| BUSINESSWEEK ONLINE : JUNE 26, 2000 ISSUE | ||||||||
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| COVER STORY
Choosing Safe Stocks in Turbulent Times Some classic defenses no longer make sense Suddenly, defensive stocks are back in style. More and more investors, anxious about a slowing economy, are checking out companies whose profits ought to be relatively immune to downswings because their products are in demand through thick and thin. But smart players are ignoring such classic defensive groups as electric utilities, tobacco, gold, and most drugmakers. In today's market, the most alluring plays shape up as energy producers, military contractors, and several consumer-products makers. Even in a slowing economy, energy producers should continue to benefit from tight supplies of crude oil and natural gas. Military contractors are poised to gain from the first major increases in defense spending since the end of the cold war. And because people buy some consumer products in bad times as well as good, the companies that make them ought to churn out steady earnings. Defensive stocks don't sizzle like technology issues. They offer dependability. ''Stocks with bullet-proof earnings will be increasingly prized as Wall Street is hit with a wave of negative earnings surprises,'' says Thomas McManus, equity-portfolio strategist at Bank of America Securities who is more pessimistic than most on the economic outlook. McManus expects profit growth for the companies that make up the Standard & Poor's 500-stock index to slow markedly, from 23% in this year's first quarter, to 9% in the fourth quarter. By contrast, he's looking for earnings of many defensive stocks to climb 10% to 15%. TEST OF TIME. In stock market downturns over the past 43 years, defensive issues have registered small gains or fallen less than other stock. According to a recent study by Leuthold Group, when the S&P lost 19% between July and October, 1998, for instance, food stocks fell only 5%, oil stocks 7%, and drug stocks 11%, while electric utilities actually gained 9%. But you can't buy just any defensive stock. Be picky and invest aggressively, say investment pros, and concentrate on stocks with prospects for good earnings growth. ''The best defense is a good offense,'' says A. Marshall Acuff Jr., U.S. investment strategist at Salomon Smith Barney. The most promising sector right now is energy, especially natural gas. Demand for natural gas has doubled over the past year, thanks in part to growing residential and industrial use. Gas has also become the fuel of choice for new power plants. Gas inventories, however, are 25% below normal because soft prices last year curbed production. As a result, gas prices, usually around $2 per thousand cubic feet at this time of year, shot to over $4. ''It could take us up to two years to drill our way out of the supply imbalances,'' predicts Michael Hoover, manager of the Excelsior Energy & Natural Resources Fund. There are currently 660 rigs drilling for natural gas in the U.S. and Canada, but Hoover figures 800 rigs are needed to meet demand. Shares of natural-gas producers have already surged 53% this year, as measured by the American Stock Exchange Natural Gas Index. Even so, say industry experts, the prices of gas stocks don't fully reflect their prospects. Hoover, for instance, expects gas prices to average $3 to $3.25 over the next two years, well above their former range of $2 to $2.50. One company he expects to benefit from the trend is Anadarko Petroleum Corp. (APC), an oil and natural-gas producer based in Houston. Its pending merger with Union Pacific Resources Group Inc. (UPR) gives Anadarko a steady source of drilling projects over the next five years, he says. Hoover expects Anadarko's share price to climb from its recent 51 11/16 to 75 over the next year. A favorite of Daniel Rice, manager of State Street Research Global Resources Fund, is Western Gas Resources Inc. (WGR) in Denver. He expects the natural-gas producer to triple its output in the coming three years. Rice also is keen on Canadian 88 Energy Corp. (EEE) because Duke Energy Corp. (DUK), a big, diversified energy-services company based in Charlotte, N.C., recently bought a 20% stake in the Calgary oil and gas producer. Duke's involvement, Rice figures, gives Canadian 88 both more management depth and financial stability. Among the big oil companies, Hoover favors Exxon Mobil Corp. (XON) and BP Amoco PLC (BPA). Their gasoline-refining operations could boom later this year if crude-oil prices, now around $30, decline to around $25 a barrel, as Hoover expects. Gasoline prices usually lag behind those for crude by several months, during which the refiners will be able to reap fat profits. Another defensive area ripe for a rebound is military contracting. The catalyst: increased U.S. defense spending as the military retools. ''When the cold war ended, Congress understandably cut procurement spending,'' says Pierre A. Chao, an analyst at Credit Suisse First Boston. ''But equipment has aged since then, and the Bosnian and gulf wars showed that military conflicts didn't end with the cold war.'' MILITARY MIGHT. Congress approved increases in defense spending in the federal budget for 1999, pumped it up by nearly $11 billion this year, to $285.3 billion, and looks likely to add several billion more for 2001. Because there is a lag before budget approvals turn into actual Pentagon spending, Chao reckons that the hikes in defense outlays won't show up in contractors' bottom lines until next year. After that, budget hikes ought to keep industry revenues from the U.S. government growing at 5% a year, on average, through 2005. That'll help increase earnings, Chao says, at a 10% to 12% annual clip for the next five years. Another plus for the contractors is a friendlier customer. ''The Pentagon used to have an adversarial relationship with the defense industry,'' Chao says. But dramatic consolidation over the past decade, combined with the weak earnings of some companies, has the Pentagon worried that national security could be at risk. So it's working more closely with the industry. For instance, defense contractors usually have scant incentive to cut costs because the Pentagon limits their profit margins. But the Pentagon may allow contractors to retain cost-savings in the future. The S&P's Aerospace & Defense Index has gained 26% since early March. Nevertheless, Chao believes the sector remains undervalued by historical standards. Defense stocks currently trade at seven times cash flow (as measured by earnings before interest, taxes, depreciation, and amortization). Chao sees that multiple moving up toward 10 times cash flow over the next two years. Chao's top picks: General Dynamics and L-3 Communications Holdings (LLL). General Dynamics (GD), the leading supplier of ships to the U.S. Navy and tanks and other infantry vehicles to the Army, will be at the head of the line when new defense contracts are handed out, Chao says. And he expects L-3, a leading defense-electronics supplier, to be a big winner as the Pentagon focuses on high-tech weaponry. Salomon Smith Barney's Acuff, meanwhile, favors Raytheon (RTN.A) and Litton Industries (LIT) because they are respectively involved in defense electronics and shipbuilding, two areas earmarked for big defense budget increases. Consumer products are an old defensive standby. But, now, many investors view the group as a minefield, because of disappointing earnings over the past 18 months by such industry bellwethers as Procter & Gamble (PG), Gillette (G), and Coca-Cola (KO). As a result, argues Lauriann Kloppenburg, equity research director at Loomis Sayles, the sector is filled with unappreciated growth stories. POSITIVES. Consider, for instance, Anheuser-Busch Cos. (BUD), the nation's largest brewer. The company's recent price hikes are sticking, Kloppenburg says. Another plus is that industry consolidation has cut capacity, giving the company room to increase market share. John Faucher, an analyst at J.P. Morgan Securities, says the biggest positive for brewers is that the children of baby boomers are entering their ''prime beer-drinking years.'' Faucher expects beer sales, which were flat during most of the 1990s, to accelerate, permitting Anheuser-Busch to increase profits at a 12% pace over the next five years. Cosmetics giant Avon Products Inc. (AVP) is favored by Heather Hay, head of global consumer-products research at Merrill Lynch & Co. She points out that half of the company's business is in emerging markets, so it stands to benefit as Asian economies rebound. Hay also praises the efforts of management, led by Avon's new CEO Andrea Jung, to expand beyond its ''Avon Lady'' sales force to shopping malls and the Internet. Pharmaceutical makers are another old defensive stalwart that has come under a cloud. Though shares of big drug companies have risen 30% since early March, ''fundamentally there's little to drive pharmaceutical stocks higher,'' says Michael Yellen, a manager of AIM Global Health Care Fund. Due to expire in the next five years are U.S. patents on more than 150 drugs worth nearly $60 billion in annual revenues. And there are big worries that the recent political hue-and-cry over soaring drug prices might eventually lead to price controls. But the pros aren't shunning all drugmakers. For instance, Faraz Naqvi, co-manager of the Dresdner RCM Global HealthCare Fund, likes Teva Pharmaceutical Industries (TEVA), an Israeli maker of generic drugs whose business he believes will benefit greatly as all those U.S. patents expire. Naqvi sees Teva's earnings growing at a 27% average annual rate over the next three years. Of course, investing defensively doesn't mean forgetting about technology stocks--which may have the brightest long-term prospects of all. ''We are going through a period of adjustment as tech values come back to more realistic levels,'' says Douglas R. Cliggott, U.S. investment strategist at J.P. Morgan Securities. While waiting for them to do so, it makes sense to sock some money into defensive plays. By SUSAN SCHERREIK _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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 RELATED ITEMS Choosing Safe Stocks in Turbulent Times TABLE: Best Defensive Plays For the Record: A. Marshall Acuff Jr. ONLINE ORIGINAL: Searching for Safety among Consumer Staples INTERACT E-Mail to Business Week Online | |||
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