Look Deeper and This Market's Not So Dull
Cast about beneath the surface and you can find some prize catches at bargain prices
(MONEY Magazine) – After watching the stock market go mostly sideways for more than a year, you may be wishing that you could just doze off and have someone wake you when things get interesting again. But now is not the time to ignore stocks. The Dow Jones industrial average may not be very active, but beneath the surface of today's market, there's actually quite a lot going on.
Some market sectors are soaring. Energy shares have climbed more than 40% over the past 12 months, and real estate investment trusts have risen by 30%. But chasing after hot groups once they're up so much is a beginner's mistake. The smarter long-term strategy is to look for high-quality stocks that have lagged the market and scoop them up while they're cheap. Over time those shares typically make up lost ground.
Such contrarianism makes sense only, of course, if you're optimistic about the market's long-term prospects. That's not an unreasonable position today, despite higher oil prices and anxiety about terrorism. The economic data strongly suggest that stocks should be trading at higher prices. Not only does unemployment keep dropping, but real GDP growth keeps being revised upward--to a 3.8% annual rate for the latest quarter. Moreover, this growth has been accomplished with remarkably little inflation beyond the gas pump. Consumer prices are up only 2.5% vs. a year ago.
If you believe in the long-term picture, as I do, then short-term problems and missed quarterly earnings targets don't undermine a stock's potential as long as it has a great franchise. I've gone through the Sivy 70 list of big growth companies, looking at shares that have underperformed by a substantial margin, and five companies stand out.
Since the Dow is up 7.3% over the past 12 months, and these five stocks have declined by at least 7%, they have lagged the broad market by a minimum of 14 percentage points. Nonetheless, they still look attractive as long-term choices capable of providing total returns averaging at least 11% a year. In addition, all five stocks have price/earnings ratios below their usual level or below the market average. Here's a closer look at them.
PFIZER The most deeply depressed is Pfizer, which we've recommended before. The stock is down 14% over the past 12 months, and its woes are well known: Several blockbuster drugs will soon lose patent protection; sales of the company's COX-2 inhibitors Bextra and Celebrex have been hurt since they were linked with an increased risk of heart problems; and a couple of promising new drugs have flopped in trials. There's even a debate as to whether Viagra increases the risk of a rare form of blindness. All this shall pass. Pfizer, the world's largest drug company, has more than 200 drugs already in development, is aggressively revamping its research and development and is sitting on more than $22 billion in cash.
3M From an all-time high just over a year ago, 3M shares recently fell to a 52-week low. Earnings reports have been mediocre, and the company faces the pressing problem of replacing CEO James McNerney, who left in July to take the chief executive job at Boeing. Nonetheless, 3M's long-term outlook is solid. The company makes an assortment of consumer and industrial products that employ specialized technology--from the adhesives used for Scotch tape and Post-It notes to films that enhance flat-screen televisions. Such products are present everywhere in modern society, and 3M is finding great opportunities overseas. In fact, more than 60% of sales now come from outside the U.S.
ALCOA Also in the bargain bin is Alcoa, down 9.4%. Investors have been concerned that the aluminum giant's cost-cutting plans are running behind schedule and that aluminum prices have been soft. In July, however, Alcoa reported a robust 14% earnings gain. The company's troubles may not quite be over, but I've recommended the stock here and in my online column because the shares of raw materials producers are an important inflation hedge. Consumer prices may not be rising fast now, but that's one of the reasons Alcoa's shares are cheap. If inflation does heat up at some point, Alcoa would likely help offset potential losses elsewhere in your portfolio.
CISCO SYSTEMS The fastest growing of the five is Cisco. Results for this maker of networking equipment have been underwhelming for the past couple of years but picked up in the most recent quarterly report, as earnings rose 16% on a 10% gain in sales. To stay ahead of low-end competition from Chinese and other manufacturers, Cisco has introduced routers that can handle much larger amounts of traffic and will offer more sophisticated systems that enable customers to improve security and sort information more efficiently. Finally, Cisco is pushing hard in China itself, and it expects the country will be the company's second-biggest market within a decade.
COLGATE-PALMOLIVE To rev up earnings growth, Colgate-Palmolive is embarking on a bold restructuring plan. In December the company announced that it would shed 12% of its worldwide work force and close one-third of its factories. Those changes didn't start happening fast enough to help first-quarter results, but I've recently recommended the stock online, in part because analysts say they are starting to see signs of real progress. Another bright spot is that consumers have proved willing to pay higher prices for fancier soaps and toothpastes, such as Max Fresh, a whitening toothpaste that contains tiny strips of breath freshener. Colgate has also announced plans to divest its laundry detergent brands, including Fab and Dynamo, so it can concentrate on more profitable products.
NOTE: As of July 20. P/E ratios are based on projected 2006 earnings. Earnings growth is compound annual rate projected for the next five years. SOURCE: Thomson/Baseline.