities and Exchange Commission chairman Christopher Cox (page 123) and Texas dealmaking legend Richard Rainwater (page 90), who worries that recent declines in oil prices will prove short-lived. Now on to the stock picks.
ALTRIA GROUP (MO) $72
In a slow-growth market, many investment pros recommend shifting into dividend-paying stocks with stable earnings and clean balance sheets. That may not sound as exciting as chasing after some hot Internet company or oil driller, but it will probably be better for your financial health. "Most individual investors get caught up in the hype," says Richard Bernstein, U.S. strategist at Merrill Lynch. "They forget that the constant reinvestment of dividends can be a huge component of building wealth."
Altria Group is happily hype-free. With $90 billion in sales, the company is the world's largest cigarette maker and, through its Kraft Foods subsidiary, among the largest food processors as well. One of our best-performing picks for 2004, the stock is up 22% this year but still sells for just 15 times trailing (the past 12 months') earnings, a giant discount compared with other consumer products firms. Lawsuits against cigarette maker Philip Morris continue to weigh on the stock, but the litigation environment has improved substantially in recent years, making the company's expenses far more predictable. Most recently Altria dodged the threat of a $280 billion penalty in a continuing civil racketeering lawsuit after the Supreme Court rejected a government appeal to hear the case.
Altria has big opportunities to grow overseas. In May the company purchased a 98% stake in Sampoerna, a leading Indonesian tobacco business, for $4.8 billion. The acquisition makes Altria the second-largest cigarette maker in Indonesia. In addition, the company acquired Colombia's largest cigarette manufacturer, Coltabaco, for about $300 million. The international tobacco segment now makes up about 50% of operating income, up from 43% a year ago. Foreign tobacco revenues increased by an impressive 15% over the year.
"Any other company [with those numbers] that didn't have the litigation problems would be selling for 18 to 20 times earnings," says Ron Muhlenkamp (whose fund we recommend in "Leaders of the Pack"). As the litigation picture improves, the P/E ratio should rise--and eventually allow CEO Louis Camilleri to split the company into two or three units. Until then, with the stock yielding 4.4%, you get paid to wait.
ARCHER DANIELS MIDLAND (ADM) $23
One curious byproduct of the recent oil spike has been the accompanying rise in sugar cane prices. What's the connection? The world's biggest producer of sugar cane, Brazil, also happens to be the biggest producer of ethanol. And higher oil prices have resulted in more sugar cane being diverted from food to ethanol production. That's led to a 60% rise in sugar prices since June of 2004.
Geoff Blanning, a London-based commodities-fund manager with Schroders, thinks sugar is the leading edge of what will be an across-the-board surge in agricultural commodity prices. So many industrialized countries are turning to biofuels to help bring down energy costs and promote energy independence that demand for corn, rapeseed oil, palm oil, and other crops is sure to soar, he says. It's already happening in Europe, where industrial demand for vegetable oils has increased 75% in a little more than two years.
Assuming you don't want to dabble in commodities futures, agricultural giant Archer Daniels Midland is the easiest way to play this food-to-fuel trend. Citigroup analyst David Driscoll is so bullish on ADM's biofuel prospects--ethanol now accounts for 23% of ADM's operating profits--that he's dubbed the company "an energy growth story." ADM is the biggest U.S. producer of ethanol, which in turn has made it a huge beneficiary of the newly passed energy bill. For starters, the bill gives refiners a 51-cent-per-gallon subsidy for every gallon of ethanol they use in their blends. Even better, it imposes a minimum renewable fuel usage requirement for refiners that starts at four billion gallons a year in 2006 and grows to 7.5 billion in 2012. Driscoll expects ADM's calendar-year earnings to rise 33% in 2006--excellent for a company with a 17 P/E and a 1.4% dividend yield.
BERKSHIRE HATHAWAY (BRK.B) $2,999
With Warren Buffett now 75 years old, his top deputy, Charlie Munger, 81, and no clear succession plan, Berkshire--also one of our 2004 picks--isn't quite the easy-to-sleep-at-night stock it used to be. In the short term, though, there's a lot to like. All those Federal Reserve rate hikes have been a boon to Berkshire's bottom line. The company has $46 billion in cash on its balance sheet. A year ago, that cash was earning just 1%. Today it's getting closer to 4%. That works out to about $1.4 billion a year in additional pretax profit.
And while Berkshire's $1.3 billion in hurricane-related insurance losses certainly cut into 2005 earnings, Katrina, Rita, and Wilma could actually wind up being good for its reinsurance business. Bruce Berkowitz, manager of the Fairholme fund, points out that many other reinsurers are reeling from Katrina and are reluctant to take on new catastrophe business. "Given Berkshire Hathaway's Fort Knox balance sheet," he says, "Buffett is going to be able to set the market prices for big catastrophes."
Finally, there's PUHCA. At Berkshire's 2001 annual meeting, Buffett noted that were it not for the Public Utilities Holding Company Act--a Depression-era law that effectively barred holding companies from having controlling stakes in utilities--Berkshire would be more heavily invested in energy. Well, PUHCA was repealed in August, and big Berkshire shareholders like Berkowitz and Weitz Value's Wallace Weitz expect Buffett to invest a chunk of Berkshire's $46 billion cash hoard in a utility or two. "People might say, 'Oh, isn't that boring, he's going to make 9% or 10% a year on his money,' " says Berkowitz. "But what if for every dollar of cash he uses [to buy a utility], he uses another dollar of float? That 10% return starts to look like 20%." (In insurance parlance, float is cash from premiums that can be invested until it's needed to pay claims.) The other reason utilities are so appealing is size. "Warren's biggest problem has been finding investing opportunities big enough to deploy all his assets," says Weitz. "That's where the repeal of PUHCA opens up a lot of $5 billion and $10 billion opportunities."
CITIGROUP (C) $49
Top bargain hunters say some of the best opportunities in the market these days are among blue-chip growth stocks that have seen their shares stagnate or tumble over the past five years, though profits have often continued to grow at a healthy pace.
Citigroup is a prime example. Back in 2000, shares of Citigroup traded for a lofty 20 times trailing earnings--roughly twice the multiple of many other financial giants, including Bank of America and Wachovia. The company had recently been formed by the merger of Citicorp and Travelers, a $36 billion deal that would allow it to sell everything from credit cards to brokerage services. But Citi got bogged down in scandals under previous CEO Sandy Weill. The company paid billions of dollars in fines and settlements for its role in financing Enron, WorldCom, and other fraud-ridden companies.
Charles Prince, who took over as CEO two years ago, is quietly remaking the financial giant into a leaner and more focused company. He has curbed the expansionary thrust that came to define it during the Weill years and is improving risk management and internal controls. He's also selling off noncore operations such as its life insurance and annuity unit to better position Citigroup for the future.
We recommended Citigroup last year, and it returned 9.1%. At 12 times trailing earnings, the stock is still selling below its ten-year average P/E of 15 and is in line with its peers. Is it a fair price? With more than $100 billion in annual revenues, Citigroup is the biggest and most diversified financial-services firm in the world, with operations in more than 100 countries. "It's a fair price only if you believe Citigroup is an average company," says veteran investor Bill Fries, whose Thornburg Value fund has posted 13% annualized returns in the past ten years. "I think it's an above-average company. That's why they're everywhere." With Citi's 3.6% dividend yield and profits growing at an above-average rate of 10% a year, he argues the shares should fetch a premium multiple. So do we.
ELI LILLY (LLY) $52
Take a close look at the government's most widely followed measure of inflation, the consumer price index, and you'll see an important split between the two dominant sectors in the economy, services and goods. Prices for medical care, education, and other services are climbing, while the costs of manufactured goods from cars to computers are dropping. As rising interest rates and raw material costs trickle through the economy, Henry McVey, U.S. investment strategist at Morgan Stanley, believes the gap will widen. As a result, he recommends that investors favor companies with pricing power--or what he calls "pricemakers." Eli Lilly is such a company.
Driven by rising demand from an aging population, sales and profits at many health-care companies are projected to grow at double-digit rates. Unlike most pharma giants, Lilly has been churning out new drugs at a rapid pace. The Indianapolis company has launched a half-dozen new products in the past two years, including depression drug Cymbalta, which could become a $2 billion blockbuster. Lilly has the best growth prospects in the industry, says Morningstar analyst Tom D'Amore, who forecasts that sales will increase 7% a year through 2008.
Give credit to Lilly's top-notch drug-discovery program. CEO Sidney Taurel pours 20% of the firm's $14 billion in annual sales back into research and development, while the industry averages 16%. "You don't find many companies that are spending 20% of their sales on R&D," says Doug Eby, co-manager of the Torray fund, which has generated 11% annualized returns in the past ten years. "They're taking a lot of cash and investing it in future growth."
Shares have fallen recently because sales of Zyprexa, Lilly's top-selling product, are expected to decline next year as a result of increased competition from other schizophrenia drugs. But fans like D'Amore believe strong sales of Cymbalta and other new drugs will offset declining Zyprexa revenues. The stock sells for 18 times trailing earnings, its lowest level since the Clintons tried to reform health care more than a decade ago, and some 20% below its historical average. Yet analysts project long-term profits will grow at an above-average rate of 10% per year. The stock yields 3%, well above the market's average yield of 1.7%. D'Amore estimates shares are worth $61.
HEWLETT-PACKARD (HPQ) $30
Like Citigroup, Hewlett-Packard comes under the heading of Fallen Star. Five years ago its shares hit their all-time high of $78. Like all tech stocks, HP was insanely overvalued; it plummeted to $11 in 2002. A big reason was former CEO Carly Fiorina's merger with Compaq Computer (see "Why Carly's Big Bet Is Failing" on fortune.com).
New CEO Mark Hurd, who took over in March after successfully turning around computer-services giant NCR, has brought an intense focus on operations. In July, Hurd announced a major restructuring to cut billions from the company's bloated cost structure over the next few years. The plan went well beyond layoffs--although it called for axing 10% of the workforce, or 15,000 jobs. Hurd is also slashing pension benefits and realigning the sales force to give each business unit its own dedicated sales team. The moves are expected to save some $2 billion a year beginning in fiscal 2007.
To spur sales, Hurd has been busy on the acquisition front. HP recently bought several small companies, including closely held software maker RLX Technologies and publicly traded software maker Peregrine Systems, to beef up its software business (which now accounts for only about 1% of total revenue). The company is already seeing signs of life. Sales rose 7% in its latest quarter, helped in part by its enterprise-computing and PC units, long some of the biggest drags on its results.
Admittedly, HP has some big challenges--namely Dell, the low-cost hardware maker, and IBM, the biggest IT-services provider. But at $30, HP shares are still selling for little more than the value of its industry-leading and highly profitable printer business, according to veteran value investor Bill Nygren, whose Oakmark Select fund has gained 11% annualized in the past five years. That means investors are assigning very little value to the nonprinter divisions--including PCs, server and storage computers, software, and IT services, which make up two-thirds of the company's $87 billion in annual sales. On a per-share basis, HP stock sells for about 0.9 times projected revenues, 30% below the industry average. At these levels, it shouldn't take much of a sales uptick to send the stock higher. Top value investors believe it is worth at least $35 a share.
KINDER MORGAN (KMI) $94
Investing in energy stocks seemed like a no-brainer this year, at least until oil fell from $70 to $56 a barrel and dragged down the likes of Chevron and Exxon Mobil with it. As the nation's largest independent oil-pipeline company, Kinder Morgan is one energy company whose fortunes aren't directly tied to short-term fluctuations in commodity prices. Whether oil is $70 a barrel or $40 a barrel, crude oil and gasoline still need to be transported from point A to point B. Plus, NIMBYism, strict environmental regulations, and the high cost of construction mean potential competitors face extremely high barriers to entry.
The result for Kinder Morgan shareholders has been consistent double-digit earnings growth and regular dividend hikes. The company has raised the dividend, now $3 a share, for four consecutive years. With Kinder Morgan's acquisition of Canada's Terasen, which is expected to add to earnings in 2006, management has already announced plans to raise the dividend to $3.50--the equivalent of a 3.8% yield on KMI's $92 share price. And with CEO Richard Kinder owning 20% of the stock but earning only a $1-a-year salary, it's a safe bet that the company's enthusiasm for returning cash to shareholders will continue.
Earnings are expected to rise 16% next year, thanks in part to Terasen, but Citigroup analyst John Tysseland thinks the bigger payoff from the deal will be down the road. With three major pipelines transporting oil from Alberta to Vancouver and the U.S., Terasen has a lucrative stake in one of the world's fastest-growing oil regions. According to Tysseland, oil production from Alberta oil sands is expected to double, to two million barrels a day, over the next five or six years. "The Terasen acquisition," he recently wrote, "gives KMI exposure to the tremendous growth opportunities presented by the Canadian oil sands."
NORFOLK SOUTHERN (NSC) $43
You'd think high energy prices would be poison to rail freight carriers, since fuel is a major cost of business for them. But in the case of Norfolk Southern, rising energy prices seem to be helping, not hurting, the bottom line.
How so? Because trains are more energy efficient than trucks, it's easier for railroads to absorb higher fuel costs than it is for their trucking rivals. Even more important has been the rising clamor for coal as power generators seek alternatives to pricey natural gas. "Coal demand has been strong, and Norfolk Southern moves a lot of coal," says Charles Bath, manager of the Diamond Hill Large Cap fund, explaining why Norfolk Southern is a top-ten holding in his energy-laden fund. Indeed, Norfolk's coal-related shipping revenue rose 25%, to $1.6 billion, during the first nine months of 2005. Overall, revenues were up 17%, while earnings jumped 39%.
Another positive: Norfolk is gaining market share from its East Coast rail rival, CSX. In the third quarter Norfolk was able to grow carload volume 1.7% and raise prices 13.9%, vs. 1.4% and 9.2% for CSX. A.G. Edwards analyst Donald Broughton thinks this gap will only widen: Norfolk's "ability to pick up and deliver loads in a reliable, on-time manner has driven more shippers to pick [it] over CSX."
PHELPS DODGE (PD) $143
Last spring CGM Funds' Ken Heebner made what will surely go down as one of the best trades of his illustrious career. Right at the peak of real estate mania, Heebner swapped out of homebuilder stocks--his biggest position in CGM Realty three years running--and plowed the proceeds into energy stocks like Arch Coal and Consol Energy.
His timing was exquisite--so exquisite that we were curious what Heebner has up his sleeve for 2006. "One word: copper," he told us (and no, Heebner is not auditioning for the stage revival of The Graduate). Heebner's copper case is pure supply and demand. Chile is the Saudi Arabia of copper, and through September, Chilean copper output fell 2.5%. In part that's because copper production requires a tremendous amount of water, which is in increasingly short supply in Chile's mining regions. Copper prices are already up 35% over the past year, but, says Heebner, "with strong demand driven by China and India and the potential for some kind of supply reduction, I think the potential for further upside is very significant." Prudential mining analyst John Tumazos contends that with copper demand rising at an 8% pace, "existing mine output can't meet demand."
Because he trades actively, Heebner wouldn't discuss exactly how he's now pursuing his copper gambit. That said, we'd be shocked if Phelps Dodge doesn't show up as a big holding in CGM's next shareholder reports. The world's second-biggest copper producer, Phelps Dodge offers the best copper exposure of any mining stock. It's cheap, trading at nine times trailing earnings, and Tumazos expects it to grow earnings 17% in 2006 --and that's not even assuming an increase in the current $2-a-ton price of copper.
WASHINGTON MUTUAL (WM) $42
We recommended this savings-and-loan giant last year, and although the stock barely budged, it still nearly matched the total return of the S&P 500, thanks to its hefty yield. Now we're coming back for a second helping. Washington Mutual continues to steal share from mom-and-pop banks. Led by ambitious CEO Kerry Killinger, the Seattle company is expanding aggressively as he attempts to remake it into the leading nationwide bank for the middle class. With $16 billion in sales, WaMu now controls $334 billion in assets through its 2,500 branch offices. That's up from just $21 billion it handled at 260 offices a decade ago.
There have been a few bumps along the way. The company got squeezed by rising interest rates, which caused home-mortgage refinancings to drop sharply. But Killinger is taking aggressive steps to turn that around--reducing headcount, closing retail mortgage-lending offices, and so on. Meanwhile, the banking unit continues to thrive, says Oakmark's Nygren. Killinger opened 184 new offices in the past year, helping drive up WaMu's net income more than 22% in this year's third quarter.
You can't argue with the numbers. The stock sells for just 11 times trailing earnings, well below the multiple of the S&P 500. Profits are projected to grow at an above-average rate of 10% a year for the foreseeable future. And the dividend yield, at 4.7%, beats the yield on a ten-year government bond. "It offers the best of all possible worlds," says Nygren.
TEN COMPANIES WITH STAYING POWER
For every bullish argument about the market in 2006, there's a bearish rejoinder. So this is not a time for impulsive bets. The stocks we're recommending here are the kind of STRONG, STEADY PERFORMERS that can hold their own in all kinds of weather.
Data as of 12/06/05. P/Es based on the previous 12 months' earnings.
WE BEAT THE S&P
The 18 stocks we selected for the Investor's Guide 2005 (see "The 20 Best Bargains in the Market" on fortune.com) gained 13.3%, beating the 8.3% return of the S&P 500. The Turkish Investment Fund was OUR TOP PERFORMER. The closed-end fund soared 71%. Another standout was Forest City Enterprises, a real estate holding company that gained 47%. Turnaround candidate Interpublic Group was our laggard, falling 28%. The advertising giant continues to struggle with operational problems and client defections.
* From Dec. 9, 2004, to Dec. 2, 2005.