Markets & Finance

Where to Hide Till the Carnage Is Over


David Braverman, senior portfolio analyst at Standard & Poor's, gained a following among individual investors back in 1995, when he designed a computerized stock screen that mimics Warren Buffett's legendary stock-picking strategy. Like Buffett, the screen looks for businesses that have consistently profitable operating histories, good long-term prospects, and have stocks that sell below their intrinsic values. Braverman still updates the screen twice a year, but now spends most of his time helping to steer S&P's investment policy.

So what does Braverman recommend after the recent carnage in tech and big-cap stocks? On Feb. 27, BusinessWeek Online reporter Suzanne Robitaille asked Braverman to survey the bear market and talk about investment strategies for the downturn. Here are edited excerpts of their conversation:

Q: What's S&P's outlook for the market?

A: It's difficult to track right now. The S&P 500 index is down 14% from its March, 2000, peak, but it rose 3.5% in January. Still, we're seeing eroding corporate earnings and lowered expectations for stocks.

An economic upturn probably won't come until the third or fourth quarter -- or maybe not until the first quarter of 2002. The mild downturn we're seeing now could spread past techs and large-cap stocks and bring us closer to a recession. A year from now, things will look a lot less gloomy. But for the near term, a defensive approach is best.

Many who play the market are too young to have seen a real recession. They saw the '90-'91 market slide but not the '73-'74 one. If you asked people last year if they thought the Nasdaq could fall from last March's high of more than 5000 down to the 2000 level we're seeing today, they would have said it would be impossible. But the Nasdaq is down 52% since last March.

Q: What do you mean by a defensive approach?

A: We recommend a [portfolio] mix of 65% in stocks, 25% in bonds, and 10% in cash. Two of S&P's favorite sectors are utilities and energy.

Q: Why?

A: These are long-ignored sectors that offer a chance to profit in a tough market environment. Utilities were the best-performing sector in 2000. Natural-gas prices have rallied to their highest levels in a decade, and deregulation has helped companies with new growth strategies. We're finding many energy stocks aren't overpriced, and we're focusing on drilling and equipment as well as exploration and development issues.

Q: There's lots of recession talk in the air. What odds does S&P see?

A: There's a 40% chance that we will fall into a recession, but a 60% chance we won't. Look at some of the recent economic data, like January housing starts, which are down sharply. That shows us that people don't have the confidence to buy right now.

Q: Could another Fed rate cut smooth things over?

A: It might help by the second half of the year, but the first half could be bumpy. And a recovery may not be as robust as we're expecting, given that the stock market generally improves four to six months before lower rates boost the economy and corporate profits. Same thing with Bush's tax-cut plan. It would give us a few more dollars in each paycheck, but the real question is how long will it take for these dollars to filter back into the economy.

Q: Zone in on tech stocks. What's S&P's advice?

A: Technology stocks are the key to getting the indexes back on a growth path, but their immediate outlook remains clouded. Right now, the average investor is overweighted in tech stocks, and these shares have fallen quite a bit. Until techs come back, people should not have more than 25% invested in this sector.

There is some bottom-fishing now, and we think investors should wait until things bottom out. Hewlett-Packard (HWP), for example, has dropped from $69 in June to about $28 last week. It could go to $36 next month, but there's still a chance it could fall to $20.

The popular Internet stocks of last year have been hit hard. eToys [is filing for bankruptcy and] and is on the verge of going out of business. Priceline.com has retrenched enormously. And these two were heavily invested in the tech sector. This shows the value of having a diversified portfolio. Beware of anyone who says, "we're in a New Age." Occasionally these folks are right, but mostly they 're wrong. By the second half of the year, it might be time to get back into techs, but we'd advise letting someone else throw in the first dollar.

Q: Getting back to energy, can you give us a top pick?

A: Seitel Inc. (SEI), an oil-services firm, is one S&P pick. Its stock has gone down a bit, but the company is expanding its exploration capabilities. This company does seismic sitings and tries to find oil. It has fairly good expertise and is an earnings-growth story. Its earnings per share in 1999 were at $0.39, and they have shot up to $1.02 last year with a projected increase to $1.29 this year.

Q: What about health-care companies?

A: Health care was the second best-performing sector in 2000 and looks attractive for the first half of 2001. The sector showed reliable revenues and solid cash flow and earnings growth. Medicare rollbacks have also helped the health-care services industry. One stock that comes to mind is RehabCare Group (RHB), which operates rehabilitation facilities and programs. RehabCare's earnings growth is substantial. S&P started following the stock in the mid-20s. [It's now around 46] and we think it could hit the mid- to high-50s.

Q: Any other stocks?

A: S&P likes Allstate (ALL), a property and casualty firm that's starting to place more emphasis on life insurance -- making it more diversified. The risk in writing homeowner's insurance has declined because people have higher wind-damage deductibles now, which makes insurance companies less exposed to liabilities from coastal storms. Car insurance costs, however, are rising as repair costs go up and as more people file medical claims. This has put pressure on pricing, and, as a result, Allstate has recently filed for rate increases.

Q: And now for the other side of the spectrum, what about stocks you dislike?

A: Advanced Micro Devices (AMD) is one. The stock has been under a lot of pressure, and the company's earnings outlook remains clouded. It's a low-end chipmaker, and the volume of chips going out the door isn't as high as they'd like.

DaimlerChrysler (DCX) is another. Daimler just took a huge [$2.8 billion] Chrysler-related restructuring charge. But even before this, Chrysler's sales in the U.S. have been disappointing, and the company reported lower earnings in 2001 than in 2000. Its market share isn't growing and in a slowing U.S. economy, there's no reason to believe that it'll perform any better.

Q: One more?

A: Great Atlantic & Pacific Tea (GAP). It operates supermarket chains. Many of its stores are older and in need of renovation. It needs lots of money to fix up the stores -- and it's doing this, but it isn't getting the return on its investment that it needs to keep renovating.

Q: How's your famous Buffett-style stock screen holding up?

A: The S&P Promising Growth stock screen is still going strong (see BW Online, 2/15/01, "Promising Growth: The Warren Buffett Way"). These stocks rose 23.2% last year, vs. a drop of 10.1% for the S&P 500. Overall, since inception, the screen stocks have risen 255%, vs.174% for the S&P 500. It was inspired by Robert Hagstrom's The Warren Buffett Way, a best-selling book that gives details of Buffett's stock-picking strategies.


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