Buy for Boom or Bust
Buy for Boom or Bust
by Stephen Leeb & Roger
S. Conrad
Personal Finance
Fractured markets like this one have
two possible futures. This article explains how to profit from
either.
Like the denizens of George Orwell's
Animal Farm, some stocks are "more equal" than
others. But when divergences run too deep, something has to give.
Either the high-flying stocks come crashing back to earth, or
the laggards become leaders.
In the season of summer rallies, the U.S. stock market
is a mix of maniacal optimism and hysterical fear. Investors continue
to bid up big name stocks to historically high levels while selling
off other stocks to valuations close to those seen only at major
market bottoms.
But before we pick the leaders and laggards that will
score big in the next year, we examine this deeply fractured market
and the two possible ways it will heal.
Jolt From Japan
Size, not profit growth has
been the key to strong stock performance over the past year. We
sampled 200 big cap stocks with a total market capitalization
exceeding $5 trillion. None had five-year annual earnings growth
of more than 10 percent and their average yearly revenue growth
was below 4 percent. But they trade at close to 30 times earnings,
despite the fact that their profit margins are declining.
In direct contrast, many companies that have grown
their earnings rapidly in recent years are trading at rock-bottom
valuations.
Table I compares price-to-earnings ratios (P/Es) and
earnings growth rates for the Ford 4,000 stock database. Under
normal circumstances, stocks with the highest growth rates have
the highest P/Es, since investors usually pay more for growth.
But today, stocks with high growth rates are, in many
cases, trading with P/Es below those of stocks with low growth
rates. The reason for this deep divergence can be boiled down
to one word: Japan.
Check out the graph comparing the performance
of the Japanese Nikkei stock market average, the broad-based CRB
index of basic commodities and gold prices over the past three
months. All three markets have moved nearly in lock-step.
As Japan goes, so go prospects for world economic growth,
commodity prices and economically sensitive stocks. Considering
the Japanese economy is the second largest in the world and accounts
for about 70 percent of the Far East's economy, that's not surprising.
During the first quarter of 1998, Japan experienced
what was probably the worst slowdown for any major industrialized
economy since World War II. The slowdown prevented the recovery
of other Asian economies and dramatically reduced world demand
for commodities such as oil.
Fear that Asia's crisis will set off a worldwide deflationary
shock wave has forced the U.S. Federal Reserve to continue to
flood our economy with money, despite signs of inflationary pressures
such as rising wages.
For example, the M3 measure of the money supply is
now growing at one of the fastest rates in more than a generation.
The result is a combination of economic fears, which
are stoked with the release of practically any Asian economic
statistic and near-record liquidity available for investment.
Consequently, the stocks most leveraged to economic
growth, including many of America's fastest-growing companies,
have plunged in the wake of selling by investors fearing the worst
for their earnings. Meanwhile, billions of dollars have been funneled
into "defensive stocks," particularly large, established
blue chip companies offering much less growth but greater safety.
Two Possibilities
There are two possible ways the current
fractured market will be resolved. The most likely scenario is
that Japan's economy will correct itself, spurring a recovery
throughout Asia.
Japan has earmarked more than $100 billion for a stimulus
package and more than $200 billion to clean up bad debts in its
banking system. They're also considering a major reduction in
income taxes. Most important, the government has committed itself
to doing whatever it takes to reassert its role as Asia's economic
leader.
A Japanese resurgence will ultimately create problems
for the U.S. economy and stock market in the form of higher worldwide
inflation. But before that happens it will trigger a recovery
in more economically sensitive stocks, which will dethrone the
blue chips as market leaders.
Five great stocks are listed in Table II and profiled
below. They're not the most leveraged stocks to economic growth.
But all are high quality fare and should hold up well if the future
isn't so rosy. And trading at valuations typical of market bottoms,
they're leveraged and cheap enough to assure you of huge gains
when Japan comes around.
The second possibility is less likely but infinitely
grimmer. Japan's efforts to revive its flagging growth will founder
and Asia will sink deeper into a recession. This, in turn, will
spread deflationary and even depressionary economic pressures,
cratering stock markets worldwide.
Few investments would perform well under such conditions.
The best bets are the five stocks listed in Table III and profiled
below. With dominant holds on industries that are virtually recession-proof,
each of these stocks has the revenue security to see it through
if we're off the mark in our optimism about Japan.
In addition, unlike today's bloated blue chips, these
defensive gems haven't been bid up to the sky. And they'll grow
faster if Japan reaccelerates.
Part I
Leveraged & Loaded
Picture a stock with explosive growth prospects in
a critical industry trading at a recession-level valuation. That's
not a dream, it's long-time Growth Portfolio Core Holding Schlumberger
(SLB).
Schlumberger has long been the world's premier provider
of oilfield equipment and services. Now it's taking advantage
of its industry's weakness to further hone its edge, buying Camco
International, a small, high-quality provider of well completion
services.
Though Schlumberger paid a premium for Camco, the acquisition
will still add at least a nickel to 1999 profits and augment growth
thereafter. And beyond the raw numbers, Camco further entrenches
Schlumberger as the top franchise provider of a full range of
integrated solutions.
Schlumberger currently trades at approximately 20 times
estimated 1999 profits. That's an even lower P/E than the stock
had during the last recession and it's the lowest relative to
the rest of the market in more than 30 years.
The reason is Wall Street's misguided belief that oil
prices will remain depressed indefinitely, triggering a depression
in the oil services industry. Given OPEC production cutbacks,
limited excess oil production capacity and prospects for a much
colder winter in 1998-99, the only way that would happen is if
Asia falls into a black hole. And even then, Schlumberger would
be far better positioned to weather the storm than its rivals.
A Japanese recovery would launch Schlumberger toward
massive three- to five-year returns. Buy Schlumberger up to
80. Note that Growth Portfolio denizens ENSCO and Rowan
are oil service companies that are even more leveraged to oil's
fate, though their smaller size makes them considerably riskier.
The Japanese banking system is the focal point for
the country's ongoing economic reform. That makes Japan's biggest
banks some of the surest and most leveraged beneficiaries of the
country's recovery, just as U.S. banks were in the early 1990s.
High Stakes play Bank of Tokyo-Mitsubishi (MBK)
is Japan's largest bank and one of its most solid. As a part of
Japan's banking reform, big banks will get the good assets of
bad banks as well as protection from their own bad assets during
restructuring, making them bigger and stronger.
The big play with Japanese banks like Bank of Tokyo
is long-term. For as far as the eye can see, Japan will feature
loose credit and almost certainly strong growth. That's a time-tested
recipe for burgeoning bank profits. Many U.S. banks now trade
10 times above their 1990-91 lows. That same wonderful fate could
await Bank of Tokyo, which currently trades near a multi-year
low. Buy Bank of Tokyo-Mitsubishi under 12.
Fear that sliding Asian demand will
keep grain prices at rock-bottom levels indefinitely has hammered
stocks of farm equipment companies like Deere & Co. (DE),
the nation's largest and most profitable farm equipment manufacturer.
Deere stock is currently trading at close to a generation-low
P/E in nominal terms and relative to the rest of the market.
Any clear sign that Asia is recovering and commodity
prices are firming would boost both profit estimates and the stock's
deeply depressed multiple to earnings. Noteworthy is that two
major drivers of farm equipment salesland prices and interestremain
extremely positive for company earnings.
It's not surprising that Deere has been an aggressive
buyer of its own shares. Firming commodity prices could send shares
at least 50 percent higher over the next 12 to 18 months. Buy
Deere under 55.
Forest products companies like Growth
Portfolio holding Weyerhaeuser (WY) have also been hit
by fear that falling Far Eastern demand will impact 1998 and 1999
profits. The reality, however, is prospects for North America's
largest private landowner and best managed forest products company
are the brightest they've been in years.
The company boasts much higher operating margins and
much higher quality management than ever before. Moreover, it's
now trading at a lower earnings multiple than it was during the
severe slowdowns of 1982 and 1991.
Even if Asia doesn't recover, the stock should trade
at a higher valuation. And if it does as we expect, Weyerhaeuser
will be in the early stages of a multi-year cycle that could see
profits reach $7 to $10 a share. That should send the stock well
past the century mark. Buy Weyerhaeuser aggressively under
50.
Nucor (NUE) has evolved from an upstart into one of the world's
most profitable and dynamic steel companies over the past decade.
Earnings have grown at a better than 15 percent annualized rate
and are squarely on track for strong growth in 1999 and beyond.
Boasting one of its industry's lowest cost structures
and an unmatched ability to control costs, the company has also
been able to dodge the traditional boom-bust cycles that have
plagued big steel companies, while steadily gaining market share
at competitors' expense.
Amazingly, investors have sold the stock off in panic
that cheap Asian imports will soon swamp U.S. steel companies'
output. That's despite the fact that steel prices have actually
been firming in the U.S.
Nucor's current P/E is lower than during the recessions
of 1982 and 1990. If the stock's valuation were just to approach
past levels and if earnings simply live up to current estimatesnear
certainties if Asia recoversthe stock should easily double in
the next 12 to 18 months. Buy Nucor aggressively up to 55.
Part II
Safe Harbors
The best shelters in an economic storm are stocks with
revenue security: Products and services people need regardless
of the health of the economy. The five stocks profiled below and
shown in the table fit the bill, and they boast low valuations
and 10 percent-plus growth potential to boot.
As the Asia crisis has taken hold, utility stocks have
been among Wall Street's most popular fare. Several superstar
companies, however, continue to trade at very low valuations relative
to their prospects for future growth.
Electricity and natural gas powerhouse Duke Energy
(DUK), a member of both our Growth and Income Portfolios,
boasts a fleet of low-cost, well-managed power plantsbuilt by
the company itselfsuperior finances, a cooperative relationship
with generally conservative North and South Carolina regulators
and a growing service area.
What's less widely known is the company's ongoing push
to become a nationwide player in America's deregulating electric
and natural gas industries. Last year, the company purchased PanEnergy,
giving it control of pipelines shipping 12 percent of U.S. natural
gas supplies and a national presence in wholesale marketing of
electricity and natural gas. This year's acquisitions include
power plants in California, setting the stage for a full-scale
invasion of that huge market.
Duke should have no trouble growing revenue and earnings
at a near double-digit rate well into the next century. The 3.7
percent dividend yield is just the icing on this very tasty cake.
Buy Duke up to 62.
Water utility Philadelphia Suburban
(PSC) has been growing revenues and earnings at a double-digit
rate in recent years, and shows no sign of slowing down. Management's
secret has been acquiring small, neighboring water systems in
the Philadelphia area that are unable to meet safe drinking water
requirements on their own.
These deals are typically done below these systems'
book value, thereby immediately adding to Philly Sub's earnings.
Profits are further boosted as the company upgrades the systems
via built-in rate hikes.
Last month's announced acquisition of Consumers
Water will enable the company to expand its strategy into
Illinois, Maine, New Jersey and Ohio, presenting a wealth of additional
growth opportunities. With the backing of 16 percent owner Vivendithe
world's largest water company and an A+ rated balance sheet, Philly
Sub has few obstacles to double-digit growth, making its relatively
high P/E a price well worth paying.
Buy Philadelphia Suburban up to 23, preferably directly
from the company (800-842-7629,
$500 minimum initial investment).
Larry Tisch, the brains behind Loews Corp. (LTR),
has been a bear for several years. That strategy has cost the
company. But, it's guaranteed to reward Tisch if inflation hits
the U.S. markets and commodity prices take off.
And not all Tisch's holdings are in the doldrums, including
84 percent of conservatively managed insurance company CNA
Financial (81 percent of 1997 operating profits), 14 hotels,
50 percent of oil service company Diamond Offshore Drilling
and Lorillard Tobacco. These businesses have been remarkably
stable revenue generators in all economic environments.
Tisch's willingness to bet bearish has scared investors
away from Loew's stock, earning it a projected 1998 P/E of less
than 10. That limits the risk of buying Loews even if he's wrong.
And if he's right, the stock is among the very few that could
double from here. Buy Loews up to 95.
Despite the best efforts of public
health advocates, global smoking continues to increase, ensuring
powerful revenue growth for tobacco companies.
Philip Morris (MO)
is the kingpin of tobacco companies, boasting such world-leading
brands as Marlboro and Benson & Hedges. The
company also derives nearly half of its revenue from a bevy of
other recession-resistant products such as Miller beer
and Kraft, as well as household brand names acquired from
General Foods.
Big Mo's biggest headache is the threat of punitive
tobacco legislation and litigation in the U.S. But, with a growing
percentage of revenue coming from overseas and other non-tobacco
businesses, that risk is receding.
Moreover, with pro-tobacco Congress members flexing
their muscles, there seems to be little chance punitive legislation
will pass, and battles in the courts are likely to remain tied
up for years. And the stock's rock-bottom valuations already reflect
a draconian scenario for tobacco suits. Buy Philip Morris up
to 45.
With America's population continuing
to age, the health care industry can also be counted on to grow
under almost any conceivable circumstance. One sure-fire play:
American Health Properties (AHE), a real estate investment
trust (REIT) holding medical office buildings, treatment centers,
acute care hospitals and other health care facilities in 21 states.
Almost completely dependent on shaky psychiatric centers
a few years ago, it launched an aggressive diversification strategy.
Today, the centers contribute less than 10 percent of overall
revenue, though they remain profitable. Funds from operations
(FFO) are rising at a 10 percent annual clip, as are dividends.
Debt has been cut to just 28 percent of capital.
With more acquisitions in the works and management
focused on cutting costs, double-digit FFO growth looks likely
for years to come, shoring up American's hefty 8 percent plus
dividend. Buy American Health Properties up to 27.
Editor's
Note: Stephen Leeb is editor
of Personal Finance, 1750 Old Meadow Rd., Ste., 301, McLean,
VA, 1 year, 24 issues, $69. He also edits The Big Picture.
Roger S. Conrad is an associate editor of Personal Finance and
editor of Utility Forecaster.
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