How to Play the Jackpot Market Made a killing? Wonder if you still can? Here's a sound strategy for investing in the hottest market ever.
By Alexander Haris, Pablo Galarza and Brian P. Murphy

(MONEY Magazine) – These days, you've either got it or you don't. Either your portfolio is juiced with Qualcomm (up 2,621% in 1999), Oracle (290%), Yahoo! (262%) and other tech and Internet darlings--or you're wondering if you're wasting time. "It's unnerving to see people making so much," concedes Victoria, 30, a public health researcher in New York City. She wants to get in on the action but worries that she's too late.

"I max out my retirement account, and I guess it's doing all right, but yes, yes, I confess, I want to win the lottery."

Pamela, 51, has done just that. A volunteer at a New York City art museum, she taught herself about the stock market following her divorce. Her first purchases were America Online and Microsoft in 1994. Among her most recent: Qualcomm, which has doubled in the two months she's owned it. Pamela holds nontech stocks too, including General Electric, but she isn't about to give up gonzo returns for the sake of diversification. "I feel pretty safe," she says. "I think we're in a new paradigm now."

Lottery. New Paradigm. 2,600% return. Welcome to what we call the Jackpot Market. It's great that so many individual investors are getting rich, but we're growing nervous about what "investing" is coming to mean. More than 80 million Americans now own stock, and increasingly, they're looking for a big killing--and tech is the winning ticket. The top 50 Nasdaq stocks account for more than a third of total trading volume, and investors are holding them an average of just three weeks. Mutual fund holders are chasing just as hard. They plowed more than $2 billion into technology-stock funds in the fall of 1999 as the sector posted scorching returns, and all but ignored the rest of the market. No wonder. A handful of tech stocks accounted for 70% of the S&P 500's 20% gain last year. Large portions of the market posted losses (see the chart above). "There's value in other sectors, but the public isn't going to buy them," says Morton Cohen, manager of Clarion Partners, a Cleveland hedge fund. "The returns are too boring."

The problem is that tech's returns may not be any less boring on the way down than they have been on the way up. Even great companies like Sun Microsystems, Cisco and Yahoo! carry price/earnings ratios that frankly scare us (88, 109 and 400, respectively) because they assume a never-ending stream of incredibly high earnings. Then there are the true rolls of the dice--unprofitable dotcoms like Geoworks, whose stock doubled one day in January based on a modest press release about the licensing of its Web software.

The market's narrowness and priciness worries no less of a bull than Wharton business school professor Jeremy J. Siegel. In his best-selling Stocks for the Long Run, Siegel argued that even if you had bought the market-leading Nifty Fifty stocks at the height of the bubble that burst in 1973, you would have matched the S&P 500's return over the next 25 years. "But the Fifty were spread over a lot of different industries," says Siegel. "This time, it's all Internet and communications. Once P/Es get above 100, things get very dangerous, and in the long run, firms are rarely worth those multiples."

In fact, Siegel's study shows how hard it is for technology companies to sustain their competitive advantage. Of the Nifty Fifty techs, Texas Instruments was the best performer from 1973 to May 1999, with an annualized return of 12.3%, more than a point below the S&P 500's. Other Nifty techs like Xerox, Digital Equipment and Polaroid did far worse.

So, does this mean that it's time to flee technology and cash out your winnings? And that if you haven't invested in tech, you should avoid it completely? No. Bearish timers have left a lot of money on the table calling this market's top. That's not a game we want to play. But we do think that in this hyperactive phase of a long bull run, there are sensible steps to take that will allow you to profit from the Jackpot Market while limiting your exposure to potential corrections.

Keep your portfolio in balance. Whether because their stocks have appreciated or they've been lured by potential returns, many investors are now holding big tech bets. We think a tech weighting of 40% of an equity portfolio is high enough for an aggressive investor. If you're conservative, you could drop as low as 20%, two-thirds the sector's weighting in the S&P 500.

If you've got a few tech stocks that have had huge gains, consider selling portions of some of the most richly valued ones, those with P/Es more than 2.5 times their projected rate of earnings growth. Look first at stocks in tax-deferred accounts, then at those you bought at least a year ago so you can take advantage of low capital-gains rates. You also might consider trimming any positions that have grown to more than 15% of your equity portfolio.

Buy tech sensibly. If you're underweighted in tech or want to maintain your current level of investment after taking some profits, there are two possible strategies. First, you can dollar-cost average slowly into the market darlings you don't own now. That will allow you to lower your cost basis should they drop, and still benefit from their rise. Second, you can look for tech stocks that haven't soared but that have exciting prospects Wall Street should come to value. We've found three such companies, discussed below, and recommend that you take a look at a fallen angel, Lucent Technologies (see the article on page 52).

Look outside of tech. Yes, more people will be using the Internet next year and 10 years from now, but there are fast-growing, quality companies in other market segments that can be had at relative bargains. One of the most enticing sectors for the long term is the pharmaceutical industry, which after years of stellar returns has recently been left behind on concerns about government- mandated price rollbacks. In particular, we like Bristol-Myers Squibb and Merck, as the story on page 33 explains. We've also identified stocks in this article in three other underappreciated areas: natural resources, retail and banking. And we've come up with two diversified mutual funds that have posted market-beating long-term returns even though they have only a small portion of their assets in technology stocks. Finally, we have developed a fixed-income strategy that will let you take advantage of today's rising interest rates.

In the end, when the stocks that are driving the Jackpot Market hit the skids--who knows when that will be, but it will be--you want to be able to count your winnings, not cry over your losses.

Bell Atlantic PRICE: $58.25* P/E: 17.6 ONE-YEAR RETURN: 7.3%

The stocks of mobile-phone makers like Nokia and Motorola have had great runs. Then there's wireless software and chip king Qualcomm. But did you know that you can buy a premier wireless network for a song? Local phone giant Bell Atlantic, which serves the Northeast, is merging its mobile unit with Airtouch to create a truly nationwide service. That will increase profitability, since the company won't have to pay other carriers to handle calls. Plus, the network runs on CDMA, Qualcomm's industry-leading operating system.

Bell Atlantic is also acquiring GTE in a $68 billion deal that will give it a first-class Internet-trafficking service. The deals should lead to a 50% increase in long-term earnings growth to 15% a year, says Credit Suisse First Boston analyst Dan Reingold. Lon Baker, a telecom analyst with fund company USAA Investment, agrees. "With its wireless plans, the GTE network and cost cutting, the company can do it."

So why is the stock at a P/E of 17.6, a valuation well below its historical discount to the S&P 500's? Wall Street is worried about Bell Atlantic's marketing spending to support a push into long distance. Its high-speed data service, DSL, isn't growing as fast as hoped, and investors are anxious about how quickly the mergers will pay off. We think those concerns are outweighed by the company's opportunities and the strength of its local service franchise. Reingold figures Bell Atlantic is worth $102 a share, 70% more than today's price.

*Price and other data as of Jan. 27.

Electronic Data Systems PRICE: $69.75 P/E: 30.8 ONE-YEAR RETURN: 34.3%

Electronic Data Systems has come a long way since it was founded by a young H. Ross Perot in 1962--but it hasn't always gone in the right direction. In 1984, General Motors paid $2.5 billion for what was then the leading computing-solutions provider to large businesses (Perot stepped down in 1986). But as part of a huge corporation, EDS failed to move quickly enough to capture the explosive growth in demand for computer services and consulting--IBM stole the lead spot in 1995.

GM set EDS free in 1996 (it still owns about 15% of the shares and accounts for 20% of EDS revenue), but EDS was still slow, burdened by lavish spending and thick bureaucracy. Revenue growth limped along, and earnings began to slide. Last year the board brought in Richard Brown, former ceo of Cable & Wireless, to fix things.

Brown ousted many senior executives and mid-level managers. He streamlined the organization, collapsing 50 overlapping divisions into four, which provide management, information technology and electronic commerce consulting. "He's not a spendthrift, and he has reinvigorated the company," says Timothy M. Ghriskey, a portfolio manager for Dreyfus, who bought shares last fall.

All signs point to a successful turnaround. Analysts say the company booked nearly $25 billion worth of business in 1999, more than double the level in 1998. And cost cuts are starting to take hold, so profit margins are likely to improve in 2000. Analysts have begun raising earnings estimates and now expect more than $2.25 a share this year--19% growth. Shares trade for 30 times that estimate.

Quantum DLT and Storage Systems PRICE: $10 P/E: 7.5 ONE-YEAR RETURN: N.A.

When disk drive maker Quantum announced last summer that it was going to free up its fast-growing data-storage business by issuing a tracking stock, investors salivated. They soon bid up DLT and Storage Systems to $22.25, 50% above the issue price. (Companies that have slow- and high-growth businesses sometimes separate the fast mover into a stock that can command a higher multiple.)

But after DLT missed analysts' earnings projections for three consecutive quarters, the stock is down by more than half. The shortfalls have been blamed on Compaq's woes, Y2K and, most recently, a bad revenue mix--that is, lower-end products were outselling high-end gear.

Not surprisingly, Wall Street expresses little confidence in management these days, but value investors remain attracted to the company's assets. Here's why: The growth of e-commerce is fueling the need for data warehousing. That in turn should drive growth of the company's core business, tape drives that are used to back up large computer systems. "Tape archiving is not going away," says T. Rowe Price analyst Stephen Jansen.

Jansen likes the company's balance sheet and notes that it's buying back shares. Plus, DLT has fast-growing units that make network-storage systems. "The top line is growing. Profits are growing. Yet it's selling at less than eight times earnings," says institutional money manager Ron Gutfleish of Pzena Investment. "This can be a growth story as it starts hitting the numbers."

Wells Fargo PRICE: $39.25 P/E: 15.3 ONE-YEAR RETURN: 14.6%

If you owned bank stocks in the past year, you might have been better off in a passbook savings account. Wall Street's outlook on the sector is improving, though it's tempered by worries over interest rates. In this environment, Wells Fargo looks like a forgotten gem. The stock recently slid 11% to $37, in part because of a disagreement among Wall Street analysts over whether the company had met or narrowly missed earnings expectations. That drop gives you an opportunity to own a bank that has a 13% long-term earnings growth rate, twice the industry average, and that holds the leadership position in online banking. "While most banks have focused on cutting costs, Wells Fargo has emphasized customer satisfaction, treating banking like a retail business," says Rob Sharps, manager of T. Rowe Price's Financial Services fund.

As the banking industry moves aggressively into insurance and investment services, that sales-driven culture should allow Wells Fargo to continue outpacing the competition in earnings growth.

Lowe's Price: $45.75 P/E: 21.3 One-Year Return: -14.9%

Home Depot has long been king in the home improvement market. Close on its heels, though, is Lowe's Cos. Both sell the same stuff (from plumbing supplies to lumber to gardening tools); Lowe's has 530 outlets, compared with 800 for Home Depot; each is forecasted to increase earnings a little more than 20% in 2000.

There's one big difference: Home Depot shares soared more than 180% over the past two years, giving the stock a P/E of around 60; Lowe's shares gained half that and carry a 21 multiple.

That could change in 2000. Lowe's, whose stronghold has been in the East, is heading west. And Lowe's is winning over investors. The company had a reputation for missing earnings estimates. But, says Steve Paspal, an analyst at Sovereign Asset management, which runs the Hancock Sovereign fund, "Lowe's is catching up to Home Depot's consistency, hitting expectations for seven of the past eight quarters." It still lags Home Depot in return on equity (a measure of how effectively management uses capital), but its gross profit margins are approaching the leader's. Both stocks fell more than 20% in January because of fears that rising interest rates would stall home building. But spending on home improvement should remain strong, and Lowe's expected 22% earnings growth looks conservative.

Nabors Industries PRICE: $30.25 P/E: 40.2 ONE-YEAR RETURN: 129.4%

Not long ago, oil was stuck at less than $15 a barrel. Weak demand caused by the economic crisis in Asia took its toll on oil companies of all stripes--earnings slid, and stock prices crashed. But a strong global economy and OPEC's willingness to cut back supply has driven crude prices to $30 a barrel. Oil stocks are moving, but the recovery is in its early stages. Now is a good time to buy an industry leader, such as ExxonMobil, if your portfolio lacks such a core holding. But for a chance at more exciting returns, we like Nabors Industries, the world's largest land-based driller.

The stock trades at 40 times its expected 2000 earnings of 75[cents] a share. But earnings could hit $1.10 a share next year as big oil refiners, bolstered by stable prices, increase their exploration and drilling budgets. Nabors should be able to sustain its current P/E, giving potential price appreciation of more than 40%. Oil would have to dip below $17 to hurt earnings, says Salomon Smith Barney analyst Mark Urness.

The stock hasn't escaped the attention of top money managers: David Alger's MidCap Growth fund and Foster Friess' Brandywine fund held positions in 1999. "Managment is a cut above the rest," says Chip Paquelet, a portfolio manager at Strong Funds, a longtime investor. "They deliver a strong return on capital and have grown the company with a consistently smart acquisition strategy."

Torray ONE-YEAR RETURN: 20.5% THREE-YEAR RETURN: 21.6%

Managers Robert Torray and Douglas Eby have a stellar record but require a patient investor. They buy large-caps when prices are weak, and such plays take time to work out. In addition, Torray is a concentrated fund, generally holding 30 stocks, so a few ill-timed bets can lead to some miserable quarters. But the long-term returns show the managers' stock picking pays off, largely because they buy only when they think the earnings growth is there to lift prices. "We don't buy bad companies just because they have low P/Es," says Eby.

The fund holds Abbott Labs and Kimberly-Clark, which, despite consistent earnings growth, sport below-average P/Es. Torray and Eby also take a close look when momentum investors flee stocks following earnings disappointments. If they think the problem is short term, they'll move in--that strategy led them recently to Xerox. The fund's solid 24% return last year was accomplished with a tech weighting of less than 20%.

Acorn ONE-YEAR RETURN: 34.4% THREE-YEAR RETURN: 19.9%

Manager Ralph Wanger isn't opposed to dabbling in tech, but only at a reasonable price. In 1999, he bought into Japan's Softbank, which has stakes in more than 100 Internet companies, including E*Trade and Yahoo!. Shares jumped tenfold last year, contributing to a 33.4% gain for the fund.

Wanger hasn't turned into a Net-stock junkie. For nearly 30 years, he has been looking for companies with above-average earnings growth and low valuations, and it doesn't matter where he finds them. These days it's in a wide range of industries, with top holdings that include Jones Apparel, Harley-Davidson and Carnival, the cruise line.

Wanger keeps just 15% of assets in tech stocks, and they are mainly turnaround plays such as Cambridge Technology, an IT consultant. "The list of companies that have grown earnings 25% for five years is very short," says Wanger. "But there's a long list of companies priced as if they will. All around there are bankruptcy courts, divorce courts, cemeteries, suggesting that things don't always work out." They have for Acorn investors: The fund's 15-year annualized return is 18%.