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Industrials in Growth-Stock Clothing S&P Senior Investment Officer Michael Jaffe provides some pointers on stocks to consider -- and avoid Investors continue to be concerned about future interest rate hikes and the stronger Japanese yen. Even so, however, the primary macroeconomic factors that affect the market look promising, says Standard & Poor's senior investment officer Michael W. Jaffe. The U.S. economy is still strong, many foreign economies are recovering, and inflation is still under control, he points out. So where should investors put their money? Jaffe, who focuses on industrial stocks, thinks plenty of companies in the sector are worth considering. He shared some of his picks and pans in a chat hosted by Business Week Online on America Online on Sept. 28. Here is an edited version of Jaffe's answers to questions from the online audience and from Business Week Online moderator Jack Dierdorff. A complete transcript is available from BW Online on AOL at keyword: BW Talk Q: Beautiful day here in New York, but things aren't so pretty down on Wall Street. I guess the good news is that today's market regained most of its losses. What's your outlook? A: The market did enter into correction territory earlier today based on both the S&P 500 and the Dow, but it bounced back in the latter part of the day. In recent days the market has been hurt by interest rate worries, including the Fed's tightening program. It has also been affected by concerns about the stronger yen since investors from other nations get pulled away from our market when the dollar weakens. But despite everything that has been going on in the market in recent days, the macroeconomic factors that have an impact on the market still look pretty positive to me. The U.S. economy is still quite solid, many foreign economies are recovering, including Asia, and our nation still has limited amounts of inflation. So all in all, I am still feeling positive about the longer-term prospects for the market. Q: You've said in the past that industrials can also be growth issues. Is that a contradiction to conventional wisdom? A: It might be a little contradictory to conventional wisdom. However, a variety of companies included in our capital goods sector are not traditionally viewed as capital goods companies. For instance, my favorite company in that sector is Tyco International (TYC), which is almost solely involved in growth areas. Since a new CEO took the helm in 1992, this conglomerate has been transformed from a highly cyclical company dependent largely on the construction market, to one almost solely in growth areas. It now derives much of its revenues from service and maintenance or long-term supply contracts. Its service and maintenance revenues are derived from fire protection systems, home security systems, and from their underseas telecommunications systems. Their long-term supply contracts are from their disposable medical products business. So although having growth companies in the capital goods sector might not go along with the traditional way of thinking, certain companies that fall into the sector are in fact growth-oriented. Q: I want to invest in stocks, but don't know which ones are good. What are some of your favorites? A: Tyco is my top recommendation. I also like Pall Corp., which makes filter products for the health-care, aircraft, and microelectronics industries. The S&P analyst who covers Pall likes it for two reasons. First, the U.K. and Canada began to make blood filtration mandatory in June, 1999, and it looks like it will become mandatory in the U.S. in 2001. They also sell a lot of products to the semiconductor industry, which is quite cyclical and seems to be poised for a rebound. The combination of the two makes us like Pall's prospects. If you are interested in a cyclical company, my favorite current choice is Smurfit-Stone Container (SSCC). It holds a 15% share of the North American corrugated market. With the U.S. economy strong and Asia recovering, it has allowed for several corrugated pricing increases since early 1999. That makes prospects look bright for an extended upturn in corrugated markets and a strong recovery in SSCC's earnings. Q: What are the prospects for Burlington Northern? A: Right now, S&P has a neutral investment rating with a positive bias on the railroads. The analyst who covers the industry believes the railroads offer value at this point because they are trading at a discount to the market multiple. He basically feels that the long-term outlook for railroads is favorable, as their core traffic base of coal, grain, and chemicals should increase at the same pace as the economy over the next decade. With track and equipment in good shape, the industry is likely to generate excess cash flow for an extended period. Burlington Northern is one of S&P's favorite railroad picks. The company is currently rated 4-STARS, or "accumulate." In S&P's equity department a 1-STAR is a "sell," and 5-STARS is a "strong buy." Q: Which industrials should we sell? A: Some of the companies that we least favor include Louisiana-Pacific, which is predominantly a manufacturer of oriented strand board. IMC Global (IGL) makes fertilizer products and we think the dismal farm economy will drag down operations. S&P thinks Air Express International (AEIC) , a freight forwarder, has very limited sales growth potential in coming periods and that the stock has a high valuation based on the company's fundamentals. There could possibly be some management problems signaled by the resignation of their chief information officer a couple of months ago. I have a 2-STARS recommendation on Oakwood Homes, which is a manufactured-home builder. The industry has been going through a difficult time in recent quarters mostly due to excess industry supply. Oakwood has been having particular difficulties because it has expanded too aggressively in recent years, and it also has a sloppy lending program. Q: Do you think interest rates will rise or decline in next two months? A: I am not feeling particularly worried about the upcoming interest rate environment. Although the Fed might well tighten one more time, I think its tightening program is probably nearing conclusion. We see interest rates settling down in coming months due to the impact of the tightening program combined with some slowing of the economy related to the Y2K situation. Q: What is outlook for USX (USX) and PPG (PPG)? A: USX is actually one of our favorite choices in the steel industry. The analyst who covers steel has a positive investment outlook for the industry, which has been suffering from bloated inventories along with high levels of steel imports. But prospects have now gotten better because of a May, 1999, antidumping ruling that should bring down the level of imports and the fact that distributor inventories have been declining. Also, the auto industry uses a lot of steel, and it is doing well thanks to a strong U.S. economy. PPG Industries is one of our favorite choices in the chemicals industry. It is rated a 5-STARS because it is focusing its resources on higher growth areas in chemicals such as coatings, specialty chemicals, and fiberglass. Q: What do you think of Toll Brothers? A: Toll Brothers builds luxury homes. Unfortunately, the stock has been pretty badly battered over the past year because of concerns about interest rates and the maturity of the home building cycle. But there are two factors that might make one interested in the company right now. First, the stock has gotten so cheap that you might want to treat it like a growth play. Investors could purchase it now and put it away until the next time investors grow enthused about the homebuilding cycle. However, given our belief that interest rates will grow more accommodating and that the job market will remain strong, investors may suddenly decide that the current homebuilding cycle still has some legs. Q: You've given us three of your favorite stocks -- Tyco, Pall, and Smurfit Stone. Any others we should take note of? A: We like AGCO Corp (AG) as a value play. It manufactures agricultural equipment, and although the sector has been having tremendous difficulties, AGCO has grown very cheap by most valuation measurements. Roper Industries (ROP) makes high-tech industrial equipment and analytical instruments, which are used mostly by oil and gas producers, semiconductor equipment makers, and industrial outfits. Although all of those are highly cyclical sectors, Roper has managed to grow EPS even during industry downturns by having an almost quasi-monopoly status as it sells sophisticated patented components to niche markets. In addition, its EPS growth has been aided by tight controls of its overhead costs.
EDITED BY LORI BONGIORNO
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