Blue Chips: Why You Need to Keep the Faith
Blue-chip growth stocks did nothing in 2005, but they remain your best long-term opportunity
By Michael Sivy

(MONEY Magazine) – Here's how I see the outlook for stocks shaping up in 2006: Large swaths of the market are now undervalued, and many giant growth stocks are out-and-out bargains. If the economy performs as expected and the geopolitical environment improves a bit, the market could take off. Of course, I could have said the same thing a year ago, and in fact that's exactly what I did write in last year's forecast story. Yet the market is down slightly since then, and the kind of big, growing businesses that I believe should make up the core of your portfolio--think General Electric, Home Depot and the like--have lost more ground.

What gives? The geopolitics aren't great yet, but they're no worse than they were last year. And the economic numbers are mostly terrific. Unemployment has fallen to 5.1%, down from 6.3% in 2003. And the economy has grown at an above-average rate for 10 straight quarters despite oil prices and Katrina. In fact, the economy expanded by an estimated 3.8% annual rate last quarter--better than forecasters expected.

Earnings per share are running 12% ahead of last year, and since prices haven't risen overall, price/earnings ratios are getting lower. Not that they were high to begin with. At this point, we've had a strong economic recovery without a matching recovery in the stock market.

In my view, that means blue-chip growth stocks are still excellent long-term buys. Moreover, one of the market's big problems seems to be purely psychological. Investors are traumatized by the losses they suffered in the last bear market. In addition, a massive federal budget deficit and sky-high oil prices have sparked fears of a return to 1970s stagflation. But such concerns don't seem to be taking a toll on corporate profits.

Even so, some forecasters worry that a recession may be on the way; others just think above-average growth in corporate profits may not continue. "Profit margins right now are just about as good as they can get," says Andy Engel, senior research analyst at the Leuthold Group, an investment analysis firm in Minneapolis. That doesn't automatically mean that stocks are a bad buy, he says, but "you'll probably get better buying opportunities sometime in the next five years."

It's Just a Phase

I'm not convinced that a recession is on the way. Yes, consumer spending could weaken if housing prices soften, or the Federal Reserve could raise interest rates too fast and tip the economy into recession. But it's just as likely that business will keep on chugging along.

Much of the reason for the recent poor performance of growth stocks, I believe, is the result not of the business cycle but of another cycle--the alternating periods of strength and weakness for growth stocks vs. the rest of the market. This phenomenon is quite noticeable if you compare shares of large growth companies that trade at high price/earnings ratios with value stocks, shares of companies in businesses like banking and consumer products that trade at lower P/Es. As you can see in the chart at left, growth stocks lost ground from 1982-85 but led the market from 1985-91. Then they fell behind value for three years and were flat for another three. From 1997 to 2000, they outperformed.

Since then, it's been downhill. Today growth stocks look about 12% cheaper than value shares. But it's rare for one of these trends to last more than six or seven years. In the long run, it won't matter that this recovery didn't start in 2005 and might not get rolling next year. Leuthold's Engel may be right about there being a cheaper entry point later, but trying to time a bottom is awfully hard to do. Better to be early than late.

What About the Long Run?

There is, however, a question about how the market will perform long term. More forecasters believe that returns will be lower over the next couple of decades than they've been in the past. There's some merit to this argument. Stocks will remain the best place for your money, but you do need to temper your expectations and recognize that the huge returns of the 1990s may not recur. In fact, even the 11% annual return of the S&P 500 since 1926 looks like too high a hurdle to aim for.

Why? Returns come from three components: earnings growth, dividends and the expansion or contraction of P/E ratios. And the latter two appear likely to contribute less to stock returns than they did over the past 80 years.

"In the 1920s," explains Peng Chen, chief investment officer at Ibbotson Associates in Chicago, "the average P/E was just over 10. Now it's close to 20. Over 80 years, that doubling has added almost one percentage point a year to stock returns." But that increase occurred as stock ownership went from being a privilege of the very rich to a popular way of saving for the mass of affluent Americans. Now that this transition is complete, "it's hard to see how P/Es can rise a similar amount again," says Chen.

As for dividends, at today's reduced levels, they don't add the oomph they used to. "Up until the last 20 years, yields on blue chips were often 4% or more," says James Stack, editor of the InvesTech Research newsletter. "But today the yield is less than 2%." Stack projects that earnings will grow an average of 7% a year over the next couple of decades.

Still, a 9% annual return--7% earnings growth plus a 2% yield--clobbers most of the alternatives. Yields on 10-year Treasuries are now around 4.5%. And sectors such as energy and real estate look over-inflated and vulnerable to setbacks.

What to Look For

It's possible to do better than that 9% hurdle without taking extra risk, I think, if you favor companies that dominate their industries and have strong finances. The best deals are likely to be stocks that aren't overly expensive. Look for shares trading at less than 20 times projected 2006 earnings.

Sort through the thousands of stocks that trade publicly, and you'll find that fewer than 200 meet all these criteria. On the next page, I list statistics on 70 blue-chip growth stocks that look promising.

Some of the companies on the list are well-known names that are widely recommended but have fallen in price since January. Citigroup, for instance, trades at less than 11 times projected earnings for 2006. And although lots of big banks are cheap, Citigroup is attracting interest now because it might be broken up. General Electric remains a superb opportunity with a 2.6% dividend yield, unusually high for that company. Home Depot, the premier retailer for do-it-yourselfers, and Cisco, the leader in networking systems, seem like bargains at current prices. And Nike has a franchise that has made a great comeback--not to mention that cool swoosh.

You'll also see a few less recognized stocks on the list that look timely. Fortune Brands, a collection of top consumer brand names from Jim Beam bourbon to Titleist golf balls to Moen faucets, trades at a 14 P/E. And Illinois Tool Works, a midwestern producer of specialty fasteners, coatings, laminates and adhesives, is just the sort of stock that ought to be rising in a healthy economy. Instead, the shares have drifted lower all year and now trade at a P/E below 15. That's a deal you can't ignore.