These are the best of times for stock investors.
Skeptical? Well, consider the following. Today nearly every relevant economic barometer points to recovery (see a round-up of CNN/Money's favorite 10 indicators).
During past recessions, the stock market had already bounced back by the time economic indicators turned upward. But because the Enron debacle has investors so spooked, prices don't reflect this improved outlook.
"Usually if you wait for fundamentals to be confirmed, you've waited too long," says Sam Stovall, senior investment strategist at Standard & Poor's. "What Enron has done is given people who've dillydallied a chance to get in not too far from where they could have last fall."
True, buying stocks in today's climate requires courage. Threats of war and future terror attacks loom large, and every day seems to bring new revelations of how corporate America has been fudging its earnings.
And even bulls acknowledge that today's market is not cheap when viewed through the lens of P/E ratios. The S&P 500 trades at 22 times projected 2002 earnings -- well off its 1998 P/E high of 33, but in line with the index's 10-year average. And even in the context of the paltry returns available on bonds these days (5.2 percent on a 10-year Treasury) , stocks seem only fairly valued, not undervalued.
But there is also much to like. The recession appears to be almost over. Stock valuations have fallen sharply. And with chief executives and their financial officers now swearing off incomplete or even deceptive accounting practices, Enron may have a silver lining.
Kurt Walters, a top stock strategist for Bear Stearns, thinks the push for greater financial transparency will lead to a lower risk premium for equities. Corporate honesty, in other words, will be rewarded with higher stock prices.
And just looking at current P/E ratios can be misleading, because it gives too much weight to depressed earnings recorded in a weak economy. At the end of 1991, for instance, the S&P traded at 26 times earnings while bonds were yielding 6.7 percent for 10-year Treasuries. Had you opted for bonds over stocks back then, you'd have missed out on the early stages of a decade-long bull market.
"When you're at trough earnings, the market is always going to look elevated," says Invesco Growth & Income's Fritz Meyer, who thinks the S&P will hit 1,400 by year-end -- up 23 percent from recent levels.
Which stocks make the most sense in today's market? To find them, MONEY took a hard look at earnings, the driver of stock prices. We asked Thomson Financial/First Call to screen for stocks covered by five or more analysts that saw rising 2002 earnings estimates throughout 2001.
From a list of 144 companies with at least $1 billion in market cap, we kept only those big enough to be included in the S&P 500 (53 names). We then screened for revenue and earnings growth that outpaced the market's 7 percent and 2 percent average rates, respectively, over the past three years. That brought us to 29 companies. We wanted above-average financial strength as rated by Standard & Poor's. Two dozen made the cut, representing sectors from airlines to financials to retail. They're listed in the table below. In addition, we profile five of the more compelling buys, which you can click straight to: Wal-Mart, Lowe's, Southwest Airlines, Morgan Stanley Dean Witter and Dell Computer.
WAL-MART Kmart's bankruptcy gives extra kick to Wal-Mart, whose ruthless price-cutting and expansion into items like groceries have helped the world's largest retailer win more customers.
"Wal-Mart has taken market share as their competitors have weakened," says Margaret Buescher, portfolio manager of CDC Nvest Large Cap Value, who considers the stock one of her fund's core holdings. "With Kmart gone, Wal-Mart has additional share to gain and they may have less pressure on [profit] margins."
Hardly cheap at around 35 times estimated 2002 earnings, Wal-Mart nevertheless trades near the middle of its five-year P/E range. Projected earnings growth for this year is 17 percent, a figure that could prove to be too conservative as details emerge about how Kmart will shrink its operations.
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Stocks to Watch
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Wal-Mart's strategy of broadening its product offerings appears to be paying off. In January, sales at Wal-Mart stores open a year or longer grew faster (up 8.6 percent) than sales at competing stores, including Target (7.6 percent). Clearly this growth story isn't over yet.
LOWE'S Two of the bright spots in this recession have been the strength of the housing market and the resilience of consumer spending, so it's little wonder that the top two home improvement retailers, Home Depot and Lowe's, both have rising earnings prospects for the year ahead. The refinancing boom that has followed last year's interest-rate cuts is triggering what some are calling a "mini wealth effect" -- extra cash in homeowners' pockets that's a perfect catalyst for kitchen renovations and other do-it-yourself projects.
Although we like both companies, we prefer Lowe's because it's cheaper and growing faster than its better-known rival. Indeed, fourth-quarter sales soared 55 percent. With $22 billion in revenue last year (compared with Home Depot's $54 billion), Lowe's is deftly using its new heft to improve profit margins by demanding better prices from suppliers.
At less than 30 times projected 2002 earnings, Lowe's is trading at almost 1.5 times its expected long-term growth rate of 20 percent. David Scott, manager of Chase Large Cap Growth, predicts that Lowe's stock will command a greater premium as it produces better and better numbers. "Lowe's," he says, "is becoming a recognized retailer name, like a Home Depot or a Wal-Mart."
SOUTHWEST AIRLINES Okay, so being the best-run airline isn't saying all that much. But Southwest still deserves respect. Despite last year's precipitous drop in air travel -- exacerbated by the Sept. 11 terrorist attacks -- Southwest still managed to make $412 million (compared with a combined $7 billion loss for the other six major airlines).
It was the company's 29th consecutively profitable year, remarkable in an industry plagued by high fixed costs, low profit margins and poor labor relations. Southwest's 18.5 percent operating margin dwarfs the industry average of 4.8 percent. And its moves last year to avoid layoffs only solidified the love fest between managers and employees that has long made Southwest one of the most admired companies in America.
Of course, none of this is a secret. At a recent $18.50, the stock trades at a 2002 P/E of 29 -- not cheap. But Wall Street sees earnings jumping 27 percent and 46 percent over the next two years, respectively.
How? Southwest has grabbed market share as the major airlines cut capacity by up to 20 percent since Sept. 11 and abandoned their low-fare, low-cost lines. This growth is expected to continue as Southwest adds new destinations and connects existing ones. While others are still picking themselves up off the ground, Southwest is in full growth mode, with $2.3 billion in cash and very low debt for an airline. Investors haven't been disappointed so far: The stock had an annualized return of 36 percent over the past five years.
MORGAN STANLEY It's been a long 12 months for Morgan Stanley Dean Witter. Its high-margin stock-underwriting and mergers-consulting businesses were mostly idle, while trading revenue barely trickled in compared with years past -- tough going for a company that derives about 70 percent of its sales from those services. Earnings fell 33 percent and the stock plunged 35 percent.
But many analysts think the worst is over, citing a gradual recovery in the capital markets that is expected to boost Morgan's earnings by 6 percent this year and 20 percent in 2003. Morgan is a global leader in financial services, with top positions in investment banking, asset management and credit cards -- plus an army of brokers (13,500) second only to Merrill Lynch.
"They've got all the pieces to be a powerhouse," says Raymond McCaffrey, manager of PBHG Large Cap Value. "They can offer everything." Plus, no big financial services company comes close yet to Morgan for profitability; it boasts a five-year average return on equity of 25 percent vs. its peers' 17 percent.
Meantime, the company has been slashing costs, including cutting 1,500 jobs in 2001. Says Chris Perry, co-manager of Turner Future Financial Services fund: "Management is a clear leader in anticipating how to manage the cost structure during difficult conditions."
Morgan Stanley's 16 P/E for 2002 is well below its high of 24 in 2000. Add in the 1.6 percent dividend yield, and you have a bargain price for one of the world's premier financial stocks.
DELL COMPUTER Dell's legendary efficiency has been an asset during the meltdown in PC demand. "They've got the widest margins in hardware production," notes Mark Schultz, a senior analyst at M&T Asset Management. "And as a result they've been able to drive down the price of hardware -- an important competitive advantage in a weak environment."
Dell's earnings shrank 21 percent last year as corporate IT spending dried up, and the stock is now close to 20 percent below its high. But in a late February report, Merrill Lynch analyst Steven Fortuna called the stock a strong buy at $24, saying it was at "the entry point we've been waiting for."
Though Dell is unlikely to recapture its raging growth of the late 1990s, it has gained market share during this recession -- that's one reason why the CEOs of Compaq and Hewlett Packard want to merge -- so Dell will benefit when corporate PC spending picks up again, which some bullish analysts think could happen as soon as later this year.
Indeed, though Dell recently stated it hasn't seen a pick-up in demand, it did say it is benefitting from the uncertainty created by the proposed Hewlett-Packard merger with Compaq. As a result, the company upped its revenue forecast for the coming quarter.
The company -- which currently gets about half of its revenue from PCs -- is also shifting its lean-'n'-mean business model to include higher-margin hardware like data storage and servers. At 35 times estimated 2002 earnings, this is a company with real growth prospects.
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