The Right Way to Play the News
It's sooo tempting to chase what's hot; look instead for what's next
By Michael Sivy

(MONEY Magazine) – It seems like the first duty of a serious investor: Follow the financial news, and use what you see and hear to make decisions about what to buy and sell. Most finance professors, however, would argue that this is a mistake—that your portfolio would be better off if you flipped on ESPN and read historical novels instead of parking yourself in front of CNBC and devouring the Wall Street Journal. But that doesn't mean the news isn't filled with opportunity. The problem is that investors tend to react to news in a knee-jerk fashion and end up buying high and selling low.

Paying attention to what's going on in the world isn't a bad idea; there's a lot you can observe just by watching, as Yogi Berra is supposed to have said. The challenge is to learn what to ignore and to come up with smart strategies for responding to events that really matter. You can't simply rush in and buy when a company has good news and bail out on bad; current developments are usually already reflected in the share price. So you should try to be a bit of a contrarian, buying when things look bleak and share prices are depressed.

But being too contrarian can also be dangerous. Sometimes bad news isn't the final low point for a stock, but the start of a slide that just keeps on going. That said, there are opportunities, and lessons to be learned, in several of today's big financial and general-news stories. So here's a look at the news, and at what you can do to profit from it.

Look for the long-term trend Bonds have been a big story over the past couple of months, as yields on long-term Treasuries have fallen from 5.2% to 4.6%. That doesn't change the fact that bonds look to be lousy performers during the coming decade.

It's true that the unexpected drop in interest rates caught market watchers off guard. That would be vital information if you worked on a bond trading desk. For individual investors, what matters is that the direction of the interest-rate trend is likely to reverse, a change that will transform the markets. As long-term yields plummeted from 15.2% in 1981 to 4.3% in 2003, investors got used to the idea that the returns on bonds could match those on stocks. Because falling rates boost bond prices, total returns averaged more than 12% a year for much of the past two decades.

We won't soon see those numbers again. In the long run, the return on bonds reflects the level of yields at the time you buy—and today's yields are low. In addition, because rates can't decline much from current levels, bond prices can't rise much. What should you buy instead if your portfolio needs income? Consider stocks with dividend yields above 2.5%, as well as preferred shares and "junk" bonds that have high initial yields.

Beware of false bellwethers Giant companies such as GM, Coca-Cola and Intel are thought of as bellwethers for their respective industries and for the economy as a whole. That idea has its flaws. Coke, for example, has plenty of troubles nowadays, but that's because of management disarray, not a slowdown in world economic growth that hurts all U.S. multinationals

The fact that investors embrace bellwethers, however, creates an opportunity for the contrarian thinker. When Intel reduced its earnings guidance in September, most semiconductor shares fell. But like Coke, Intel isn't the reliable signpost it once was. Intel's bread and butter remains the PC chip, and that's no longer where the action is. The best long-term prospects for chips are in audio, digital television, wireless Internet connections and the like.

Some chip-related stocks that followed Intel down are ripe for bargain hunting. The most compelling may be Applied Materials, the world's leading maker of semiconductor-manufacturing equipment. Even though the company's core business grows, on average, more than 15% annually, it's tied to the ups and downs of capital spending. That makes Applied Materials' share price extremely volatile. The stock reached a high of $57 in early 2000 and since then has fallen to $16. Shares trade at about 14 times estimated earnings for the fiscal year that ends October 2005.

Know if bad news is good news The hurricanes that pounded Florida and the Gulf Coast at summer's end did tens of billions of dollars in damage. As the extent of losses becomes known, stocks of property and casualty insurers can be expected to fall, hitting bottom within six months to a year. But then they are likely to be strong candidates for a recovery.

Why is that? The P&C industry's biggest problem isn't bad weather, it's competition. When losses are low, insurance companies undercut one another on price, and the industry's profitability suffers. By contrast, after a major disaster that forces companies to pay out billions in settlements, insurers get more conservative about writing policies. Losses from insurance underwriting (before investment income) were greatest in 2001 and have been declining since Sept. 11. Bargain hunters willing to wait for the underwriting cycle to improve can look at leading P&C insurers, including Allstate, Chubb, The Hartford and St. Paul Travelers. But AIG looks most attractive for growth investors. The company's diverse business mix could propel earnings at a 15% annual clip over the next five years. Nonetheless, the stock is down by a third from its December 2000 high. At $68, AIG trades at 15 times current earnings and just over 13 times next year's projected results.

Don't always rush to buy on a dip Colgate-Palmolive stock fell $9, or 16%, within a few days after the consumer-products giant lowered its earnings guidance in late September. A couple of Colgate's business lines, such as a tooth-whitening product, have been disappointing. And the company has had to step up marketing expenditures to compete with a resurgent Procter &Gamble in the toothpaste market.

On the plus side, Colgate's sales are on track, and profits could pick up again. But even after falling to a two-year low, Colgate stock isn't cheap enough to be a clear buy. Earnings growth is expected to run only 11% a year, and the dividend yield is 2%. At a current $45 a share, Colgate trades at about 17 times estimated 2005 earnings. P&G offers similar total-return potential. At $54 it trades at a modestly higher valuation. But it holds the dominant industry position and has a more consistent track record, which makes the stock a better buy.

Seek to minimize risk There's one final lesson for the news-conscious investor: Don't immediately jump into the stocks that, at first glance, seem to offer the best chance for a huge rebound. Instead, investigate whether there are less volatile alternatives with more solid fundamentals. Imagine, for example, that you thought the oil sector was underpriced 2½ years ago, when crude was trading for less than $26 a barrel. You could have bought Schlumberger, the volatile oil-services giant that is a favorite of investors trying to ride the ups and downs of energy. But taking that volatility risk was unnecessary. ConocoPhillips, a much less risky big oil company with diverse lines of business, actually outperformed Schlumberger over the same period. And should oil prices drop, Schlumberger's shares are likely to suffer far more.

A similar case at the moment is the airline industry, which has been much in the news lately because U.S. Airways has sought bankruptcy protection for the second time in two years. The whole industry is in worse financial shape than usual because the cost of jet fuel is up and competition is fierce. Contrarians may be tempted to buy one of the big troubled airlines and wait for a recovery.

Aerospace suppliers, though, are a much less risky way to play that recovery because their businesses are more solid. After all, upstart carriers and the defense department are spending big money. Take Honeywell, which makes guidance systems and other instruments. It has projected earnings growth of 13% annually over the next five years. In addition, the stock pays a dividend of 2.1%. At a current $36, the shares are trading at 17 times estimated 2005 earnings, a very fair price for a company with such a standout growth rate.

Look beyond the headlines

To profit from financial news, resist the impulse to just do something. These picks are strategic, but not obvious, responses to recent stories.

THE RECENT BOND RALLY seems like a bullish sign. But yields, which move in the opposite direction of prices, are now so low that their next big move has to be up. That would hurt returns. Consider these alternatives.

SOURCE: Lehman Brothers.

INTEL'S TROUBLES sent chip stocks down. But that business no longer relies solely on PCs. Now some stocks, like Applied Materials, the leader in chipmaking equipment, are a bargain.

NOTE: As of Sept. 28. SOURCES: iSuppli, Thomson/Baseline.

Semicinductor revenue growth by source

2003-2008 annualized

P&C INSURERS have to pay out tens of billions of dollars because of the hurricanes. But that will lead to a more conservative and profitable industry, helping companies like AIG.

NOTE: As of Sept. 28. SOURCES: A.M. Best, Insurance Information Institute, Thomson/Baseline.

Return from underwriting before investment income

BARGAIN HUNTERS may think that Colgate's recent sell-off makes it a great value. But even after the decline, Colgate, at a P/Eof 17, isn't cheap enough. Rival P&G has a much more impressive record.

NOTE: As of Sept. 22. SOURCE: Thomson/Baseline.

RATCHETING DOWN RISK remains job No. 1 for investors. Troubled airlines are cheap, but they're also risky. Makers of airplane systems and components look like a smarter way to play a recovery.

NOTE: As of Sept. 28. SOURCE: Thomson/Baseline.