"Enronitis...Has Evolved into Tyco-sis"


"Focus on the consumer and look for companies with good earnings prospects and visibility." That's the advice of Sam Stovall, senior investment strategist for Standard & Poor's, for a market with high valuations and many worries weighing on it.

With terrorism, accounting, and earnings among the concerns for investors, Stovall adds, "It could take quite some time before this market begins to head convincingly higher." For now, he says S&P recommends overweighting stocks in the consumer discretionary, consumer staples, and materials sectors, as well as selected names in energy. For example, S&P rates Exxon Mobil a buy.

In the retailing group, Stovall reports that S&P has buys on Chico's FAS, Costco, Electronics Boutique, Sears, and Wal-Mart, among others. At the other extreme, he says, S&P suggests underweighting health care and technology. And in tech he expects telecom-equipment companies to be the last to recover.

Stovall made these and other comments in an investing chat presented June 11 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Sam, it seems as if I have to keep asking the same question -- how much longer do we have to tolerate these down days in the overall market?

A: I wish I knew the exact day in which this downdraft would come to a conclusion. Unfortunately, the market is being tarred by investor concerns surrounding terrorism, accounting, research regulations, earnings, and the dollar. Add to that the fact that valuations are anywhere from twice to 50% higher than they have been historically, and you see little reason for investors to be enthusiastic about stocks.... It could take quite some time before this market begins to head convincingly higher.

Q: Is XOM

(Exxon Mobil) a buy? I keep reading positive S&P comments about it, but its fair value is listed as 28, and it's trading close to 40. It seems to be overvalued.

A: First off, XOM is ranked 5-STARS, and in S&P's Stock Appreciation Ranking System (STARS) a 5 is a best buy, a 3 is a hold, and a 1 is a sell. The integrated oil and gas industry, which XOM dominates, is up 1.5% year-to- date, vs. the more than 10% decline for the S&P 500. We do favor many of the stocks in the energy sector, since we believe that a recovering economy and the rollover of OPEC output cuts will boost investor interest.

The fair value that you mention is a quantitatively driven price using historical relative valuations and projected earnings increases. It doesn't take into consideration investor sentiment or geopolitical events. Fair value has a very good track record, but fair value and STARS do not always agree. Since S&P likes the outlook for Exxon Mobil, you will have to decide when to sell.

Q: Are medical stocks such as STJ

(St. Jude Medical) a good buy in these times?

A: S&P recommends underweighting the entire health-care sector, mainly because the biotech and pharmaceutical industries, on which we have negative outlooks, represent more than 70% of the market value for the sector. That said, we still favor some industries in this sector, such as hospitals and HMOs, as well as selected medical-equipment companies likes St. Jude Medical, which is ranked 5-STARS.

Q: Any hope for Lucent (LU)?

A: We have an underweight recommendation on the technology sector, since valuations look ambitious, and the group's near-term technical outlook appears bearish. When tech does finally turn around, it will likely first be led by semiconductor stocks, followed in order by software, hardware, networking, and storage companies, with telecom-equipment stocks pulling up the rear. We have the LU shares ranked hold because we believe they have been beaten down as far as they're likely to go.

Q: How do you feel about Enronitis spreading to other well-managed energy companies, such as Duke Energy (DUK)?

A: Enronitis in our opinion has evolved into Tyco-sis, an infectious condition that spreads pessimism among investors. Basically, what that means is that investors are likely to be very skeptical about the investment prospects of companies that either engaged in aggressive accounting practices or might somehow be caught in the web of regulator scrutiny regarding energy trading. As a sector, we have an underweight recommendation on utilities, which are down more than the market as a whole year-to-date.

Q: Which leads to this question -- what do you think about Tyco (TYC) and its chances for a turnaround in the future?

A: We currently rank the TYC shares 2-STARS, or avoid. In a worst-case scenario, the company and its officers could be charged with income-tax evasion and falsification of records. Although TYC has a solid roster of businesses, the game will likely be over for the company if it's unable to rid its balance sheet of CIT's $20 billion of debt. In light of Tyco's almost nonstop list of challenges, we recommend that investors put funds elsewhere.

Q: What about AOL (AOL)?

A: S&P has a 4-STAR ranking (accumulate) on AOL.... We view the company as a value play and believe it to be very compelling when compared with other large, diversified media companies. We, too, however, have been disappointed by the stock's recent performance, since it has tumbled along with other cable companies. Yet we view AOL as much more than a pure-play cable company, since it also offers Internet services, movies, music, and publishing.

Q: What sector would likely be the one to lead the market out of its sideways pattern?

A: Interestingly enough, nearly 60% of the industries in the S&P's Super 1500 are in positive territory year-to-date and are up an average of 10.5%. It's because these industries contain smaller-cap companies that most investors are unaware of the breadth of outperformance within the broad benchmark. S&P currently has overweight recommendations on the consumer discretionary, consumer staples, and materials sectors, as well as favoring selected energy industries.

Q: Which are some hot Russell 2000 stocks? Or perhaps you can invoke the S&P SmallCap and MidCap indexes.

A: How about if I take it from a different standpoint and list for you some 5-STAR stocks with market value of $5 billion or less that currently have high 13-week relative strength? Using this criterion, you would find CHS

(Chico's FAS), WEN

(Wendy's International), STZ

(Constellation Brands), GMCR

(Green Mountain Coffee), CPG

(Chelsea Property Group), HPT

(Hospitality Properties Trust), TRI

(Triad Hospitals), ASD

(American Standard), IGL

(IMC Global), and PTV

(Pactiv).

Q: How do you feel about Siebel Systems (SEBL)?

A: We have SEBL ranked 5-STARS.... It has been a tough ride for the applications-software industry, in which the SEBL shares are found. This group has declined by more than twice that of the S&P 500. Yet when the software industry turns, we believe that the SEBL shares will be among the leaders.

Q: Would PAYX

(Paychex) be a good pick for a slow recovery?

A: In general, the payroll-processing companies, even though they're regarded as technology companies and therefore likely economically sensitive, are in fact included in S&P's industrial sector. They're actually quite defensive in nature because, whether the economy is expanding or contracting, payrolls have to be processed. And even though some would think that reduced employment would adversely affect these companies, what could also be said is that companies look to outsource this process and thus eliminate payroll overhead. We currently have a 4-STAR ranking on the PAYX shares.

Q: This is a new one to me -- what about Tractor Supply (TSCO)?

A: It's not a new one to S&P analysts. The TSCO shares are ranked 4-STARS. This specialty retailer targets the hobby market and part-time farmers and ranchers (which means that their customers are outstanding in their fields -- bad joke). Today we reiterated our accumulate ranking on the shares, since the company said that it anticipates better-than-expected results for the second quarter. The shares are trading at a p-e of 23 times the low end of the company's 2002 guidance, which compares well with its implied growth rate.

Q: Any retailers to recommend besides TSCO? We have a question about Gap (GPS) and the turmoil they've been having lately.

A: The retailers that S&P has 5-STAR rankings on include BKS

(Barnes & Noble), CHS

(Chico's FAS), COST

(Costco), ELBO

(Electronics Boutique), NLS

(Nautilus Group), S

(Sears), and WMT

(Wal-Mart).

Specifically about Gap, which we have ranked 2-STARS: May same-store sales for the entire retailing group were hurt by cool springtime weather. The good news is that retailers are doing a better job of managing their inventories, and we see little earnings erosion ahead. Yet we find that the discounters are still favored by consumers, as are companies that offer merchandise for the home. However, the GPS shares remain among the retailers with the lowest STARS ranking.

Q: To conclude, Sam, what broad investment strategy would you suggest for now?

A: For now, I would maintain a defensive approach, since there are many factors weighing on investors' emotions. Combined with that, valuations remain historically high, and we are entering a historically weak season for the markets. When buying, focus on the consumer and look for companies with good earnings prospects and visibility.


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