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Where do you put your money now?
Solid corporate profits and pitiful yields on bonds will focus the spotlight on stocks in the coming year. Here are our picks for stocks worth watching.
By Jeffrey R. Kosnett, Kiplinger
This time last year, the 2-year bear market was already over -- but hardly anyone knew it. Yes, stocks were off their lows, set on Oct. 9, 2002, but the earlier losses still haunted most investors. The air was heavy with gloom and resignation.
A year and 2,500 Dow points later, what a difference. "There was a bottom, and it's been hit," says Stacey Bartlett, a 31-year-old market researcher and caterer in San Francisco. She and her husband, Norman, 32, a management consultant, are saving for a house as well as for retirement by firing money at a diversified collection of stock mutual funds. "The fear that all of our funds could go south is gone," Stacey says.
It isn't just this renewed optimism that distinguishes the current climate from the despair of the bear market. For the first time in years, investors seem to be paying attention to the issues that most affect share prices. They're no longer fixating on Enron or terrorism or bogus Wall Street analysis, as they did during unpleasant times.
Investors today are focusing on earnings, dividends, the level of share prices and the prospects for the economy. They are not even letting the mushrooming mutual fund scandal discourage them from buying stocks. Stacey Bartlett, for one, says she's shocked that "mutual funds have become the next corporate scandal." But that won't deter her, she adds.
No repeat of 1990s
Jack Byrd says the beating he took during the bear market isn't keeping him away. "Stocks are the only game in town," says Byrd, 39, whose family owns a 900-acre cattle-and-timber farm in Amelia, Va., a half-hour southwest of Richmond. Since June, he's scooped up what he regarded as opportunities: Cummins (CMI, news, msgs), Florida Rock Industries (FRK, news, msgs) and Altria Group (MO, news, msgs) (formerly Philip Morris) -- the last one because of its fat 5.3% yield. A favorable profit outlook, Byrd says, should help stocks rise another year.
We agree. But don't count on a reprise of 2003's great returns. This decade is unlikely to resemble the second half of the 1990s, when 20% to 30% yearly run-ups were the norm. What's doable for stocks of large companies is an 8% price gain, plus a 2% dividend yield, for a total return of 10%. That would put the Dow Jones industrial average close to 11,000 by the end of '04.
Not everything about the market's comeback has been rational. In fact, the scariest part has been the occasional re-emergence of irrational exuberance. In general, the best-performing stocks of 2003 were the lowest-quality companies. Take theglobe.com (TGLO, news, msgs), an Internet "dot-bomb" that began the year at 6 cents and erupted to $1.50, even though the online PC-game seller has lost 50 cents for each dollar of revenue over the past year.
If penny stocks were the only things that were working, we'd be far more skeptical about the durability of the recovery. Fortunately, larger, more established companies are also up, and for good reason: Their profits are rising smartly. In a critical test for stocks, third-quarter earnings for companies in Standard & Poors 500 stock index ($INX) jumped 19% from the same period in 2002, according to Zacks Investment Research. Even more significant, sales rose 10% -- a sign of a healthier business climate. As a result, a broad cross-section of important stocks acts as if this is truly a new bull market. Since March, Intel (INTC, news, msgs) is up 114%, Caterpillar (CAT, news, msgs) 67%, and American Express (AXP, news, msgs) and Citigroup (C, news, msgs) have each jumped about 50%.
Stocks are also back in favor because the alternatives are unappealing. Money-market funds yield less than 1%, 10-year Treasuries yield 4.3%, and the best five-year certificate of deposit yields just a bit more than 4%. After a big rally in low-rated debt, better-quality "junk" bonds yield only 8% or so -- hardly enticing given the risk.
But the main driver of rising share prices will be solid earnings growth. Analysts see profits jumping an average of 12% in 2004, according to Thomson First Call. We don't think stock appreciation will match earnings gains point for point because a strengthening economy -- witness the 8.2% gain in the third-quarter gross domestic product -- could raise concerns about higher inflation, which could push interest rates up later in 2004.
Plenty of cash
Even with the 2003 price advance, stocks are not expensive. The S&P 500 sells for 18 times the 2004 consensus of analysts' profit estimates. For much of the 1990s, by contrast, the market's price-earnings ratio fluttered in the 20s, despite higher interest rates and inflation. Current P/Es are nowhere near past extremes, notes market researcher Steve Leuthold. Moreover, portfolio managers and individuals have tons of cash at their disposal -- $2.1 trillion in money-market funds alone. Relative to the size of the market, this potential buying power, says Andy Pilara, manager of RS Contrarian Value (RSCOX), is "the most since the Great Depression and World War II."
There will be a presidential election in 2004, but investors won't pay much attention to politics -- at least until the Democrats select their nominee. In any case, says Gordon Halcomb, an accountant and financial adviser in Mechanicsville, Va., President Bush is unlikely to do or say anything to upset investors -- "if he wants to get re-elected." Halcomb, 55, is buying stocks of such companies as health- and disability-insurance provider Aflac (AFL, news, msgs) and payroll-processor Paychex (PAYX, news, msgs) both of which benefit from job and wage growth. "As long as interest rates are low and inflation is not a problem, the economy won't go awry," he adds.
What could go wrong? Consumers, after spending feverishly in 2003, may be ready for a rest. That would harm retailers and other businesses that depend on household spending. That's why Jim Luke, director of the growth-stock team for BB&T Asset Management, says he's "not wildly optimistic about stock-market returns." Even so, Luke thinks stocks could return 8% or 9% in the coming year. Hardly reason for panic.
What will work best
As always, there are subplots within the big picture. Shape your strategy for the coming year around these themes:
Think big. Shares of small companies crushed their larger brethren in 2003. We're not suggesting that small-company stocks are about to collapse, but the gap will narrow. Many classic blue chips have lagged since the stock market bottomed, so this is a perfect time to buy their shares. Five that merit your attention:- American International Group (AIG, news, msgs). The weak economy hurt the insurance businesses of this financial giant, and the bear market depressed revenues from variable annuities. But with stocks up and the economy growing, AIG's prospects are much improved.
- Coca-Cola (KO, news, msgs). A double play: The soda giant benefits from a weaker dollar and the global economic recovery, which puts more money in the pockets of thirsty consumers in Brazil, China and the rest of the world.
- General Electric (GE, news, msgs). It stands to benefit from the global economic rebound via its airplane-engine, financial and entertainment businesses. With a 2.7% dividend, "GE gets you a yield that's four-fifths of the five-year Treasury yield, plus a chance at growth," says James Abate, an investment director at GAM, a money-management firm.
- Microsoft (MSFT, news, msgs). It's not the world-beating stock of its youth. But after losing more than half their value over the past four years, shares of the software leader are now almost a value at about 20 times expected 2004 profits. (Microsoft is the publisher of MSN Money.)
- Pfizer (PFE, news, msgs). Big pharmaceutical companies are short on new products and face competitive challenges from generics. But Doug Nardi, a portfolio manager at Scudder Private Investment Counsel, says that at a price-earnings ratio about the same as its growth rate, Pfizer's stock is cheap. It also pays a 2% dividend.
Healthy choices. Health-care stocks aren't just a place of refuge during a sluggish economy. Except for the biotechnology and generic-drug sectors, which have seen some stocks gain 100% or more over the past year, many health-care companies offer above-average returns with below-average risk, particularly drug distributors, HMOs and hospital chains. Look for companies that stumbled but now appear to be recovering. These include drug distributor Cardinal Health (CAH, news, msgs), hospital owner Triad Hospitals (TRI, news, msgs), testing leaders Laboratory Corp. of America (LH, news, msgs) and Quest Diagnostics (DGX, news, msgs) and Baxter International (BAX, news, msgs), a diversified medical-equipment supplier.
The best of tech. As the 50% run-up in the Nasdaq Composite Index ($COMPX) since March shows, tech stocks have led the market's recovery. Improving orders are combining with deep cost cuts to sharply boost earnings at tech companies. Since businesses are flush with cash and finally are loosening their budgets, the rebound is sure to run well into 2004. The blue-chip names -- think Cisco Systems (CSCO, news, msgs), Microsoft, Intel and Dell (DELL, news, msgs) -- are the ones to own, not the $2 lottery-ticket technology stocks that roared in '03.
The industrial revival. Manufacturers keep closing plants, which is bad for workers but good for holding down costs. Add that to increased orders and a weak dollar, and you have a recipe for higher profits for makers of steel, tools and machinery. Truckers and railroads, which depend on the shipping of manufactured products, are key beneficiaries. The stock of United Parcel Service (UPS, news, msgs) is timely. UPS says it's seeing excellent package volumes and can easily generate 15% profit growth in 2004.
Oh, my aching bonds
In the investing world, what's good for the goose isn't necessarily good for the gander -- the gander, in this case, being bond investors. Bond owners had plenty of opportunity to exult as yields plunged for much of the first half of 2003, and bond prices, which move inversely with interest rates, soared. But when yields on 10-year Treasury notes hit 3.1% last June, the lowest in 40 years, that was below the "stupid level," says Jeff Gundlach, a bond manager for the TCW Galileo funds. Since then, 10-year yields have climbed back to 4.4%, meaning that many bond investors lost money in the second half of 2003.
Even with the rise in yields, long-term Treasuries don't offer particularly good value. Inflation, expected to run at 2% in the coming year, will erode half of the interest income from a 10-year note. If interest rates rise in 2004 -- which is a distinct possibility -- those holding long-term bonds will be hurt more than owners of short-term debt.
Gary Pollack, head of fixed-income research for Deutsche Bank Private Wealth Management, predicts that yields on 10-year Treasurys will reach 5.5% in 2004. If he's right, those bonds will lose 8% of their value, on top of the 11% they've already surrendered. You're better off keeping maturities short, no longer than five years for Treasury notes. That will get you a yield of 3.4%. Or, if you're willing to shop for the highest payers, you can get a five-year CD yielding 4.2%. Fund investors should consider Vanguard Intermediate-Term Corporate (VFICX) with a 30-day yield of 4.4% and an average maturity of 5.9 years. If you want something less risky, use Vanguard Short-Term Corporate (VFSTX), with a 3% current yield and an average maturity of just 2.4 years.
Municipal bonds offer the best value. Many insured tax-free issues yield 4% -- that's the equivalent of nearly 6% from a taxable bond for someone in the 33% federal tax bracket -- or more. Most munis are issued with maturities of at least 10 to 15 years, but because municipals do not trade as frequently as Treasuries, it's safer to hold longer maturities. If you prefer funds, a good choice is Vanguard Insured Long-Term Tax-Exempt (VILPX). It sports a 30-day yield of 3.6%, and its average maturity is 7.5 years.
Low-rated junk bonds had a terrific 2003. The coming year will be much tougher. Junk bonds (those rated BB+ and below) yielded 10 percentage points more than government bonds in October 2002. Now, the yield gap has shrunk to four points, making high-yield debt treacherously expensive.
If you're like Sam Graham, an 81-year-old retired public-health physician from Powhatan, Va., who depends on the $1,000-a-month income generated by junk-bond funds, stick with them. But if you're scouting for good total return and income is incidental, this isn't the time to buy junk bonds. Actually, it's time to cash in some fund shares.
For similar reasons, you should approach real estate investment trusts with care. A sound economy means that REITs should find it easier to maintain and raise their dividends (which in general don't qualify for favorable tax treatment). But after four successive years of positive returns (with double-digit gains in three of those years), yields on property-owning REITs have dropped to 6%, on average. At that level, many investors often start to bail out of REITs.
Higher interest rates can torpedo stocks by choking off economic growth and making fixed-income investments more appealing. But we don't see rates climbing enough to do either. Moreover, with most dividends now taxed at 15%, stocks provide stiff competition to bonds for the affection of yield-hungry investors. You can see why the odds are good that stocks will beat bonds for the second year in a row.
Sleeper stocks
Ready for prime time. Big blue chips should flourish in 2004, but it may be more rewarding to invest in less-obvious names. These stocks could produce nice gains in 2004:- Air Products (APD, news, msgs). Shares of the industrial gas-and-chemical supplier have lagged for years. But Jim Luke of BB&T Asset Management thinks sales and earnings are ready to expand dramatically. Although Air Products has been raising its own earnings forecasts, its stock has barely moved. At $47, it trades at 18 times the 2004 consensus earnings estimate of $2.59 per share and yields 1.9%.
- Flextronics (FLEX, news, msgs). The leading contract electronics manufacturer is well positioned to benefit from increased consumer spending on high-tech gear. Joe Zock, president of Capital Management Associates, says the stock, at $15, is depressed in part because "a zany jury" ordered Singapore-based Flextronics to pay $934 million in a contract dispute. Flextronics, whose customers include Dell, Hewlett-Packard and Sony-Ericsson, likely will shell out much less, if anything, when the case is resolved.
- Goldman Sachs (GS, news, msgs). If you're eager to cash in on the revival of mergers and other investment-banking activity, go for the best, says Doug Nardi, a manager at Scudder Private Investment Counsel. The stock rose 42% over the past year, but, at $97, sells for just 17 times the 2004 consensus forecast of $5.56 per share.
- Inco Limited (N, news, msgs). Pilara, manager of RS Contrarian Value, is bullish on companies that sell to China. Inco, a Canadian company, is the world's leading nickel producer. Nickel is used in making stainless steel, which China imports and produces in copious quantities. Inco's profits are depressed because of strikes, but analysts see earnings quintupling in 2004, to $2.22 per share. The stock sells for $33.
- RPM International (RPM, news, msgs). This is a small Midwestern manufacturer whose brands you may know -- DAP, Rust-Oleum -- but whose shares you've probably never tried. At $15, it's a bargain, selling at just 12 times the 2004 consensus profit estimate of $1.21 per share. And it yields 3.5%. Lanny Thorndike of Century Small-Cap fund says RPM is dependable and has little competition and a well-diversified revenue base, with half of its sales going to industrial customers.
Copyright 2003 The Kiplinger Washington Editors, Inc.
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