Get ready for a rebound
Investor Daily: Jeff Mortimer, chief investment officer of Schwab's mutual funds, says you need to be prepared for a rapid rise in share prices.
(Fortune Magazine) -- As the stock market convulses in 400-point spasms, holding to a steady course takes a lot of nerve. For some encouragement - and a few timely stock picks - we turned to Jeff Mortimer, chief investment officer of Charles Schwab's mutual funds unit.
Mortimer, who has studied bear markets going back to the 1920s, makes a compelling case for putting money into stocks now. It's not that he sees an immediate recovery. "There's probably some rough sledding for the next three to six to nine months," he says. In fact, he believes the market may dip back to its Oct. 10 lows - maybe several times.
But bull markets reward those who invest before the gloom lifts. Mortimer points out that 47% of the gains are typically packed into the first 12 months, well ahead of when most investors feel comfortable getting back in. "Equity markets will have moved significantly higher before we read that the recession is over in the papers," he says. Instead of trying to time the market, Mortimer says, it's important to start building positions for its eventual return.
To get specific suggestions for today's bruised market, we consulted Schwab's Equity Ratings system. Once a week the in-house stock-picking model puts 3,200 U.S. stocks through a quantitative wringer to produce a slate of buy, hold, and sell recommendations for Schwab fund managers and clients. Each stock is screened on 19 metrics, from price-to-book to short interest ratios, and rated in four broad categories: fundamentals, valuation, momentum, and risk.
The system then grades the group on a bell curve, with the top 5% receiving A's, the next 25% getting B's, and so on. The A's and B's, about 960 securities in total, are Schwab's bets to outperform in the year ahead.
Since Schwab first started using Equity Ratings six years ago, top-rated stocks have regularly beaten their benchmark, the Dow Jones Wilshire 5000. From May 6, 2002, through Nov. 10, the weekly rosters of A-rated stocks returned an average of 19% before costs in the following year, compared with 11% for the index. B-rated stocks returned 17%. Here are four promising picks for 2009.
Amgen (AMGN, Fortune 500) (AMGN, $56), the second-largest biotech company (after Genentech), has seen its rating rise from B to A over the past year. In fact it now ranks near the very top of all 3,200 stocks in the screen thanks to strong free cash flow growth and a four-quarter streak of beating Wall Street analysts' earnings expectations.
Health-care stocks tend to perform relatively well in bear markets - Amgen is up 20% in 2008 - but that's not factored into the screen. "It's a company that's doing very well right now, and the fact that it's economically less sensitive is icing on the cake," says Schwab's Greg Forsythe, who leads the Equity Ratings research team.
On the flip side, the model doesn't shy away from battered industries. Take Texas homebuilder D.R. Horton (DHI, Fortune 500) (DHI, $6). As the stock plunged 55% over the past year, it moved up into B territory on the screen. Mortimer says this isn't merely because the shares are cheap; the company's strong working-capital and free-cash-flow growth get high marks.
"We're not just jumping up and down at the stock price," he says. "The model sees fundamental strength here that the world isn't giving DHI credit for." Forsythe points to another positive sign: Short-sellers, who gorged on Horton shares earlier this year, have been covering their positions. "They think the stock is no longer overvalued," he says, "or that the worst has already happened."
Another B stock from a distressed sector, Polo Ralph Lauren (RL) (RL, $40), has dropped 35% this year. But the high-end preppy clothier comes up strong in Equity Ratings for staying surprisingly healthy in the bleaker-by-the-minute retail environment.
"Its last four quarterly earnings reports have all come in at least 30% above analyst expectations," says Forsythe, and the company's three- to five-year profit growth forecast hovers above the S&P 500 average. Still, the stock price keeps sinking amid the pullback in consumer spending. Shares now trade at a price/earnings ratio of 9.7, compared with an average P/E of 12 for the S&P 500.
Sharp drops have helped push other stocks into buying territory, including Chicago-based food giant Sara Lee (SLE, Fortune 500) (SLE, $9), which is down 42% this year. Based on Sara Lee's size and the stability of its revenues, Schwab's model rates the stock as relatively low risk.
"Our methodology sees Sara Lee as a consistent company in time of great volatility," says Mortimer. Forsythe adds that because many investors have written off Sara Lee as a low-expectation stock, the company hasn't gotten enough credit for being a slow-and-steady performer - a decisive advantage in today's rocky environment.