A Cautious Bull Among the Bears


Despite all the uncertainties in the economy, Michael Farr, president of investment firm Farr, Miller & Washington, sees "the greatest risk over the next five years as being not invested in equities."

"It's my job to be worried," Farr says, but he looks at gains in corporate earnings, historically low price-earnings ratios, and low interest rates and concludes that the fundamentals are attractive for the long term.

Technology is one area Farr likes now, with spending on tech at levels not seen since 1999. Among his preferred names are Dell Computer (DELL), First Data (FDC), Cisco Systems (CSCO), and Oracle (ORCL). And although consumers have been pinched by high energy prices, among other things, he looks with favor on providers of staples such as Colgate-Palmolive (CL) and drugstore chain CVS (CVS).

These were a few of Farr's remarks in an investing chat presented Oct. 27 by BusinessWeek Online. He was responding to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow.

Michael, are you worried about the market outlook? And the economy's?

I'm always a little worried -- it's my job to be worried. I don't understand why the market is more worried now than in previous months. In fact, I see little that has changed in the broad economic landscape and a great deal that has changed for investors.

With another quarter of earnings gains coming in, the estimated p-e multiple for the S&P 500 based on 2006 earnings is now 15 times. These are historically inexpensive levels during a period of low interest rates and significant earnings growth. I see the greatest risk over the next five years as being not invested in equities.

So are you buying stocks these days? What are you focusing on?

American Power Conversion (APCC) had a weaker-than-expected earnings report today. We're buying the stock on that weakness. And also General Electric (GE), United Technologies (UTX), Education Management (EDMC), Home Depot (HD), O'Reilly Automotive, (ORLY), Staples (SPLS), Wal-Mart (WMT), PepsiCo (PEP), CVS (CVS), Eli Lilly (LLY), Stryker Medical (SYK), Waters (WAT), Dell Computer (DELL), First Data (FDC), Cisco Systems (CSCO), Oracle (ORCL), Nokia (NOK), Citigroup (C), Bank of America (BAC), and American International Group (AIG).

That's a longer list than usual for me -- but I think indicative of the valuations we perceive.... One broad category that I like right now is technology.

At this point, the long-term fundamentals are compelling, and we're investing money for our clients based on the strength of current fundamentals.

You mentioned tech -- which areas and companies do you like?

Spending on technology as a percentage of GDP has returned to all-time high levels not seen since 1999. Price-earnings ratios for many technology companies are at a market multiple, or are only at a slight premium to market multiples. In many cases, tech shares are selling for half the p-e's they commanded in 1999. Yet earnings growth is significant.

While I don't expect a return to the dizzying levels seen in the tech dot-com boom, we think that purchasing these growth rates at current prices may be a very good idea. Some names we like are Dell Computer, at 17 times next year's earnings, with an 18% earnings growth rate; First Data, 15 times next year, 13% growth rate; Cisco Systems, 16 times next year, 15% growth rate; Oracle, 15 times next year, 12% growth rate.

Compare that with an S&P that's 15 times next year's earnings, with a projected 7% growth rate, and I think you'll see why we favor these shares.

You earlier listed a number of stocks as names you're buying or would buy -- what's the common thread, if any? Valuations?

Valuations, earnings growth, superior management, expanding market share, dominant market position, and exceptionally strong balance sheets. We haven't taken a top-down approach to select industries, to select sectors, and decided what companies we would like to own.

Instead, we've taken a fundamental bottom-up approach to our analysis, culling through the thousands of publicly traded shares and sifting until we find what we believe are among the strongest and best. Those shares now fall into broad categories: technology, health care, financial, and consumer.

Are you a bit contrarian in liking consumer stocks now? Some analysts worry about consumer spending being pinched.

We're very specific about the investments that we're making in the consumer sector. We agree that the consumer is becoming more pinched. The negative savings rate and record levels of credit-card debt worry us. We take a somewhat defensive approach, in that we believe that the consumer in almost any economic condition will continue to buy certain staples, such as toilet paper, soap, and toothpaste.

We like Colgate-Palmolive (CP) and we like CVS. We like Staples. We would probably include fast food in that list if we could find the proper valuation -- I've mentioned Wendy's (WEN) in past chats, but they seem pretty fully valued at these levels. Also, during times of consumer squeeze, you can usually invest in the "sin stocks" of tobacco and alcohol -- Anheuser-Busch (BUD), Altria (MO).

The tobacco stocks are always fairly safe. People will continue to spend when they're addicted. The problem with these addiction stocks is the ongoing liability, but some of that seems to have been removed from the tobacco stocks in this country. Europe is another issue entirely.

Bond yields have spiked this week -- how come? Should investors avoid bonds, given that interest rates are going up?

Bond yields are, of course, still low historically. This increase seems well overdue to us. The Fed has raised rates 12 times. At various points, the yield curve has become close to inverted, meaning that short-term rates have been close to being higher than long-term rates. Even Alan Greenspan has confessed to being puzzled.

Well, we remain in a relatively tight range and feel that the 10-year note could drift higher to the 4.75% level, maybe as high as 5%. We don't see inflation, and the fact that these interest rates have remained rather contained shows us that the broad market doesn't fear inflation, either.

Today, bond manager Bill Gross, who manages the largest bond fund in the country, PIMCO, said he expects 2% inflation next year and perhaps a recession. These relatively low long-term rates that haven't responded to several rounds of monetary hikes indicate that Mr. Gross may have a point.

What does that mean for the economy? It means while certain sectors are healthy, there's a longer term problem, in that we're still amid the recovery from the last recession, and the higher cost of oil, as well as the cost of financing government debt, the Iraq war, and several billions of dollars for hurricane recovery and rebuilding create great pressure on a tender economy.

Do you like any energy or other commodities stocks?

"No" is my answer. Energy shares in the S&P 500 were among the bottom-performing sectors from 1993 to 2003. Energy shares for that period returned approximately 4% per year. From 2003 through third-quarter 2005, energy shares have been returning about 45% per year. Had you owned them for the previous 10-year period, you would have looked like a goat.

These are deeply cyclical shares -- they don't offer the fundamental sustainable growth, expanding market share, or stability that we look for according to our discipline. Since valuations have moved up at a rate of 45% per year over the past two-and-a-half years, we would caution investors against new commitments and encourage them to pare back existing gains.

With Big Oil profits coming in very big, do you think there might be a backlash from consumers paying big for gasoline and home heating?

Yes...the already overburdened consumer needs higher gasoline and heating oil like a hole in the head. These are the sorts of ramifications that affect holiday buying, travel, vacation planning, etc. Wal-Mart was complaining in their August report of the drag created by higher gasoline prices. They certainly aren't getting happier, and neither is the consumer.

So any market impact from this would hit the consumer sector?

I think it could affect holiday buying and curtail other consumer spending. I think it will be harder to pay adjustable-rate mortgages that are on the rise. I think it will impact vacation planning, and I think broad consumer discretionary spending will suffer.

This leads to a question on financial stocks -- how do they look?

This is one of the toughest areas of our portfolio. There's no good argument in an official rising-rate environment for financial companies. The opportunity is one for the long term. Bank of America and other financials are now being priced to reflect the difficult road ahead. Therefore, at 10 times earnings, with a 4.8% dividend, at a time when the 10-year Treasury is yielding 4.5%, we believe that these shares will represent significant values for the patient investor.

The keys here are patience and the understanding that shares could go lower before you're rewarded. They haven't done much for a while but have paid their dividends consistently. And those dividends are tax-preferenced.

What do you see as the market impact of today's news about a bigger-than-expected drop in durable-goods orders? Does this imply a slowing of capital spending?

Durable-goods orders are traditionally volatile. It's a volatile report. Yes, it shows a slowing. Yes, it's consistent with consumer confidence. It's really more an expression of manufacturing confidence. We really need to see the purchasing managers' index. We expect that number to be weak as well.

But these are short-term numbers. It's going to take a month or two to determine if we see a trend. If Bill Gross is right, then this weaker trend will continue, and economic growth will become subdued, at the very least.


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