Saturday, September 09, 2000

The Sophisticated Investor

What to do when market seems bewitched

By John Waggoner
USA Today

        Watching the stock market is like visiting the little girl in The Exorcist, a 1970s movie about satanic possession. Sometimes the market is sweet and cute; other times it giggles while it throws your stocks down the stairs.

        But beneath the stock market's evil veneer is just a frightened child. The market is worried that the economy, and corporate earnings, will slow. So it's rewarding companies that post reliable earnings gains. Those that disappoint get a quick tour of the staircase.

        For investors, that means you should look for stocks of stable companies, or funds that invest in them. It's not as tricky — or as boring — as it seems.

        So what's scaring the stock market? First, there's the Federal Reserve Board, which has pushed up short- term interest rates six times the past two years in a bid to slow the economy and curb inflation. It's not likely the Fed will tighten again soon. But it typically takes a year to 18 months before higher rates take full effect.

        Economists such as David Jones of Aubrey G. Lanston, a government bond dealer, say the economy should slow modestly from its 5.3 percent pace in the second quarter to 3 percent or so in the third quarter. “We're seeing evidence that earlier rate hikes are paying dividends,” he said.

        But investors may not like those dividends. Standard & Poor's said earnings for the S&P 500 stock index this year should average 13.1 percent, versus 16.8 percent last year. For 2001, S&P sees earnings growth falling to 8.4 percent. The trend here is not your friend.

        “When earnings slow, people tend to pay up for companies with more predictable gains,” said Arnold Kaufmann, editor of The Outlook, S&P's respected stock newsletter. “With the economy slowing, that tendency will increase.” That trend has been firmly in place for a few years — and it's continuing.

        For the past eight months, the 10 largest stocks in the S&P 500 are up 30.4 percent, versus 3.3 percent for the index. “It's still the big guys,” Mr. Kaufmann said. (Those stocks are General Electric, Intel, Cisco, Microsoft, Exxon Mobil, Pfizer, Citigroup, Oracle, Nortel Networks and IBM.)

        The problem: Many of those big names look awfully expensive these days. GE, for example, sells for 50 times earnings, versus 27 for the S&P 500. Intel sells for 48 times earnings. And Cisco is 179 times earnings.

        So what's an investor to do?

        Frederick Reynolds, manager of the Reynolds Blue Chip fund, (800) 773-9665, said the biggest and best are worth paying for. “You're not going to find the best companies on earth hiding under a toadstool,” he said. “Sometimes you can get away with having spent too much.”

        And he should know: He has driven the fund to a 321 percent gain the past five years, versus 194 percent for the S&P 500. His current favorites include many in the health-care sector, such as Merck and Pfizer. And he likes companies that sell low-priced products to the world, such as Coca-Cola.

        But if you're worried about prices, take a tip from Bill Miller, star manager of Legg Mason Value Trust, (800) 577-8589.

        He looks for low-priced stocks and holds them until they get to be well above levels that would make most value investors tremble. His celebrated stake in America Online has led some to question his credentials as a value investor — including Lipper, which classifies the fund as a growth fund.

        Whatever. Mr. Miller has driven the fund to a 325 percent gain the past five years. He has a great eye for value, and right now he likes this market. “Most stocks are cheap this year,” he said. “The average company is doing pretty well, and is available at modest prices.” He likes Albertson's, for example, the chain of food and drug stores. It sells for about 10 times its estimated 2000 earnings.

        Another favorite: Kodak, which Wall Street has spurned because of fears that digital photography will fog its earnings. But its film business is growing nicely, Mr. Miller said.

        Suppose you don't want to pick stocks. More adventurous souls might buy Mr. Reynolds' fund. If you're worried about buying high-priced stocks in a slowing economy, consider Mr. Miller's fund — or one of these large-company value funds:

        • Selected American Shares, (800) 279-0279, 2000 return 12.9 percent, last five years 204 percent.

        • Vanguard Growth & Income, (800) 662-7447, 2000 return 5.3 percent; last five years 200 percent.

        • UAM Analytic Enhanced Equity, (877) 826-5465, 2000 return 2.5 percent, last five years 195 percent.

        • Fidelity Dividend Growth, (800) 544-8888, 2000 return 12.5 percent, last five years 192 percent.

        • American Century Income & Growth, (800) 345-2021, 2000 return 1.5 percent, last five years 182 percent.

        They won't be saints in a downturn. But they won't be devils, either.


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