The Bears Are Still in Charge


Michael Farr, president of investment firm Farr, Miller & Washington sees no clear sign of an end to the bear market, and little chance for a decisive turn as long as oil prices remain high and the threat of war with Iraq looms.

"The end of this bear market has been predicted at least eight or nine times by esteemed colleagues," says Farr. "One of these times, they're going to be right." Until then, he does see a few stocks worth buying, among them Citigroup (C), Dell Computer (DELL), First Data (FDC), Staples (SPLS), PepsiCo (PEP), and Kimberly-Clark (KMB). But he advises against bonds as a haven, on the ground that rising interest rates, among other things, make them riskier than stocks.

Farr sees three possible Iraq scenarios: a peaceful end, a quick victory, or a long, drawn-out conflict. Under the first two, he expects the markets and the economy to improve, but under the third he fears a skyrocketing price of oil and a drop in economic growth to as much as -3%.

These were some of the comments Farr made in an investing chat presented Feb. 20 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Michael, the market just can't seem to get its act together -- do you see any end to this downward drift?

A: I think I see the same end that everyone else sees, so I hesitate to burden our participants today with the same old story. The Federal Reserve week before last said that interest rates are low enough and money supply high enough to foster an economic recovery. But as long as the price of oil remains high and the threat of war looms, I think the markets are likely to do little.

Q: What do you think of the latest economic reports out today on wholesale inflation, the trade deficit, and jobless claims? Do you think the Fed has less wiggle room? You mention that rates are already low enough.

A: Well, I was quoting the Fed in saying that rates are low enough. This morning's economic data were something of a shock. The trade deficit widening to a record $44.2 billion is an unhappy development. The jobless claims were not much of a surprise, but the increase in the price index does not bode well for inflation, though there does seem to be very little pricing power between the manufacturing sector and the end consumer, which is bad for profits.

Q: What are your feelings on Johnson & Johnson (JNJ), Cardinal Health (CAH), and Washington Mutual (WM)? Pharma, health care, and financial.

A: Let's start with Johnson & Johnson. I like them overall, I think it's fairly valued. It's much more diversified than pure pharmaceuticals. They make medical devices and medical supplies. At 20 times next year's earnings, I think it's fully valued. I'd be a holder of the shares here -- I view it as a core holding. We own the stock.

On Cardinal Health, I like the group, but CAH has really struggled. The stock has come down almost 15 to 20 points since October and November. We've seen profitability in hospitals continue to decline, and margins are minuscule. That affords very little pricing power to companies like CAH to expand their profitability. Longer term, I like the company, but I wouldn't be in a rush to get in at these levels.

Washington Mutual is a financial company that has done well and has held up well so far in 2003 when others have not. It's highly leveraged to the mortgage market. While rates have been coming down, volumes have also been diminishing. It's a good company, but not too fairly valued at these levels. I think the growth prospects are limited.

Q: An asset-allocation question -- how much should be in stocks and how much in cash at this point in time?

A: That depends a lot on who's asking the question -- individual, institution, age, needs. Typically, for a 50-year-old, the rule of thumb is something around 55% in equities, 5% in cash, and 35% in bonds. That's a very general rule of thumb for a 50-year-old. I think that investors need to be very careful of bond funds at this market juncture.

Q: What do you think of Corning (GLW)?

A: I don't think that I've ever been invited to the BusinessWeek Online chat when someone hasn't asked about Corning. The company will continue to have issues. The stock price has rebounded from the $1 level to the $5 level, but I think at this stage it's not for the faint of heart and would not be a core position in a conservative portfolio. The company is losing money and is expected to lose money again in 2003.

Q: Someone usually asks about this, too -- how about gold?

A: Gold is always good. When I used to give training classes for young stockbrokers, I would always tell them to have a gold stock to recommend, mostly because clients would always agree to buy gold stocks. Gold is a hedge against inflation. It's a safe haven in times of uncertainty -- it has appreciated mightily over the past year. Some see this as a long-term trend -- I do not. I think that as the global uncertainties begin to subside and economic numbers improve, the price of gold will come down a bit and stabilize. That's nothing more than my professional guess.

Q: Is there any hope for McDonald's (MCD)?

A: Not much. It's a mature company facing mature company issues -- and the law of big numbers. When faced with a diminishing market share, they resorted to discounting their menu and put forth the very popular dollar menu. That has not been profitable for them -- it has only been to maintain their market share. I believe that Wendy's (WEN) is a much better choice for investors in that group, and I own Wendy's. I also do still own some McDonald's. I'd be a better seller of McDonald's.

Q: Michael, what's the biggest concern that you're hearing from your clients? Are many of them still hesitant to buy stocks, given the uncertainty of war with Iraq?

A: The biggest concern we're hearing from clients is "When will it all be over, how much lower can it go, will a quick war with Iraq help or hurt the markets and the economy?" After three years of deteriorating values in their portfolios, clients are just wanting to know when it will be over. We have outlined three likely outcomes with Saddam. There is the diplomatic solution where he goes into exile. Second is a swift, decisive battle that ends in victory for the U.S. And then there's the worst scenario: extended war and no resolution.

With the first two scenarios, we expect the price of oil to go down, uncertainty to decrease, and the markets to improve. Under the third and worst case, we think the price of oil could escalate to $50 a barrel or higher. GDP growth could deteriorate to -2.5% to -3% if a prolonged war were to occur. Estimated cost for this war is somewhere around $80 billion, if that's the quick, decisive version. If it were to go on, costs are estimated at $8 billion a month. With the trade deficit running so high, this would be a very difficult pill for our economy to swallow.

Q: What large-cap consumer and drug stocks do you like here?

A: Stocks that we are recommending for our client portfolios in the consumer area would include Home Depot (HD), Staples (SPLS), PepsiCo (PEP), Kimberly-Clark (KMB), Wendy's, JNJ, Pfizer (PFE), and Waters (WAT).

Q: Given that the market is likely to keep focusing on the threat of war, are you recommending that investors buy bonds, since they're safer?

A: No. I think the risk in owning bonds is high and becoming higher. Interest rates are at historical lows. The bond market has rallied strongly over the past 15 years. We think that bond funds are probably riskier than holding bonds outright.

That said, when interest rates rise, bond prices fall, and so the eventual reversion to the mean will diminish the investment in the bonds, perhaps rather rapidly. Long-term bonds are much more volatile than shorter-term bonds, so I'd keep them short. And remember the No. 1 rule for bonds, never speculate for income. Don't reach for an extra percentage in yield, ever.

Q: Your opinion, please, on Altria (MO) and General Electric (GE)? Isn't MO Philip Morris?

A: The name has changed to the Altria Group. The valuation is inexpensive. It's compelling. The dividend is compelling. The unknown liability of litigation risk, not only in this country but around the world, makes the risk high for us to recommend it to our clients.

GE appears to be a great value at these levels -- 12 of their 13 subsidiary business are showing admirable growth in a difficult environment. Their long-cycle businesses continue to suffer, but General Electric is trading at 14 times next year's earnings, and most analysts expect double-digit earnings growth for GE, almost twice that of the average S&P 500 stock. We own it, we've owned it for many years, and continue to buy it at these levels for clients for whom it's appropriate.

Q: Do you think the market is headed low, to test the October low? Are we still in a bear market?

A: You know, we're very close to the October low now, and we essentially did test that low at the end of January. The notion that the market is "testing" anything of a technical nature is always best judged in hindsight. Nobody has any idea. I think that many valuations for many individual companies are compelling at these levels, but 10 years from now we're going to look at this market and consider it very inexpensive.

And yes, we're still in a bear market. We'll be in a bear market until the market starts to recover. The downtrend has lasted a solid three years and has not reversed. The end of this bear market has been predicted at least eight or nine times by esteemed colleagues. One of these times, they're going to be right.

Q: We touched on your favorites in health care and consumer sectors earlier. What are your favorite names in the financial and tech areas?

A: In the financial sector, I like Citigroup (C), and I'm looking at American International Group {AIG) and Berkshire Hathaway (BRK) closely, though I'm still doing my work on both of them. In tech, Dell Computer (DELL) and First Data (FDC) are my two best.

Q: Any hope for airlines? Is US Airways Group (UAWGQ) a buy at 18 cents?

A: Any hope for airlines? No. US Air at 18 cents? Go to Las Vegas, you can lose just as much money, but you'll have a lot more fun.

The real answer is, with all prices high in a regulated industry, the global uncertainties have wreaked havoc. They're commodity-dependent for fuel, they're regulated, it's a terrible business model. US Air would be a tremendous gamble. I wouldn't know anything about speculating on penny

stocks, so I'm not the best source of advice on that.

Q: You mentioned Berkshire, so try this audience question -- Mike, excluding yourself, is Warren Buffett the greatest investor of all time?

A: God bless you, and thank you. I didn't know that Mom was online. Warren Buffett is a fabulous investor about whom many books have been deservedly written, and many more will follow. His dogged adherence to his discipline is what makes him great. Stick to your discipline, don't be swayed by the latest noise from the markets or the media.


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