Magazine

The Quest For Quality


Go figure. Despite a growing economy and healthy corporate profits, enthusiasm for stocks has headed south. Obsession with NASDAQ has given way to NASCAR. CNBC is hawking John McEnroe over John Bogle. Real-time war has edged out real-time quotes. And "Money Honey" Maria Bartiromo just stopped reporting from the floor of the New York Stock Exchange.

The truth is, stocks aren't sexy these days for several reasons. Investors have been spooked by rising interest rates. The upcoming Presidential election is too close to call. Oil prices, though now a tad below $40 a barrel, are still sky-high. Worries over terrorism, Iraq, and the Mideast are ever-present. And just when you thought it couldn't get any worse, statistically speaking, it's a lousy time of year for stocks. According to the Stock Trader's Almanac, a market-timing guide, $10,000 invested in the Dow Jones industrial average in 1950 and kept there from May 1 to Oct. 31 each year would by now have accumulated a loss of $1,652. In contrast, the same investment kept in the market for the six months from Nov. 1 to Apr. 30 for those years would have shown a $461,774 gain.

Mix all that together and it's no surprise that skittish sentiment is besting bullishness. Most strategists see stocks ping-ponging in a trading range for the next few months -- possibly until after the Nov. 2 election. Then, they say, a breakout could occur, sending stocks higher, with the major indexes ending up in the upper single digits this year over last. Says Jason Trennert, chief investment strategist at New York's ISI Group Inc.: "Investors have been focusing on macro risks. The upcoming election, in particular, is a potential slimy ointment. But after that, they'll focus on strong corporate profits."

They ought to: Earnings should continue to dazzle this year as the economy improves. In the last three quarters, analysts expect profits to grow 20%, 14%, and 15%, respectively, over the same period last year, according to earnings researcher Thomson First Call (TOC). Indeed, the second quarter of 2004 looks to be the fourth consecutive one with higher than 20% year-over-year earnings growth -- for only the fifth time in 40 years.

Still, investors are wondering where to put their money -- and it is a bit of a conundrum. As interest rates rise, the price of bonds will fall, and despite glowing earnings, stocks seem to be going nowhere fast. The Standard & Poor's 500-stock index has risen only 2% this year, with the NASDAQ Composite Index down 0.2% and the Dow Jones industrial average losing 0.5%.

WEATHER-RESISTANT PICKS

The way out: look for quality stocks. No, that's not boring eat-your-peas-and-carrots advice. Quality stocks are usually a sound haven in uncertain times. And the fact is, while most smaller, lower-quality stocks have been basking in their moment in the sun, high-quality stocks haven't found their way to the beach yet. But they're now poised with sand pails in hand to arrive.

What constitutes a high-quality stock? Companies with strong balance sheets and consistent earnings tend to make the grade, as do dominant industry players. Quality stocks often happen to be larger-cap stocks -- though generally not mega-caps -- and they can have either growth or value properties or both. Plus, they often pay a dividend. Some names to consider: Wachovia (WB), Pfizer (PFE), PepsiCo (PEP), Anheuser-Busch (BUD), and Johnson & Johnson (JNJ).

Many quality stocks are selling at reasonable prices, and many are relatively cheap compared with other stocks. Consider this: Since quality stocks are generally larger-caps, they make up most of the market. And, surprisingly, the overall market isn't overvalued. The S&P is trading at around 17 times the expected earnings of its components over the next 12 months. Sure, that compares with an average price-earnings ratio of about 15 over the past 50 years. But with interest rates still low and bonds an unattractive alternative, investors should expect to pay a bit more than usual for stocks.

One thing is pretty certain: This year is unlikely to see a repeat of 2003's eye-popping 25% gains. Last year was a sweet spot for investors -- monetary policy was lax, with interest rates at 40-year lows and earnings accelerating faster than a Ferrari with a tailwind. Many stocks, bouncing off painfully low prices, seemed to defy gravity. Indeed, 92% of all stocks in the S&P ended up in positive turf last year, the highest percentage since 1980.

Small stocks, particularly speculative stocks without consistent earnings or, in many cases, any earnings at all, have been the stars of late. Strategists point out that this often happens in the early stages of an economic recovery because the market is usually flooded with liquidity and investors are willing to take on more risk. But now we're entering the next phase of the rebound. At this point, says Richard B. Hoey, chief economist and chief investment strategist at Dreyfus Corp. (MEL): "Financial liquidity is ample but not excessive. Most sound businesses prosper, but a growing proportion of companies with poor business models begin to stall." Hoey calls this much more selective stage The Revenge of the Cycle.

One good reason it should pay to be selective is that earnings growth will likely start to slow as year-over-year comparisons begin to get tougher. For 2004 as a whole, analysts expect profits to be up 18% over last. But in 2005 they expect a smaller rise of around 10% year-over-year, according to Thomson First Call.

That brings us back to those quality stocks. Not only do they fare much better than speculative stocks as profit growth slows but they also are not as badly hit by rising interest rates since they tend to be better capitalized. With the Federal Reserve poised to hike short-term rates by as much as two percentage points by yearend, that's key. Quality stocks are able to weather tighter liquidity and sustain profitability because of their defensive nature and strong business models. One example is Citigroup (C). Its geographic and product diversification makes it a bulwark in almost any market. By contrast, small-cap stocks often suffer when rates rise since they're less diversified. Also, smaller companies generally take on more debt, so rising rates mean their cost of capital increases, and that eats into their fledgling profitability.

An added attraction of many quality larger-caps: dividends. These companies can afford to pay them because they have consistent earnings and ample free cash flow. With market returns expected to fall to single digits for some time -- a bit below the average 10% annual return on the S&P over the past 50 years -- dividends can add oomph to a portfolio. Over the past 78 years, they accounted for 41% of the S&P 500's total return, according to Ibbotson Associates Inc.

Already, many companies have increased their dividends. Omnicom Group Inc. (OMC), the advertising conglomerate, and 3M Co. (MMM) raised dividends this year. Microsoft Corp. (MSFT) doubled its dividend last year, to 16 cents a share. According to S&P, the average dividend-paying company has upped its payout by 18% this year. But a high dividend alone won't hack it -- a company needs to be growing its earnings and have healthy free cash flow, too. Says Dreyfus' Hoey: "Often investors will be attracted to a low-priced stock with a high dividend only to find out that a company's underlying business is eroding."

STABILITY COUNTS

Quality stocks are often dominant players in their industry. If they're not, they're on their way to becoming so. For instance, generic drug companies such as Teva Pharmaceuticals Ltd. (TEVA) are giving some of their big rivals a serious run for their money these days as drug patents expire.

Because of their leadership characteristics and strength, quality stocks are better equipped to handle the uncertainty of terrorism and geopolitical shocks. Finally, investors are much more likely to buy and hold solid, stable stocks, making them less volatile.

In this issue of BusinessWeek, we've worked to ferret out stocks that will perform well in an insecure market. We've grilled top money managers, strategists, and high-ranking stock analysts. (Analysts and their firms don't hold the stocks, nor do they have an investment-banking relationship with rated companies unless otherwise stated. Money managers, conversely, usually hold the stocks they mention in their portfolios.) We've also crunched some numbers ourselves. We're not merely looking at sectors but taking into account areas and styles of investing that will work as rates rise, profits begin to slow, election worries mount, and geopolitical woes linger.

Despite the gloom, the economy continues to strengthen. So we've looked hard for stocks likely to benefit from the upturn. A good place to start is capital goods. As companies start to spend money again, heavy industrial stocks such as Caterpillar Inc. (CAT) should start to shine.

Of course, energy remains on everyone's mind. The big runup in oil prices has propelled many a good Texas tea stock. Some utility stocks are good values. Beaten down post-Enron, many have returned to profitability. A big plus is that many also pay attractive dividends.

Big health-care stocks are ailing from spiraling medical costs, a dearth of new drugs, and and the prospect of more post-election Medicare cutbacks. One player to watch is United Surgical Partners International Inc., which (USPI) performs outpatient procedures at a fraction of the cost hospitals charge.

For those who still think good things come in small packages, there's hope. While small-cap stocks are likely to underperform large caps overall in the next months, some shrewd niche bets could reap healthy rewards. Hotel construction, for example, has been weak since the World Trade Center disaster. So a shortfall of hotel rooms could make lodging real estate investment trusts (REITS) good plays.

DON'T FORGET THE NET

International stocks could spice up your portfolio, too. Although markets around the world have seemingly moved in lockstep for some time, many are now diverging sharply. One example: While the U.S. economy has been heating up for a couple of years, Japan's is just starting to accelerate. An index fund that reflects the overall Japanese market could be a good pick. Check out iShares MSCI Japan (EWJ) fund.

Some quality plays can even be found in Net stocks -- especially retailers. Consumer e-commerce in the U.S. will grow nearly 40% this year, to $144 billion, and the prices of many of these stocks make them reasonable bets.

The bottom line is that as rates rise and profit growth starts to slow, the stock market is likely to take its lumps. What worked last year or last month may not work today. But with some smart moves, investors can position themselves to come out ahead. Says Henry McVey, chief U.S. investment strategist at Morgan Stanley (MWD): "You have to be willing to migrate up the cap curve, sell [volatile] stocks, and focus on earnings consistency." That's what quality investing is all about.

By Marcia Vickers


Silicon Valley State of Mind
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