Investing Against the Grain


When the market is surging and everyone is buying, that's the time to sell. And conversely, the time to buy is when stocks are bottoming. That's one way Michael K. Farr, president of investment managers Farr, Miller & Washington, sums up his investing strategy.

Right now, Farr ventures a prediction that the market will wind up the year 5% to 10% ahead, depending on how well earnings recover. He favors four sectors: consumer, financial, tech, and health care -- particularly the first two. He has one unusual pick as a consumer stock, American Power Conversion, which he describes as a nontech way to play tech. APCC makes power-surge strips and backup supply boxes for servers and computer networks.

Noting that interest rates will have to climb above 3% to have a negative effect on Citigroup and Wells Fargo, Farr sees more room on the upside for these stocks in the financial sector. In the defense area, he speaks warmly of United Technologies, the only stock in that group he owns.

Farr made these and other market comments in a chat presented Mar. 28 by BusinessWeek Online on America Online, in response to questions from the audience and BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts from the chat follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Michael, when you were here a couple of months ago (see BW Online, 12/6/01, "Emotion, the Enemy of Investing"), you described the market as being "consistently inconsistent." Is that still your view? Where do you see the market going for the rest of the year?

A: The key to being a successful adventurer of any kind is understanding your terrain. The market's terrain is always uncertain. Successful investors need to design portfolios that can endure dramatic and unexpected drops, while still benefiting from market increases.... With the disclaimer that no one can predict short-term markets, let me venture out onto the thin branches and guess that the markets will close some 5% to 10% higher by yearend.

This is really going to depend on earnings increases that correspond to current positive economic news.... I think investors over the past few years, and after Enron, are waiting to see the evidence before they put the buy orders in.

Q: Speaking of earnings, what do you see for the first-quarter earnings season? Do you expect any sectors to really shine or disappoint?

A: I think that we should look for fewer disappointments than usual, because earnings estimates were slashed through the end of last year and post-September 11. I think that you could see some surprise positives from the tech sector as a result of late-quarter orders, and despite the turbulence and weakness in GE (GE), they will make their numbers.

Q: In the near term, would you favor small and intermediate stocks?

A: I think that the small and intermediate [mid-cap] stocks have a greater potential return over the next 12 months, but investors need to be prepared for greater volatility. Large-cap stocks are always more comfortable because they can withstand significant declines that certain small caps cannot.

Q: What sectors do you feel are worth a look?

A: I like four sectors...consumer, financial, tech, and health care. Of those four sectors, I think the consumer and the financials are still the most comfortable places to be right now. Tech will bear out over time. I think it represents good long-term value, but is a very volatile place for the next 12 to 18 months. We still need to see the orders come through in tech, and I still think we're recovering from the Nasdaq 5100 hangover.

Q: What stocks specifically do you see as the best investments now? What have you been buying?

A: In the consumer sector. I like American Power Conversion (APCC), and I like Honeywell International (HON). United Parcel Service (UPS), Target (TGT), Staples (STLS), PepsiCo (PEP), and Wendy's (WEN) are also good. In the financials, I like Wells Fargo (WFC) and Citigroup (C). I think that rates will have to go up something above 3% to negatively affect these two companies, meaning there's more room on the upside there.

Q: What are your thoughts on Tyco (TYC)?

A: Tyco remains mysterious, and the story remains complicated. Tyco wanted to be another great consolidated, amalgamated company like GE, but as management became frustrated with static and falling valuations, they changed course and suggested that a breakup would bring better value. This change in management philosophy and direction, combined with a murky balance sheet and suggestions of Enron, brought the stock's price low.

This was complicated by some questionable fees that were paid to a director for the sourcing of the CIT Group acquisition. I think that while Tyco shares may have potential, they have proven to be not my kind of stock, given the change in management direction, and the lack of transparency with regard to their balance sheet. I would avoid Tyco shares.

Q: Is MMM

[3M] more likely to attain that GE-like status than Tyco?

A: No, I don't think so. I think 3M as a multifaceted manufacturer is a reasonably well-run company, but it's commodity- and human-capital-intense, and I think will have a rather slow and steady growth rate and will not achieve the price-earnings multiple premium that has been afforded to GE. I think the question is, will GE maintain this p-e multiple, or will it begin to trade more like a traditional diversified manufacturer and finance company?

Q: Some big-name techs: What are your thoughts on Oracle (ORCL), Cisco (CSCO), and Intel (INTC) for this year and three years out?

A: Well, I think if you were to own all three for the next three years, you would probably keep pace with the market -- and may even stay ahead of the broad market. Oracle is my least favorite of the three. I think that the trading pattern continues in a negative vein and will take longer to recover.

Cisco, of the networking stocks, I think has potential, probably within a one- to three-year horizon, but I'm concerned about the number of stock options outstanding as employee incentives. They have created a huge number of phantom shares that, when realized, will dilute earnings and present significant challenges to the company.

Intel is subjected to two negative forces. The first is the slowdown in all sorts of tech sales, and particularly hardware sales. And second, semiconductors have become much more of a commodity business, and competition is increasing. For the long term, I think Intel is a very well-run company and is the most conservative investment of the three. It may take some time before any of these three is a "comfortable" investment.

Q: How do you feel about defense? Any buys there now?

A: I think that there are buys in the defense sector. The only stock in that group that I own (and may add to) is United Technologies (UTX). I think at 15 times earnings, and with a projected earnings growth rate of 14% over the next five years, these shares will benefit from increased tech spending and represent reasonable value at these levels. The stock, after its recent runup, is not cheap.

Q: Any thoughts about media stocks? Especially radio?

A: I don't follow the radio stocks, though I am curious to look at them now. In the broad media sector, I think that AOL (AOL) represents value. In spite of recent trouble, I think the Time Warner portion of the company is worth $18 to $19 a share, and the deep discount on the online-subscriber portion makes the stock look very attractive in the long term. Near-term, I think it will continue to be volatile.

Q: How do you feel about the grocery industry for 2002?

A: It feels like a defensive and comfortable place to be. The grocery industry has such small margins that it's hard to judge the effect of difficult economic times, and also to judge how they will fare when their cost of capital increases. That said, I think that Albertson's (ABS) and Safeway (SWY) are two of the stronger names in the industry. I would look to those names first. Safeway appears the less expensive of the two.

Q: Into troubled telecom -- what about WCOM

(WorldCom)?

A: Good question. What about WorldCom? I'm not sure WorldCom knows. The spin-off of the two tracking stocks clouded an already cloudy situation. MCI is unprofitable and will act as a drain on the combined companies. The WorldCom portion particularly, with regard to the Internet backbone, feels like it should represent value over time, though on the heels of an SEC inquiry, it seems that it could be a long time before investors are rewarded in this name.

Q: Cable stocks such as Cablevision (CVC) and CHTR

[Charter Communications] -- prospects?

A: I don't follow either of those names specifically. I like the cable industry as far as potential for growth. In terms of vertical integration, the cable companies can provide several products, and combine these products to market directly to the consumer, meaning that if you have a set-top box that has your PIN and credit card in it, cable companies can allow for interactive TV, shopping, and access in ways that serve the consumer, and build profiles that they can take advantage of in a proprietary way.

Q: Early on you cited APCC as a favorite in, if I recall correctly, the consumer area, but isn't that a tech stock?

A: Good question! It looks like a tech stock, because American Power Conversion makes the power-surge strips into which we all plug our computers. They also make the battery backup supply boxes for servers and computer networks. So APCC, while closely related to the tech industry, is still a manufacturing stock, but I think a very good nontech way to play tech.

They are the industry leader, the chart pattern is very positive, they are almost $3 billion in market cap. Earnings growth over the next five years is expected to be 13% to 14%, and the stock is selling at 16 times next year's estimates. This is a well-managed company whose shares are selling at what I would consider compelling prices.

Q: Michael, I bought Kmart (KM) at $1. Is it time to sell? Do you think it will survive?

A: It's a hard question for me, because I would not have bought it at $1, and therefore I would not have made the 60% on my money that you have made. Having made 60% on a retailer that's in the bankruptcy courts, I would say take that profit, count your lucky stars, and if it goes higher, don't look back. You made good money on a bad and difficult situation.

Q: Can you leave us with a few of the best names to look at in the current market, Michael? And your wisdom on strategy?

A: I think that all investors need to be focused on the long term. Those focused on the short term fall under the category of speculator. Investing needs to be done dispassionately, and emotion is the foe of the long-term investor. High-quality companies that are well managed, with good earnings, if held over time, will be profitable and will mitigate risk.

I like American Power Conversion as a defensive name. I like Pepsi, Wendy's, Pfizer (PFE) , EMC (EMC), AOL, SBC Communications (SBC), Wells Fargo, and Citigroup. My rule for intuition is: "If it feels bad, do it." When the market surges through irrational levels, and everyone feels good, you should sell. When it's bottoming, and everyone feels bad, you should buy.

Be dispassionate, bet on quality, and think long-term, and you'll be rewarded. Don't expect the road to be without bumps -- just look for the pot of gold at the end of the road.


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