Best Investments 05
Growth stocks are selling for a song. Financials and home builders are ready to run. And drugmakers are a whole lot healthier than Wall Street thinks. WHAT TO BUY NOW
By Jon Birger

(MONEY Magazine) – We know you're fretful about the stock market and your investments. You're not alone. War, oil, terrorism—it's no wonder the major stock indexes were shaky in 2004, even as corporate earnings rose a robust 18%. Still, there are reasons for optimism, a point Michael Sivy hammers home in his forecast beginning on page 60. Interest rates remain low, inflation is in check, and corporate profits and the economy are growing. And stock valuations today are as attractive as they've been in years. The stocks in the S&P 500 are changing hands for just 17 times their earnings; the last time the market was this cheap when profits were growing in the high teens was 1994 and 1995. In fact, the parallels with 10 years ago are striking—from the moribund state of investment banking to investors' pessimism on real estate and drug stocks. And that was the start of a long bull run.

It would be too much to expect a repeat of the late '90s, but it's an axiom of sound investing that the time to buy is when valuations are low and investors are biting their nails. To be sure, going your own way isn't the easiest thing to do. Everyone else thinks you're wrong—and if it turns out you are wrong, you won't have much company to cry with. But this looks like an opportune time for a contrarian bent. Three huge anxieties are keeping investors out of large chunks of the market that appear to have quite a promising future. Consider:

• Aftershocks of the 2000 market collapse continue to scare off buyers from shares of big, fast-growing companies.

• Fears of an interest-rate spike have kept a lid on the share prices of financial services companies and home builders even as they post strong results.

• The Vioxx mess and concerns about a near-term lack of blockbuster drugs have obscured the fact that aging Americans will demand more of what the pharmaceutical industry sells.

If you're willing to take action now and wait for the pack to catch up, read on. We've homed in on nine picks that should allow you to take advantage of market neuroses. For investors looking for bond income, the range of opportunities now is narrower—yields are slim. But two smart strategies can get you more income for your buck.

A couple of operating instructions before you plunge in. First, this isn't a guide to building a portfolio. These are timely buys—some rather risky—that you should consider adding to a diversified portfolio or using as a way to adjust your asset allocation. Second, there's no fixed expiration date on opportunities. Some may pay off and become fully valued this year, others may take longer to bear fruit. We'll keep an eye on them.


Growth stocks haven't been this cheap in years. Risk: A weak economy might keep them cheap.

Blue-chip stocks with double-digit earnings growth used to be the Ray Romanos of the market: Everybody loved them, and price never seemed to be an obstacle. At their peak in 2000, the typical growth stock on the S&P 500 traded at 70 times earnings, according to the Leuthold Group. That all changed after the technology bubble burst. Large-cap growth racked up double-digit losses in 2000, 2001 and 2002. Today these stocks trade at about 20 times expected earnings. Much like the market as a whole, the last time big growth was this cheap was 1994—a near-perfect time to have bought health care, tech and other growth plays.

There's obviously risk here: If the economic recovery flags in 2005, so will earnings, and these stocks will remain cheap a while longer. But if you can handle the potential volatility, this is a broad opportunity. You can capture it, in fact, by buying one of the dozens of well-run growth funds out there. The default choice is Vanguard Growth Index, which holds 400 companies and has a razor-thin 0.23% expense ratio. Over the past decade, its 10.5% annualized return beat 86% of large-growth funds, according to Morningstar.

If you prefer to buy individual stocks, Texas Instruments (TXN) and Procter & Gamble (PG) stand out. Texas Instruments boasts a 20% projected five-year growth rate, making it one of the five fastest growers on Michael Sivy's list of America's 70 best blue chips. (Subscribers can get the list at /sivy70.) Yet its price-to-earnings ratio of 22 is not far above the average for a growth stock. The company's earnings can have sharp ups and downs, but the chipmaker is well positioned in fast-growing markets including mobile phones and digital televisions. That makes it more attractive than some other big chipmakers that rely more on the maturing personal-computer market.

Consumer products juggernaut P&G trades for 21 times 2005 earnings. That's slightly more than the average growth stock, and the company's projected growth of 11% is on the low end. What you're buying here is a consistent performance record: annual sales growth of 4% to 6% and an amazing 16 brands, from Tide to Pampers, that rack up sales of $1 billion or more a year. Merrill Lynch analyst Chris Ferrara believes that in the coming year, the company will likely benefit from growth in China and Eastern Europe. That means P&G could also profit from our weakening dollar.


Improved business practices make builders a buy. Risk: A fast rise in interest rates

Buying housing stocks today is like buying dotcoms in January 2000, right? Well, no. "The media has been hung up on this [real estate] bubble idea," says Ron Muhlenkamp, manager of the Muhlenkamp Fund. "I'll start worrying when the media starts saying housing prices will go up forever." Muhlenkamp, mind you, is no patsy for the housing industry. In 1987, the veteran value investor penned an essay titled "Wake up America—Houses Don't Make You Money." But today, home builders Centex and NVR are among Muhlenkamp's biggest holdings.

So what's changed since the 1980s?

A lot. Rates on 30-year mortgages are 5.7% today vs. nearly 10% in the late 1980s. The typical homeowner allocates a smaller share of his income to mortgage payments today than he did in 1980, 1990 or even 2000. Yes, rates are expected to rise, but for home builders a gradual increase should be offset by a couple of other underappreciated factors. First, there are the aging baby boomers—folks 55 and older boast the highest home ownership rates. Second, home builders have gotten better at pacing themselves. Fifteen years ago, overzealous builders put up more houses in California, New York and New England than those frothy markets could absorb. Today there's a mere four-months' supply, nearly a 35-year low.

The big risk, of course, is that interest-rate increases don't turn out to be gradual at all. That could trigger a sharp drop in demand for new houses. But after two years of big gains, housing stocks still look cheap enough to make that a risk worth taking. Despite analyst estimates of 16% earnings growth for the group in 2005, builders trade at an average P/E of just 7. That makes housing the stock market's cheapest sector, as measured by both price-to-earnings and the ratio of that P/E to growth rates.

The simplest way to tap this value play is through CGM Realty, a concentrated real estate fund that has lately been heavy on builders. (Muhlenkamp's excellent fund is too diversified if you want a straight play on the sector.) If individual stocks are your game, any one of the big builders—D.R. Horton (DHI), Lennar (LEN), Pulte Homes (PHM), Centex (CTX)—are worth a look. Even if real estate does cool off, their deep pockets will allow them to keep grabbing market share from contractors and private developers who still control the bulk of a very fragmented industry. Our pick of the bunch, though, is Centex. Its commercial construction business provides some buffer should higher mortgage rates soften the residential business.


As long as Americans keep getting older, there's money in pharma. Risk: No one's sure how much is in the new-drug pipeline

Let's be clear: This is a contrarian bet appropriate only for patient, risk-tolerant bargain hunters. "The time to buy is when there's blood on the streets," says manager John Buckingham of the Al Frank Fund, channeling Nathan Rothschild. "It's hard to imagine it getting any more bloody than in the drug sector." For starters, there are the headlines about Merck's withdrawal of the popular pain-reliever Vioxx over concerns that it may increase the risk of heart attacks. But even more worrying to Wall Street is the fact that many blockbuster drugs are losing their patents in the next few years, meaning that generic knockoffs can flood the market and drive down prices. And there aren't enough new pills on the way.

As a result, the typical major drug company now trades for just 14 times profit projections vs. a P/E of 17 for the S&P 500. This despite the fact that drug companies' average net profit margin is a fat 20% and their dividends to shareholders run at about 2.5%. And the demand for drugs is obviously growing as baby boomers age—some Lipitor with your steak?—and life expectancies increase. Still, for the pharmas to really be a bargain, you have to believe that all those worries about the shortage of new drugs are overdone. They are. Over the past 10 years, the FDA has approved an average of 32 new drugs a year. Meanwhile, the industry is spending $33 billion on research and development, up from $8 billion in 1990, and it's a good bet that this will produce a few more billion-dollar drugs. Of course, the process of getting any of these drugs approved will take years, and Wall Street has a hard time looking beyond 2006. "If you are looking at the group, there are products in the pipeline or in approval that should offset expiring patents," says Douglas Christopher, a pharmaceutical analyst with Crowell Weedon & Co. "The trouble, on a company-by-company basis, is timing."

For investors with a three- to five-year outlook, though, Wall Street's short-term focus appears to have created a historic opportunity to pick up traditional growth stocks at value P/Es. Since it's not obvious which companies' R&D spending will pay off (and once it is obvious, those stocks won't be bargains), your best bet is just to buy 'em all. Ross Levin, a financial planner in Minnesota, recommends buying "a bucket of pharma" through an exchange-traded portfolio. The only one that focuses exclusively on drug companies is Pharmaceutical HOLDRs (PPH). More than 85% of it is invested in the eight biggest U.S. drugmakers. It can be bought through a broker like any stock, but you have to buy a round lot of 100 shares.

Another way to bet on the industry's comeback without worrying about the state of any one company's product pipelines is through IMS Health (RX), a consultancy that was spun out of Dun & Bradstreet in 1996. IMS collects information from 29,000 data suppliers from over 100 countries, including drug manufacturers, retailers, pharmacists and hospitals. Then IMS sells back its findings to the folks who originally supplied it. It also advises companies on drug launches and is hired to fire up sales forces. The stock is weighed down by negative perceptions of the drug industry, but over the past 12 months, IMS booked net profit margins of 19% on sales of $1.5 billion. Wall Street expects it to grow earnings 13% in 2005; at a recent $22 the stock had a P/E of just 17. "IMS has all of the positive characteristics of drug companies combined with the attributes of data companies—that is, great cash generation, predictability and low incremental capital needs to support growth," says Bill Nygren of the Oakmark Select fund. IMS is among his top holdings.


A return of IPOs and mergers would boost investment bank profits. Risk: Dealmaking is still a shadow of what it once was

They're baaack. Investment bankers aren't yet dancing like it's 1999, but there are signs that the four-year slump in stock and bond underwriting and merger-and-acquisition dealmaking is coming to an end. With Google leading the way, last year was the best year for initial public offerings since 2000, according to Thomson Financial. In the ultralucrative M&A business, investment banks handled $538 billion worth of deals through late November, up from $468 billion in all of 2003. And while M&A is still a shadow of its former self, there's reason to think more companies will be turning to Wall Street for marriage advice.

Why? Just look at corporate balance sheets. S&P 500 companies now have nearly 10% of their assets in cash, double the relative cash positions that prevailed 10 years ago. T. Rowe Price financial services analyst Jeff Arricale says this cash buildup indicates an unwillingness to plow more money into existing operations. The payoff is too uncertain. "It's hard to find organic growth, and what that likely means is that a lot of companies are going to turn to mergers and acquisitions to generate growth," says Arricale. The falling dollar adds to the possibilities by making U.S. companies more affordable to foreign buyers.

An M&A resurgence is not a sure thing. But it would pay huge dividends for Wall Street, generating big advisory fees while also creating related underwriting business. Says Arricale: "If there are some big deals, companies are going to have to issue equity or debt to finance them." One way to play this is through Citigroup (c). It's a well-diversified megabank that's been using its leverage as a commercial lender to bully its way into more lucrative investment banking assignments. A more direct investment banking play—and perhaps the stock best-positioned to take advantage of an M&A rebound—is Goldman Sachs (GS). At a recent $104 a share, Goldman now trades at 12 times its projected 2005 profits—well below its average P/E of 17 since going public in 1999. "Goldman still has that shine of being the best investment bank on the planet," says fund manager Matthew Kelmon, who has 8% of his Kelmoore Strategy fund invested in the company's stock.

These days Goldman is making most of its money off of trading and its own investments—in everything from bonds to power plants. And there are those who wonder if Goldman's weaknesses on the lending side could eventually make it a weaker competitor to Citigroup in M&A. But right now it remains a leader. It's also the rare financial company that could benefit from a modest rise in interest rates. Higher rates would encourage corporate clients to finance deals by selling stock (a Goldman strength) rather than via bonds (a weakness). All in all, if investment banking rebounds the way Kelmon anticipates, he sees a 20% upside for Goldman shares in 2005 and even more longer term.


Junk and foreign bonds beat going long. Risk: High-yield debt is more tied to economic ups and downs

With interest rates still low, it's tough to get a big payout from your bond investments nowadays. What to do? You might be tempted to try and squeeze out extra yield by getting into longer-maturity bonds, but you won't be well rewarded for taking on the extra interest-rate risk. (Rising rates mean falling bond prices, and longer bonds generally fall furthest.) The yield on 10-year Treasury bonds was a slim 4.2% in November, not an awful lot more than the 3.5% you could get on a safer five-year bond.

So instead of going long to get more yield, go low—in credit quality, that is. High-yield or "junk" bonds are offering up to 3.5 percentage points more than Treasuries of similar maturity. This is a supplement to your core bond holdings, not a replacement for them. After all, you're adding some risk here: Junk bonds (defined as those rated below BBB) pay investors more because there's a higher chance the businesses behind them will fail to make their payments. But with a strong economy, default rates are running at just 2%, compared with the historical average of 4.75%. Two caveats: First, prices of junk bonds have had a strong run in recent years, so you shouldn't expect huge returns beyond the yield. And you should favor the higher-credit issues in the junk spectrum, because you won't get much extra yield by taking a chance on shakier bonds.

You can best mitigate credit risks by buying junk through a mutual fund—over time, junk funds tend to be more volatile than conventional bond funds but steadier than stock portfolios. Pioneer High Yield fund is at the head of its class. It yields 5.6% and has logged annualized returns of 13.78% over the past five years. Manager Margaret Patel says that she's recently been shifting the portfolio towards higher-quality junk.

If you want even more yield than junk can offer—and are even more adventurous—consider an emerging-markets bond fund. The economic health of many developing nations is steadily improving, so that they have less debt as a percentage of their gross domestic product. Almost 50% of emerging-market debt is rated as investment grade (including that of Hungary, Malaysia and El Salvador), yet in aggregate the sector yields over 8%. And as these countries have become less reliant upon external borrowing, they are issuing fewer bonds. Scarcer bonds and improved creditworthiness should add up to higher prices. The best play here is Payden Emerging Markets Bond fund, which limits its risk by holding no more than 20% of assets in any one country and favors the sector's highest-quality issuers. It yields 6%.

Notes: Stock data as of Nov. 29. P/Es based on projected 2005 earnings. Fund data as of Nov. 26. [1] Annualized. N.A.: Not applicable. Sources: Thomson/Baseline, Morningstar, the funds.

The Update

How did our Best Investment picks for 2004 do? Four of the stocks in our portfolio notched double-digit returns, which offset the losses of the other two. The result: an average total return of 15.9% since we chose them, ahead of the 12.6% return of Standard and Poor's 500-stock index.


Notes: Returns are from Dec. 3, 2003 to Nov. 29, 2004. Stock prices as of Nov. 29. Source: Bloomberg.