Don't Let The Clouds Scare You Away
The market's nervous. That makes this a good time to show a little daring.
(MONEY Magazine) – Corporate earnings growth is slowing down. Inflation is picking up. Rising interest rates threaten the housing market. Expensive gasoline is eating away at consumer spending. It's no wonder that dark clouds have settled over the stock market, with all the major indexes down for the year.
But just as turn-of-the-millennium investors suffered from irrational exuberance, consider the possibility that many investors today, including you, have come down with a case of irrational melancholy. Look at the bright side:
The U.S. economy is still expected to grow 3% or better this year. Corporate balance sheets are strong. The dollar, at a low against the euro in December, has held the line since. The job market continues to show improvement. Merger-and-acquisition activity--generally a good indicator of corporate optimism--is going gangbusters. And inflation remains quite low by historic standards.
Given contradictory signals, it's tough to make a near-term forecast except to say it's unlikely that today's variable economic winds will gather into a great destructive storm. So how do you invest optimistically, but not recklessly, in an uncertain time? The three-step strategy below is a cautious bet on at least modest economic growth, yet it will help you avoid overpriced sectors and give you some protection if the Dow stays choppy. It also gives you a way to do what all successful investors must: zig when the market is zagging. "The risk/reward relationship tends to be better," says Dreyfus chief economist Richard Hoey, "when people see everything in shades of black."
» MAKE A BET ON GROWTH Stocks of smaller companies have had a multiyear rally, but the playing field is tilting toward large-company stocks, argues Standard & Poor's equity analyst Richard Tortoriello. With interest rates rising and growth slowing as this economic cycle ages, the diversity and scale of large companies give them a better shot at increasing their earnings than small ones have. In the meantime, growth stocks remain undervalued as risk-averse investors have piled into slower-growing, low-priced value stocks. Four years ago growth stocks traded at twice the valuation of value stocks, according to data from the Russell Investment Group. That premium has dropped by 60%. The Leuthold Group said in April that big value stocks were trading for 18% more than they usually cost.
If you have been loading up on value stocks and funds lately, those numbers suggest that it might be time to sell some of your winners and go for more growth. The MONEY 50, which is this magazine's list of top-rated mutual funds, offers several options (see the box at right). All were down for the year as of late April, but Jensen Portfolio (JENSX) was ahead of the S&P 500 index.
» ROOT FOR A FALLEN PLAYER If you're thinking of putting new money into the market, look for an undervalued franchise--a company that dominates its industry and is increasing earnings yet is trading well below its usual level. You're still anticipating growth and a turnaround in market sentiment. But even if that's slow in coming, you're buying a bargain that should reward you down the road.
Consider networking giant Cisco ($17.50; CSCO), which is battling Wall Street skepticism despite continued growth in revenue and earnings. Over the next two years, earnings per share will grow twice as fast as that of the S&P 500, according to Merrill Lynch analyst Tal Liani, who recently upgraded Cisco to a buy. But judged on the basis of its price/earnings ratio, Cisco is only 10% more expensive than the S&P--a bargain in light of the 37% markup the stock has enjoyed in the wake of the tech bubble. Cisco's critics say the company faces lower operating margins and increasing competition from Chinese gearmakers. And they doubt the company can meet its revenue targets. But fans say that, given Cisco's reputation for quality, the threat from cut-rate pricing is overstated and the company can meet its sales goals.
Similarly snubbed is Citigroup ($46.75; C), which under CEO Chuck Prince is trying to focus its business and cleanse itself of past scandals. While trading in line with big U.S. banks based on estimated 2006 earnings, Citigroup is cheap vs. other global financial services players. John Buckingham, president of Al Frank Asset Management, a Citigroup shareholder, notes that the stock's price hasn't improved over the past four years, while earnings have. Buckingham says he thinks the market is focusing on old missteps, such as Citigroup's involvement in the WorldCom debacle. "The bad news," he says, "will fade."
» GO FOR THE GOODS Wall Street values companies in two ways: by their projected earnings and by the quality and value of their assets. This may be a good time for you to look at the latter. Here's why: The '90s were all about building empires. Today, Wall Street is pushing CEOs to break up their companies on the theory that the faster-growing pieces will be worth much more on their own.
In the media business, an attractive candidate is Liberty Media ($10.25; L), led by cable-TV legend John Malone. Liberty, which has minuscule earnings but holds major stakes in Rupert Murdoch's News Corp. and programmer Discovery Communications, shed its international operations last year. In March it announced plans for another spin-off. John Linehan, portfolio manager of the T. Rowe Price Value Fund, a Liberty stockholder, estimates the stock is worth $13 to $15, if the company can avoid big tax liabilities in the breakup. While success isn't certain, Malone has "never met a tax he's liked," says Linehan.
Another jigsaw puzzle with valuable-looking pieces is Altria Group ($65.25; MO), parent company of Kraft Foods and Philip Morris USA, the nation's largest tobacco maker. It used to be that investors hoped to split up the company because tobacco litigation held down the valuation the food business got. But as court cases have wound down, the belief is that the cash-rich tobacco operations will benefit from comparisons to other cigarette makers. Analysts value the parts of Altria at $79 to $91 a share. The big catch: The company has to resolve three court cases before any breakup can happen. Still, Altria is "my best asset play," says David Dreman, chairman of Dreman Value Management. Meantime the stock pays a 4.5% dividend, so you get paid to wait.
HOW TO INVEST FOR UNCERTAIN WEATHER
Fears of an economic storm that will sink the market look overblown, but prospects for stocks remain unsettled. So you want a strategy that works whether the clouds lift or linger.
Step 1 Go for Growth
Growth stocks are undervalued, while value stocks are starting to look expensive. If you've been loading up on the latter, consider rebalancing.
Step 2 Buy Fallen Stars
A few great companies aren't getting the respect, or P/Es, they deserve. Buy in at low prices today, and you can afford to wait for the picture to brighten.
Step 3 Acquire Assets
Breaking up companies in the hope of getting higher prices for their best assets is in vogue and should remain so even if economic growth slows a bit.
NOTES: Data as of April 25.  Not applicable. SOURCE: Thomson/Baseline.