Corporate profits finally started rising year-over-year in the second quarter of 2002. In the next 12 months, earnings of S&P 500 companies are expected to grow 12%, according to Thomson First Call. But that's pretty modest, and due mostly to cost-cutting. Some strategists don't think capital expenditures and sales growth, both harbingers of better earnings, will pick up until late 2003 or 2004.
GOOD GUYS THAT WIN Other shackles are keeping the bull in check for now. The economy is growing relatively slowly, and unemployment has spiked higher. With the S&P trading at about 17 times estimated 2003 earnings, stock valuations may still be a tad high, despite low interest rates. (Investors are often willing to pay more for stocks when rates are low because bonds and deposits don't yield much.) The possibility of war with Iraq weighs heavily on the market, as investors take a more gingerly approach to stocks. Companies are postponing spending until the conflict is resolved, and transportation and travel-related stocks like airlines and hotels are suffering.
How do you ferret out great stocks amid this gloom? Pay heed to the wisdom of the grandfathers of fundamental stock analysis, Benjamin Graham and David L. Dodd. They believed that stocks with undervalued assets would appreciate to their true market value. Graham, who was a mentor to Buffett, said he wouldn't buy a stock unless it had the potential to gain at least 50% within two to three years. Some other advice from the duo: It's best to buy stocks in companies which are selling for less than their intrinsic value--what the business would be worth if liquidated--such as Providian Financial (PVN ) and British Petroleum (BP ).
That doesn't mean investors should abandon growth stocks, by any means. It's always smart to look for stocks with strong long-term earnings growth prospects like Cisco and German software giant SAP (SAP ). It's a good idea to target companies with growing revenues. On the whole, revenues are harder to manipulate than earnings. Revenue growth should come from organic growth--customers buying more merchandise at regular prices--rather than acquisitions or price discounting.
Finding companies that prize transparency and offer up good, untainted earnings numbers is also a must. Studies show squeaky-clean companies perform better than others. Baseline, an equity research company, recently started an Earnings Purity indicator, which measures how much a company's announced operating earnings have been inflated by unusual write-offs over the preceding 12 quarters. Unusual write-offs are nonrecurring expenses such as acquisition charges or closing costs that are treated as if they didn't exist, thus inflating operating earnings. Interestingly, the 62 companies in the S&P 500 that expense options outperformed the S&P by more than six percentage points in 2002, according to Baseline. Some companies that score high on the firm's "purity" index: American Express (AXP ), United Parcel Service (UPS ), and Wal-Mart (WMT ).
FEW SECTOR BETS Equally important is sound trading discipline. For instance, Jack Caffrey, strategist at J.P. Morgan Private Bank who runs a U.S. equity portfolio, says he revisits a stock that drops 10% below what he paid to see if there's a reason to sell. He sells if it falls 15%. On the upside, he reviews a stock that has gained 20% but typically sells when it's up 25%. Taking an active, disciplined approach doesn't mean market timing or day trading. As Bernard Baruch, financier and statesman, said: "Don't try to buy at the bottom and sell at the top. It can't be done, except by liars." But in this trader's market, chestnuts like "buy and hold" and "stocks for the long term" don't cut it, either.
Dividend stocks, in particular, are good bets. The Bush Administration's proposal to cut individual taxes on dividends has already given these stocks a lift. If the plan goes through, they could really rock. Some strategists are recommending aerospace and defense, utilities, financials, and health-care stocks. Even so, "It's hard to make sector calls because the fundamental conditions of these companies are so diverse, and the recovery in capital expenditures will be happening on a company-by-company basis," says Piper Jaffray's Belski.
That means diversification, along with quality picks, is the key. In the latest BusinessWeek/Harris Poll (page 76), a surprising number of investors expect stocks to perform poorly over the long run. And many think a stock crash is "very likely." Back to Graham and Dodd, who believed a portfolio should be spread among at least 15 different sectors or styles. Says Michael Kenneally, chief investment officer at Banc of America Capital Management: "If you took the best company in each industry and pulled them all together, you'd probably have a great-performing portfolio."
Sounds simple. But first, of course, you have to find those companies. BusinessWeek hopes to take some of the guesswork out of it.
Copyright 2002, Bloomberg L.P.
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