Company Focus
Recent articles:
• Own a piece of China's Google wannabe, 7/27/2005
• Stocks that will ride Europe's next boom, 7/27/2005
• Cable companies are now cash machines, 7/20/2005
More...
| | Company Focus
11 stocks from the years top value pros
While a key market model screams buy, many value-stock experts say that's baloney. These picks from some of the year's top value managers could do well whatever happens next.
By Michael Brush
How easy is it to feel uneasy about stocks these days? Let us count the ways.- The big indexes are at four-year highs.
- Rising interest rates threaten to squelch economic growth.
- A typically weak season for equities lies just around the corner.
With that backdrop, its no surprise many pundits are telling investors to dump stocks.
Here's the problem with their warnings: This actually may be the best time in 25 years to load up on stocks. Thats the message from a market gauge that has the stamp of approval of no less an authority than the Federal Reserve.
The screaming buy signal comes from a powerful market-timing instrument known among market pros as the Fed model -- because it was tried and tested in a Fed study several years ago.
Right now, the Fed model is sending off such a bullish signal for stocks that Prudential Securities is telling investors to put all their money into equities. Thats unusual advice on Wall Street, where gurus typically recommend having at least some exposure to bonds at all times.
I continue to be very bullish about stocks, says Ed Keon, quantitative research director at Prudential. He predicts the S&P 500 will advance 10% and hit 1,340 by the end of the year. And he thinks that index could be up 30% by sometime in 2006.
If all this sounds off the wall, keep in mind that Keon made an even wilder market call using the very same Fed model in 1999, when he told investors to dump stocks and buy bonds. What happened next? The Nasdaq Composite ($COMPX) fell a painful 78% between March 2000 and October 2002. The S&P 500 ($INX) dropped 49% in the same time frame. Bonds, meanwhile, advanced about 10% a year on average between 2000 and 2004.
Keeping a balance
How does the Fed model work? Basically, it relies on the idea that stock and bond prices have a relationship that holds steady in the long run.
Simply put, the model shows that the yield on the 10-year Treasury bond should be about the same as the next 12 months' earnings yield on stocks. The further those numbers move apart, the greater the opportunity to profit when the gap inevitably closes. (You calculate the forward earnings yield for a stock by dividing its forward annual earnings projection by its stock price.)
Today, the 6.5% forward earnings yield on S&P 500 stocks towers over the 4.33% dividend yield on ten-year bonds. The distance hasnt been that vast since 1980 -- roughly the beginning of a 20-year surge in stocks. Heres another striking message from the Fed model. Stocks look as undervalued now -- compared to bonds -- as bonds were undervalued compared to stocks in early 2000, or the peak of the stock market bubble, says Keon.
When things get out of whack like this, over time they react in a way that the cheap asset class benefits, says Keon.
Fighting the last war
Why might investors be valuing stocks incorrectly? One reason, says Keon, could be that theyre still afraid since they got burned so badly by stocks during the 2000-2002 meltdown. Theyre also spooked by events on the world stage.
So investors are extremely risk-averse, and they favor assets that appear safer because they have been going up: bonds and real estate. Bonds and real estate have gone straight up, so people think they are a sure thing, says Keon. Unfortunately, unless the Fed model fails -- something it hasnt done in fifty years -- bonds and real estate will decline while stocks continue to advance in the next year or two.
Jeers from the value seekers
Given the steady advance of stocks over the past three years, its no surprise that value managers think Keon is off his rocker.
Robert Rodriguez believes stocks are so pricey that he has a 34% cash position in his FPA Capital fund (FPPTX). His market screens for cheap companies turned up just 78 stocks recently, not far from all-time lows of 25-30. When markets are more reasonably valued, he can have 250-400 candidates to evaluate.
The market is very fully valued and very risky, agrees Barry James, of the James Equity fund (JALCX). We expect trouble later this year, and we are trying to batten down the hatches.
Keon concedes that part of the realignment of stocks and bonds may come from bonds losing value. But he thinks most of it will come from stocks going up. Thats because he believes the value guys -- like most investors -- are off track in their belief that rising rates will knock annual earnings growth down to around 6%.
Related news and commentary on MSN Money
Keon points to second-quarter earnings that, so far, are 12.8% ahead of the same quarter a year ago -- a sign the recovery has not been derailed. Plus, he says, inflation is under control, so the Fed wont have to raise rates so much that it kills off the recovery. This earnings cycle looks like it is going to be longer than expected, says Keon.
Hedging your rally bets
As an investor, how should you deal with this clash between the Fed model and the skeptics?
My solution: Lets assume the Fed model is right, because it has such a solid record. But lets go with stock picks from conservative value investors, whose buys won't depend on an overall market surge.
To begin my hunt, I tracked down fund managers who have done the best job of picking large-company value stocks over the past three years. From that list, I focused on this years best performers.
This approach lead me to Mark Hillman, at Hillman Aggressive Equity (HCMAX), the best large-cap value manager this year with 11.4% in gains, as of last week. It also helped me find Barry James at James Equity Fund, (up 9.5%) and Charles Bath at Diamond Hill Large Cap Fund (DHLAX) (up 9.8%). I also consulted Jamie Dlugosch, whose newsletter, The Rational Investor, was ranked No. 2 by Hulbert Financial Digest for 2004 performance. Dlugosch contributes to MSN Moneys Strategy Lab and he recently launched a mutual fund called The Rational Investor Fund, which does not yet have a ticker symbol.
Heres a quick look at where these pros find value in todays market.
Value among the recent winners
Oddly, stocks most favored by our top value investors are in groups your stomach might tell you to avoid because they have rallied so much, or homebuilding, energy, basic materials and utilities. But there is some logic to this.
Homebuilders, for example, regularly post earnings growth of 15%-25%, and analysts expect them to do so for years to come. Yet they still carry paltry single-digit price-to-earnings ratios.
Old-school thinkers believe they deserve it -- because housing is cyclical. But value investors think the cyclicality is gone, thanks to things like immigration and more professional management.
These companies trade for single-digit multiples but continually put out 25% profit growth, and they have done that for 20 quarters. At some point you have to say there is a new dynamic here, says Dlugosch, who favors Orleans Homebuilders (OHB, news, msgs) and Hovnanian Enterprises (HOV, news, msgs).
Another good example is D.R. Horton (DHI, news, msgs), believes Hillman. They have managed their growth through a number of horrendous interest-rate cycles, some of them far more horrendous than what may happen this time around, he says.
Energy: Plenty still in the tank
Likewise, the dramatic climb of energy stocks looks scary. But investors afraid of these stocks are making a basic error, says Bath. Theyre assuming that oil will drop back to $40 or below.
Bath thinks this is wrong because theres a global supply-demand imbalance that will take years of investment to correct. Chinese growth is not going to sit back and wait for the world to produce more oil, he says. The earnings at these companies are not rolling over in the near future. Bath says he would buy more of his favorites -- ConocoPhillips (COP, news, msgs) and Apache (APA, news, msgs) -- if they werent already among his largest holdings.
In basic materials, Bath makes a similar case for Phelps Dodge (PD, news, msgs), the worlds second-largest copper producer, also trading near highs for the year. Again, he says it will take years of investment to overcome supply-demand imbalances in copper. Meanwhile, global economic growth will keep pushing demand. Dlugosch recommends steel distributor Ryerson Tull (RT, news, msgs) for similar reasons, even though its trading near its 52-week highs. The stock recently sold for $19. Dlugosch says its a buy below $18.
E.I DuPont de Nemours (DD, news, msgs), in contrast, has sold off dramatically this year. That makes DuPont one of the cheapest stocks in Hillmans large-cap universe. A series of problems, from restructuring charges and write downs, to high energy prices and low-cost competition, have hurt growth. The stock fell to $43 recently, from $54 in early March. But DuPont has the chemical industry's most attractive balance sheet and at some point it should return to rolling out innovative products.
Finally, Barry James at James Equity favors utility stocks like Sempra Energy (SRE, news, msgs), Edison International (EIX, news, msgs) and WPS Resources (WPS, news, msgs) even though these trade near 52-week highs, too. Despite the gains, they still look cheap compared to the market, says James. And they are posting healthy earnings growth -- in part because of cost-cutting now that they are more lightly regulated.
They have another thing going for them, says James. As companies that pay big dividends, they should hold up relatively well even if Keon and the Fed model are wrong and the overall market sells off.
|
